Oil, Housing & Stablecoins

June 18 (Wednesday)

Energy: A Middle East Scare. Israel’s strikes on Iran have the world on edge and oil prices rising. The nation’s bombings have killed many senior Iranian leaders, but a lengthier attack reportedly would be necessary to achieve Israeli Prime Minister Benjamin Netanyahu’s goals of wiping out Iran’s nuclear capabilities and destroying its ballistic missiles.

Iran’s response has been tepid—so far. The country’s leaders reportedly have told Arab officials they would be willing to resume negotiations with Israel as long as the US doesn’t join the attack, a June 16 WSJ article reported. The US has bombs theoretically powerful enough to destroy Iran’s nuclear facilities located under mountains.

Conversely, if talks don’t resume, Iran could accelerate its nuclear program and expand the scope of the war. A cornered Iran might resort to using unconventional weapons, like biological or chemical weapons that the US has accused the country of having. President Trump's comments Tuesday calling for Iran’s “UNCONDITIONAL SURRENDER” and a “real end” to the conflict didn't ease tensions in the region.

The price of Brent oil futures has risen 5.0% since the war began on June 13 (Fig. 1). We had expected the price of oil to rise—but because of declining US production and resilient economic growth, not because of a war in the Middle East (see our Morning Briefing dated May 8, 2025).

Here’s an update on how the war has impacted the state of the Oil Patch:

(1) US production starts to slow. With oil prices in the low 60s earlier this year, US oil producers started to slowly reduce the number of drilling rigs in use. The number of US oil rigs recently peaked at 627 in December 2022 and since has fallen to 439 rigs. It’s only recently that the amount of oil being produced has dropped modestly, from a peak of 13.6 million in April to a recent 13.4 million (Fig. 2).

Offsetting US production declines are OPEC+ oil production increases. The organization is expected to put more than two million barrels a day (mbd) of oil back on the market by this fall as it reverses the production cuts it had voluntarily agreed to in hopes of bolstering the price of oil. Prior to the war’s outbreak, the US Energy Information Administration (EIA) believed global production would exceed global consumption through 2026, which was expected to keep the Brent crude oil price average at $66 this year and $59 in 2026. Israel’s attacks will likely throw those forecasts out the window.

(2) War’s impact on oil production & transportation. So far, Israel hasn’t inflicted any major damage on Iran’s oil production facilities. But if it does, it could take a substantial amount of oil off the market. Iran’s oil production has rebounded over the past five years to 4.2 mbd, up from the pandemic lows below 3 mbd (Fig. 3).

There’s also some concern that Iran could shut the Strait of Hormuz, the waterway between Iran and Oman. Roughly 20 mbd of crude oil, condensate, and petroleum products travels through the narrow passage to get to end markets, the EIA estimates. That’s roughly 20% of global petroleum daily consumption. China, India, Japan, and South Korea purchase about 69% of the oil that travels through the Strait and would be the most affected if a closure occurred, the EIA reports. The US imports from Gulf countries only a minimal amount of oil transported through the Strait.

Yesterday, two oil tankers were on fire after colliding in the Gulf of Oman, near the Strait of Hormuz. The collision was due to navigational issues, not airstrikes. Maritime officials warned that navigational systems were being jammed in the Middle East due to the fighting between Israel and Iran.

We’re hopeful that the war will be short lived and the price of a barrel of oil will slip back into the $60s sooner rather than later.

(3) Earnings rebound expected. The S&P 500 Oil & Gas Exploration & Production industry was having a tough time before the war caused oil prices to spike. The industry’s stock price index is up 1.7% ytd through Monday’s close but 19.0% below its April 10, 2024 peak of 711.28 (Fig. 4). The industry’s forward revenues per share and forward operating earnings per share have been trending downward for three years (Fig. 5 and Fig. 6). Analysts are expecting the industry’s forward earnings per share to fall 12.3% this year and climb 12.2% in 2026 (Fig. 7).

Consumer Discretionary: Homebuilders’ Cracks Are Showing. The combined pressure of high mortgage rates, low affordability, and rising inventories has taken a toll on the homebuilding industry over recent quarters. Yesterday, Lennar reported earnings that missed analysts’ forecasts and were sharply lower than last year.

We’ve been watching homebuilders’ rising inventory levels for a while. Here’s a quick look at how higher inventories have eroded homebuilders’ results as well as why their stock prices might have stopped declining, having discounted the tougher environment:

(1) Lennar disappoints. Lennar, one of the nation’s largest home builders, reported $1.90 of adjusted EPS for Q2, missing analysts’ forecast of $1.94 and well undershooting the year-earlier $3.38. Lennar continues to see “softness in the housing market due to affordability challenges and a decline in consumer confidence,” said co-CEO Stuart Miller in a press release.

Lennar’s average home sale price, net of incentives, fell to $389,000 in Q2, down 8.7% y/y, but its deliveries rose 2.2% y/y to 20,131 homes. This quarter should continue that trend, with the average sale price dropping further to $380,000-$385,000 and deliveries rising to 22,000-23,000. Down more than 40% from their September peak, Lennar’s shares already reflect much of the industry’s difficulties and have moved mostly sideways since April.

(2) Fighting against the tide. The selling environment has been tough for homebuilders since mortgage rates started climbing in summer 2021. The 30-year mortgage rate, at a recent 6.84%, is more than twice those of the pandemic years and north of the more “normal” rates around 4.00% in the years prior to the pandemic. Lofty mortgage rates have sharply undercut housing affordability despite the strength in consumers’ incomes (Fig. 8 and Fig 9).

Mortgage rates tend to track the 10-year Treasury bond yield, which climbed during the Federal Reserve’s last interest-rate tightening cycle. Some fear that the high federal deficit may keep both bond yields and mortgage rates elevated whether or not the Fed resumes rate-cutting this year or next.

As mortgage rates have risen, the inventory of homes on the market has also climbed. The months’ supply of existing homes on the market rose to 4.4 in April, up from a low of 1.9 in January 2022. But that’s nowhere near the 10-month-plus inventories during the Great Financial Crisis (Fig. 10). New home inventories are more concerning, at 8.1 months of supply in April, the US Census Bureau reported (Fig. 11).

Given this backdrop, it’s not surprising that homebuilder sentiment dropped to 32 in June, down two points from the prior month and well below the 50 marker that separates positive and negative sentiment.

(3) Industry data. The S&P 500 Homebuilding stock price index has fallen 33.5% from its October 18 record high (Fig. 12). While the industry has managed to keep revenue flattish, operating EPS have fallen sharply, reflecting homebuilders’ willingness to offer buyers financial incentives to keep homes moving off their lots (Fig. 13 and Fig. 14).

The industry’s revenue is expected to drop 3.9% this year but rise 3.3% in 2026 (Fig. 15). Likewise, earnings are forecast to tumble 22.6% this year but rebound 10.2% in 2026 (Fig. 16). If mortgage rates moderate and the economy remains on sound footing, the drop in homebuilders’ share prices may be over, and they may even start building off their new, lower base.

Disruptive Technology: Are Stablecoins Coming? The market capitalization of stablecoins has surged more than 12-fold over the past five years, to almost $250 billion from only $20 billion in 2020. Stablecoins are cryptocurrencies whose value is tied to another asset. The stablecoin issuer typically holds that asset, often US Treasuries or gold, in reserve. For example, Tether issues stablecoin tokens called “USDT.” If USDT’s market cap is $150 billion, Tether has in reserves very liquid cash or cash-like assets, such as US Treasury bonds, valued at $150 billion.

About 83% of stablecoins are pegged to the US dollar, the largest of which is Tether’s USDT. President Trump’s family’s company, World Liberty Financial, launched a stablecoin, USD1, in June.

Since the introduction of stablecoins in 2014, they’ve generally remained a niche product used only by investors involved in the cryptocurrency markets. That soon could change: There’s a bill working its way through Congress that establishes federal regulations regarding stablecoins.

Here's a look at the stablecoin bill and proposed regulations being hashed out in Congress and the companies hoping to take stablecoins mainstream in the near future:

(1) What’s the Genius Act? If passed, the Guiding and Establishing National Innovation for US Stablecoins Act, more commonly known as “the Genius Act,” would establish federal regulations for stablecoins with market caps over $10 billion. The bill includes a requirement that issuers hold a reserve of assets underlying the stablecoin and requires issuers to grant coin holders priority for repayment in the event of a bankruptcy.

While expected to pass, the bill has gotten some pushback. Critics would like the bill to include more stringent monitoring of stablecoin purchases to prevent illegal activity, such as money laundering, as well as evasion of government sanctions.

(2) Banks coming to market? Once federal regulations are in place, establishing the rules of the road, stablecoin issuance is expected to jump. Traditional financial institutions are expected to issue stablecoins. Banks could use stablecoins to process some plain-vanilla transactions, like cross-border payments, more swiftly and less expensively. Banks also want to issue stablecoins to prevent customers (and their deposits and transactions) from defecting to other institutions that do offer stablecoins.

Some of the nation’s largest banks—including JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo—reportedly have discussed issuing a stablecoin together, a May 22 WSJ article reported. The issuer would be Early Warning Services, the operator of peer-to-peer payment system Zelle, and Clearing House, a real-time payment network.

(3) Is bank competition coming, too? Banks are correct to be worried about the competition from crypto firms entering traditional banking markets. A group of crypto firms including Circle and BitGo plans to apply for bank charters or licenses, and Paxos is considering similar moves, an April 21 WSJ article reported.

Likewise, Walmart, Amazon, and Expedia Group reportedly are evaluating their ability to issue stablecoins. Doing so might let them sidestep banks and the interchange fee they pay to payment processing companies Visa and Mastercard. Even if they decide not to issue their own stablecoins, retailers could decide to accept the stablecoins of others, like Circle’s USDC or PayPal’s PYUSD. By year-end, Shopify’s retailer clients will be able to offer their customers the option of paying with Circle’s USDC stablecoin. Customers who do will receive 1% cash back in local currency on their purchases.

The Genius Act legislation may limit stablecoin issuance to US-regulated financial companies. But Mastercard and Visa investors aren’t waiting to find out: On Friday, they sent the stocks of both payment processors toppling 5% (versus the S&P 500’s 1% decline) when the WSJ reported Walmart’s and Amazon’s interest in selling stablecoins.

(4) If you build it, will they come? If the Genius legislation becomes law, the next question is whether consumers will trade in their credit cards and debit cards for stablecoins? Doing so would require consumers to trust their stablecoin issuer, because stablecoins aren’t federally insured like bank deposits. It would also require that consumers take the time to learn how to establish crypto accounts and transfer funds using the system.

In the US and other developed nations, the transition might require incentives like stablecoin issuers offering higher interest rates than banks do or retailers offering rebates on purchases made with stablecoins. For folks in countries that are not stable or are fighting high inflation, buying stablecoins backed by US dollars might make sense.

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Concentration Here & There

June 17 (Tuesday)

Asia Strategy I: High Time Asian Markets Diversified. “What’s good for Samsung is good for Korea.” This maxim, riffing off CEO Charles Erwin Wilson’s observation about General Motors and America in the 1950s, has become even truer over time in Asia’s fourth-biggest economy.

