January 2025 brought with it plenty of changes in the economy and financial markets. The second Trump administration was inaugurated with a flurry of proposals aimed at sweeping changes to trade, immigration, fiscal and foreign policy. The U.S. economy, which has not posted real quarterly growth less than 2.4% since 3Q22 showed obvious signs of slowing. American consumers, the seemingly irrepressible engine of global growth, reported in survey after surveying their optimism for the future was faltering. After five consecutive quarters of gains (4Q23 through 4Q24) that aggregated to a 39.6% total return, the S&P 500 finally lost momentum and turned in a down quarter. More surprising, the MSCI Europe Large Cap Index outperformed the S&P 500 by more than ten percentage points in the quarter. The Magnificent 7 which seemed Teflon coated when it reached an all-time high in mid-December 2024 subsequently fell more than 20% to end the first quarter in bear market territory. While the yield on the 10-year U.S. Treasury Note fell over the quarter, the yield on March 31 of 4.23% was the highest for that instrument to end a first quarter since 2007. What does it all mean? We will venture some answers on the following pages.

1Q25 Economic Review

Economic trends and developments over the first quarter pointed to a stable but cooling economy. Manufacturing appeared as if it was on the verge of a recovery, but that trend faded as the quarter progressed. Services started strong but weakened by March. Services is one of our economic bellwethers as the sector accounts for around 70% of all U.S. wages. The labor market remained stable with job creation staying just ahead of labor force growth, initial unemployment claims were flat. Personal income growth was solid, and consumer spending recovered following a brief hangover after the holidays. Inflation remained sticky and that prompted the Fed to hold the line on further cuts to its target rate. Growth slowed late in the quarter as concerns over trade policy changes from the Trump administration boosted uncertainty and delayed corporate and consumer decisions, spending, and investment.

1Q25 Financial Markets Review

Financial markets discounted concerns about policy, slowing growth and sticky inflation as the quarter progressed. Equities retreated on skepticism about overly optimistic earnings growth and rich valuations. The Magnificent 7 and information technology exposed equities suffered the most as more investors focused on a possible peak in Artificial Intelligence (AI) capex and return on AI investment after China’s DeepSeek model was revealed. Long-suffering international equity markets rallied as fiscal stimulus in Germany and China held out the promise of improved growth and the possibility of finally being a viable investment alternative to the U.S. Even before the initiation of the trade war we were skeptical this trend would be enduring.

Bond yields rallied early in the quarter as it became apparent that inflation would not fade rapidly, and the Fed would be forced to pause its campaign to ease monetary policy. Yields eased late in the quarter as growth concerns came to the fore. Credit spreads widened modestly over the quarter but did not indicate that credit investors were overly concerned about the chance of recession.

Outlook for the remainder of 2025

We are not quite to having a recession as our base case for 2025, but we are quickly approaching that point. Trump administration trade policy has thrown the global economy and financial markets into turmoil. Unless there is substantial reversal in trade policy, recession will be difficult to avoid. Our base case is that the U.S. real GDP for 2025 will come in somewhere between (1.0) % and 0.5%. Uncomfortable but not catastrophic. The trade war on its own would be unlikely to cause a deep or long recession. Knock on impacts could lead to a more serious downturn and that is our current bear case.

Financial markets are likely to remain volatile throughout the year barring a negotiated end to the trade war which revives hopes for stronger profit growth and financial system stability. We see the S&P 500 trading in a range from 4500 to 5500 with risks weighted moderately to the downside. Interest rates are likely to remain volatile too, with the 10-year U.S. Treasury yield varying between 3.5% and 5.0%. We are maintaining our neutral asset allocation which currently calls for a 60% equity/40% fixed income split for clients on our balanced allocation model.

We are not proponents of market., We believe exceedingly few investors have durable market timing capabilities, even the ones who have generated the best long-term returns. The 50-year compound total return on the S&P 500 through December 31, 2024, is 12.4%. That figure is inclusive of numerous corrections and bear markets over that period. It is an often-uncomfortable truth that generating attractive equity returns over time requires consistency and endurance rather than timing. We will remain vigilant for economic and market developments that would suggest we should become more conservative or more aggressive in our asset allocation.

