On the one hand we have the “transitory” market, where earnings have held up and the economic data has been reasonably strong. So far, we have defied the expectations of higher inflation and slower growth that some economists expected post the changes in trade policy. In this scenario, the disruptive effects of fluid trade and tax regimes are short lived, and the economy and labor markets are strong enough to overcome dislocations.
On the other hand, we also have a market people fear is whistling past the graveyard, ignoring the problems that are on the horizon and vulnerable to a lagged effect of policy change that could come with some real pain points for both the economy and investors. The tough, and as of yet, unanswered questions on tariffs include the potential impact on margins, the risk of higher prices to consumer spending and the risk to global growth that could stop equities from their recent march upward.
How these two potential market vectors play out is unknown, and the recent action in the Middle East only adds to the variables for investors.
In theory, the ultimate driver of equities is earnings, and while earnings and the economy are correlated, it’s not always as linear as we would expect. The rolling sector slowdowns we had after the Covid pandemic were eclipsed by the resilient technology stocks, and this year technology stocks are doing some of the heavy lifting for market earnings without reaping the same price action rewards they have in the past two years.
When the Federal Reserve was raising rates into 2023 there was much discussion about long and variable lags, and that seems to have been rekindled with the recent changes in trade policies. Will the impact start to be clear in the data? The increase in imports prior to the tariff changes was clear, but inflation numbers still do not reflect higher prices due to higher tariffs.
Earnings have been better than expected, especially on the technology front, and that story has subsumed the concerns about companies in other sectors withdrawing guidance. It is clear that lower-end consumers are having a difficult time, but spending and wages seem to be reasonably good. That, coupled with the labor market holding up, has been good enough to keep equities moving higher, or at least was good enough for equities to recover losses seen in April. We are back to where we started the year on the index levels. You could be forgiven for missing the sharp drawdown in April that was very close to a technical bear market.
As we look towards the second half of the year, there are still potential storm clouds on the horizon. The dizzying movement of both tariff levels and timing make it tough to parse what has actually been affected vs what will be affected, and economists and Wall street analysts are always looking for immediate gratification in data, even if real world effects can take longer to play out.
Do we get a surge in inflation as businesses try to hold onto high margins by passing on costs to consumers? Do we get a pullback in spending because collectively we bought things ahead of the changes and therefore borrowed activity from the future? Or has there been enough positive economic activity that companies can weather the storm and continue to put up good earnings, easing the fears of the bears that have been run over in this equity market recovery?
These are some of the questions investors have to grapple with. The future of Federal Reserve Policy is also a major question, and with inflation looking a little better, the calls for the Federal Reserve to cut rates have gotten a bit louder.
The recent moves in the Middle East threaten to throw all of this into the background however, as one of the reasons inflation has been moderating is lower energy prices. While it is too soon to predict the length and depth of this conflict, it could have a tipping point effect on markets if energy prices move meaningfully higher, compounding the concerns about higher corporate costs.
The global world order started to shift even before Covid, and that shift has accelerated. The move away from global supply chains to onshoring and friend-shoring had already begun, and it is now accelerating. The dislocation and potential increase in costs is coming, the question will be how long it lasts and to what extent moving production and procurement creates a higher long term cost profile for companies based in the US. This can also have a direct impact on earnings depending on the ability to push prices higher commensurate with the potentially higher cost structure.
What is a higher cost to some may also come as higher revenues for companies that supply equipment, materials and services to corporations re-shoring production, so it is not a one-way street as corporations change their behavior, and some companies’ earnings may benefit from this shift.
We see the growth in capex continuing on the technology and AI (Artificial Intelligence) front. The demand for electricity and ancillary services that data centers and cloud expansion require is also a positive earnings driver and it has helped S&P 500 earnings advance even with all of the other uncertainties investors face.
The labor market seems to be holding up and this is a key component for the economy and the Federal Reserve. Anecdotal evidence points to potential softness with some larger corporations, even in the tech space, making announcements about layoffs. With inflation looking a little more tame, this could get the Federal Reserve to cut rates if labor markets start to weaken. The concern about inflation accelerating because of tariff issues likely keeps the Fed on the sidelines for now with monetary policy.
Investor expectations on the political front are also part of the backdrop for 2025 and into 2026 as there is a bill to be passed to stave off a financial deadlock that would raise the debt ceiling. If this runs into opposition, it could be a negative for equity markets. Additionally, deregulation and the potential for more M&A that could result is another one of the positives that has been driving markets, and that is another point of risk should it not materialize.
We are thinking about the current Middle East situation as the most disruptive near term risk, as a spike in oil prices or a contraction in oil exports if there are transportation problems is a risk that was not on the radar screen until it happened and has the potential to be very disruptive to global energy prices.
Quality as a factor has not fared as well in 2025, and while we can appreciate that risk tolerance sometimes comes with the outperformance of riskier stocks, we continue to favor quality balance sheets and cash flows in an uncertain environment.
The views expressed are those of the Alpine Saxon Woods, LLC management team as of the date indicated, and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Performance data quoted represents past performance and does not guarantee future results. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
