Relief Rally, And Then What?
The rally in risk assets gained some traction Friday afternoon as rumors began to swirl that the Trump administration is going to be more surgical and less scorched-earth with tariffs come “Liberation Day” on April 2nd. We got additional confirmation over the weekend, where administration sources indicated that the April 2nd rollout won’t include sector-specific tariff packages. For now, and this could change in the next five minutes, the tariff regime is shaping up to be narrower in scope than feared at the peak of uncertainty earlier in the month. Still, Trump and this administration want fast and measurable results, with tariffs under the reciprocal tariff framework designed to hit immediately upon those countries with tariffs on the U.S. and running a trade surplus.
Over the next several weeks, we'll learn more, including what retaliatory measures counterparties take. So, don’t get too complacent with the notion that we are out of the woods. A key part of the tariff initiative from this administration is to raise revenue to fund other areas of their agenda, in particular, tax cuts. We’re already seeing internal strife within the Republican party on how to legislate President Trump’s tax policy priorities into law. Senate Republicans are pushing to use “current policy” to finesse the math on tax cuts, and House Budget Chair Jodey Arrington is open to the accounting gimmick – if it's coupled with deep spending cuts to maintain deficit neutrality.
The framework the House Republicans are working off of would include $4.5tn in tax cuts, along with $2tn in spending reductions. This allows Republicans to claim that Trump’s 2017 tax cuts cost nothing, using the “current policy” baseline to wipe away over $4tn in projected deficits. Bipartisan budget hawks rightly call this out for what it is, smoking mirrors: “It lets you lie about what you are doing,” says Marc Goldwein of the Committee for a Responsible Federal Budget, calling it a “massive budget-buster over time”. “It basically tells financial markets and the bond markets we have really just given up on controlling deficits,” said Kent Smetters of the Penn Wharton Budget Model. The CBO just confirmed the stakes, projecting debt-to-GDP hitting a mind-blowing 250% by 2054 if tax cuts are made permanent.
House Republicans are rallying behind Trump’s preference for “one big beautiful bill,” while the Senate is hedging with a two-bill plan should the political winds shift. Speaker Mike Johnson has set Memorial Day as a soft deadline for delivering Trump’s agenda, but Republican consensus on the budget remains elusive. When/if it happens, the details of this bill will matter to the bond market and interest rates, which will carry over into equity markets. Since yields began to climb in 2022, we've witnessed that the level of outstanding federal debt ($37 trillion and counting) and deficit matter more than they ever have. Congress might be able to trick the general public with some accounting magic to get a bill passed, but they won’t be able to fool the bond market.
Let this be another reminder from me: Mr. Market does not care what your or my personal view is on these issues. That doesn’t mean they are not important, but this administration got elected—not you or me—which means they are going to do what they think they were elected for, and we as investors have to be able to sift through what is signal and what is noise. That is what matters for compounding and/or preserving one's capital. Yes, I am concerned about the potential abuse of executive branch authority. Yes, I am bothered by the bureaucratic barriers that are being put in place to thwart executive branch authority. Yes, I am worried that compromise has become a hard-no in our legislative process. But, what is most troubling to me is the accelerated pace at which our society is fracturing. Torching Tesla’s and demonizing our adversaries is not the right path. Regardless of your view on Trump’s ‘flood the zone’ approach (I’m not a fan), the risk that it crashes and burns increases dramatically as his administration finds itself bogged down by persistent attacks. The margin for error was already razor-thin, given the setup coming into his term. Now, he has united the opposition forces, possibly rendering it nearly impossible to reach a negotiated outcome.
Please don’t shoot the messenger. I’m not taking a side here; instead, I'm trying to make a subtle point that people, life, and community are more valuable and important than politics. I want to think we’d all be better off if we could improve our ability to agree to disagree and then find a way forward.
As for markets, a relief rally is underway in the equity market, which, given the dramatic decline in sentiment and positioning over the last month, could provide a substantial tailwind should investors need to chase equities higher.
The Nasdaq has been the epicenter of pain trade to the downside, with a peak-to-trough decline of roughly 14% and is down nearly 8% year-to-date. However, as I type, it is breaking above key short-term resistance, with its RSI bouncing off oversold levels. Should we close above current levels or higher, things could squeeze to the upside as we close in on the quarter's end.
The S&P 500 is following a similar pattern as it pushes above the negative trend line that has been in place since its correction started.
Getting there would be quite a feat, but a possible visit up to the 50-day moving average around 5,920 is not out of the question. Keep in mind that a lot of damage has been done to various parts of the equity market: the Philadelphia Semiconductor index (SOX) is down more than -22% from its July record peak, and the 20-member Dow Transports is down -18% from its closing high last November. Both of these industries are seen as leading indicators for the economy, which begs the question: are they nearing a bottom and indicating that most of the pain is behind us, or are they leading the charge while indicating other parts of the equity market have some catching up to do? I don’t know the answer to that question, but I will be using these sectors as reference points to gauge the health and sustainability of this relief rally.
There are a couple of other catalysts at play that suggest this rally could have some runway into the end of Q1. Given the disparity in performance between stocks and bonds for the quarter, pension rebalancing is heavily skewed to the buy side for equities and to the sell side for bonds. Additionally, last Friday was options expiration for a lot of March contracts, with some quarterly contracts expiring in another week, but a lot of negative gamma on dealer books has been reset which will trigger some charm flows should the VIX index continue to slide – it peaked at just under 30 on March 11th (two days before the intra-day low on the S&P 500 at 5,504) and has been falling ever since (flirting with an 18-handle as I type).
