Market Commentary

Caught in the Crosshairs

By Rob Sigler, MBA

April 30, 2025

The U.S. economy finds itself in the unenviable situation of facing threats to growth from every angle.  Policy uncertainty is as high as it was during the early part of the pandemic.  Consumer confidence has fallen to levels below the 2008 Great Financial Crisis.

 

Nearly 70% of Americans believe that unemployment will be higher in 12 months.  As a result, most are worried about job security.

 

Meanwhile, businesses are rapidly recalibrating their outlook to match this reality.  They are slashing their earnings outlooks.

 

They are slowing new orders of parts and equipment.

 

And they are revising down their corporate capital expenditure plans.

With that ominous backdrop, in this essay we explore what likely comes next, why those who are worried about inflation are paying attention to the wrong concern, and why it is important to understand that the economy and the stock market are not the same thing.

We contend that the economy is slowing to stall speed at present, and if we remain on our present course, a recessionary outcome is likely.  Consumer spending behavior is quite predictable.  Individuals make consumption decisions based on their income and wealth.  When they become concerned about job security, they consume less.  When stores of wealth, like homes or stock and bond portfolios fall in value, they consume less.  While retail sales have remained solid to date, we argue that is likely an illusion of strength.  More probably, it represents a distortion as individuals front-end load purchases in advance of anticipated tariffs.  For example, if you needed to replace an aging automobile, you may have done so recently to avoid a potentially higher price in the future.  That said, when we look at truly discretionary purchases (like airline bookings, leisure hotels, restaurants reservations, etc.), we are seeing real-time damage.  People are canceling trips, eating out less, and hunkering down.  Traditionally, when the Fed sees this type of behavior, they spring into action, lowering interest rates.  Unfortunately, unable to predict what tariffs are going mean for price stability, they are erring on the side of inactivity to make sure that they keep inflation expectations anchored.  We think that means they will be late to stimulate the economy.

What do we think will happen next?  The consensus opinion right now is that we are going to encounter stagflation, a particularly insidious event where the economy stagnates, and inflation accelerates.  We disagree.  The only times that our nation experienced stagflation accompanied oil shocks.  The first occurred in 1973 when OAPEC (Organization of Arab Petroleum Exporting Countries) implemented an oil embargo against countries that supported Israel in the Yom Kippur War.  The result was a 300% rise in the price of oil.  The second episode was brought on by the confluence of the 1979 Iranian Revolution, an Iranian oil worker strike, and the subsequent Iran-Iraq War that initiated in 1980.  The net effect was a 10% reduction in global oil supply and a doubling of oil prices in a year.  The argument being voiced today is that tariffs are also an exogenous shock, much like oil’s dramatic rise was in the 1970-80s.  Here is where we differ.  It is imperative to understand that goods and services have varying degrees of demand elasticity.  What does that mean?  Price elasticity of demand is a measurement of how demand changes in response to changes in prices.  Goods that are highly elastic see demand fall sharply in response to higher prices, while goods that are inelastic see demand hold steady.  A good becomes more elastic when there are readily available substitutes, when it is a nice to have item, not a necessity, and when consumers have more time to react.  Oil (and gasoline by proxy) in the 1970s and 1980s was a very inelastic good.  It was not substitutable.  It was used in necessity applications like power generation and transportation.  Additionally, the price changes arrived as a bolt from the blue with no time to prepare.  Furthermore, gasoline represented a very significant proportion, 8%, of the average consumer’s discretionary wallet in 1980.  Faced with a doubling of prices, consumers tried to change their behavior by conserving on automobile trips, carpooling, and canceling driving vacations, but the effect was largely unavoidable.  With gasoline eating up a larger proportion of spend, other items in the consumption basket had to be sacrificed.

