Special Market Commentary: Tough Talk On Tariffs
By Brian Andrew, CFA® – Chief Investment Officer
Markets have been thrown into turmoil due to the tariff discussion dominating headlines. As the U.S.’ new Administration emphasizes the need for a much tougher tariff policy, on all of our trading partners (China, Europe, Mexico and Canada in particular), investors, originally sanguine about new policy, have decided that risks are too high. Assets that rallied post-election, have given all of their gains back. The S&P 500 Index is down 4.5% since January 1st while the tech heavy NASDAQ is down over 7.5%. Bear in mind the S&P 500 Index is still up over 10% during the last 12 months. And, international stocks have done very well due to a less austere discussion surrounding fiscal spending.
Tariffs have several implications. Think of them as a tax on goods entering the U.S. This tax must be paid by the company importing those goods. They have two choices. They can pass that added cost onto consumers in higher goods prices or they can reduce their profit margins. Keep in mind that profit margins remain elevated and near all-time highs. And, consumers have been enjoying decent wage growth and a strong labor market.
More importantly, we don’t yet know what the level of those tariffs will be and how long they’ll last. It seems certain though, that they are not just being used as a negotiating tactic and that we will see a higher effective tariff rate. Fortunately, we have the tools to model the impact on inflation, interest rates and economic growth depending upon the policy outcome.
If the most dramatic tariffs are implemented we can expect inflation to be at least .5% higher while economic growth could be haircut by .5% to 1.0%. This would result in slightly higher interest rates and lower corporate earnings growth, reducing stock values. We’ve been noting that large cap growth stocks have done very well and extended their rallies. We view the decline in prices to be favorable given the very positive long-term outlook for tech growth.
Bond Markets
Bond price volatility has also increased during the the first quarter of 2025, however, bonds are showing better performance versus stocks. The yield on the 10-year Treasury has declined from a high of 4.80% to a low of 4.15% and now stands at 4.25%. This rally in interest rates has extended across most maturities, driven by investors seeking the safety of fixed income investments, and attracted by their current real rates of return. The yield fall has left bond portfolios with positive returns this year.
While the discussion of tariffs has been about the potential to increase inflation, bond investors seem to be more focused on the potential for a decline in economic growth which is why yields have fallen and bond prices have rallied.
Credit spreads (the difference between corporate bond yields and Treasuries), although slightly wider than their recent lows, remain resilient as investors pursue the additional income they offer. In contrast to 2024, higher-quality investment-grade corporates have outperformed high-yield bonds year-to-date. With yields around 5%, the demand for fixed income is likely to persist, as these elevated starting yields provide both stability and current income. It is interesting to note that while stock investors have pushed prices down, due to concerns about earnings, bond investors believe that corporations have strong balance sheets and are able to make interest payments.
Our Fixed Income portfolios generally have an average maturity that is aligned with our benchmark, which means interest rate sensitivity is about the same and less than 5 years. We have a diversified income stream coming from different bond market sectors. Year-to-date, the bond portfolios have benefitted from the addition of these other sectors and our outside managers’ active management. Bond benchmarks have generally returned over 2% for the year.
Stock Markets
Equities have also experienced heightened volatility at the start of 2025, with domestic markets largely surrendering their gains since the President’s election in November. Investors are recalibrating their near-term growth outlook amid uncertainty surrounding tariffs and their potential impact on the economy and corporate earnings.
Investors are worried that prolonged tariff uncertainty could lead to reduced corporate investment and hiring, potentially triggering an economic contraction. This could lead to higher unemployment and lower consumer spending. The tech sector has been particularly impacted, as its high valuations entering the year were based on strong earnings optimism which has now called into question. As long as Federal policy uncertainty remains as high as it is, stock valuations could remain muted.
Equity portfolios that are diversified through a global investment mandate, can have as much as 28% allocated to international stocks. As foreign markets have rallied, this has helped cushion those stock portfolios from the worst of the domestic selloff. International stocks, as measured by the MSCI All-Country World Index, have rallied to start the year, returning more than 9.0%, compared to the S&P 500’s almost 2% year-to-date decline. Stock portfolios underweight large cap growth stocks, technology stocks in particular, have faired better than the broad market.
Taken together, a balanced portfolio between with these characteristics has a slightly positive return year-to-date. This reflects the benefit of the diversified approach.
We understand that this volatility and the uncertainty surrounding the current Administration’s future policies makes for an emotional environment. We want to stay focused on our diverse approach, the long-term secular themes we believe generate growth and look for opportunity as this tough tariff talk continues.
If you have any questions, don’t hesitate to reach out to your Merit financial advisor for personalized guidance.
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