Tariffs … On Again … Off Again …

Markets seem to be getting a little numb from the continuous flow of news regarding some tariffs being imposed and others being exempted. Starting on April 2nd, President Trump imposed “reciprocal” tariffs on all trading partners. The next day the S&P 500 cratered -4.83%.

Having focused the world’s attention exclusively on this issue, a week later, on April 9th, President Trump postponed these tariffs for 90 days to give time for trade negotiations to take place. The S&P 500 rallied +9.53% (even though the 90-day grace period did not apply to China).

Then, on May 12th, President Trump postponed the tariffs on China too. The S&P 500 rallied another +3.25%.

On May 23rd, disappointed with the progress of trade negotiations with the European Union (EU), President Trump imposed a new 50% tariff starting June 1st. Since this announcement came after the market closing that Friday, there was no S&P 500 reaction.

Over the weekend however, President Trump had a “good” conversation with the President of the European Commission, Ursula Von Der Leyen, and the tariffs on the EU were postponed until the original deadline of July 9th. When the markets reopened last week from the Memorial Day Holiday on May 27th, the S&P 500 rallied +2.05%.

On May 28th, the US Court of International Trade ruled the President may not impose large scale tariffs under the 1977 International Emergency Economic Powers Act (IEEPA), thus the April 2nd tariffs were invalid. While the S&P 500 rallied +1.5% intra-day, the rally lost steam as the Administration appealed the ruling immediately. The S&P 500 closed flat -0.055%.

The next day, May 29th, the Appellate Court ordered a stay on the lower court’s ruling and scheduled a hearing of arguments for June 9th. The S&P 500 again closed flat +0.032%.

Finally, on Friday May 30th, President Trump made public his dissatisfaction with the trade activities of China, implying new actions against China will be forthcoming. Markets initially declined modestly but by the end of the day the S&P 500 once again closed flat -0.00%.

In summary, investors may be getting fatigued by the continuous back and forth (tariffs on — tariffs off) environment. Their reactions seem to be getting more muted with every step of the negotiating process. Also, since the S&P 500 gained 6.1% in May, investors seem to have priced in their expectations for successful trade negotiations, and for the time being they don’t want to sweat over every little detail of the process. Instead of worrying about a process they cannot control, investors choose to focus their attention on the flow of economic data, which is pretty good given the ongoing trade saga.

The Federal Reserve’s preferred inflation measure, the Personal Consumption Expenditure (PCE) for April came in at 2.1% (year-over-year), lower than the March reading of 2.3%. Inflation seems to be getting closer to the FED’s target of 2%.

Personal Incomes for April increased by 0.8% (year-over-year), higher than the expected 0.3%, but not too high to cause fears of reigniting inflation.

The April trade deficit of $87.6 Billion was pretty much half the March $162 Billion trade deficit, demonstrating the effect of the announced tariffs. More imports before the tariffs, fewer imports after.

New weekly unemployment claims remain at normal levels (around 200k) although the continuous unemployment claims seem elevated (1.92 M), indicating that workers who lose their job have a harder time finding a new one.

Having looked at the data, it is time to address the question in every investor’s mind: Can the stock market have a sustained rally at this point?

While the S&P 500 experienced a correction (-1,161 points or 19%) between February 19th and April 8th, it has rallied since then (+929 points or 18.6%). Being 231 points away from the previous market top means the market is not cheap anymore. Particularly since economic conditions are much more uncertain now compared to February, causing many companies to withdraw their 2025 earnings guidance due to “lack of visibility.” If the executives operating these businesses confess lack of visibility, we wonder how investors are so confident about the future prospects of these businesses?

In our opinion, it doesn’t make sense for investors to be more confident than the managers of these businesses, when they admit they are flying blind. We need to see positive developments in the following 4 areas before we can conclude the market has potential to enjoy a sustained rally:

1.) Successful Trade Negotiations Culminating in Trade Deals With Major Economies.

While there is no doubt the US Court of International Trade ruling (about the boundaries of the government authority under the 1977 IEEPA) slightly diminishes the negotiating power of the US administration, the Trade Act of 1930 provides plenty of authority to the administration to impose tariffs. For instance, Section 122 authorizes the President to address balance of payment deficits and/or protect the dollar by imposing up to 15% tariffs up to 150 days, which can be extended with congressional approval (or through lapse for a day and re-impose).

Section 301 authorizes the President to impose any tariff for any duration after an investigation (it will probably delay such tariffs 2-3 weeks to compile the necessary reports.)

Section 338 authorizes the President to impose up to 50% tariffs on imports from countries that discriminate against the US (like Section 301 but requires no investigation in exchange for the 50% upper limit on tariffs).

Section 232 offers the President much more flexibility on sectoral tariffs (steel, autos, pharmaceuticals) than general tariffs applied to all imports (could be used more extensively if legal challenges to general tariffs become a serious obstacle).

The point is tariffs will not go away unless new trade deals are signed. For the markets, the sooner this happens, the better. In our last month’s newsletter, we wrote about the importance of signing a trade deal with India, which is the real threat of taking business away from China. With an expansive population and cheap labor force, US companies could move some of their operations from China to India, if China refuses to cooperate. The EU, Japan, Canada, and Mexico need to be brought into the trading coalition. Failure to have such deals signed by the deadline of July 9th (preferably sooner) and we will most likely not be talking about a market rally this summer…

2.) Stabilization of the Downward Earnings Revisions.