How is the episode similar, yet different?  Admittedly, the magnitude of tariffs and the breadth with which they are being applied, bears a strong resemblance to a shock.  That said, unlike the past oil shocks, many of these tariffs can be navigated or avoided.  As consumers, we have little wiggle room on necessities like power, home heating, and transportation.  The good news however is that the U.S. is now largely energy independent.  And in fact, oil and gasoline prices have fallen sharply in the past three months.  Other must-have categories like housing and basic foodstuffs are also relatively immune.  While imported seafood from Japan, or vegetables from Mexico might be more expensive, you will likely find that prices have fallen for chicken, pork, and grains based on less demand from China.  In other words, you have substitution options.  Meanwhile, on most other goods and services, consumers will respond to high prices the way they customarily do.  They will consume less, substitute for cheaper goods, and/or delay purchases altogether.  Bottom line, we believe the old economic adage that high prices are the cure for high prices is just as valid today as it was in the past.  Please don’t misunderstand.  This is still bad news for the economy.  Demand is going to slow, and we will probably enter a cyclical recession.  However, unlike consensus belief, we are unlikely to have a persistent inflation problem.

Why is that distinction important?  It means that the Federal Reserve will ultimately arrive at the conclusion that they don’t need to worry about price stability.  In other words, they will figure out that they aren’t handcuffed.  They will deploy the same playbook they always do to end cyclical recessions.  The Fed will ride to the rescue by lowering interest rates.  That eventually will make financing things like cars, homes, and other durable goods attractive once again.  That will stimulate consumers to buy things and ultimately demand will rebound.  Companies will respond by reinstituting capital expenditure programs and by employing more people.  A virtuous circle will begin anew.

Now, let’s turn to the turret to markets.  This will be difficult to reconcile, but the economy and the market seldom work in synchrony.  The market anticipates the future.  For example, we aren’t in recession presently, yet the market is experiencing severe volatility.  Whether they realize it or not, investors are collectively embedding in a higher chance of recession as they sell stocks.  Price levels reset based on fear of what may happen to earnings.  However, in similar fashion, the market tends to improve well ahead of the turn in the data.  To wit, the stock market is generally up 12%, 1 year from the start of the recession.  Read that carefully.  I didn’t say it is up 12 months from the end of a recession.  The market predicts the future.

What could cause investors to shift their thinking to optimism?  First, it is highly likely that we will start to see some trade deals.  Why?  The “father of economics,” Adam Smith described it best way back in 1776.  He theorized that individuals (or in this case, nations) following their own self-interest, will arrive at beneficial outcomes for society as a whole (something now simply referred to as the “invisible hand”).  Let’s use Japan as an example.  Japan’s exports to the U.S. represent 5% of their entire GDP.  By contrast, our exports to Japan represent 0.004% of our GDP.  In other words, we can afford to lose Japan.  They cannot afford to lose us.  It is in their best interest to make a deal.  By the same token, President Trump needs to stockpile some wins to bolster his standing.  His approval rating in multiple surveys hovers between 39% to 45% (CNN, CNBC, ABC, CBS, Gallup).  That is the lowest for any newly elected president in more than seven decades.  Over 70% of Americans disapprove of his handling of the economy (Washington Post-ABC News-Ipsos).  He needs some positive momentum to keep his power base, and more importantly, he desperately needs to buttress his negotiating hand versus China.  Are nations ready to deal?  Multiple Southeast Asian countries (Vietnam, Taiwan, and Cambodia) have all offered zero for zero tariff deals.  The EU has offered zero for zero trade tariffs on industrials and autos.  India, Japan, and Korea all have delegations that are meeting with the Treasury Department.  It seems likely that we will get some favorable announcements.  Second, as deals get completed, consumer expectations on pricing will start to settle down.  Investors will realize that we don’t have a runaway inflation threat.  They will conclude that the Fed will bail us out of this hole with lower interest rates.  Thus, don’t be surprised to see markets rally well ahead of the recovery in the economy.

It is for these reasons that we believe it is prudent to stay the course on equities.  While there could be volatility ahead, we have line of sight on what could improve the situation.  Our purposeful diversification across domestic, international, and emerging equities is yielding better relative performance than those solely exposed to the U.S.  We think that will continue.  Meanwhile, our bond portfolios have offered a nice port from the storm, producing positive year to date returns.  If we are correct on our inflation outlook, we believe this could accelerate when the Federal Reserve starts lowering interest rates in earnest.  Finally, our call to overweight uncorrelated diversifiers in the form of alternatives like private infrastructure, triple net real estate, distressed debt, asset backed securities, and private equity stands.  We believe the return potential of these instruments remains compelling and offers stability against uncertainty in other asset classes.

We welcome your questions.

 

 

About the Author