They don’t call South Korea “The Republic of Samsung“ for nothing. Founded in 1938, the sprawling conglomerate is often credited for South Korea’s rise from one of the globe’s poorest nations in the 1950s to the thriving tech power it is today and for the global appeal of the $1.8 trillion Korea Exchange.

Yet Samsung’s 20% share of the KOSPI index leaves Korea Inc. in something of a tail-wagging-the-dog dilemma. What’s more, at the start of 2024, the combined sales of Korea’s top four family-controlled groups, or “chaebols,” generated nearly 41% of the nation’s GDP. The four: Samsung, SK Hynix, Hyundai Motor, and LG. Consider the following:

(1) A broader problem. Korea isn’t the only top economy in Asia confronting a market-concentration problem that puts the fate of any one bourse in very few hands. Taiwan is an even more extreme case.

Taiwan Semiconductor Manufacturing Company (TSMC) wields a 68% market share of the Taiwan Stock Exchange (TWSE). Understandably, TSMC, with its trillion-dollar market capitalization, is the pride of the tech-heavy island economy. The globe’s biggest and most advanced semiconductor foundry is the top supplier for Apple Inc. and Nvidia Corp. Its dominance makes TSMC an obvious crown jewel in the power struggle between the US and China.

(2) Taiwan’s extreme example. But TSMC is also Exhibit A not only for the risks of sectoral concentration in an economy—chips, in this case—but also for increased market volatility. Where TSMC goes on a particular day, so goes the broader TWSE Capitalization Weighted Stock Index. This limits diversification opportunities for investors seeking broader market exposure. And increases risk if, say, geopolitical intrigue comes for TSMC.

In an October 17, 2024 earnings call, Morgan Stanley’s Charlie Chan asked the TSMC brass how they might “handle the potential antitrust risk, given your near monopoly,” saying he’s “a little bit concerned, same as other investors.” TSMC executives, including CEO C.C. Wei, seemed surprised by the query and pivoted to other issues.

Market dominance is a challenge shared by TSMC’s top customers as well. Nvidia recently drew the attention of US antitrust regulators, while Apple routinely confronts regulators’ antitrust questions in the US, European Union (EU), Japan, and beyond. Such is life in the trillion-dollar valuation club, where the travails of one company can quickly destabilize the broader market.

(3) The China factor. China also finds itself listed among countries with stock markets where the 10 largest names collectively constitute a 50% or greater share of the broad index’s capitalization. Other major economies on that list—besides Korea and Taiwan—include: Brazil, France, and Germany.

In Taiwan’s case, the index is dominated by TSMC, Hon Hai Precision (Foxconn), MediaTek, Quanta, and Fubon. In Korea, it’s Samsung, SK Hynix, KB Financial, Hyundai Motor and Naver.

In China, the market-swaying giants are Tencent, Alibaba, and Meituan. As Morningstar points out in a January report, “China’s market concentration has shifted from ‘old economy’ companies to ‘new economy’ players like Tencent, Alibaba, and Meituan. Despite their dominance, regulatory challenges and economic headwinds have weighed on performance. For instance, Alibaba’s stock has more than halved over the past five years due to regulatory scrutiny and a weak consumption environment.”

Asia Strategy II: Japan’s Good Example. Japan’s equities market stands out as a comparatively diversified one. This may cut against the conventional wisdom, given how much global attention is focused on behemoths like Toyota, Sony, Mitsubishi UFJ Financial, and Hitachi. In a March 2024 report, Peter Oppenheimer of Goldman Sachs called Japan “the best diversification opportunity” among developed markets. The broader Topix, Oppenheimer argues, has nearly 2,000 companies. Here’s more:

(1) India’s growing appeal. In this regard, India fares reasonably well, too. Over the last five years, India’s weight in the Morningstar Emerging Markets Index has doubled. The reason: structural reforms by Prime Minister Narendra Modi’s government, which are boosting foreign investment. These upgrades helped pave the way for mid- and small-cap companies to list and grow, creating investment opportunities across Asia’s third-biggest economy.

Yet India has a role in efforts to create an Asian version of the US’s “Magnificent-7” (i.e., Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla). The Asian “Super 8,” identified by UBS, groups Korea’s Samsung, Taiwan’s TSMC and Hon Hai; China’s Tencent and Lenovo; Japan’s Tokyo Electron; India’s Infosys; and Singapore’s ASMPT.

(2) Asia’s ‘Fantastic Four.’ Not to be outdone, Societe Generale has its own China-specific “Seven Titans” club. It includes Alibaba, BYD, JD.com, NetEase, Semiconductor Manufacturing International Corporation, Tencent, and Xiaomi. There’s also China’s “Fantastic Four” companies, which are deemed to be disrupting global tech markets and aiding Asia’s biggest economy in its rivalry with the US. The four: TikTok, drone maker Da-Jiang Innovations, robot company Unitree, and AI upstart Deepseek.

Will such herding lead to even greater market concentration in China and beyond in the Asia-Pacific region? Only time will tell. But Asia would do well to broaden the leadership of its stock markets, making them less susceptible to extreme fluctuations and more appealing for long-term investment.

Europe Strategy: EU’s Steady Giants. The “steady giants” of European equities may lack the flashiness and excitement of their US tech counterparts, but their solid performance warrants attention. In particular, Europe’s relatively boring financial stalwarts have outperformed the Mag-7 since 2022, Joe confirms.

The EU MSCI provides investors with a diverse group of large- and mid-cap stocks. The 10 largest stocks that anchor the EU MSCI account for 20.0% of the index’s total capitalization. This elite group mirrors Europe’s low-risk but diversified equities profile, spanning sectors from Technology, Consumer Staples, and Healthcare to Financials, Energy, and Industrials. The 10 titans are: enterprise software leader SAP (index weighting, 2.6%), semiconductor equipment giant ASML (2.4%), consumer staples powerhouse Nestlé (2.3%), four pharma stalwarts—Roche (1.9%), Novartis (1.9%), AstraZeneca (1.8%), and Novo Nordisk (1.8%)—multinational banking behemoth HSBC (1.7%), key energy player Shell (1.7%), and industrial giant Siemens (1.5%).

In terms of country weightings in the EU MSCI, the prominence of the UK and Switzerland underscores the enduring strength of financial centers outside the EU, while Germany and France remain the political and industrial engines inside the EU.

Let’s review some of the EU MSCI’s sector concentrations and constituents before a quick look at the index’s country weightings:

(1) ‎Financial giants don’t (entirely) depend on the ECB. Financials stocks dominate the EU MSCI, representing 22.7% of the index’s market capitalization. European banks recently have faced compressed net interest margins as the European Central Bank (ECB) has lowered rates. But HSBC, despite lower net interest margins y/y during Q1, has maintained solid underlying profits growth, thanks to a focus on its wealth division and a favorable asset mix. The bank, which has been buying back its shares, has undergone a restructuring to cut costs and simplify its organizational structure.

(2) Industrial sector growth is set to be domestically fueled. Industrials, representing 18.51% of the index, have muddled along amid soft economic growth and tepid global demand. Looking ahead, this sector will benefit from the EU’s increased spending on energy infrastructure and rearmament. Siemens, the German engineering behemoth, sees limited impact from global tariffs this year and remains confident in its global supply-chain diversification.

(3) Healthcare is innovating and aging well. Healthcare holds a 13.8% weight, led by Roche, Novartis, AstraZeneca, and Novo Nordisk in the top 10 constituent weightings. In 2025, the pharmaceutical sector will be shaped by AI-powered drug discovery and innovative treatment approaches. Europe’s broad demographic shift toward an aging population will provide structural support to the industry in the years ahead.

(4) Tech is strategic but not dominating. Less than 10.0% of the index is represented by information technology companies. Right behind SAP in the weightings is ASML, arguably one of Europe’s most strategically important companies. The Dutch firm leads in extreme ultraviolet (EUV) lithography semiconductor equipment, making it indispensable to chipmakers worldwide.

(5) Country weights are UK-heavy and Spain-light. The EU MSCI’s companies are heavily concentrated from just a handful of countries, with the UK topping the list (22.4%), followed by France (16.8%), Germany (15.6%), Switzerland (14.6%), and the Netherlands (6.9%). Together, these five nations represent more than three-quarters of the index’s weight.

Notably absent from the upper tier is Spain, despite its economic importance in the region. Spain and other countries that have a small equities presence fall into the “Other” category, which has a 23.7% weighting in the EU MSCI index.

US Strategy: The Seven’s Flickering Magnificence. In 2024, the Mag-7 beat the S&P 500 for the 11th time in 12 years, recording a collective market-capitalization gain of 46.3%. That’s nearly double the S&P 500’s 24.4% rise last year. During the last week of the year, they represented nearly a third of the index’s total market capitalization, or a record-high 32.0% market-cap share. That’s down to a 29.7% share currently (Fig. 1).

This year has been a challenging one so far for the Mag-7. The uptrend in their consensus revenue and earnings growth forecasts has slowed amid relatively high valuations. Earlier this year, investors aggressively bid down the group’s capitalization into bear-market territory, but most of the lost ground has been regained. Joe shares the details below:

(1) Rapid recovery from bear market. The Mag-7’s collective market capitalization peaked at a record-high $18.4 trillion on December 24 before tumbling 28.6% to $13.2 trillion through April 8. While it has risen 29.6% since then through Friday’s close, to $17.1 trillion, it’s still 7.4% below its record high and down 3.1% ytd. However, that’s just a few good trading days away from surpassing the S&P 500’s 1.6% ytd gain and resuming its leadership in the bull market (Fig. 2).

Indeed, the Mag-7’s market capitalization is still in positive territory on a y/y basis, as it has been for much of the time since 2013 (Fig. 3). The group is up 9.2% y/y, not far behind the 10.3% gain for the S&P 500. Still, that’s down substantially from the 75.0% y/y performance at the end of 2023.

(2) Slower gains to record highs in consensus forecasts. The Mag-7 stocks’ collective forward revenues rose 15.8% during 2024 (Fig. 4). It’s well off that strong pace so far in 2025, rising just 3.9% ytd, but to a new record high of $2.4 trillion. Their forward earnings soared 35.6% last year and has risen just 6.7% ytd (Fig. 5). (FYI: “Forward” revenues and earnings refers to the time-weighted average of analysts’ current-year and following-year consensus estimates. The forward profit margin is calculated from forward revenues and earnings.)

The Mag-7’s forward profit margin improvement last year was stunning. Their collective forward profit margin started the year at a record 21.6% and finished at a new record high of 25.4% (Fig. 6). It has continued to improve so far in 2025, rising to 26.0% during the June 13 week and just 0.3ppts from a record-high 26.3% during the May 2 week.

(3) Forward revenues growth rate edging lower. While the Mag-7’s forward revenues growth estimate is down from its record high, it remains well above the S&P 500’s estimate, as it has since 2013. Indeed, the group’s latest reading of 11.8% is still more than double the S&P 500’s 5.4% forecast (Fig. 7).