Trade Policy Concerns

As feared by many, President Trump announced on April 2^nd, Liberation Day, sweeping new tariffs on most U.S. goods imports. While Trump’s use of tariffs cannot be surprising given his consistent statements in favor of them, the size and scope of the tariffs were a surprise to most. Tariffs are another name for taxes on the consumption of foreign made goods. The cost of tariffs is borne by exporters, and U.S. companies and consumers who benefit from trade. The Liberation Day tariffs include 10% on nearly all imports plus additional “reciprocal’ tariffs on most of our largest trading partners. The Liberation Day tariffs are in addition to tariffs already put in place on imports from China, on imported automobiles, steel, and aluminum products and on most USMCA non-compliant imports from Mexico and Canada. All in, the Trump 2.0 tariffs take the overall tariff rate to approximately 20% or 10 times where they stood when 2025 began.

While Trump and his trade team refer to unfair trade practices among America’s trading partners as the primary driver of tariff strategy, there are multiple factors at work. The Trump 2.0 tariffs, if they remain in place, could produce around $600 billion in annual revenue for the U.S. Treasury. Some observers have taken this to mean Trump views tariffs as a consumption tax or an alternative to raising personal income or corporate taxes to reduce the budget deficit. Others assume he will use tariff revenue as a way to offset the continuation of soon to expire tax cuts from his first term and perhaps implementation of additional cuts. Some, including some of Trump’s economic advisors say the tariffs are in part a way to rebalance the distribution of income and wealth in the U.S. between capital and labor or between the top 10% of the income distribution and the bottom 90%. In that way of thinking, a bear market in equities and even a short recession are not undesirable outcomes.

Regardless of the reasoning behind the tariffs, few would argue that the latest round was not surprisingly large and haphazardly conceived and initiated. Despite Trump’s aggressive rhetoric, many assumed this round of import duties would be only marginally larger than those enacted in his first administration and largely maintained by Biden. Instead, we have the highest blended tariff rates in the U.S. since early in the 20^th century. The roll out of the Liberation Day tariffs was handled poorly. The calculation of the reciprocal tariffs was based on a faultily applied formula that exaggerated their magnitude. Some of the of the largest levies target poor countries that export low value items to the U.S. and lack the economic wherewithal to buy substantially more of our exports.

While rebalancing global trade to terms fairer and more favorable to America is a worthy goal, the current round of tariffs appears overly focused instead on reducing our trade deficit. A certain portion of the trade deficit is undoubtedly due to unfair practices by our trading partners. It is also true, however, that a sizable portion of the trade deficit stems from internal economic flaws. Mechanically, the trade deficit stems from a large lack of domestic saving relative to domestic investment. This imbalance means we as a nation must import capital from abroad to fill the gap. That imported capital leads to a capital surplus that is the mirror image of the trade deficit. One way to materially induce domestic saving would be to reduce the federal budget deficit, the primary source of our dissaving. Federal debt and deficit spending have been viewed as serious issues for more than forty years and, except for a few years in the late 1990s, the problem has only worsened.

There is no denying that unfair trade practices have cost American manufacturing jobs and drawn investment and employment away from our shores. Certainly, China has been a bad actor in international trade for at least a couple of decades in its rise to become manufacturer for the world. It is fair to question, though, whether the tariffs will succeed in bringing a material number of manufacturing jobs to the U.S. In fact, it should be noted that manufacturing production in the U.S. is near all-time highs. Manufacturing employment has suffered as our factories have gotten more productive and the focus has shifted to higher value products and processes that often require fewer employees. Would bringing low value manufacturing like textiles and some industrial components back to the U.S. really be beneficial? New factories take years to plan, permit and build. These factories would also likely depend more on automation so while jobs would be created, the number would be unlikely to match the amount of American manufacturing jobs lost over the past few decades. Additionally, the most recent job openings report from the Bureau of Labor Statistics shows that the U.S., at the of February, had 482,000 manufacturing job openings.

