Trending
Written by: Cliff Corso | Advisor Asset Management
“Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security.” — John Allen Paulos (American professor of mathematics at Temple University)
Lessons from Q1
We approached the investment landscape for 2025 with Cautious Optimism.
Optimistic because the economy entered the year with a good head of steam, corporate profits remained solidly positive and generally supportive of the employment outlook albeit, with some softening expected.
Cautious because of the threat of Tariffs, Trade Wars, and Sticky Inflation. The impending changes in policy are both broad and huge posing uncertain impacts in terms of results and timing. Hence, we provided a playbook which we intended to be ‘all weather’ with a goal of providing solid returns over a 12 month+ horizon while intending to mute the volatility and tail risks underlying our ‘cautiousness’ along the way.
The Trump Administration’s Tariff announcements certainly accelerated our "Cautiousness." The Tariff package was broad and larger than most expected sending the markets into a tailspin as of this writing. Also at present, the Tariff announcement actually didn’t decrease uncertainty as some hoped as responses from other countries are awaited. Post this announcement, Citi expects forceful rate cuts and a recession while other banks expect higher inflation and no rate cuts — how’s that for clarity? Without the expectation of the above normal market results of the past two years, we hew to the John Allen Paulos quote and prepare for an era of Higher Volatility and Uncertainty. Our playbook for this year was designed to weather this type of uncertainty and can be summarized as a focus on the “3 D’s” — we look to add more Diversification, Dividends (and income) and Deliberately selected, specific investment themes into the asset allocation mix.
Threat of the ‘Triple T’s’
As for the fundamental impacts, we believed the economy would slow from 2.5%+ GDP to perhaps 1.0% annualized for 2025 due to our expectation that we have now entered an era of elevated volatility and uncertainty. Borne from the ‘Triple Threat of T’s’ — Tariffs, Trade and the impending battle over Taxes but also aggravated by sticky inflation leading to uncertainty around interest rate policy as well.
So far at the end of the first quarter, we have realized what we expected and perhaps then some. Here are some key market results for the first quarter:
- S&P 500 — down 4.3%...driven lower by the concentration in the ‘Mag 7’
- ‘Mag 7’ — down approximately 16%...but not as bad when we look at the equal weight version of the S&P
- Equal Weight S&P — down only 0.6% (capturing our diversification and broadening market themes)
- Global Stocks ex US — up over 5% (also capturing the diversification theme)
- Dividend Stocks — outperformed and were up about 2% (capturing our dividend and income theme)
- Defense Sector — up over 14%* (an example capturing our deliberate thematic investment theme) *spdr xar
- US Bonds — up about 2.7% (diversification and income)
It should be denoted of course that the markets are down anywhere from 1 to 6% further from quarter end as fears of a slowdown and a stagflation lite scenario seem to be the main likely outcome (our view from the get go).
“Spinach vs Dessert” — Looking forward
With major stock indices in or near correction territory, tariff policies shifting seemingly daily and consumers and businesses having difficultly figuring where it all settles, a pullback in spending would seem logical at this moment. We are at the ‘spinach phase’ of the policy implementation. Higher prices should be expected at this phase as the longer-term goal is to level the playing field for US companies and bring manufacturing and jobs back to the US — arguably a worthy goal but not a cheap or quick proposition. At present, our view is that it is likely the cost of tariffs will be shared in different proportions (depending upon industry, country, and product) by companies, consumers and foreign exporters. And if they last at punitive levels for more than a few months the consequences will be further uncertainty and increased recession odds which will need to be followed carefully. Borrowing from books, game shows and a movie, Hopefully, the “Art of the Tariff Deal” turns into “Let’s Make a Deal” quickly or we will face the specter of the “Quick and the Dead” (more like the “Unquick and the Dead” for our economy). As the research firm Stategas points out below, a full blown ‘Independence Day’ tariff regime including reciprocal taxes and a Value-Added Tax (VAT) could add up to 1.8% of GDP. This would take the Federal Tax revenues as a percentage of GDP close to 20%, levels which have spelled trouble for the economy in the past:
Source: Strategas
So now, one looming question here is when does the ‘dessert phase’ start? And will it start soon enough to provide the support to keep the economy moving forward? Tariffs should bring certain jobs back, but timing is certainly a question in addition to the cost impact. For example, underutilized factories here (e.g. Auto plants) could come pick up production sooner, however, would there be enough cheap labor to help soften the inflation side of the equation? Given the breadth and scale of the global supply chain reordering, it seems likely to be more of a multi-year endeavor. Tax relief is targeted for the 2nd half of this year but the administration’s hoped for result might be a nail biter given the additional conservative goal of bringing down the deficit and slim margins in congress. On the positive side, deregulation efforts have begun in some sectors and should help certain industries such as banking and energy (oil prices may decrease but the industry could benefit as would the consumer) which is also positive from a short- to intermediate-term economic perspective.
