INSIGHTS

On April 16, 2025

Viewpoints Special Edition — Tariffs, Volatility, and Uncertainty

Bottom Line Up Front          

In our view, the tariff tantrum is unlikely to push the United States into a recession and our view of a positive 2025 remains plausible. Uncertainty creates volatility, but as that dissipates the policy balance between increased taxes through tariffs and decreased taxes through tax cuts may be net stimulative to the U.S. economy.

We believe the market will be volatile and oscillate with the news cycle, but the underlying strength of the U.S. economy will pull through any persistent uncertainty and the second half of the year will likely be more stable.

Certainly Uncertain

With the first quarter of 2025 finished, market themes have changed decisively alongside meaningful shifts in policy out of the Trump Administration relative to the Biden Administration. The new administration’s aspirations around tariffs and government spending cuts have placed markets in a new and uncertain world relative to the outlook at the start of the year.

While the final destination for tariffs remains unclear and the scale and scope continues to fluctuate, we maintain a generally positive outlook for growth and believe that the U.S. economy will continue its post-pandemic expansion in 2025. While the economy has softened from the robust pace we saw in the fourth quarter of last year — and the likelihood of a reacceleration in growth has dropped materially — we are not seeing much in current data that is outright recessionary.

We try to focus on bottom lines — not headlines — and we think data under the hood has been constructive. For markets, corporate earnings growth was very robust in the 4th quarter, and the earnings recovery outside of the Magnificent Seven has continued to gain steam. For the economy, data around growth has been soft to start but also very noisy — weather in January and February and a historic rush of imports in anticipation of tariffs have likely made growth look worse than it actually is. For the U.S. consumer, confidence has fallen meaningfully across several surveys, though political affiliations in an increasingly divided country seem to be playing a much larger role in consumer attitudes than in prior cycles.

While we maintain our positive outlook, risks to the U.S. economy and markets have increased since the start of the year. Inflation continues to be stubbornly high, inflation expectations are becoming increasingly unanchored, and disinflation appears to be losing steam. Tariffs are also likely to lift inflation relative to expectations at the start of the year and could place the Federal Reserve in a tricky position of having to potentially decide between tackling inflation or supporting growth when both of its mandates are at odds.

Markets          

While 2024 was a year that saw markets rise consistently and the S&P 500 set more than 50 record highs, 2025 has seen volatility return in meaningful fashion. Worries around tariffs, their effect on economic growth, and the emergence of new Artificial Intelligence (AI) models in China alongside concerns surrounding their impact on investment returns for capital expenditures for AI compute have dragged the S&P 500 into its first correction since October 2023, and the Nasdaq 100 into its first bear market since 2022. We believe markets are likely to be choppy until clarity on the outlook improves.

Source: Pence Capital Management | As of February 26, 2025

Perspective is an important aspect of investing, and while periods of volatility are certainly uncomfortable, they are often part and parcel of a healthy market. The last two years in markets have largely been a glide upward with markets delivering two years of 20%+ returns for the first time since 1998. Gains have also been extremely narrow with more than half of total returns between January 2023 and December 2024 attributable to the “Magnificent Seven” technology companies. The results of this disparity of returns left markets extremely concentrated, with 36% of the S&P 500 comprised of just eight names and 62% of the FTSE All Country World Index being represented by the United States.

2025 has so far been a substantial change to the Magnificent Seven theme and — for the first time in a long time — diversification is paying off. Just as the U.S. (and specifically U.S. Technology) has dominated market returns, recent market declines have been extremely concentrated in the Magnificent Seven technology stocks — and their extreme weights in U.S. indices have exacerbated the market correction. More than 100% of the decline in the S&P 500 in the first quarter was attributable to just those seven companies.

Source: Pence Capital Management | As of April 4, 2025

The lopsided fortunes of the Magnificent Seven and their dominant position in global indices has made 2025’s Great Rotation in markets feel particularly vicious, but headline movements haven’t told the entire story. Inside the United States, the 493 companies outside of the Magnificent Seven (the S&P 493) are having a great year relative to Big Tech after a decade of underperformance, while value stocks have meaningfully outperformed their growthier counterparts.

The Trump Administration’s maximalist policy around tariffs has seriously altered the outlook on markets in 2025, but we believe that claims around the outright demise of U.S. exceptionalism have been greatly exaggerated. The United States remains the best shop in town in terms of earnings growth, and the strength of the U.S. consumer has historically been something that investors underestimated at their own peril. It’s well within the realm of possibility that this theme changes as developments occur on tariffs and companies provide their new outlooks, but given the low relative exposure of the U.S. economy to exports relative to the rest of the globe it’s a very reasonable assumption that the U.S. — in aggregate — weathers any turmoil better than its global counterparts. The adage that “When America Sneezes, the Rest of the World Catches a Cold” has held true time and time again, and there’s little reason to assume this time will be different.

