Tariff Volatility

The U.S government’s announcement last Wednesday evening of larger-than-expected reciprocal tariffs on all trade partners kicked off a swift and violent reaction across global capital markets. As of this writing, the S&P 500 is down ~12% YTD and is now ~16% below its February high. Developed international markets have fared slightly better, with a 9-11% decline depending on the region. Emerging markets have been the relative outperformers, with a 6% decline, but volatility is high, and prices are changing quickly.

We’re still in the early innings of the tariff shock and have no material insight into how negotiations will unfold with the U.S.’s major trading partners. However, it is noteworthy that the Trump administration appears steadfast in their current policies and has been, at least in recent communication, unfazed by the stock market’s reaction. It’s possible the administration’s muted response to equity market weakness stems from their desire to see reductions in the 10-year U.S. Treasury yield, which has declined 60 basis points to 4.2%, and in the price of oil, which has fallen ~24% from its January high.

Markets Behaving Rationally

Despite the political rhetoric and geopolitical anxiety, capital markets are largely behaving in a manner consistent with prior such episodes.  As with any significant unexpected announcement, uncertainty rises, and market volatility correspondingly increases.  Further, greater uncertainty leads investors to increase discount rates for riskier assets, prompting many to sell rapidly rather than wait for a clearer picture of future business fundamentals.

• U.S. Treasury securities, still perceived as a relative safe haven, rose sharply, causing yields to decline.
• High yield corporate bond spreads spiked from ~280 basis points to ~430 basis points, reflecting an increased possibility of recession and broader financial distress among these weaker and more highly levered companies.
• Traditional defensive sectors (e.g., consumer staples and utilities), perceived as more recession-proof than consumer discretionary companies, performed relatively better.

In sum, capital markets are behaving as one would expect given the unexpected size of the tariff surprise and as investors assess a new economic reality that has widened the scope of potential negative outcomes for the global economy and increased the odds of a recession.

We have continued to note that U.S. equities have been trading at historically rich multiples, and while elevated valuations have never been a catalyst for a market correction, they typically exacerbate downside moves when an unforeseen event reverses investor sentiment. 

We are likely experiencing such an event. Recent price declines have lowered the S&P 500 forward P/E multiple to 19.4x; however, this is still above the 10-year average of 18.3x and assumes that aggregate first quarter earnings are set to grow 7%. These estimates will likely be challenging to attain if the current tariff landscape persists. Until there is further clarity on trade policies, we expect price volatility to remain elevated, likely in both directions.  Valuations remain elevated relative to historical norms – hardly a positive signal for those looking to ‘buy the dip,’ but not necessarily a clear catalyst for further declines either.  We continue to recommend that investors maintain a cautious stance as we work through upcoming economic weakness that appears increasingly likely to lead to some form of economic recession amid ongoing uncertainty and market volatility tied to tariff policies.

What We Are Doing

• We have high transparency into our underlying portfolios and have been monitoring price movements closely. As with any volatile period, we are increasing our touch points with managers to understand any exposure or position changes. Our focus remains on the financial underpinnings of our underlying positions.
• We, and our managers, will be monitoring first quarter earnings reports closely as these will provide commentary on the impact of tariffs on supply chains and a preliminary look into company financial forecasts to assess any dampening of customer demand.
• Market volatility can also create opportunities and open capacity at interesting managers who have been closed to new capital. We are canvassing our network to source any opportunities to upgrade our portfolio.
• For clients with tax-managed equity exposure, recent market volatility has provided ample opportunity for tax loss harvesting. Adding new cash to these investments allows for dollar cost averaging of this exposure while recharging loss harvesting potential from these allocations.

What Our Managers Are Doing

• The highest priority for our managers has been to re-underwrite each of their positions based on the updated tariff schedule to understand the immediate financial impact on each underlying business. The more complicated issue for our managers is evaluating the impact of a potential recession.
• Panic selling typically results in the proverbial “throwing out the baby with the bathwater”, and our managers are re-engaging with their investment pipelines to potentially “high-grade” their portfolios with companies that are now trading at more attractive valuations.

Concluding Remarks

While periods of volatility can be uncomfortable, they are a natural part of long-term investing and now is a time for calm and balance. Our intention is to respond to real impacts rather than to each headline. We, along with our managers, will continue assessing the impact of the changing tariff regime on a fundamental level, and we will rely on deep research and analysis to act if, and when, appropriate. Importantly, while the current environment presents challenges, it also creates opportunities for our existing managers to upgrade their portfolios and may open new capacity with previously closed managers.