While corporate earnings increased by 5.9% in the 4th quarter of 2024, they declined by 3.6% in the 1st quarter of 2025. Moreover, chip producers report losing sales as a result of the restrictions on China, and retailers report higher costs for their imported merchandise. As a result, US companies have been giving either lower earnings guidance or no guidance at all for 2025. Those who dared to provide downward guidance got punished by investors. For example, the clothing retailer GAP reported on May 29th that it expected tariffs to subtract $150 million from its bottom line this year. On May 30th, its stock price tanked almost 20%. Even though this second area is dependent on the successful resolution of the first area (trade deals), at the end of the day it is earnings that matter the most to investors. Hype can lead markets higher, but it is earnings that sustain market rallies.

3.) Lower Interest Rates.

Interest rates represent the cost of money for different uses and maturities. Money (liquidity) is the blood flow of the economy. When it costs more to borrow funds, consumers may postpone big ticket purchases (houses and autos), and businesses may postpone new investments and refrain from hiring more workers. Both slow economic activity, reduce business earnings, and drag markets lower.

Furthermore, with the US government debt at $36.5 Trillion, each 1% increase in the interest rate costs $365 Billion annually to service the debt. This limits the government’s ability to spend on other programs, thus restricting economic growth.

Moreover, the higher the yield on Treasury bonds (and corporate bonds) the more attractive they appear as investment alternatives to stocks, thus more funds may be diverted to fixed income instead of equity markets.

Currently, the yield on the 20-year and the 30-year Treasury bonds is around 4.95%, while the yield on the 10-year Treasury bond is around 4.45%. Under normal economic conditions (where there is no recession or high inflation), typically we don’t see sustained market rallies if the 10-year Treasury bond yield is above 4%. This implies that for this market rally to have legs, interest rates need to drop by 0.5% to 1.0% throughout the yield curve.

For these yields to drop, someone needs to buy Treasury bonds, as the price and the yield of fixed income securities move inversely (interest rates go up, prices go down and vice versa). Given the ongoing trade antagonism, it is unlikely the buyer of Treasury bonds will be foreign governments. Why would they want to lower the yields of the country that threatens them with punishing tariffs? We certainly do not suggest the Federal Reserve (FED) restart quantitative easing (QE) to buy Treasury bonds, as this “money printing” could re-ignite inflation. However, a more dovish FED could be instrumental in incentivizing investors to buy Treasury's, thus lowering yields. For instance, the mere suggestion that the FED may be considering easing its monetary policy could prompt individual and institutional investors to try to front run future FED Treasury purchases. Therefore, the FED could bring yields lower simply through public comments without actually purchasing any Treasury bonds itself.

A more cooperative Fed could also suspend or eliminate the banks’ mark-to-market reporting requirement for their Treasury’s. In other words, banks would not have to report unrealized losses from their Treasury holdings on their financial statements. Undoubtedly, banks and insurance companies would buy more Treasury's and bring yields lower, thus boosting the economy and the markets.

4.) Deregulation of Industries.

Along with trade restructuring and tax cuts, President Trump’s third major economic campaign promise was the deregulation of the US economy. Compared to the first two, reducing some regulatory burden from some industries should be a relatively easier task for the administration. Not that it would be met without objections, but reducing excessive government regulatory requirements from US businesses will reduce costs, improve efficiency, and increase business profits. For instance, reducing some Environmental Protection Agency (EPA) restrictions may allow mining for rare earth metals, which are needed for the high-tech industry and the military. We need to recognize the possibility that some species may be displaced from these areas. We need also to remember from economics that there are no easy solutions to real problems— Only tradeoffs.

Similarly, reducing the almost 10-year long period of clinical trials in the pharmaceutical and biotech industry could bring new treatments to patients faster. While no one wants the undesirable side effects of new drugs, we also need to consider those patients who may not have 10 years to wait before a new cancer treatment is approved. Once again, there are no easy solutions, just tradeoffs. Can the administration introduce some deregulation and efficiency gains in the US economy without undue human risk? Let’s hope it can.

In conclusion, the current stock market rally has a tall order and a fast-approaching deadline to meet. Valuations are expensive once again, the CNN Fear and Greed Index registers Greed again, and we need to have multiple key trade deals signed by July 9th, upward earnings revisions for the 3rd and 4th quarters, interest rates dropping by 0.5% to 1.0%, and legislation promoting deregulation of key productive activities. Currently, none of these areas gets a check mark. Until we can assign a check mark in most, if not all these 4 areas, we remain cautious as the recent stock market rally (which is really just a recovery from the April decline) looks fragile.

We need to be aware however, that if and when these 4 areas get a check mark, along with the possible tax cuts (which we will address in a future newsletter) once finalized by the Senate, have the potential to propel the stock market to new All Time Highs.

With so much uncertainty, we currently recommend a balanced approach of having some liquidity (either as cash reserves, Treasury's, or both) to take advantage of a possible market correction, as well as some high quality equity positions to participate during the next market rally phase. In our view, this is not an environment to go all in, as there are many issues still unresolved. Yet, it is entirely possible these issues can be resolved favorably, and the market will jump to higher levels. The key for investors is to (always) manage their emotions, leave politics aside, and focus on the developments in the 4 areas we outlined above. If progress is made, we recommend increasing exposure to equities. If not, reducing exposure to equities, raising cash, and waiting for a better entry point could be advantageous.

As always, we are here to answer your questions, provide you with our insights, and assist you in your investment journey.

Stay Fierce!

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