Source: Pence Capital Management | As of March 21, 2025

However, subtleties on a company-by-company basis and heavy sector compositions within the S&P 500 mean that the U.S. economy and corporate America could retain resilience and markets may remain challenged. Movements so far this year have been primarily about valuations and earnings differentials — that U.S. markets are expensive relative to the rest of the world while the difference between earnings growth for the most important companies in the U.S. and international markets has narrowed significantly. As an example, the gap between earnings growth in the Golden Dragon China Index and the Magnificent Seven is set to get cut in half in 2025, but the Magnificent Seven commands a multiple 50% higher than the China Index. We don’t think this will overly impact U.S. investor allocations given the political risks, but that is a meaningful change for international investors — which have been a key source of U.S. equity demand in recent years. According to Goldman Sachs, foreign investors have nearly doubled their ownership share of the U.S. equity market from roughly 10% in 2010 to 18% in 2024.

Ultimately, the largest determinant on forward returns will be whether the U.S. economy falls into a meaningful recession, as the S&P 500, on average, returns 12% a year after a correction if the economy avoids a downturn. Our base case remains that the U.S. will continue its post-pandemic expansion in 2025, but there remains great uncertainty to that forecast. There are certainly reasons to be optimistic, as corporate earnings continue to look strong and President Trump’s policy around tariffs is one part in a two-step policy of Tariffs and Tax Cuts. We see a high likelihood of forthcoming action on tax cuts, but until the dust settles investors should get comfortable with being uncomfortable.

The Four T’s: Trump, Trade, Tariffs, and Taxes

While the initial catalyst for market drawdowns was the worries around AI capital expenditures, increasingly volatile trade policies out of the Trump Administration has firmly taken the reigns as the largest driver for markets. President Trump’s April 2 “Liberation Day” announcement, where reciprocal tariffs well above market consensus estimates were announced, have thrust markets and the global economy into a new and uncertain paradigm.

Given the day-to-day nature of the administration’s trade policies, it’s difficult to take a definitive view on the ultimate outcome at this time. A full realization of the tariffs proposed would result in one of the largest increases in effective tariff rates on imports for the United States in history, with tariff rates well in excess of the levels seen after the 1930 Smoot-Hawley Act. With forthcoming tariffs imposed on Pharmaceuticals and Semiconductors through Section 232, the effective tariff rate on U.S. imports would rise to 27% — the highest effective rate on imports since 1903.

At this moment, the range of outcomes from tariffs is vast, and there is much that remains unclear. We do not know the ultimate extent of trade levies, nor do we know the level of price pass through increases by companies to consumers. So far, indications are that companies intend to pass prices on, with 77% of businesses telling the Richmond Federal Reserve in February that they plan to pass costs onto consumers in some form. Nearly half of companies indicated plans to pass on the entirety of costs onto consumers, which would have meaningful impacts on the future path of inflation.

At the same time, tariffs enacted “with the stroke of a pen” can be removed just as easily. There also remains a very reasonable possibility that the result of this episode is lower tariff rates, globally. Officials in the Trump Administration stated that, as of April 6, more than 50 nations have reached out to the White House to begin trade talks since President Donald Trump rolled out sweeping new tariffs. Cambodia, Vietnam, and Taiwan — all significant U.S. trade partners — have indicated willingness to slash tariffs on U.S. imports to zero. Given Taiwan’s significance to global semiconductor production, this is a meaningfully positive development.

Other trading partners have shown more reticence toward negotiation, with China in particular taking a uniquely hardline stance — raising tariffs on U.S. imports by 34% beginning April 10, and restricting exports of seven types of rare earths, among other measures.

Country-by-country willingness for negotiations so far have largely correlated to dependence on exports to the United States and the fiscal room a particular country has for stimulus. China’s dependence on the United States has decreased significantly since 2017, and the country never instituted meaningful fiscal stimulus measures in response to COVID. Given this, we think that negotiations between the United States and China will be particularly tenuous, which could have outsized impacts on U.S. technology companies given their reliance on the country for production.

The impact of tariffs is set to be fairly substantial, but it is one part of the administration’s plan for tariffs and tax cuts. With the movement in markets and declines in approval ratings for Republicans at-large, we think appetite on the tax side has shifted in a more favorable way — that politicians likely support bigger tax cuts, smaller spending cuts, and larger deficits than was signaled at the start of the year. We have already seen some evidence of this given disparities between the tax packages adopted by the House of Representatives and in the Senate and the relative timing of each.

The House, which moved on taxes first in March, passed a resolution calling for $4.5 trillion in tax cuts and $2 trillion in spending reductions — with significant cuts signaled for Medicaid. The Senate, which adopted their framework for tax cuts in early April, allocated more than $5 trillion in tax cuts over a decade but only called for $4 billion in spending cuts, though that number will likely rise as the bill becomes more fleshed out. Included in the $5 trillion is a full reauthorization of the Tax Cuts and Jobs Act, alongside $1.5 trillion in new tax cuts — with apparent appetite for many of Trump’s campaign policies, such as reviving expired business tax provisions, relaxing the $10,000 cap on the state and local tax (SALT) deduction, expanding the child tax credit and implementing Trump’s proposals to remove taxes on tips, overtime pay and Social Security benefits.