What will the impact of the new tariffs be if they remain in force? They will certainly slow the economy as supply chains are reconfigured and costs for imported goods rise. The best estimation is the tariffs would represent a 1.5% to 2.0% hit to GDP growth in the first year. With most estimates for GDP growth in the 1.5% to 2.0% range coming into 2025 it is fair to say chances for a recession this year have risen toward 50% if not higher. While the tariffs are unlikely to spark an enduring rise in inflation, there would be a significant one-time jump in prices for imported goods and their substitutes as supply chains rebalance. Inflation stands little chance of getting down to the Fed’s 2.0% target in the next twelve months and could go above 4.0% for a while. This sounds like the perfect recipe for stagflation or rising prices accompanied by anemic at best economic growth. The Fed has historically come to the rescue of the economy and financial markets by cutting interest rates and providing liquidity but will likely be more cautious in this circumstance given inflation is already above target and likely to rise further. Absent serious dislocation and freezing up of financial markets, we expect the Fed to stay on the sidelines for some period while they try to gauge potential outcomes.

This cycle of doom and gloom is driving the ongoing significant dislocation in financial markets. The bigger long-term question is whether the tariffs drive material retaliation from our trading partners and whether they degrade America’s reputation as a solid and fair-minded economic ally. It is not clear how things play out, but the potential long-term reputational damage is clearly a bigger threat than a few quarters of negative GDP. Rapidly rising yields on U.S. Treasury securities and a materially weaker dollar are signs to watch for a potential loss of confidence in the U.S. Given that the U.S. Treasury market is the deepest and most liquid in the world by a wide margin, it would be exceedingly difficult for the rest of the world to quit Treasuries cold turkey.

Despite this litany of legitimate worries, I do not think it is wise to get too carried away with doom and gloom. Even with the reputational hit the nation is facing, America in many ways will remain indispensable to much of the rest of the world. Our economy accounts for approximately 25% of global GDP. Our consumption expenditures account for 25% to 30% of global consumption. There is no substitute that could fill this hole. China and European Union cannot just say “Who needs the U.S.? We will just trade with each other.” Trade for China and Germany, especially, makes up a far greater percentage of GDP than it does for the U.S. and those economies are likely to face more pain than the U.S. Additionally, while our allies may not like us as much, they cannot afford to exit our security umbrella. While Germany has committed to spend billions of incremental dollars on national defense and much of NATO seems likely to follow, western democracies simply cannot fully turn their backs on the U.S. from either and economic or security perspective for years to come.

Are there so-called off-ramps from the aggressive new trade policy?  Just prior to publication, Trump blinked and paused for 90 days reciprocal tariffs on most countries beyond the blanket 10% rate. .  At the same time he further increased tariffs on China such that the trade-weighted level of tariffs rose slightly. This development provides the opportunity for trade deals to be struck that reduce foreign barriers and allow the new tariffs to decline to more manageable levels. Legal challenges to the tariffs could at least temporarily reverse their implementation. Congress could take back the President’s authority to implement tariffs or refuse to cooperate on essential legislation like the budget, taxes and the debt ceiling unless the tariffs are rolled back. This would require substantial GOP cooperation which seems unlikely at best unless things get much worse economically or financial markets enter freefall. In short, we anticipate that economic and market pain and uncertainty will likely have to worsen before we would see a broad pullback on tariffs.

While we are likely in for a period of painful economic adjustment and financial market volatility, this is not a time to abandon discipline. We have bolstered our equity portfolios by adding higher quality, more defensive stocks and reducing some of our heavily trade-exposed positions.

We will watch for the development of additional risks which could suggest more defensive moves. We will equally search for opportunities to pursue attractively priced new investments that are being unfairly punished during the current turmoil. We appreciate your trust, and we will continually strive to earn your business.

Kurt Funderburg
Chief Investment Officer