For some perspective, the Mag-7’s forward revenues forecast bottomed in early 2023 at a record low of 8.0%. That followed the release of ChatGPT just a few months earlier in November 2022, when investors were still unclear about the magnitude of AI’s potential. By mid-2023, Nvidia began to epically exceed forecasts on a scale not seen since Cisco did so in the 1990s. The forward revenues growth forecast proceeded to soar 6ppts to a two-and-a-half-year high of 13.9% by the end of 2024. It since has slipped to 11.8% as of the June 13 week, but that reading remains well above the S&P 500’s 5.4%.

(4) Forward earnings growth forecasts are down markedly. Analysts following the Mag-7 companies currently think the group will grow earnings 16.6% over the next 12 months (Fig. 8). That’s the lowest such reading in over two years and is just 5.3ppts above the 11.3% earnings growth that analysts forecast for the S&P 500 companies in aggregate.

To place the 16.6% earnings growth currently expected over the next 12 months into perspective, it’s nearly twice the record low of 8.6% in late 2021, when y/y growth comparisons hit a speed bump. But it’s well below the record high of 24.6% hit during the May 24, 2024 week amid the AI capital spending boom.

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Japan’s Rough Road, China’s Silk Road

June 16 (Monday)

YRI Weekly Webcast. Dr Ed is on vacation this week. He will be back for next Monday's webinar on June 23 at 11 a.m., EST. Replays of the weekly webcasts are available here.
 
Bank of Japan I: Tokyo’s Rough Road in 2025. Any list of central bank chiefs who can’t wait for 2025 to end would be a long one, with the Bank of Japan (BOJ)’s Kazuo Ueda right at the top. Yet Governor Ueda likely began the year pumped.

Back in January, the BOJ was well on track to exit Tokyo’s deflationary era policy framework. That month, the BOJ hiked its benchmark interest rate from 0.25% to a 17-year high of 0.50% (Fig. 1). Team Ueda also was reducing its ginormous government bond-buying program by $2.8 billion each quarter (Fig. 2).It was trimming its 80% share of the exchange-traded-funds market.

Then came US President Donald Trump’s trade war. The BOJ’s January rate hike came the same week President Trump returned to the White House for a second time. Like most policymakers in Asia, the BOJ and the Ministry of Finance figured that Trump’s threatened trade war might mean 10% tariffs here and there, but not much more.

Now the harsh reality of Trump’s Tariff Turmoil (TTT) is hitting Japan even harder than it is China, the real target of Trump’s ire. This has the BOJ shelving its rate-hike cycle, which it will confirm by standing pat at this week’s two-day monetary policy meeting.

Let’s have a closer look at the economic escape room the BOJ finds itself trapped in:

(1) Tariff pain galore. Expectations for the tariff onslaught to come have chilled business and household spending enough to push Japan’s Q1 GDP into the red, contracting 0.2% y/y (Fig. 3).

Q2 will likely see an even bigger drop. Trump’s 30% China tariff (down from 145%, but still prohibitively high) is disastrous for Japan. Many top companies—including Olympus, Panasonic, Sony, and Toshiba—sell parts that China Inc. uses to power its manufacturing industry. Japan also is grappling with a 25% auto tariff, 50% tariff on steel and aluminum, and a 24% “reciprocal” tariff if Prime Minister Shigeru Ishiba doesn’t offer loads of concessions in trade-deal talks.

Add to that Japan’s 3.6% consumer price inflation rate (Fig. 4). Until recently, taming upward price pressures topped Ueda’s agenda. Now, stagflation risks abound. Ueda is caught between the BOJ’s price-stability agenda and not wanting to be blamed for tipping Japan back into recession. This fear will be front and center at the BOJ’s June 16-17 meeting.

(2) Tightening cycle interrupted. After all, if 2025 had gone according to plan, Ueda’s board would be raising rates to 0.75% or even 1.00% this week and ending quantitative easing (QE) once and for all, while withdrawing hundreds of billions of dollars from the stock market.

Instead, Ueda is expected to hold rates steady this week despite an inflation rate nearly twice the BOJ’s 2.0% y/y target.

Bank of Japan II: Avoiding Blame. The blame game is actively played in BOJ leadership circles. It’s the Tokyo political establishment’s modus operandi to prod the BOJ into easing aggressively, then blame the central bank when things go bad.

In the late 1980s, at the end of Japan’s “bubble economy” era, BOJ Governor Satoshi Sumita took the fall for years of corporate excess. His successor, Yasushi Mieno, was derided as Japan’s Paul Volcker for tightening too much. Years later, it was Toshihiko Fukui‘s turn in the political woodchipper.

Ueda’s current predicament is all the more hellish given that it’s not the first time a BOJ chief was excoriated for leading the economy astray with a monetary policy shift:

(1) Lessons from the past. Fukui is the one BOJ leader of the last 25 years who understands first-hand what Ueda is experiencing. By 2006, Fukui ended the QE strategy that the BOJ pioneered in 2001. He also was the first to step away from the zero-interest policy the BOJ implemented in 1999. In 2007, the Fukui-led BOJ managed to get rates up to 0.5%.

Then, the backlash: Fukui was blamed for the recession that followed, which was exacerbated by the global financial crisis of 2008. Once Fukui’s successor Masaaki Shirakawa arrived at BOJ headquarters in 2008, his first course of action was to cut rates back to zero and restore QE.

(2) Ueda’s conundrum. Is Ueda about to suffer the same fate? A Reuters poll of 60 BOJ watchers finds most think that Ueda won’t hike rates again in 2025 and that the BOJ will throttle back on its quantitative tightening.

One big possible tweak: Instead of trimming bond purchases by 400 billion yen ($2.8 billion) per quarter as planned when the year began, the BOJ may pivot to cuts of just half that, or 200 billion ($1.4 billion) every three months.

Perhaps that move is Ueda’s best gambit at this point?

Bank of Japan III: The Trump Unknowns & Preexisting Knowns. There are two big risks to Japan’s economic trajectory this year: 1) Trump’s next round of tariffs, and 2) the myriad preexisting conditions that Japan carried into the trade war.

The first risk remains something of an imponderable. Trump’s claims of a framework for a detente with China fueled hopes that “Tariff Man” had learned his lesson on imposing crushing import taxes. Not so much, it appears: Trump says he’ll set unilateral tariff rates in the next week or two.

Ishiba’s ability to avoid the worst of Trump’s wrath is also an open question. Trump seemed to view Japan as easy prey, figuring that he could conclude a deal with Tokyo first. Yet Ishiba has proven to be a worthier sparring partner than Trump World imagined.

The other concern is the structural economic weaknesses that Japan carried into 2025:

(1) Stratospheric debt. One of those weaknesses is the largest debt burden among developed nations—a GDP ratio of roughly 260%. That leaves limited fiscal space for Ishiba’s Liberal Democratic Party to increase spending to support growth, particularly after Moody’s Investors Service revoked Washington’s last AAA rating.

This limited fiscal space is a problem, as “Japan’s economy lacks a driver of growth given weakness in exports and consumption,” says Yoshiki Shinke at Dai-ichi Life Research Institute. “It’s very vulnerable to shocks,” particularly Trump tariffs.

(2) Shrinking real wages. Japan also suffered from weak wage growth before Trump 2.0 arrived. A year ago, Japanese unions scored their biggest hikes in 33 years in annual “shunto” negotiations—5.58%. Yet in real terms, wages actually fell in 2024 for a third consecutive year. If CEOs were reluctant to fatten paychecks in pre-trade war 2023 or 2024, they’re likely to be even less inclined now.

Add tariff fears to the financial planning calculus of consumers whose incomes don’t stretch as far as they used to, and it’s no wonder that tariffs and tariff threats aren’t damaging just exports and industrial production, according to a report by Stefan Angrick of Moody's Analytics, but household spending as well. As we see in the US, expectations for further wage gains drive today’s spending decisions. In Japan’s case, many consumers are deciding to retrench.

China’s New Silk Road I: On Track. As Trump’s policies derail trade relationships virtually everywhere, Xi Jinping’s China is keeping one of its top economic strategies on track—literally.

The reference here is to the “Belt and Road Initiative” that Xi unveiled at the start of his presidency in 2013. It aimed to create a new Silk Road of trade routes linking China with the rest of the globe. Financing infrastructure development, Xi believed, would buttress China’s “soft power” by way of economic “hardware” projects.

The “belt” refers to ancient overland trade networks linking Asia and Europe. The “road” part of this juggernaut involving 150 countries includes building road and rail links, ports, and energy and digital infrastructure.

Consider the following:

(1) Railways paying off. A dozen years on, Xi’s ambitious infrastructure blitz is having a moment. Exhibit A: how China’s big bet on railways alone is beginning to pay off.

Take Southeast Asia, which in recent years has leapfrogged over the US and European Union to become China’s top market. More than a decade ago, Xi’s inner circle targeted the 10 members of the Association of Southeast Asian Nations (ASEAN) for a boom on next-generation high-speed railway infrastructure.

In 2015, Xi’s Communist Party turned heads with a deal with Indonesia, which chose China over bullet-train-pioneer Japan. The 88-mile route linking Jakarta and Bandung has been an economic game-changer. That same year, China signed a deal with Laos for a 260-mile railway linking the capital city Vientiane and the border town Boten to create a direct route to China’s Yunnan province. Both lines have opened since.

Then came China-loan-driven projects in Malaysia, Thailand, and Vietnam.

(2) Good morning, Vietnam! In February, when Vietnam raised its GDP target for 2025 to at least 8% y/y, it cited the multiplier effect from the $8.3 billion rail project to China. For an export-reliant economy keen on ramping up infrastructure investment to boost growth, this project is just the thing.

Contrast this dynamic with the cold shoulder ASEAN is getting from Trump World. Along with 30% tariffs in China, Southeast Asia is grappling with the fallout from Trump’s 50% tax on steel and aluminum and, in some cases, the threat of disproportionately high “reciprocal” tariffs.

China’s New Silk Road II: Trump’s Tariffs. Trump hit Cambodia with a 49% tariff on goods imported to the US, while Laos (48%), Vietnam (46%), Thailand (36%), and Indonesia (32%) were also slapped with higher levies than South Korea (25%) and Japan (24%). That was on "Liberation Day" April 2. On April 9, those tariffs were postponed for 90 days. Whether Trump will keep these levels or change them is still unclear, making it impossible for governments to devise growth policies.

China’s Belt and Road project, a.k.a. its “new Silk Road,” is about far more than infrastructure. Xi’s vision was to develop a broad, interdependent market that China could harness to expand its political and economic power. Some view this as China’s attempt to recreate the US’s post-World War II Marshall Plan.

The enterprise also grew out of the 2008-09 global financial crisis. China, then under the leadership of Xi’s predecessor, Hu Jintao, supported the economy with a 4 trillion yuan ($558 billion) stimulus boom. It prioritized roads, bridges, airports, and especially railways.