The Economy, DOGE, and the Federal Reserve

We think that many of the current issues in markets surround sequencing, and that if tariffs had come after tax cuts, markets would likely be in a different place. So far this year, the U.S. economy has displayed a generally good level of health, with strong levels of job additions and plenty of caveats for the aspects that did show weakness.

The United States added 504,000 jobs in the first quarter of 2025. This was a slowdown from the 628,000 jobs in the fourth quarter, but well above the 400,000 jobs added in both the second and third quarters. This is consistent with a general slowdown in the economy, but not emblematic of an economy that is already in the midst of recession. Additionally, there is little evidence that job cuts by DOGE are having a material impact on unemployment. Jobless claims are exactly in line with seasonal patterns in recent years, and the Federal government has shed just 15,000 jobs since January — a decline of just 0.5% in the context of over three million federal workers. The outlook gets murkier as we progress through the year, but it’s important to note that the federal government has not been a huge job creator in this economic cycle. Just 0.6% of the 16.9 million job additions since December 2020 have been at the federal level, and the impact of a hiring freeze from the White House has largely immaterial impact on aggregate job creation — all else being equal.

Source: Pence Capital Management | As of March 2025

For the aggregate economy, the picture is noisier. As of April 3, Real Gross Domestic Product (GDP) is poised to decline 2.85% in the first quarter which, if realized, would be the largest quarterly drop in economic growth since June 2020. The indicated decline, however, does not tell the whole story as the United States has experienced a historic level of imports as businesses have rushed to build inventories and front run tariffs. The flood of imports into the United States is set to lower GDP growth in the first quarter by nearly 5%, which would be largest drag on U.S. growth from imports in a quarter in recorded history.

When calculating GDP, imports are subtracted to ensure that only spending on domestic goods is measured. The purchase of domestic goods and services increases GDP because it increases domestic production, but the purchase of imported goods and services has no direct impact on GDP. Imports function as an accounting variable rather than an expenditure variable in aggregate, but imports and spending flow through data at different times — imports are a drag on growth now but could boost growth later as consumer purchases occur, or the products are placed into business inventory.

With trade excluded, growth in the United States looks fine, in our view. Final Sales to Private Domestic Purchasers — which strips out more volatile categories of Government Spending, Inventory builds, and Trade — remains well into positive territory. Growth there has slowed from last year to be sure, but it does not look recessionary. First quarter numbers also appear to be impacted by extreme weather across the United States, with January 2025 being the coldest January in the United States since 1988. These are typically transitory events with periods of payback activity, as consumers are much less likely to go shopping, buy a car, or look for houses in the middle of a blizzard, but weather doesn’t normally put a permanent halt to planned activity.

While these are positive themes for the economy, they present a real conundrum for the Federal Reserve. As of April 7, markets are pricing almost four cuts from the Federal Reserve in 2025; we think this is dramatically mispriced. With underlying growth in the United States looking strong, the labor market remaining resilient, and upside risk to inflation through tariffs, the Federal Reserve’s ability to respond to weakness is limited. Inflation in 2025 has remained sticky and talk of tariffs has materially lifted consumer inflation expectations — which is a particular focus for the Federal Reserve. When consumers believe that inflation in the future will be higher than today, they often increase their spending and generate the inflation they were worried about. Inflation expectations have been heavily influenced by political affiliation — with dramatically different views between Democrats and Republicans — but Independents are seeing pretty dramatic lifts in their views on inflation as well. Ultimately, we think tariffs do likely lift inflation from where it is today, but we do not expect an interest rate hike from the Federal Reserve. If the labor market does begin to deteriorate materially, the Federal Reserve has plenty of room to ease monetary policy.

Conclusion   

Going forward, we remain highly attentive to risks to our outlook of a continued economic expansion in 2025. There is much in the world that remains uncertain, but we expect clarity to improve in forthcoming weeks. With the first quarter earnings season, we will get important insight into the economy and their outlook for the year from the largest banks in the country. Later in April, we will get commentary from America’s Mega Cap Technology companies around their exposure to the tariffs, moves they are making to mitigate the impact, and their forward-looking outlooks.

We believe that the fundamentals inside the U.S. economy were resilient at the start of this tariff episode, and while the risk of recession has risen, we continue to think the U.S. will continue its post-pandemic expansion in 2025. The range of potential outcomes for 2025 is large, but there are several positive developments inside of global markets that give us optimism for a sustainable recovery over the long run. Diversification is now paying off, and bonds — for the first time in a very, very long time — are both providing meaningful yields for investors, and dampening volatility after several years of being a hindrance in diversified portfolios.

CRN: 2025-0403-12454 R

The opinions and views of this commentary are that of Pence Capital Management and are not necessarily those of Advisors Asset Management.