SUMMARY
Despite some progress in US tariff talks, trade and growth remain at risk. Markets may thus have rallied too much lately.
KEY TAKEAWAYS:
Despite trade tensions de-escalating, investors may be underestimating tariff pain
The Fed is likely to cut rates less than previously expected amid tariff price soreness
Recent equity upside may be getting ahead of the economic outlook
We see a case for shorter duration, quality fixed income
Sometimes, pain relief can produce a sensation of euphoria, even if the patient remains in greater discomfort than they were prior to the ailment.
Financial markets can experience similar effects. Following the US’s decision to lower the tariff on Chinese goods from 145% to 30% for 90 days, investors were in celebration mode.
As of May 17, US equities had recovered by 23% from their April lows. As such, the S&P 500 Index traded on a valuation of 22 times consensus forecast earnings for 2025.
But while the peak tariff shock may have passed, we believe investors may have been too swift to dismiss tariff pain. Their reaction is almost as if the economy had received an “all-clear” signal.
In reality, tariffs on imports from China and elsewhere are still set to cause unpleasant symptoms for businesses and consumers. We expect pressure on corporate profit margins and slower consumer demand in the second half of 2025.
On its recent earnings call, Walmart, the US’s largest bricks-and-mortar retailer, noted a growing customer bias towards value and convenience. It also indicated it may have to raise prices further in response to tariffs.
Even after the lowering of tariffs on China therefore, the prognosis for US growth and corporate earnings is still worse than at the start of the year.
The Fed isn’t rushing to administer monetary treatment
The US administration has been vocal in calling for the Federal Reserve to lower interest rates to support growth. However, the Fed is in “watchful waiting” mode. Rather than rushing to inject the US economy with a monetary shot in the arm, it is on pause until there is a meaningful economic slowdown.
Encouragingly, the labor market remains stable, and the inflation data has improved. Last week’s CPI data showed year-over-year headline inflation falling to 2.3%, the lowest monthly figure since 2021.
Even so, core inflation remains elevated. And recent surveys point to possible tariff-induced price increases ahead. This supports the Fed’s proposed treatment strategy.
Markets are now pricing in about two Fed rate cuts in 2025, down from a peak of four in early May. Other global central banks have more freedom to ease monetary policy, by contrast. We therefore expect more divergence between US interest rates and those in many other places for the rest of 2025.
X-raying market fundamentals
We are encouraged by the recent evolution of trade discussions. However, we are not ready to return our economic and earnings growth expectations to pre-tariff levels. For that to happen, we need to see more material progress toward meaningfully lower tariff rates over the next 8-10 weeks.
We continue to believe that consensus US earnings per share (EPS) forecasts are likely too optimistic. On 22 times 2025 earnings, the S&P 500 Index looks more than fairly priced to us.
Notably, analysts forecast that most (64%) of the 2025 S&P 500 EPS growth will once again come from the tech and communication services sectors. As in 2023 and 2024, AI-related growth may once again prove more durable than that from trade- and consumer-sensitive segments.
We would not bet against large US corporations’ ability to navigate uncertainty. However, we are biased toward equity strategies such as seeking earnings sustainability ahead of an uncertain second half of the year.
Despite the recent surge in equities, our tactical positioning remains neutral.
We see a need for fundamental catalysts to drive the markets much higher from here.
These might include an increase in confidence in US corporations’ ability to maintain and grow earnings above current estimates.
Additional fiscal stimulus that strengthens consumer sentiment might also help.
In fixed income, we continue to prefer up-in-quality, short-to-intermediate duration bond exposure. This reflects both the inflationary risk from tariffs and pressure on the pricing of longer-duration assets because of fears about US government overspending.
Until the prognosis improves, we believe such portfolio positioning may prove healthier.