Here’s some background info:

(1) Going global. By the time Xi came to power, China’s need for mega-projects was largely sated—hence, the pivot to exporting its economic model beyond China’s borders. Along with tapping new markets, China pushes its surplus cement, steel, and technology, while securing minerals for high-tech products. Much of the work is done by mainland China companies employing Chinese labor and financing from Chinese banks, including the gigantic Asian Infrastructure Investment Bank.

Yet the initiative has come at a very high cost. As much as China benefits from Belt and Road, it has also caused serious reputational damage. Critics argue that Chinese companies, often state-owned entities, reap most of the benefits, while developing nations are forced to take on crushing debt loads.

(2) Bumps in the Belt and Road. “It hasn’t all gone smoothly,” writes James Guild, an expert on economic development in Southeast Asia in an op-ed for The Diplomat news site. “These projects have been plagued by delays and cost overruns. They have become intensely politicized and touched off debates about whether the economic value created is worth the debts being incurred.” So, Guild concludes, “Chinese investment in Southeast Asian rail infrastructure clearly carries an array of risks.”

Stephen Olsen at the Institute of Southeast Asian Studies notes that Beijing does itself no favors with the lack of transparency when signing project contracts, often with other opaque governments. This masks the “potential debt traps for participating countries” and the ways China uses “economic leverage” to exert political influence.

Many observers worry that Xi’s Belt and Road push has increased corruption in places that can least afford it with projects that aren’t ready for global prime time. Elaine Dezenski at the Washington-based Foundation for Defense of Democracies, says that by 2023, Belt and Road’s 10th anniversary, Argentina, Ethiopia, Kenya, Malaysia, Montenegro, Pakistan, and Tanzania were “are all dealing with extreme debt-to-GDP ratios that force crippling decisions in order to service the debt.”

Beijing’s building boom also has environmentalists in a whirl. In a 2021 report, for example, the Council on Foreign Relations detailed how Xi’s ambitious program had “sparked backlash over pollution, environmental damage, and population displacement concerns.”

(3) Xi doubles down. But the upsides are getting renewed focus thanks to Trump’s trade war. In mid-April, Xi took time out of his busy schedule sparring with Trump and deflation at home to visit Southeast Asia. It was hardly a coincidence that he stopped in Vietnam, Malaysia, and Cambodia, three economies particularly disillusioned by TTT.

“Economic disruption poses a major risk for trade-dependent Southeast Asian economies, stemming from Trump’s use of tariff barriers against countries with trade surpluses, as well as a broader policy of decoupling from China,” explains James Crabtree at the Asia Society Policy Institute. China is well positioned to exploit these countries’ reduced US engagement, he says, by deepening its relationships with them through bilateral and multilateral initiatives, particularly investment deals and expanded BRICS—Brazil, Russia, India, China, South Africa—cooperation.

Also, Crabtree adds, “Trump’s early decision to shut down the US Agency for International Development creates additional opportunities for Chinese influence.”

China’s New Silk Road III: Geopolitics Remade. The extent to which Belt and Road’s reach worries Team Trump is apparent in how it pops up in diplomatic disputes. So worried was Panama about Trump’s threat to retake the canal that it ended its involvement with Belt and Road in February. In May, Trump World slammed Colombia for joining China’s initiative.

In peace talks with Ukraine last week, the US asked President Volodymyr Zelenskyy’s government not to allow China access to its rare-earth-minerals market. The subtext: Russia’s invasion, and resulting US sanctions, are helping to revive the so-called Middle Corridor route connecting China and Europe through Central Asia via Kazakhstan, Azerbaijan, Georgia, and Turkey.

China, not surprisingly, is rapidly increasing its footprint in Central Asia. In December, construction began on an $8 billion railway linking China, Kyrgyzstan, and Uzbekistan, a network aimed at creating a supply route to Europe.

As China recreates the Silk Road of old, with all railways leading to its export and supply-chain centers, Trump’s mercantilist, tariffs-only Asia policy risks alienating the globe’s most dynamic economic region.

Twelve months ago, the common narrative of Belt and Road was one of debt traps, carbon footprints, and China exporting its overcapacity. The extreme trade tensions of today have officials in Southeast Asia and beyond more interested in tapping into global value chains and production networks than picking sides between Beijing and Washington.

For better or worse, and for all the strings attached, China is offering a route to growth for developing nations bracing for the collateral impacts of US tariffs, one track at a time. If Trump 2.0 has a plan to counter China’s global infrastructure ambitions, now seems like a good time to share it.

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China, Staples & Quantum Computers

June 12 (Thursday)

China: The Trade Standoff Ends in a Draw. The trade standoff between China’s President Xi and US President Trump is over—for now at least. Both sides seem to have realized that they faced mutually assured destruction if the US put 145% tariffs on Chinese goods and China withheld the sale of rare earth minerals to US manufacturers.

Going forward, the question is: Which country will be the first to eliminate its vulnerability? Will the US develop rare earth minerals processing facilities slower or faster than China can reduce its dependence on US exports and high-end semiconductors?

Here’s a look at where things stand now after the Xi-Trump trade standoff:

(1) A taste of the potential damage. The trade skirmishing between the US and China only lasted a few weeks, but that was time enough to give both sides a more tangible sense of what they could be in for with a cutthroat trade war.

Rumblings of the trade war caused US imports from China to surge as merchants stocked up on goods manufactured in China. But when the tariffs actually kicked in, US imports of Chinese goods dried up. Chinese shipments to the US sank 35% y/y in May, the biggest percentage decline since February 2020, when Covid shutdowns hurt trade flows.

The skirmish has started to impact China’s manufacturing machine. China’s Caixin manufacturing purchasing managers index dropped sharply, from 50.4 in April to 48.3 in May (Fig. 1). And the slowdown in the manufacturing sector appears to have increased the deflationary pressures in China as factory gate prices dropped 3.3% in April y/y, the largest decline in a year.

The US wasn’t unscathed. In May, Ford Motor shut down for about 10 days production at its Chicago assembly plant, where it makes the Ford Explorer and Lincoln Aviator, because it lacked the minerals needed in its braking systems. Several Asian and European auto manufacturers had to pause production due to the lack of rare minerals as well.

China agreed to the restoration of rare earth export licenses for US manufacturers, but only for six months, maintaining its leverage in future negotiations, a WSJ article reported yesterday.

(2) Will semis win too? In return for China’s selling US companies rare earth minerals again, the US government agreed to relax restrictions on US companies selling to China ethane and jet engines and parts as well as allow Chinese students to attend US universities.

Negotiators did not say whether the US had agreed to sell China more of the US’s most sophisticated semiconductors. But many investors seem to have thought so: The stock price indexes of the S&P 500 Semiconductors and the S&P 500 Semiconductor Equipment both outperformed the Information Technology sector on Monday and Tuesday of this week. The Semiconductor Equipment industry index jumped 5.2%, while the Semiconductors industry index gained 1.9%; the broader Technology sector inched up only 0.7% (Fig. 2).

Consumer Staples: A Look at the Good & the Bad. At first glance, the S&P 500’s Consumer Staples sector seems to be gliding through 2025 with ease. Its 5.7% return ytd through Tuesday’s close makes it one of this year’s top performers among the S&P 500’s 11 sectors. But there’s a lot going on beneath this sector’s surface. Its component industries have a wide variety of ytd returns, bracketed by Tobacco’s strong 38.2% ytd gain and Brewers’ sharp 9.1% ytd loss.

Here’s the performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Industrials (9.1%), Communications Services (7.8), Utilities (6.0), Consumer Staples (5.7), Materials (5.5), Financials (5.3), Real Estate (3.2), S&P 500 (2.7), Information Technology (1.8), Energy (-1.4), Health Care (-1.7), and Consumer Discretionary (-4.7) (Fig. 3).

Now consider the wide ranging ytd performances of the S&P 500 Consumer Staples sector’s industries: Tobacco (36.9%), Drug Retail (21.7), Consumer Staples Merchandise Retail (7.4), Consumer Staples (5.7), Soft Drinks (3.7), Personal Products (-1.2), Packaged Food (-2.5), Household Products (-2.8), and Brewers (-8.9) (Fig. 4).

The industries’ performances can often be traced to company-specific events. The stock price index of the S&P 500 Tobacco industry has benefitted from a popular new chewing pouch, while the Drug Retail industry’s stock price index popped on news of the $24 billion acquisition of Walgreens Boots Alliance. Conversely, trouble with its 2023 Hostess acquisition has hurt JM Smucker’s results, and tariffs have taken a toll on a swath of food companies and brewers. Let’s take a look:

(1) Nicotine pouches are hot. Philip Morris International sells tobacco products internationally, but it’s the company’s newest product, Zyn nicotine pouches, that has lit a fire under its stock. Zyn pouches don’t contain tobacco, but they do contain a powdered form of nicotine derived from tobacco leaves that release nicotine when chewed on. The pouches are discrete and have flavors like mint, coffee, and cinnamon.

Philip Morris’s shipments of Zyn jumped 53% y/y in Q1, boosting the company’s revenue from smoke-free products up to 42% of total revenue. Analysts expect Philip Morris’s adjusted earnings to climb from $4.52 a share in 2024 to $7.47 this year and $8.27 in 2026. Its shares have rallied 48.8% ytd and 72.7% over the past year.

The other stock in the S&P 500 Tobacco industry is Altria Group, which had a 13.7% decline in US tobacco product volumes but an 18% jump in the volumes of on! nicotine pouches during Q1. Altria shares are up 12.0% ytd and 26.0% over the past year.

The excitement about these new products has pushed the S&P 500 Tobacco stock price index to new record highs for much of this year (Fig. 5). The industry’s revenues per share and earnings per share have also been hitting record levels this year (Fig. 6 and Fig. 7). Revenue is expected to grow 5.1% this year and 5.5% in 2026, while earnings are forecast to jump 9.9% this year and 7.3% next year. The Tobacco industry’s forward P/E has certainly improved, but it remains below the S&P 500’s forward P/E and is still below its own record P/E level (Fig. 8).

(2) Trouble selling Twinkies. JM Smucker surprised Wall Street with an earnings forecast for its fiscal 2026 (ending April 30) that was much lower than expected. The food company has struggled with its 2023 acquisition of packaged baked goods maker Hostess, price increases on green coffee beans, and tariffs. The shares fell 15.6% on Tuesday’s news.

Smucker expects fiscal 2026 adjusted EPS to hit $8.50-$9.50, below the $10.25 Wall Street was expecting and below fiscal 2025’s $10.12. Adjusted for divestitures, Smucker’s net sales decreased 1% y/y to $2.1 billion for the fiscal quarter ending April 30, and its diluted EPS fell 13% to $2.31, better than the $2.24 analysts expected.

The company took non-cash impairment charges totaling $980 million related to its $5.6 billion Hostess acquisition. Consumers “continue to be selective in their spending, largely driven by inflationary pressures and diminished discretionary income, causing the sweet baked goods category to recover slower than we anticipated,” said CEO Mark Smucker in the prepared earnings remarks. He also attributed some of the underperformance to the company’s management of the division.

