Dissecting This Week’s Market Correction

In line with consensus forecasts, we have lowered our growth expectations for GDP this year, reflecting some notable developments over the past few weeks. First, it is more apparent today that the Trump administration will likely enact more sizable tariffs than previously expected, with some estimating that the average tariff rate may rise from an average of roughly 2% to as high as 10%. Tariffs act as a tax and a growth headwind. Second, there is an increased emphasis on cost savings through the Department of Government Efficiency (DOGE), which acts effectively as fiscal tightening, creating an additional growth headwind. Third, the overall sense of uncertainty is increasingly being reflected in falling business confidence, as both large and small businesses have put plans to hire and invest on hold pending more clarity on policy. The longer the uncertainty prevails, the more likely it is that weaker sentiment will translate into reduced activity — yet another growth headwind. And last, we are starting to see signs of a growth slowdown in the economic data, with growth trending to below 2%, which is slightly less than potential.

Although the first half of 2025 may prove challenging from a growth perspective, given the high levels of uncertainty we noted and a seemingly higher tolerance in Washington for a growth air-pocket, we maintain that the U.S. will avoid a recession this year.

The unfortunate answer to that question is "it’s complicated." Tariffs are taxes on imported goods and can directly increase the costs for households and businesses that consume them. The magnitude of price increases depends on several factors, including whether the businesses importing goods intend to fully pass on tariff-related price increases to consumers or choose to absorb them by decreasing their own profit margins. It also depends on the reactions of the exporter. For example, will they lower the price of goods to partially offset the tariff impact and prevent prices in the U.S. from rising to uncompetitive levels. And foreign exchange also plays a role: If the U.S. dollar strengthens, it can offset some of the inflationary impact. In addition, tariffs can reduce the availability of imports and could potentially disrupt supply chains, which can create inflation as consumers are forced to pay higher prices and/or pursue less optimal substitutes.

All that said, tariffs represent a one-time price increase, and they should not, absent other factors, create more durable inflation over time. In light of the tariff threats this year and the likely retaliation, we have increased our outlook for inflation slightly, although we still anticipate that inflation trends will be favorable overall and that disinflationary progress will be enough to enable the Fed to resume the rate cutting cycle sometime in mid-2025.

According to FactSet, analysts have revised Q1 2025 S&P 500 earnings estimates downward from 11.6% at the start of the year to 7.3% currently, with revisions hitting all 11 sectors of the index. Not surprisingly, the most acute cuts have been in Materials, Industrials, Consumer Discretionary and Consumer Staples — the sectors that are most exposed to changes in trade policy. These four sectors also had the highest percentage of companies citing the word "tariff" in their Q4 earnings calls.

Despite reduced expectations for Q1 earnings, analysts remain optimistic for the remainder of the year and anticipate full-year earnings growth to be roughly 11.6%. With full-year estimates barely changed, most of the market downturn we have experienced this year has come from valuation contraction, with the S&P 500 price-to-forward earnings ratio sitting at 20.1 — still elevated in historical terms, but below the over 22 level at the beginning of the year. We do think earnings estimates may be vulnerable to further downgrades if the policy related uncertainties continue, and this may begin to bleed through to corporate and consumer activity. That said, we know from experience that the U.S. companies we invest in have proved to be remarkably resilient, extremely agile, and are entering into this period with very strong balance sheets. As such, we remain constructive on U.S. equities.

While our attention is drawn to the red on our screens and to the negative returns across U.S. equity markets, it is important to recognize what is working well in 2025: Diversification. Often called the last "free lunch" on Wall Street, diversification has gotten a bit of a bad name over the past several years as bonds failed to play their traditional role as portfolio ballast, and as U.S. large caps — particularly large-cap technology and AI stocks — continued to roundly beat non-U.S. investments. This year, however, the tide has turned: Bonds are playing their traditional role in portfolios as diversifiers and risk mitigators, and the returns across high-quality corporate and municipal bonds are positive year-to-date. Next, while the U.S. market continues to face downward pressure, developed ex-U.S. markets and emerging markets have posted positive returns, and this only underscores our view on the importance of maintaining global diversification. And last, investments in global infrastructure and in equity-based natural resources have also provided positive returns and a port in this U.S.-equity storm.