Market Commentary Q1 2025 – Navigating Policy Uncertainty
The stock market entered 2025 riding the optimism of above-average earnings growth expectations, a growing economy and moderating inflation. In a matter of weeks, a seemingly orderly market rotation quickly escalated into a historic rout following extraordinary trade policy changes from the Trump administration.
In our view, risk premiums at the start of the year were not properly discounting the potential economic repercussions of a prolonged trade war, seemingly anchored towards the softer negotiation tactics of Trump’s first term. Perhaps this will be considered an overreaction in time, but for now, we believe the market is rapidly adjusting to the increased uncertainty of paralyzed global trade activity, raising the probability of a recession and/or stagflation for the economy in the short-term.
As a result of these growth concerns, Treasury bond yields have moved lower and expectations for rate cuts have increased since the start of the year. In our opinion, the Fed’s ability to meaningfully cut rates in an environment of low unemployment and/or rising inflation will be very difficult, especially when graded against their dual mandate.
Regarding structural universal tariffs, economist support is likely scarce at best. Global supply chains were developed over several decades and U.S. consumers and businesses have benefitted tremendously, despite potential opportunities to improve fairness in trade. Ignoring the merits of specialization, onshoring manufacturing plants in a matter of months or even years doesn’t seem practical, so we believe the more reasonable solution is a compromise on tariffs. Based on the initial retaliatory responses from U.S. trading partners, and the stock market’s reaction, there appears to be at least some doubt in the likelihood of a successful imminent compromise.
The risk also appears relatively binary in nature, in that we either succeed in negotiations with trading partners, or we don’t. We believe the risk of a recession increases the longer tariffs remain substantively in place. The ability to pivot, as needed, could reduce the potential materiality of any economic slowdown, in our view.
While self-imposed trade policy headwinds appear to be relatively “fixable”, fiscal spending remains a longer-term dilemma for the U.S. economy. As the U.S. focuses on spending cuts, other countries such as Germany and China have implemented additional stimulus measures. Supported by these fiscal initiatives, discounted valuations and a weaker U.S. dollar, international stocks have shown relative strength to start the year.
Over the long-term, we believe the U.S. maintains structural advantages for capital formation, supported by a more pervasive entrepreneurial and pro-business mindset. American businesses have shown incredible resiliency, adapting to various political and economic regimes over time. We believe globalization has been a major disinflationary tailwind over the past several decades, and a reversal is likely to test this resiliency.
In the near-term, we believe corporate earnings estimates are too high and are likely to be revised down in the coming months as companies revise or simply remove their outlooks due to prevailing uncertainty. While most businesses are likely to feel the effects of an economic slowdown or potential stagflation scenario, we believe companies with relatively strong pricing power and defensible balance sheets can weather this environment better, on average.
Over the past 45 years, the S&P 500 has experienced an average intra-year decline of 14%, posting positive returns in 34 of those 45 years, with an average annual return of 10.6%. Living through regular market declines is the ante for investors who choose to invest their money into stocks. While market declines all come with unique catalysts, they are almost all discomforting for investors in the moment. When sentiment is most gloomy, buying opportunities can be most prevalent, but more so in retrospect. We appear to be at or near that level of sentiment today.
When we started the year, we lowered our return expectations for U.S. large cap equities for the second half of this decade, primarily due to elevated valuations. With the recent market selloff, valuations are starting to look more reasonable, increasingly so for mid and small cap companies, which we continue to see as the most attractive areas for capital returns in the coming years.
Further, when we have periods of indiscriminate selling, it affords us opportunities to acquire or increase our conviction in high quality companies at discounts to what we see as their long-term intrinsic value. Understanding things may get worse before they get better, we stand ready to take advantage of these opportunities.
Authored by: Jack Holmes, Chief Investment Officer