However, the snack category in general has been difficult for many companies. Some analysts attribute the underperformance to the growing number of people taking drugs like Ozempic for weight loss and swapping salty and sugary snacks for high-protein snacks, like Greek yogurt and meat sticks. It’s quite a turnabout from the pandemic, when our couch potato habits invited junk food.

Smucker is also dealing with price increases on green coffee that it has had to pass through to consumers and declining sales in its pet food segment. The company has felt the impact of tariffs on the green coffee beans it imports into the US as well as the impact of retaliatory tariffs on goods it produces in the US and sells in Canada, like peanut butter, coffee, and ice cream toppings. The company believes the direct and indirect impacts of tariffs hurt last quarter’s EPS by $0.25.

Smucker isn’t the only packaged food company having a tough time of things. The S&P 500 Packaged Foods stock price index has fallen 2.5% ytd and 25.5% from its May 5, 2023 peak (Fig. 9). The industry’s revenues have been essentially flat in recent years and are expected to inch up 1.4% this year and 2.0% in 2026 (Fig. 10). Its earnings growth prospects remain lackluster as well: After earnings dropped 8.0% in 2023, they were up 2.4% in 2024, but a decline of 6.9% is forecast for 2025 improving by 6.6% in 2026 (Fig. 11).

The best thing about the industry is its depressed forward P/E of 16.3 times EPS (Fig. 12).

Disruptive Technologies: IBM’s Quantum Leap Forward. IBM announced on Monday that it will be able to deliver a large-scale, fault-tolerant quantum computer by 2029. The powerful computer will include 100 million quantum gates on 200 logical qubits. Key to producing a fault-tolerant quantum computer is an ability to correct the errors that pop up in quantum systems, which IBM now feels confident it can do.

“We’ve cracked the code to quantum error correction, and it’s our plan to build the first large-scale, fault-tolerant quantum computer,” said Jay Gambetta, vice president of IBM Quantum, according to an article in IEEE Spectrum. “We feel confident it is now a question of engineering to build these machines, rather than science.”

Here’s a quick look at other major developments in the industry:

(1) Many companies in the quantum race. IBM is one of many companies chasing the quantum brass ring. Amazon, Google, and Microsoft each recently introduced quantum computing chips. In addition to the tech giants, many smaller companies are developing systems. One of them, IonQ, a US quantum computing company, announced earlier this week its plans to acquire UK startup Oxford Ionics for $1.1 billion. Together, they plan to develop systems that have 256 qubits in 2026, more than 10,000 qubits by 2027, and two million qubits by 2030.

(2) Solving the AI energy problem. It may be more energy efficient to run artificial intelligence (AI) programs on quantum computers than it is to run AI programs on traditional computers. In one study, the quantum computer used 30,000 times less energy to complete the AI task than a classical super computer, a January 25 article in Quantinuum reported. The company has been “rebuilding” machine learning techniques for Natural Language Processing using quantum computers.

(3) Security problems ahead. It is possible that quantum computers will be able to break the encryption that protects everything from bank accounts and email to online transactions and national secrets. Analysts believe that Q-Day (when quantum computers can break encryption codes) will arrive anywhere from 2029 through 2055. The bad guys are thought to be planning ahead, gathering encrypted data today that they will be able to unlock in the future using quantum computers. And members of the crypto community are debating whether quantum computers will be able to break the encryption used on the blockchain. If they can, the entire world of crypto currency could be at risk, unless a new generation of encryption is established.

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On Korea, Europe & US Earnings

June 11 (Wednesday)

South Korea I: Losing the Discount? As South Korea’s new president gets to work, its stock market is enjoying a burst of optimism that the nation is about to get its financial act together.

For decades, the stock market of Asia’s No. 4 economy has suffered a “Korea discount” depressing valuations relative to Asian peers’. Proximity to North Korea is one explanation. The bigger problem is the economic dominance of a handful of family-owned conglomerates with weak governance standards. While not publicly traded themselves, these politically connected behemoths have propelled Korea into the orbit of the top-12 economies. Yet their monopolistic ways hog the economic oxygen startups need to grow, prosper, and disrupt. The culprits include Samsung, Daewoo, Hyundai, LG, Lotte, and SK.

Enter new President Lee Jae-myung, who’s pledging to level playing fields and increase competitiveness against Chinese companies encroaching on Korea’s strongest industries. Here's a deeper dive into the suddenly fluid situation:

(1) New management. Lee vows to improve governance and shareholder returns, taking a page from Japan’s decade-long effort to strengthen capital markets. On June 4, his first day in office, foreign funds propelled Korean stocks higher on expectations that Lee’s election will end six months of political chaos and the power vacuum that followed.

(2) Political bedlam. The crisis began on December 3, when President Yoon Suk Yeol declared martial law, claiming it was a “desperation” attempt to get opposition lawmakers to pass his legislative agenda. The stunt led to Yoon’s impeachment and removal from office.

Lee’s election is a chance to turn the page. The Korea MSCI is the best performing stock price index of MSCI’s country indexes so far in June, with a gain of 8.5% (US$) and 6.3% (local currency) through Monday’s close (Fig. 1). And the return of US-based funds “signals a structural improvement in the foreign demand cycle, helped by a stabilizing won-dollar exchange rate,” Lee Kyung-min of Daishin Securities told The Korea Economic Daily.

Lee’s focus, noted Jeremy Chan of Eurasia Group, “will remain primarily on protecting the interests of retail investors” over institutional giants. Yet Lee’s to-do list is a daunting one. While Korea Inc. veered inward for 122 days, China slid further into deflation and US President Donald Trump launched an epic trade war.

The immediate emergency is stabilizing Korean GDP, which contracted 0.2% y/y in the first quarter. Trump’s tariffs on China (30%), autos (25%), and steel and aluminum (50%) are taking a toll on the $1.7 trillion economy.

South Korea II: Taking on the Goliaths. Lee must also act swiftly to wrest control from the family-controlled Goliaths known as “chaebols.” This involves strengthening antitrust enforcement to reduce chaebols’ ability to marginalize small to mid-sized companies that they deem to be threats.

Lee must work harder than his five elected predecessors to reduce bureaucracy, incentivize innovation, and phase out seniority-based promotions and pay. He must empower women to diversify the workforce and boost a sliding birthrate.

Here’s more:

(1) Long to-do list. Lee has pledged to revise Korea’s commercial code to phase out rubber-stamp directors and strengthen boards’ fiduciary responsibilities to shareholders.

Yoon tried his hand at some of this, rolling out a “Corporate Value-Up” program, modeled after Japan’s governance push. But Yoon was all talk; Lee must do much better, and fast.

(2) Wooing global capital. For years, Seoul has lobbied index giant MSCI to upgrade its stock market to developed-market status. This would pull powerful waves of international capital Seoul’s way—and get Korea out of the orbit of China and India.

To no avail. Though Korea lifted its short-selling ban in March, MCSI is calling for increased transparency, fewer outdated regulations, looser limits on corporate ownership, and increased currency-trading hours.

Yoon’s martial law gambit reminded investors why the Korea discount persists. But Lee’s determination to prepare the stock market for global prime time is putting Korea in the spotlight for all the right reasons.

Global Central Banks: ECB Wins Inflation Battle—But Not the War. Eurozone equity markets rallied on Friday, as investors applauded the European Central Bank’s (ECB) Thursday, June 5 interest-rate cut. The cut reflected an inflation victory: In the face of fragile economic growth and trade uncertainty, the ECB grabbed at perhaps the last opportunity to lower rates as inflation fell below the bank’s targeted 2.0% y/y.

Could this be the last rate cut for a while, after eight cuts so far? Melissa and I think so. On Saturday, ECB policymaker and Croatia’s Central Bank Chief Boris Vujcic said as much. On Sunday, ECB policymaker Joachim Nagel said that the bank can take its time on policy because rates are now “neutral” rather than “restrictive.”

However, ECB head Christine Lagarde hesitates to celebrate sub-target inflation prematurely. She told reporters: “Victory laps are always nice, but there is always another battle.” Lagarde is wary of overly aggressive cuts. Long awaited Eurozone fiscal stimulus, particularly on defense spending and taxes, could push inflation higher just as a US trade deal is reached—and the potential diminishes for a deflationary tariff-induced recession. Taken together, fiscal spending might not have a deflationary offset if a happy end to US trade tensions boosts the confidence and spending of consumers and businesses.

Another reason that inflationary risks might come to the fore: Further war-related energy sanctions on Russian oil could cause a second mini-energy crisis as Europeans are forced to find alternative energy sources to replace the remaining Russian flows to Europe, as we discussed in our June 4 Morning Briefing.

Here's a closer look at the situation confronting the ECB:

(1) ECB’s cautious victory lap. On June 5, the ECB cut its key interest rate by 25 basis points (bps) from 2.25% to 2.00%, continuing a long-standing easing cycle that began after borrowing costs peaked at 4.0% in September 2023 (Fig. 2). The latest rate cut signifies that the ECB views shoring up weak economic growth as the higher priority over mitigating inflationary risks. That order may be reversed if trade uncertainty resolves.

In the background, the ECB is unwinding its asset purchase portfolios “at a measured and predictable pace,” as principal payments from maturing securities are no longer reinvested. Ostensibly, such tapering, a restrictive monetary tool, seems inconsistent with the easing represented by the recent rate cuts. The bank, however, is likely aiming to lower assets on the balance sheet near normal before pausing rates to avoid a net restrictive posture. Total assets have come a long way down from near €9 trillion during 2022 to near €6 trillion through May, closer to the €5 trillion pre-pandemic level (Fig. 3).

(2) Inflation marches lower. For the first time since September 2024, Eurozone headline inflation fell below 2.0% in May to 1.9% y/y. That’s substantial progress since inflation peaked above 10.0% during the October 2022 energy crisis (Fig. 4).

In the baseline of the new ECB projections, headline inflation is set to average 2.0% in 2025, 1.6% in 2026, and 2.0% in 2027.

(3) Growth is in the trenches. Eurozone real GDP growth, at an annualized rate of 1.2% through Q1, remains subdued (Fig. 5). It is, however, showing signs of life after a close call with a recession at the end of 2023. For this year, the ECB sees real GDP averaging just 0.9% during 2025, reflecting a stronger-than-expected Q1 and weaker prospects for the remainder of the year. Staff see real GDP growth averaging 1.1% in 2026 and 1.3% in 2027, boosted by anticipated fiscal and defense spending.

Some positive signs of Eurozone economic growth recently have emerged, including April’s near 5.0% y/y rise in German industrial factory orders from strong domestic demand (Fig. 6).

(4) Fiscal front line fires the bazookas. Europe’s fiscal frontline is arming itself with unprecedented spending, and with that comes clear inflationary risks. Germany’s new grand coalition has removed defense spending above 1.0% of GDP from the “debt‑brake” and unleashed a €500 billion infrastructure investment bazooka.

The European Union’s unprecedented €800 billion ReArm plan, including a €150 billion fiscal loan instrument, is likely to throw a log on the inflation fire. And Germany’s new €46 billion tax relief package adds another layer of fiscal stimulus.

