It’s no secret that the exceptional market returns over the last two years have been driven primarily by a handful of the largest technology companies in the U.S. markets. Recent market volatility, which has been triggered by tariffs and breakthroughs in Artificial Intelligence (AI) by a Chinese technology company, is a reminder that even the strongest of bull markets can suffer corrections, especially when market-leading stocks are priced to perfection.
It’s often been said that “uncertainty breeds market volatility”. Since making new all-time highs earlier this year, the U.S. equity markets are providing a real-time example of this belief. While the current state of the markets is both elevated and unwelcome, volatility is a reality that equity investors must endure.
So, how did we get here? Short answer – Government spending has grown faster than the Gross Domestic Product (GDP). As of March, the current U.S. national debt is approximately $36.2 trillion. The current U.S. annual budget deficit is approximately $1.8 trillion. Government spending is now in the 20% to 25% range of GDP and the Federal Reserve balance sheet, along with the M2 money supply, has ballooned accordingly.
The resulting inflation from all of the Government money in the system has had a positive effect on those who own assets (stocks, real estate, etc.), as asset prices have moved higher. However, inflation has a negative effect on consumers (basically a tax) as well as the overall economy. The days of ‘easy’ money are over, as are the days of the U.S. Government printing and spending at the onset of every new ‘crisis.’
Enter a new administration with an ambitious new agenda. Reminiscent of 1981 when Ronald Reagan (after defeating Jimmy Carter in the 1980 election) inherited an economy with double-digit inflation and interest rates hovering near 20%. Like Reagan’s economic plan, the Trump administration will attempt to encourage economic growth by enacting pro-growth policies, reducing government spending, and cutting tax rates. One difference is that when Reagan took office, facing a severe recession, the Price Earnings Multiple (PE Ratio) on the S&P 500 index was 8.5. Conversely, the Trump administration takes over an S&P 500 index, fueled by government spending and inflation, at all-time highs and a PE ratio of 27.
The uncertainty surrounding the Trump administration’s tariff policies will invariably have some effect on inflation, supply chains, employment, economic growth, and corporate profits. President Trump’s announcement of the tariffs sent the markets reeling back into correction mode, sending the major indexes down approximately 4% – 6%. The sweeping tariffs-which include an across-the-board 10% tariff on imports and will top 50% for some countries, including China- far surpassed what most analysts anticipated. Volatility has spiked, and recession fears have been elevated. Some of these tariffs may be well intended, such as a necessity to combat other countries that have abused their trading status with the U.S. While any reconfiguration of the world economic order will come at a cost, the establishment of a new landscape will allow corporations to regain confidence and begin investing within the new framework. Any such transitions usually create new investor opportunities as companies adjust their operations. As a general rule, though policy and economic uncertainty are difficult for both CEOs and investors alike, we are usually better served to focus on actual data rather than get caught up in the multitude of theories as to what might happen in the wake of a change in policies.
As we digest the never-ending stream of breaking news, we must always try to discern between the short-term headlines and the longer-term structural trends. Market corrections occur regularly. Over the past 40 years, the S&P 500 index has seen a drop of at least 10% in 18 of those years. Since 2000, after the S&P 500 has experienced a correction of at least 10%, the average total return over the following 3-year period was 35%. And looking back to 1928, the S&P 500 index has been positive 73% of the time; an average of 3 years out of every 4.
Many investors tend to overreact to volatility, decreasing their exposure to risk assets in the markets. Over the long term, this can be a mistake. This is especially true today as the U.S. and the rest of the world are on the verge of an AI-driven revolution, a theme that has just gotten considerably cheaper to access. Technology is changing the world faster than most anticipated. Productivity and automation are soon to follow. These expectations could arguably be recognized and reinforced by economies across the globe.
Uncertainty about U.S. policy will remain high. We assume a slowdown in U.S. economic growth, and a negative impact on inflation. We can also assume a significant effect on countries outside the U.S. And let’s not overlook the existing geopolitical risks as the conflict in the Middle East continues, and a resolution to the Russia-Ukraine war remains uncertain.
If anything, our economy is resilient, though we now see the economy slowing to 1% – 1.5% in 2025 as higher tariffs weigh on disposable income, consumer spending, and business investment. We expect core PCE inflation will remain sticky at approximately 3.5% – 3.75%, still above the Federal Reserve’s 2% objective. The market is currently pricing in 2 – 3 interest rate cuts by the Federal Reserve this year. So, we do see a softening economic environment, but not a recession at this point in time. We will, as will the entire industry, continue to monitor policy developments and their potential impact on economies and corporations across the globe.
