BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Negative
The Tariff Tantrum
"Though we see the same world, we see it through different eyes."
- Virginia Woolf
Investors are facing changes to the policy landscape that have not been confronted in many years. The scope and arbitrary nature of the tariffs turned out to be far higher than anyone had imagined, leaving the world, and the markets, in a state of shock. While the economy entered the tariffs on decent footing, the risk of a global trade war clearly complicates the outlook. Markets once preoccupied by the potential inflationary consequences of the new policies have grown increasingly anxious about their growth implications. The correction and historic volatility have led to extreme investor pessimism and made it hard to stay focused on key signals, while discounting the noise. We will do our best to distill our outlook.
We see a couple different paths forward relating to tariffs. Our base case assumes the tariff announcements are a negotiating tactic by the administration to restructure global trade over the coming years, where these tariffs are rolled back to something less extreme over 3-12 months. Admittedly, this assumes economic rationality. There is still plenty of risk with this strategy, but the direst outcomes (e.g., prolonged economic contraction, sustained bear market, etc.) have a better chance of being avoided. Secondarily, and we place lower odds here, the tariffs remain as announced for too long, and the economy will have a harder and harder time fighting off the forces that ultimately push it into a prolonged recession. While it is prudent to raise the odds of a more pronounced slowdown, our base case continues to assume slow, but non-recessionary, growth.
In times like these, it is important to have an investment process in place that removes emotion from the equation. A process that focuses on key signals, and removes the noise, if you will. At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental, and macro analyses indicate. Currently, our short-term metrics are in a negative position while our longer-term view is positive.
For those who have been following our market updates (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated our expectations of slow, but non-recessionary, growth. Given the tariff news and associated volatility, there are adjustments to consider, but our overarching views remain the same. Ultimately, another year of economic and earnings growth will overcome the macro headwinds and support a grind higher in equities. We believe it is a good time to be active and want to be thoughtful regarding portfolio construction and risk control.
The Technical Perspective
From a long-term perspective, price trends have moved quickly back to key (upward sloping) support levels (e.g., the 200-week moving average on the S&P 500). However, tactical signals have deteriorated with the increased volatility. We suspect forced liquidations are adding fuel to the fire. Leadership has flipped with defensive sectors outpacing pro-growth groups recently. As profit-taking has increased in former leaders (e.g., technology), equally weighted indices have started to pick up and have helped to broaden the market. There is work to be done here, and it remains an opportunity for tactical repositioning as leadership shifts. We are intently focused here as we consider portfolio tilts.
The narrowness of the market (and elevated weights) is adding to the selling pressure. As investors rebalance or take profits (or liquidate), the heavier weights are having an outsized impact. We are encouraged by the higher performance dispersion within sectors and industries, as it supports more active oversight. The correction has shown a light on this development. We expect the lower correlations backdrop will continue as the year progresses, an environment we welcome.
Encouragingly, investor sentiment is now decidedly negative (e.g., bull-bear surveys reflect a historically negative bias). Bull markets tend to die on euphoria, not skepticism, so we like this update. We have been noting that positioning (e.g., investors have poured well over $7.5 trillion into money market funds) should act as a buffer to sizeable pullbacks, but the volatility is keeping those potential allocations in check. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher or lower). While there is certainly a high bar for allocations given elevated risk-free rates, our view is that investors have room to increase equity exposure.
The Macro Perspective
Uncertainty surrounding new policies (e.g., tariffs) has raised slowdown odds, but a global easing cycle and decent economic growth will serve as offsets. Some real-time economic models have flipped negative for the first quarter (note: the adjustments have to do with tariff-related accelerated inventory adjustments and should self-correct). We see sluggish growth for the balance of the year. Prior to the tariffs, globally, there were encouraging signs of economic optimism. China, and increasingly Europe (stimulus related), had seen their economic surprise models turn positive. For some time, macro worries have centered on slow global growth and still tight financial conditions (i.e., restrictive monetary policy). We can now add tariffs to the list. We understand the concerns but continue to see plenty of growth optionality and view easing global central bank policy as a sustained catalyst.
Interest rates will continue to carry outsized significance. We believe ultra-low interest rates are a thing of the past and investors should embrace more normalized levels. We expect lower, but not low, interest rates going forward with a milder cutting cycle in which the Fed recalibrates the policy rate. With decent growth, the Fed doesn’t need to be aggressive with the size and number of rate cuts. Tariffs may have changed that calculus, however. The Fed is trying to find a neutral rate, which in their eyes is neither accommodative nor restrictive, and we suspect they find it this year. The recent growth concerns have raised rate cutting odds (and lowered the dollar). For some time, one of the most pressing questions for investors has been: Can the Fed find a neutral policy rate without causing a deep recession? So far, so good.
Geopolitical and political events will represent increasingly material considerations for investors. While particularly difficult to position for, we have several market- and non-market-based factors to lean on that help assess materiality and support positioning. We are aware of the uncertainty associated with a new administration, but see counterbalances (e.g., tariff uncertainty vs. deregulatory tailwinds and lower taxes) ultimately offsetting much of the impact.
The Fundamental Perspective
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Headwinds, such as higher financing and input cost pressure, have been more than offset by acceptable demand trends. Estimates for revenues and profits have been revised higher over the past few years and were a stalwart defense against any recession forecast. However, they have stalled out and are a risk given the macro uncertainty. We expect a muted earnings season (e.g., management teams have little incentive to be aggressive with their forecasts) but still expect growth rates to accelerate this year.
Valuations are now back below their long-term averages. The pullback has shaved 2.5x turns off the market's valuation (P/E), the quickest reset in years. However, valuation dispersion within sectors and industries remains elevated with a historically sizable gap between the highest- and lowest-priced assets. We see opportunities in both groups (continued leadership in one, reversion to the mean in the other). Several of the secular growers are commanding high multiples, but also market-leading profitability. Value-oriented pockets offer opportunity, but investors will need to be selective.
The credit backdrop will be important to monitor as a check on fundamentals and a proxy for risk tolerance. Credit spreads have widened with the selloff in stocks, but at this point remain manageable. One of the defining criteria between recessions and slowdowns has been the behavior of the credit markets. Both investment-grade and high-yield spreads vs. Treasuries are stable and remain below recessionary levels. Encouragingly, corporate cash flows remain healthy, and balance sheets are in good shape.
Concluding Thoughts
The market is trying to navigate a tariff-induced growth scare. Clearly a challenging backdrop, but this is a man-made headwind and could change at any given time. While our base case assumes economic rationality will take hold, we won’t be stubborn enough to wait. Our investment philosophy is based on a dual mandate of growing and protecting client assets. Without any change, our focus will shift from “how” one is positioned, to “if” they should have exposure at all. We are staying active, using the volatility to harvest losses while opportunistically deploying capital where appropriate. At this point, our cash weightings remain residual in nature, and we are focusing on strategy positioning vs. our respective benchmarks to control risk. Of course, should the backdrop continue to destabilize, we will take a more defensive stance.
Should you have any questions or comments, please contact BakerAvenue. We are happy to share our thoughts in greater detail, and we welcome the opportunity to speak with you.
Disclosure: Past performance is not indicative of future performance.