(5) Edging towards trade battlefield ceasefire. Meanwhile, after months of escalating tariff threats, EU and US negotiators are edging closer to a trade truce. The US administration’s tone on Eurozone trade is easing ahead of the July 9 trade-talk deadline.

Referring to Eurozone movement to reach NATO defense spending targets, US Trade Representative Jamieson Greer said last week that the EU had provided “a credible starting point” for trade talks and that negotiations were advancing quickly. Just a couple of weeks ago, President Trump had threatened 50% tariffs on all European goods.

If a deal is secured in the coming weeks, the inflationary pressure from Europe’s aggressive fiscal stimulus would outweigh the disinflationary drag from tariff-related uncertainty. The ECB’s June 5 statement observed: “[I]f trade tensions were resolved with a benign outcome, growth and, to a lesser extent, inflation would be higher than in the baseline projections.”

François Villeroy de Galhau, Governor of the Bank of France and member of the ECB Governing Council, echoed this sentiment, stating recently that he does not believe deflation is a threat today.

That's all the more reason for the ECB to lay down its interest-rate paring knife for a while.

US Strategy I: Record-High S&P 500 Forward Earnings Resume. After a brief timeout from successively hitting new record highs for eight weeks, a streak that ended with the April 3 week, the S&P 500's forward earnings resumed that pattern last week (Fig. 7).

When S&P 500 forward earnings last hit the record-high mark during the April 3 week nine weeks earlier—which also marked Trump’s euphemistically named “Liberation Day”—industry analysts’ earnings expectations reflected more bark than bite from Trump’s Tariff Turmoil. Forward earnings fell just 0.9% from its April 3 record high to its subsequent low three weeks later (during the April 24 week).

However, the S&P 500’s price index bore all the bite marks of the tariff uncertainty. The index narrowly avoided falling into a bear market on April 8, bottoming then at 19.8% below its February 19 record high (20.0% and above is bear market territory). The index since has reclaimed nearly all of that lost ground: As of Monday’s close, it has improved to just 2.2% below its February high.

While none of the S&P 500 sectors have recovered fully to record-high forward earnings or index prices yet, most are just a short path back into that club, as Joe shows below:

(1) Many sectors nearly have record-high forward earnings. During the May 29 week (the latest available), very few sectors were in the forward earnings doghouse (Fig. 8). Tariffs have not been the roadblock to higher earnings that investors had expected (at least, not yet?).

Seven of the 11 sectors are less than 2.4% from their forward earnings record highs and could be readmitted into the record-high club a month from now when Q2 reporting season begins. The highly cyclical Energy and Materials sectors face a longer trudge back. Their forward earnings are still in deep bear markets, down 41.8% and 27.4% from their respective record-highs during mid-2022.

While Trump’s tariffs haven’t affected forward earnings much yet, that’s not to say they won’t. China remains the US’s biggest trading partner and still controls many crucial supply chains.

(2) A few sectors remain in an index price correction. The market’s rebound since April 8 has followed along with the forward earnings and pulled all the sector price indexes higher. None are in a bear market any longer. More than half of the sectors are less than 4% from a new record high, and five are still in or near a correction (Fig. 9).

Here’s how far the sectors remain below their record-high index prices: Industrials (-0.1%), S&P 500 (-2.2), Information Technology (-2.3), Financials (-2.3), Consumer Staples (-2.5), Utilities (-2.8), Communication Services (-3.5), Materials (-9.9), Consumer Discretionary (-12.0), Health Care (-14.7), Energy (-15.4), and Real Estate (-19.3).

US Strategy II: Low Q2 Earnings Expectations Remain. Last week’s data show that analysts still expect the S&P 500 to record relatively low earnings growth of 5.6% y/y in Q2 (Fig. 10). That was up just 0.1ppt since the week before.

The not particularly bullish analysts collectively forecast that only two of the 11 sectors will grow Q2 earnings faster y/y than the broad S&P 500 index: Communication Services and Information Technology. Among the other nine sectors, only Energy's Q2 earnings is expected to decline y/y at a double-digit percentage rate. The rest are expected to post relatively low single-digit percentage gains or declines in earnings.

Here's how the sectors’ y/y Q2 earnings growth forecasts rank: Communication Services (31.1%), Information Technology (17.1), Health Care (4.9), Real Estate (2.7), Industrials (2.1), Financials (2.0), Utilities (0.0), Consumer Staples (-2.5), Consumer Discretionary (-3.6), Materials (-4.4), and Energy (-25.3).

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The Fed Remains On Hold

June 10 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Federal Reserve I: Fed Up With Uncertainty. Speaking in South Korea last week, Federal Reserve Governor Christopher Waller faced a standing-room-only crowd of businesspeople thirsty for answers about US policy. Yet Waller seemed to have far more questions about the direction of the globe’s biggest economy than explanations.

Waller said on June 2 that the volatility surrounding President Donald Trump’s tariffs “has created considerable uncertainty about where trade policy will settle.” As corporate chieftains in the US struggle to navigate Trump’s Tariff Turmoil (TTT), Waller said “economic policy uncertainty among businesses is very elevated, and this has affected measures of sentiment and confidence for consumers and businesses.”

What Waller effectively admitted is that Fed officials face extreme visibility challenges of their own as the second half of 2025 begins, never mind 7,000 miles away. Think of Fed Chair Jerome Powell and the voting members of the Federal Open Market Committee (FOMC) as like airline pilots anticipating thick fog hiding the horizon that will force them to fly by instrument.

At the moment, the navigational aids available to Powell & Co. suggest that the economy is aloft and well. For all the adverse conditions through which the US flew in April and May and the storms and turbulence that lie ahead, the Fed remains on autopilot, as robust employment acts as a sizable tailwind.

This leaves the Fed unlikely to shift course and ease even as Trump and Wall Street clamor for rate cuts. This is especially true of next week’s June 17-18 meeting. But that’s not to say things won’t change abruptly as Trump’s 30% China tariff, 25% tax on autos, 50% levy on steel and aluminum, 10% across-the-board tariff and the trajectory of “reciprocal” taxes take their tolls near and far.

Let’s look more closely at the Fed officials’ views from the monetary cockpit:

(1) Risks abound. Waller’s bottom line is that “the context for this uncertainty about tariffs is that hard data on the fundamentals of the economy lately has been mostly positive and supportive of the Federal Open Market Committee's economic objectives.”

On June 3, Fed Governor Lisa Cook told a New York audience that “while the economy remains solid, the economic environment could become highly challenging for monetary policymakers. At our most recent policy meeting last month, I supported the FOMC's decision to leave our policy interest rate unchanged. The current stance of monetary policy is well-positioned to respond to a range of potential developments.”

That same day, Atlanta Fed President Raphael Bostic told reporters that “there’s still a ways to go in terms of the progress that we’re going to need to see. I’m not declaring victory on inflation yet.” In an essay published on June 3, Bostic added that “I continue to believe the best approach for monetary policy is patience. As the economy remains broadly healthy, we have space to wait and see how the heightened uncertainty affects employment and prices. So, I am in no hurry to adjust our policy stance.”

(2) Economy stands its ground. Perusing recent data and other Fed speeches, it’s hard to detect an urgent need for Fed action. Friday’s employment report was Exhibit A. Amid intense fears of an abrupt slowdown—including those of Trump himself—the US added an above-expectations 139,000 jobs in May, while the jobless rate stayed at 4.2%, near historical lows (Fig. 1 and Fig. 2).

The print belied Trump’s social media pleas for rate cuts. On June 4, two days before the jobs report, a soft May reading from payroll firm ADP had Trump posting: “ADP NUMBER OUT!!! 'Too Late' Powell must now LOWER THE RATE. He is unbelievable!!!"

(3) Trump pounds the table. Of course, if Trump’s instrument flying skills were better, he might’ve known that APD has been an unreliable barometer. The official payrolls gain reported by the Bureau of Labor Statistics (BLS) was reminder enough of that—139,000 versus ADP’s 37,000 increase in May (Fig. 3). That followed another misleading signal in April, when ADP reported 60,000 versus BLS’s 177,000 gain.

Last Friday’s employment data are unlikely to alter views that Fed Governor Adriana Kugler expressed a day earlier in New York. Kugler stressed that, all things considered, she’s more worried about turbulence on the inflation front than a sharp slowdown. The impact of the tariffs on producer and consumer prices, she said, will be “the first-order effect.”

Kugler noted that “down the road, when prices go up, consumers and businesses will react, and demand will come down, and that’s when you expect maybe to have a bigger effect in terms of a slowdown in economic activity and employment.” The tariff factor, she made clear, supports her view that it’s best to stand pat on rates to assess the magnitude of the inflationary fallout.

“Disinflation has slowed,” Kugler said, “and we are already seeing the effects of higher tariffs, which I expect will continue to raise inflation over 2025. I see greater upside risks to inflation at this juncture and potential downside risks to employment and output growth down the road.”

Federal Reserve II: Inflation Risks Top Downturn Risks. Research from Fed staff, Kugler cautioned, shows that the pass-through of tariffs into prices can be “relatively quick” and that if “elevated tariffs persist, even just in the short run, larger effects may be coming soon.”

Also on Thursday, Philadelphia Fed President Patrick Harker argued that the central bank’s wait-and-see approach is still the right one. “Even in a time of uncertainty, we remain as certain and deliberate as ever in our approach,” Harker said in Philadelphia, adding that he’s comfortable with recent decisions to “keep the Fed’s policy interest rate steady.”

Speaking on June 5, Kansas City Fed President Jeff Schmid seemed to have a similar flight plan in mind. “While the tariffs are likely to push up prices, the extent of the increase is not certain, and likely will not be fully apparent for some time,” Schmid said in Kansas City. “Likewise, the extent of the drag on growth and employment is also unclear.”

(1) Tariff effects galore. Of course, the gauge that might be most telling is how the FOMC’s post-meeting Summary of Economic Projections for June differs from the March version.

Back in March, it’s doubtful that any Fed officials had Trump imposing a 145% tariff on China on their Bingo card. Even today’s 30% is higher than many of the levies in the 1930 Smoot-Hawley Tariff Act, which deepened the Great Depression.

On March 19, when Trump’s China tariff was still around 10%, FOMC meeting participants’ median projections for real GDP growth were 1.7% in 2025, down from 2.1% expected on December 18, and 1.8% in 2026, down from 2.0% in December (Fig. 4). Yet their unemployment forecasts remained low, barely budging from their December meeting to their March one: In March, the median expectations for the unemployment rate were 4.4% in 2025 and 4.3% in 2026; in December, they were 4.3% for 2025, 2026, and 2027 (Fig. 5).

Moreover, inflation has proven to be more subdued than the Fed had expected in March: The Personal Consumption Expenditures (PCE) price index increased at a 2.1% y/y rate in April, below the FOMC meeting participants’ March median forecast of 2.7% and December median forecast of 2.5% (Fig. 6). The Fed targets a 2.0% y/y inflation rate—so April’s reading was close to ideal.