The key now is the fading hope that the economy does not get too much indigestion on the way from spinach to dessert. We need to be careful what we wish for here as the consequence may be that inflation remains at or even above 3%. This would not surprise us, and this may limit the Fed’s intention of lowering rates much this year. Of course, if it is a harder economic fall then we would expect an accommodative Fed. But given our long-held view that the base inflation rate may now be closer to 3% than 2% an easing might only be a temporary panacea. If inflation stabilizes at 3%, that can be okay in our view as most of the past several decades inflation has been more in the 3% range than 2%. We note that markets can do quite well in a 3% inflation environment if inflation is reasonably stable. It just means a 3.75%+/- Fed Funds rate and a 4.5%+/- 10 year is a likely range we would expect. Again, that is okay as these levels are normal. We should avoid the temptation of anchoring lower rate expectations borne from the experience of the ‘lost yield decade’ due to the Global Financial Crisis. Finally, in this type of environment (stickier inflation, a less accommodative Fed and higher volatility) the predictability of bond/stock correlations is less durable which supports our view that the right playbook going forward embodies principles of the ‘3 D’s.’
Ideas around our playbook suggest allocations along the following lines:
Diversification
U.S. Domestic — Lighten exposures to cap weighted indices like the S&P. We have seen the potential impact of high correlations within their construction. Correlation works great on the way up but can cut the other way in volatile markets and on the way down. Add some equal weight exposure. Also, consider adding Value to the mix. Many sectors in the Value category not only sport a larger margin of valuation safety but generally reflect a quality bias. We would recommend looking specifically for quality within the Value category to further mute volatility. Also consider quality Mid Cap which should be a beneficiary of the ‘America First’ policies coming to our shores. Again, quality is paramount in this category too. Finally, consider adding to International exposure. Foreign markets have underperformed the US for many years and the valuation gap is wide and poised to close. We have been struck by how quickly global policies are changing as a result of our policies. Witness Germany, the economic engine of Europe and historically a fiscal “Ebenezer Scrooge.” Germany is looking to spend significant capital on infrastructure and defense as it looks to create a more self-reliant Europe. The US dollar is also potentially nearing the end of its secular run further arguing for international exposure.
Dividends and Income
· Fixed Income — Consider moving some exposure into short to intermediate maturity durations. We think sticky inflation and the volatility tariffs will have on inflation (and less durable stock/bond correlations cited earlier) argue for staying a bit defensive in fixed income for now. That said, we do like the 5%+ yields achievable in the category of short to intermediate fixed income. Even with 3% inflation, real yields are at or above 2% on quality credit while rate risk is muted. We also like preferred strategies which offer exposure to banks, insurance and energy with 6% + yields while ranking above equities in the capital stack.
· Private Credit — We view this area as attractive given the expectation of sticky inflation and the ability of private lenders to capture higher yields on floating rate loans while interest rate duration risk is low. Mid-sized companies should benefit from the America First policies afoot and private lenders are most senior in a company’s capital stack (above equity and unsecured bonds). Focus on experienced active managers who have been through cycles and can carefully select quality companies in diverse sectors.
· Dividend Stocks — Dividends and Income can represent a more predictable and durable component of total return. We view quality dividend payers and growers as an attractive opportunity. Historically, dividends drove one-third of total returns vs. 14% at the low a couple of years back. We see a reversion to the mean occurring for dividend payers as the days of low/zero rates driving broad PE expansion are in the rearview mirror.
Deliberate
· Sectors with Secular Tailwinds — Sectors driven by factors beyond the typical business cycle should be more immune to the vagaries and uncertainties of the moment. For example, we have long favored Defense which is in for a multi-year investment cycle. We also like to play AI from a ‘pick and shovel’ perspective and like areas such as data centers and select energy sectors (natural gas).
· Volatility Mitigating Strategies — There are few analysts who have mid double-digit forecasts for the equity indices this year while there are many who expect corrections and volatility. We would suggest allocations to strategies like buffered products to allow for significant upside capture while mitigating the downside.
John Allen Paulos’s quote on uncertainty is a perspective that should resonate with investors today. Or, borrowing from a TV show past: ‘Be Careful Out There!” We believe a strategic allocation framework that prepares for uncertainty is the right step looking forward.