As we look forward, we’re going to learn a lot over the next 30-60 days:
Clarity on the tariff front, including retaliatory measures from trading partners.
Q1 earnings season kicks off in a couple of weeks, where it will be interesting to hear the degree to which companies are pushing ahead or pulling back as a result of policy uncertainty. Given the weakness we’ve seen in various consumer confidence surveys lately, which was corroborated by Delta Air Lines' recent results, it is expected that the Q1 earnings season will be on the weaker side. Perhaps last week's results were some foreshadowing of what’s coming down the pipe: Nike (NKE) traded down 5% following slowing growth, weak margins, and a reduction to its forward guidance. Lennar, the country’s second-largest homebuilder, traded down 4% following its earnings report last week, where margins continued to come under pressure. FedEx traded as much as 11% lower following weaker results but managed to climb back to a -6% slide by the end of the day. Either way, this was a broad array of businesses touching many parts of the U.S. economy that didn’t paint an upbeat picture for the upcoming earnings season.
Additionally, we’ll get data on the labor market and inflation over the next several weeks. Next Friday, we’ll receive the March payroll report, which is expected to show cuts to government jobs and the dramatic decline in immigration starting to negatively impact job growth. Inflation data will be reported in mid-April, where the trends here look pretty constructive over the next several months. Perhaps this will give the Fed some wiggle room to guide more aggressively towards additional monetary easing this summer. The Fed took a big step last week by reducing the cap on Treasurys rolling off its balance sheet from $25 billion per month to $5 billion. On the margin, this represents a subtle shift towards a more accommodative monetary policy; however, if the trend in economic growth continues to weaken, they will be forced to become even less restrictive from their current stance.
Cross-border fund flows are another thing for investors to keep in the back of their minds as this administration pushes forward with its vision to reset global trade policy and reassert America’s prominence on the world stage. The flip side of current account deficits is capital account surpluses. The proceeds from trade surpluses with U.S. trading partners get plowed back into U.S. assets and securities. Should this administration succeed in its objective to shrink the trade deficit, it will also shrink the capital account surplus, thereby removing a significant tailwind for U.S. asset prices. Foreign investors hold a record $20 trillion in U.S. equities and saw their exposure balloon by +$4 trillion or +27% over the past year. What happens when these flows abate or even reverse? We are likely seeing a glimpse of this already play out, which is why the All Country World Index ex-U.S. (ACWX) is up 8.5% year-to-date while the S&P 500 is down -4%. Why is the ETF that tracks Mexico (EWW) up +10% ytd or Canada (EWC) +1% when these regions are expected to be the most negatively impacted by the change in U.S. tariff policy?
European equities are up double digits partly because of fund flows but also because of relatively cheap valuations vs. U.S. equities and a dramatic pivot in fiscal policy. Germany’s bazooka-sized spending package cleared its last parliamentary hurdle last week while paving the way for as much as €1 trillion in civilian and defense investments to jolt the region’s economy. We’re seeing more countries step forward in reducing their military reliance on U.S. defense companies, and unfortunately, this might just be a first step among many (see Bloomberg snippet below). Perhaps Europe should be sending President Trump a thank you for arresting them from the state of complacency and inertia they’ve been in.
So, where does this leave investors? Well, I advocate using this rally as an opportunity to reposition your portfolio for those who were beaten up in this high-beta / momentum unwind. Sure, sentiment and positioning have gone through a thorough and necessary cleanse, but valuations remain high, and upside catalysts look underwhelming. Yes, we could get a change-of-heart type of announcement from this administration on the policy front, but what is that worth? A couple of percent on the upside, maybe 5-6%? That takes us back to all-time highs, and then what? If this correction took us down into the low 5,000s on the S&P 500 with earnings, growth, employment, and inflation remaining near where they are today, then I would say you have an excellent backdrop for increasing risk exposure and adding equity risk. But I just don’t see a lot of upside to fundamental drivers (unemployment is already in the low 4’s, double-digit earnings growth is already penciled in for 2025, inflation has stabilized at an acceptable level, profit margins are at all-time highs, and valuations are still elevated) – with the S&P 500 trading around the 5,800 – 6,000 level, its hard for me to get too excited about the upside for U.S. equities.
This doesn’t mean I’m a raging bear; to be fair, this correction created some tactical opportunities. If I’m a bull on anything, it's on diversification, which is working how it should for the first time in several years. With the Fed now on hold and the yield curve flat, we can expect the bond market to be range-bound for the next several months, so you can at least clip your coupon on fixed-income instruments. I know nothing is exciting about that, but when you’re finding instruments paying reasonably secure mid-single digits (which exceeds the S&P 500 dividend by a factor of more than three) and you couple that with high-quality U.S. and foreign equities, some gold, commodities, and maybe a dash of Bitcoin – you’re looking at a portfolio that should perform well in both a best case and worst case scenario. All the while it gives you optionality to adapt and adjust along the way. Retaining flexibility at a time of elevated uncertainty is a strength, not a weakness, in the current environment.
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