(2) Inflation worries overdone. Looking to June, upside risks to inflation are indeed possible as tariff effects filter into finished prices. Yet fears of an inflation surge aren’t backed by recent Fed bank surveys. Take the Cleveland Fed’s Inflation Nowcasting model, which suggests an unalarming 2.4% y/y CPI increase.

Even so, Wall Street is bracing simultaneously for upside surprises in inflation and downside risks to growth. The level of economic uncertainty ginned up by TTT over the last three months has been even worse than that created by Covid-19 during the Trump 1.0 era, said Gita Gopinath, the International Monetary Fund’s first deputy managing director. In a Financial Times interview last week, Gopinath said: “This time the challenge is going to be greater for them compared to the pandemic. During Covid, central banks were moving in the same direction … easing monetary policy very quickly.”

(3) Asia on the frontlines. The Bank of Japan, for example, is in rate-hike mode. Other monetary authorities that are easing are doing so cautiously as they struggle to assess the inflationary fallout from the trade war. One such official was in the Seoul audience that Waller addressed last week: Bank of Korea (BOK) Governor Rhee Chang-yong.

A week earlier, on May 28, Rhee’s monetary policy board cut its seven-day repurchase rate by 25 basis points to 2.5% (Fig. 7). That same day, the BOK nearly halved its 2025 GDP forecast to 0.8% from its earlier projection in February. As Rhee put it on May 28: “Since growth momentum has weakened more significantly than initially expected, we believe there’s a possibility rates will be cut more than we thought going forward.”

Days later, Rhee explained how the policy chaos emanating from Washington has been reducing the BOK’s economic visibility in real time. Rhee noted that uncertainty over what Trump does with reciprocal tariffs next month (Korea risks a 25% levy) is proving just as disorienting as sectoral tariffs. Asia’s fourth-biggest economy is highly sensitive to input costs for its exports of semiconductors, steel, aluminum, and cars. As of now, each is subject to separate Trump duties.

Making matters worse for BOK officials is that no one can say where Trump’s China tariffs are heading. Or, for that matter, where US Treasury yields are bound for. As Rhee told Waller and the rest of the audience on June 2, risk aversion among foreign investors suddenly growing weary of US assets is increasing volatility in Korea’s government bond market.

Federal Reserve III: The World’s Central Bank. There’s still considerable PTSD in Asia from US yield spikes of the past. Namely, the 1997-98 Asian financial crisis, an episode that bore the Fed’s fingerprints. To be sure, the epic collapse of economies in Thailand, Indonesia, and Korea was caused by too much overseas debt, extreme overinvestment, and crony capitalism. But it was the Fed’s 1994-95 tightening cycle that pushed developing Asia over the edge.

Under then-Chairman Alan Greenspan, the Fed doubled short-term rates to 6% in 12 months. The tightening cycle arguably contributed to the bankruptcy of Orange County, California, the Mexican peso crisis, and the demise of Wall Street securities giant Kidder, Peabody & Co. The dollar’s multi-year rise made currency pegs impossible to maintain. First, Bangkok devalued, then Jakarta and Seoul followed suit.

Consider the following:

(1) The global perspective. The internationalization of US rate decisions over the last 30 years has made Fed watching a global game. The Fed has 12 districts; but from the respect of its impact reach, it’s as if Latin America were the 13th, East Asia the 14th, Eastern Europe the 15th, and the BRICS—Brazil, Russia, India, China, and South Africa—collectively the 16th. In 2013, mere talk that the Fed might step away from its post-2008-crisis quantitative easing, the so-called “taper tantrum,” slammed Brazil, India, Indonesia, South Africa, Turkey, and other emerging nations.

As such, worries that Trump might pivot back to trying to fire Powell are decidedly global worries. Such a step could further upend confidence in the dollar, damage trust in the US financial system, and send long-term Treasury yields skyrocketing. Elisabet Kopelman at SEB Research has said the fact that the dollar has fallen in recent months along with stocks while long-term interest rates are “decoupling” from shorter maturities sends “new warnings that the market no longer has the same confidence in the US” (Fig. 8).

(2) Powell’s job security. Many took solace in a May 22 Supreme Court ruling signaling that the Fed chair is legally protected from a president angling to fire him or her. Still, Phil Suttle at Suttle Economics speaks for many when he says “the chances of the Trump administration accepting this ruling and moving on are very low.”

Washington’s fiscal trajectory could be its own challenge for the Fed, if long-dated Treasury yields were to spike. The same goes for central bank officials from Seoul to Frankfurt. Yet the bottom line is that the Powell Fed seems comfortable with its wait-and-see approach on rate cuts. And the Fed is finding that the balance of data is validating this disposition.

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Americans Are Still Working For A Living

June 09 (Monday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy I: Acing Another Stress Test. Trump’s Tariff Turmoil (TTT) certainly caused lots of uncertainty for workers and their employers, particularly during April and May. It was widely expected that consumers might cut back their spending because of the uncertainty, especially if businesses responded to Trump’s tariffs by reducing their payrolls. So far, the evidence shows that consumers are still spending, and businesses are still expanding their payrolls.

The most widely anticipated recession of all times remains a no-show. It didn’t show up over the past three years when the Fed tightened monetary policy. It hasn’t happened so far this year as a result of TTT. The economy continues to pass stress tests that in the past might have brought on a recession. So far, so good.

The odds of a recession in 2025, according to Polymarkets.com, rose from around 20% during January and February of this year to over 60% during March and April (Fig. 1). On Friday, the odds were back down to 27%. Not surprisingly, the S&P 500 has been inversely correlated with the Polymarkets.com recession series (Fig. 2).

In the past, recessions were usually caused by the tightening of monetary policy, not because of the effects of higher interest rates on demand but because the tightening triggered a financial crisis that quickly turned into an economywide credit crunch that caused a recession (Fig. 3). Over the past three years, we’ve often discussed this widely overlooked phenomenon that we call the “Credit Crisis Cycle.” Several of the recessions since the 1970s were either caused or exacerbated by oil supply shocks that caused oil prices to soar (Fig. 4). The bursting of speculative bubbles also played a central role in causing a few recessions in the past, particularly in 2001 and in 2007.

This time has been different. Fed tightening, soaring oil prices, and burst financial bubbles all have occurred since early 2022, but without precipitating a recession:

(1) The tightening of monetary policy from March 2022 through July 2023 was significant. Over this period, the Fed implemented a series of rate hikes, totaling 11 increases over 16 months, moving the rate from a range of 0.00%–0.25% to 5.25%–5.50%. There was no recession.

(2) The price of West Texas Intermediate crude oil soared over $120 per barrel during the first half of 2022. Again, there was no recession. Instead, the price of oil has been mostly falling since mid-2022. It was down to $64.77 on Friday. In the past, such a decline would have been attributable to a global recession caused by the oil price spike. This time, the global economy is growing. Instead, the oil price weakness reflects too much oil available. The lower oil price is undoubtedly boosting economic growth around the world, except among oil exporters.

(3) The S&P 500’s forward P/E soared from its bear-market low of 15.5 in October 2022 to 22.5 at the beginning of this year (Fig. 5). Arguably, that was a meltup led by technology stocks that was reminiscent of the tech bubble of the late 1990s. But the recession that followed the tech wreck during the early 2000s hasn’t been repeated this time, so far. Instead, the S&P 500 experienced a correction, as its forward P/E dropped from 22.5 on February 19 to 18.0 on April 8 and then rebounded to 21.7, once again led by the Information Technology sector.

It is too soon to be sure about the impact of TTT on the economy. However, the odds of a recession have declined, according to Polymarkets.com, as we noted above. Our assessment of the odds of a recession did rise in March, though we didn’t cross over into the dark side, i.e., seeing odds of 50% or above. On March 5, we raised our subjective probability of a recession from 20% to 35% after Trump slapped tariffs on Canada, China, and Mexico. On March 31, we raised the odds of a stagflation scenario—which, we said, “may include a recession”—from 35% to 45%. In late March, Trump started to tout his April 2 “Liberation Day” reciprocal tariffs, which he postponed for 90 days with the significant exception of China.

We lowered our odds of a recession from 45% to 35% on May 4 and to 25% on May 13, which was one day after Trump agreed to cut tariffs on Chinese imports to 30% from 145% and China agreed to lowered its levies on American goods to 10% from 125%. So we lowered our recession odds because Trump continued to moderate his stance on tariffs. In addition, the labor market remained impressively resilient. We also were less concerned about a negative wealth effect on consumer spending, as the stock market had rebounded significantly.

Additionally, we expected that capital spending related to datacenters for cloud computing and the onshoring of manufacturing will remain robust—and still do. On May 19, we summed up what remains our outlook today as follows: “So the odds of our Roaring 2020s scenario is back up to 75%. In this scenario, the S&P 500 rises to 6500 by the end of this year. It could keep going to 7000 in a meltup.”

US Economy II: Labor Market Remains Resilient. The monthly employment report released by the Bureau of Labor Statistics (BLS) has lots of data about the labor market. Often, there’s enough to help economists who are either optimistic or pessimistic on the economic outlook to make their respective cases. We try to be objective: Instead of picking over the data for morsels that fit our narrative, we let the data tell us what’s what. We don’t do faith-based economics in our shop!

In our opinion, Friday’s report for May’s labor market indicators is an upbeat one, on balance. It confirms that the labor market remains resilient. So do lots of other recent labor market reports. There’s not much in the report to warm the cold hearts of the “diehard hard-landers.” The much feared Sahm Rule has yet to be triggered, as the unemployment rate remains at 4.2%. Let’s review the report:

(1) Payroll employment. The best news was that payroll employment increased 139,000 during May. That was much better than expected, especially after last Thursday’s ADP report showed a gain in private payrolls of only 37,000 for the month (Fig. 6). In the BLS report, private payrolls rose 140,000 during May. The ADP releases haven’t been useful indicators of the same month’s BLS payroll changes for quite some time.

Continuing to lead employment gains are the services industries that are getting a big boost from retiring Baby Boomers, including the Health Care & Social Assistance, Leisure & Hospitality, and Financial Activities categories. This demographic development has been our main explanation for the resilience of consumer spending for the past three and a half years. So far, so good.

May’s total payroll tally was weighed down by a 22,000 drop in federal government jobs (Fig. 7). Thanks to Musk’s DOGE Boys, federal employment is down but by only 43,800, or 1.9%, during the first five months of this year, leaving 2.936 million still employed by the federal government (Fig. 8). However, that drop has been more than offset by gains in state and local government employment. As a result, total government jobs are up 217,200 so far this year.

Excluding the federal government, payroll employment rose 161,000!

Also noteworthy is that construction jobs rose 4,000 in May to another record high (Fig. 9). In a recession scenario, the opposite would be expected; postwar recessions of the past were always associated with declines in construction jobs. Yet the construction industry remains strong despite the rise in mortgage rates of the past three years and the glut of office buildings on the market.

Hard-landers often get excited when they see declining employment in the temporary help services industry. This series has been clearly signaling a recession for the past three years. It peaked at a record 3.176 million during March 2022 and dropped 666,000 through May of this year (Fig. 10). So far, it has clearly been yet another misleading indicator of the business cycle. The labor market has been very tight since the Covid lockdowns were lifted during the spring of 2020. Employers seem to be relying more on permanent full-time employees than on temps.

