Longer Days, Shorter Patience

Amid all of the other market-moving news, we continue to focus on U.S. economic data for clues about the next move from the Federal Reserve. This week, all eyes were on the inflation data as the Personal Consumption Expenditure (PCE) index — the Fed’s preferred measure of inflation — was released. In a bit of good news, and consistent with our own forecast, we continue to see inflation drifting lower toward the Fed’s 2% target. We have reiterated our view that this journey would be uneven, bumpy and unpredictable, and it certainly has been, but we are continuing to see that the direction of travel is south. The PCE rose 0.28% for the month to a year-on-year core inflation rate of 2.6% — its slowest pace since March, 2021.

While the Federal Open Market Committee will likely be heartened by the trend in inflation, there were other elements of the data release that may garner even more attention. Monthly income growth was significantly higher than estimates, but there was a notable downside surprise in spending. Real consumption (adjusted for inflation) fell in January, and may provide yet another signal that demand is ebbing. Recall the relatively weak retail sales data from a few weeks ago: Since then, we have seen more signs of a growth slowdown, including the flash Services PMI report, which indicated a service sector contraction.

Our view remains a soft economic landing and a cooperating inflation trend, both of which support the Fed continuing to cut the policy rate later this year. We continue to expect two cuts in 2025 — or potentially three. Importantly, our view has been that the Fed will cut rates because they can and not because they must, and this is an important distinction for investors. If the Fed must cut rates, it would be a function of a more acute slowdown in economic activity, which would raise recession fears. That would be perceived as unequivocally bad news for U.S. equity markets. We are watching the growth outlook carefully and, while we remain constructive under the view that U.S. growth will settle in the 2.0% to 2.5% range in 2025, we are also mindful that there is quite a bit of uncertainty around that forecast.

There have been several “reversal-of-fortune” trends apparent on the global equity landscape. Most prominently, non-U.S. stocks generally have continued to outperform the broad U.S. benchmarks. As of market close on February 27, the developed ex-U.S. benchmark has gained 2.76% in February and advanced over 8% year-to-date, while the emerging markets benchmark gained nearly 3% in February and 4.8% year-to-date. Both benchmarks have roundly outperformed the S&P 500 index, which lost over 2.8% this month and has returned a fractional loss year-to-date. The obvious drivers of positive relative performance of non-U.S. equities include relatively undervalued regions, poor investor sentiment, which has been depressed for quite some time, and underweight investor positioning. As consistent advocates for a globally diversified portfolio, we continue to see attractive return opportunities and growing diversification benefits for U.S. investors willing to hold non-U.S. exposure.

Within the U.S. market, there have also been some trend reversals. We see this most notably in the relatively weak MAG7, which has led the underperformance of large-cap technology stocks: This was best reflected in the NASDAQ’s decline of 5.5% and 3.9% for the month and year-to-date, respectively. Accentuating the positive, we proffer that the broadening of market participation beyond the MAG7 is actually a very healthy sign: Confidence in market advances tends to build with a broadening base and a more stable and solid foundation. Many investors have been concerned about market concentration, worrying that a hiccup in market leadership would lead to a broader market downturn. However, we have seen the opposite: The equal-weighted S&P 500 is up roughly 1.7% year-to-date, in contrast to the capitalization-weighted index’s fractional loss. Not surprisingly, we have also seen a trend reversal in growth stocks outperforming value stocks, with large-cap value now solidly in the lead with a 3.65% advance year-to-date, presenting nearly a mirror image to large-cap growth’s loss of 3.4%. Again, this argues strongly for maintaining a diversified portfolio. Lastly, small-cap stocks continue to underperform their large-cap brethren for both the month and the year. We had been confident that better relative performance would play out for small caps in 2025, but so far, we see the strong headwinds of a potential growth slowdown more than offsetting the impact of a meaningful decline in interest rates, which is so important to Russell 2000 index constituents.

Tariff uncertainty has been weighing on investors, companies and economies over the last month. Barring any last-minute pivots, scheduled tariffs of 25% are set to go into effect for Mexico and Canada next week, along with an additional 10% increase in duties for China. These would accompany a 25% tariff on steel and aluminum scheduled to begin March 12. 

Although we’ve witnessed the “escalate-to-deescalate” tactic used in negotiations with Canada and Mexico, a 10% increase on Chinese duties went into effect this month. In our U.S. Economist Ryan Boyle’s recent paper, The Return of Steel and Aluminum Tariffs, he notes that, unlike tariffs targeting a single nation, the March 12 metal tariffs are more likely to be enacted, as they are intended to bring about lasting change — the president declared “no exceptions” when the tariffs were announced.

If next week’s tariff are enacted, along with the metal tariffs the following week, the impact on Canada and Mexico could be significant — with Canada being the largest supplier of steel to the U.S., totaling roughly 25% of U.S. imports, and Mexico its third largest supplier. Similarly, Canada represents roughly 40% of all U.S. aluminum imports.

The full economic impact of proposed tariffs remains to be seen. This is an evolving and ongoing topic, with expectations that, broadly, the administration will gradually increase tariffs in an attempt to leave room for negotiations.

Our guidance, outlined below, assumes a heightened level of uncertainty that will drive more volatility across both equity and bond markets.

First, despite the volatility we’ve seen in equities so far this year, it’s important to remember that 2025 follows two years of extraordinary global equity performance that were driven in particular by the exceptional performance of U.S. equities. It is possible that your overall portfolio is currently overweight to risk and may be more significantly overweighted to U.S. equities. Now is the time to ensure that your asset allocation remains goal-aligned and diversified. Second, many of the policies being discussed today are potential drivers of inflation. We continue to recommend inflation protection for portfolios, and this can be accomplished through the use of Treasury Inflation Protected Securities (TIPS). We recommend that you talk to your advisor about how to implement TIPS in your portfolio. And last, given the higher level of uncertainty and the likelihood of more market volatility ahead, we continue to recommend that investors ensure proper funding of their portfolio reserves. Remember, this is the part of your portfolio designed to fund your goals during times of market uncertainty. It can be used as a buffer against the perils of the common investor pitfall of selling equities in periods of distress.