(2) Earned Income Proxy. Aggregate weekly hours in private industry rose 0.1% m/m to a record 4.7 billion hours during May (Fig. 11). Average hourly earnings rose 0.4% m/m during May. As a result, our Earned Income Proxy for wages and salaries in private industry rose 0.5% m/m to a new record high last month (Fig. 12). That augurs well for May’s personal income, retail sales, and consumer spending reports. This is confirmed by the Redbook Retail Sales index, which rose 5.5% y/y through the May 30 week (Fig. 13).

(3) Household employment. So what’s left to bring some joy to the pessimists? Payroll employment was revised down by 95,000 during March and April. That still leaves the average gain over the past three months at 135,000. That has been enough to keep the unemployment rate right around May’s 4.2%, consistent with the low pace of initial unemployment claims (Fig. 14).

The household measure of employment (which counts the number of people employed rather than the number of full-time and part-time jobs) might have cheered the naysayers. It fell 696,000 during May. This is an extremely volatile series on a m/m basis. It has been weaker than payroll employment for some time. In February, the annual benchmark revision boosted it by 1.9 million for January 2025 compared to December 2024. We expect a boost like that will happen again with the next revision.

(4) Hourly wages. May’s 0.4% m/m rise in average hourly earnings in private industry (AHE)—the most widely followed monthly measure of wage rates—was led by bigger gains in Information (1.3%), Financial Activities (0.7%), and Professional & Business Services (0.6%). Among the lowest wage increases were those in Retail Trade (0.0%), Utilities (0.1%), Leisure & Hospitality (0.2%), and Transportation & Warehousing (0.2%) (Fig. 15).

AHE was up 3.9% y/y in May. The PCED headline inflation rate was 2.1% through April. So inflation-adjusted wages rose around 1.8% y/y (Fig. 16). That’s a solid increase. Real wages declined from April 2020 through June 2022. They’ve recovered nicely since then. That’s yet another explanation for the resilience of consumer spending.

Movie. “Your Friends & Neighbors” (+) is a TV series starring John Hamm as Andrew Cooper (“Coop”). Coop loses his lucrative job at a hedge fund after he loses his wife to a professional basketball star. He desperately needs cash to pay his bills. He turns to burglary, stealing from his neighbors’ homes when they aren’t home. It’s entertaining but too preachy about the meaninglessness of living in a wealthy suburban community, especially if the alternative lifestyle presented involves robbing your friends and neighbors to remain there. (See our movie reviews archive.)

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Essential Minerals, Retail & Crypto

June 05 (Thursday)

Materials: Appreciating Rare Earth Minerals. “People who live in glass houses should not throw stones.” That’s a saying that President Trump should have taken to heart before slapping aggressive tariffs on Chinese imports, because China has one thing that the US lacks and needs: rare earth minerals. These minerals are necessary components of high-tech equipment like automobiles, robots, and military equipment.

China mines about 70% of the world’s rare earth minerals, and it processes about 90% of them. In the wake of Trump’s tariffs, China began to require exporters of rare earths to get licenses to sell their goods internationally—and those licenses have been slow to come when they’ve come at all. So the exports of these minerals from China has slowed to a crawl. There’s a growing concern that global auto manufacturers will have to pause production if they can’t get their hands on enough magnets made from rare earth minerals. The US is left to depend on a small company, MP Materials, to boost the production and processing of rare earth minerals domestically.

President Trump understandably is upset about the situation, and Secretary of State Marco Rubio countered China’s moves by announcing plans to cancel the visas of Chinese students inside the US. China response: Calling Harvard a “party school” and touting its own universities. Chinese AI company DeepSeek expressed pride that its founders were educated in China.

Such ridiculous tit-for-tat among world powers could easily have been avoided. The US government has long known that America’s dependence on China for rare earth minerals was a problem, but it never acted on the recommendations of the studies it had commissioned.

Most recently, the House Select Committee on the Strategic Competition between the United States and the Chinese Communist Party, established in 2023, warned in a December 12, 2023 report that the US was too dependent on China for rare earth minerals. Here are some of its suggestions that the US should have heeded:

(1) Identifying the problem. Robert Lighthizer, US Trade Representative during President Trump’s first term, explained to the committee how the US and much of the world was dependent on China for numerous critical minerals and their refining and processing. China has leveraged its industrial policy—including economic controls, trade protectionism, low environmental standards, and technology transfer—to solidify its indispensable positioning. The committee believed that China would use its position as leverage in a prospective conflict with Taiwan.

“Congress must decrease the United States’ reliance on the PRC [People’s Republic of China] for these critical materials,” the report concluded.

(2) Concocting a plan. The report also recommended creating a reserve of rare earth minerals to insulate US producers from price volatility and the US government from the PRC’s prospective weaponization of the minerals. In the event that China were to flood the market with these materials, the US reserve could purchase the excess and stabilize the prices. Having such a price stabilization mechanism in place would entice more US companies to enter the rare earth mining industry.

The report suggested that Congress and the executive branch work to source these minerals from countries that are friendly to the US and that they create incentives, like tax breaks and prizes, to encourage domestic manufacturing. It recommended that the Commerce Department investigate whether dumping or other practices that distort the market for rare earth minerals and magnets are going on, in which case the department should impose “material injury tariffs.”

Also recommended: Increasing recycling programs of government-owned products that have rare earths or magnets in them, working with colleges to increase the number of workers with the skills necessary to build a rare earth minerals industry, and studying deep seabed mining and its impact on the environment.

The report concluded: “Never before has the United States faced a geopolitical adversary with which it is so economically interconnected. … The United States now has a choice: accept Beijing’s vision of America as its economic vassal or stand up for our security, values, and prosperity.”

Again, that report was dated December 12, 2023! Did Peter Navarro (a.k.a. Ron Vara), Trump’s Senior Counselor for Trade and Manufacturing, read the report before he recommended that the President start a trade war with China?

Consumer Discretionary: Consumers Go Bargain Shopping. Dollar General and Ollie’s Bargain Outlet Holdings both cater to lower-income consumers looking for a bargain. Dollar General is much bigger, with almost 21,000 stores compared to Ollie’s 582. Both reported better-than-expected Q1 results on Tuesday, but Dollar General’s shares surged 15.9% on the report, while Ollie’s shares fell slightly—though they’ve soared 134% over the past three years versus Dollar General’s 48.9% decline.

On their Q1 earnings conference calls Tuesday, both retailers’ management teams had much to say about consumers, tariffs, and their results. Here are some quick takeaways:

(1) Strapped consumers want bargains. Dollar General’s CEO Todd Vasos shared insights into recent consumer behavior on the company’s conference call: “During our recent customer survey work, 25% of DG customers reported having less income than they did a year ago, and nearly 60% of our core customers noted that they felt the need to sacrifice some necessities in the coming year.” He added that more middle- and higher-income customers are shopping at Dollar General.

On Ollie’s conference call, CFO Robert Helm observed that customers have been exercising greater discretion over their purchase decisions: “Consumers are looking for value and prioritizing their spending around their immediate needs. We saw continued evidence of this in the first quarter. Demand for consumer staples was consistently strong throughout the quarter, while demand for certain seasonal categories was impacted by the weather,” he said, adding that seasonal categories started the quarter off soft due to unseasonable May weather.

(2) Talking tariffs. Dollar General’s imports are relatively small, with direct imports in the mid- to high-single-digit range of its overall purchases and about 70% of them from China. Dollar General’s indirect imports are about twice as much, with about 40% from China. The company did not increase its inventory to protect itself from tariffs; its inventory levels fell 5% y/y even as the store base increased by 156 stores.

“While the tariff landscape remains dynamic and uncertain, we expect tariffs to result in some price increases as a last resort, though we intend to work to minimize them as much as possible,” said Vasos. Dollar General expects tariff rates to stay at current levels through mid-August, when President Trump’s 90-day pause on increased tariff rates on goods from China is expected to expire. After that, tariff rates may jump to the levels announced on April 2.

To offset the impact of tariffs, Dollar General is negotiating with its vendors to reduce costs in several ways, including negotiating cost concessions, shifting production to other countries, reengineering products, and substituting products. Management expects to successfully mitigate “a significant portion of the anticipated tariff impact on our gross margin” but anticipates some “incremental pressure” on consumer spending.

Ollie’s buys much of its inventory from companies that are going out of business in closeout sales. It has benefitted from the increasing number of retail store closings, including Big Lots, and supply-chain disruptions. There’s a “tremendous amount” of excess inventory available for the company to purchase, and its own inventory was up 16% at the end of Q1.

As it buys more closeouts, Ollie’s reduces its reliance on Chinese imports. Imports are about 20% of Ollie’s mix, and management assumes current tariff levels will remain in place for the rest of the year.

Tariffs will take a larger bite out of Dollar Tree's Q2 results than expected. The company warned yesterday that it accepted delivery of some products while Trump's 145% tariffs on Chinese exports were in effect, resulting in $70 million of unexpected Q2 costs. Subsequent tariff-mitigation efforts should benefit the company during H2. The shares tumbled more than 5% Wednesday.

(3) The results. Dollar General gave an optimistic forecast for 2025 that includes sales rising 3.7%-4.7% this fiscal year (ending January), up from prior guidance of 3.4%-4.4%. Same-store sales are forecast to rise 1.5%-2.5%, and EPS are expected to hit $5.20-$5.80, up from $5.11 last year.

Results benefitted from Dollar General’s expanding partnership with DoorDash and its ability to process both SNAP and EBT transactions on delivery orders. The company is also expanding its Retail Media Network, a digital advertising platform on its website, apps, and in-store.

Dollar General is in the S&P 500 Merchandise Retail stock price index, but its impact on index performance is overshadowed by Walmart and Costco. The index has risen 11.0% ytd through Tuesday’s close (Fig. 1). Analysts expect margin pressure this year. Revenue is forecast to climb a modest 2.8% in 2025 and 5.1% in 2026, but earnings are thought likely to inch higher by 1.6% this year then jump 10.8% in 2026 (Fig. 2 and Fig. 3). The industry’s forward P/E is an unusually high 37.7 (Fig. 4).

Ollie’s also raised its 2025 sales forecast but kept its earnings forecast unchanged. Sales are expected to total between $2.58-$2.60 billion this year, up from a prior $2.56-$2.59 billion. Same-store sales are forecast to grow 1.4%-2.2%, up from 1.0%-2.0% previously. The company didn’t change its EPS forecast of $3.65-$3.75.

The retailer’s Q1 sales rose 13.4% to $576.8 million, propelled by the opening of 25 stores and 2.6% same-store sales growth. Adjusted EPS rose to 75 cents, up from 73 cents a year ago and beating analysts’ consensus estimate of 71 cents.

Disruptive Technologies: Big Banks Want in on Crypto. Some of the nation’s largest banks—including JPMorgan, Bank of America, Citigroup, Wells Fargo—are discussing whether to work jointly to issue a stablecoin in an effort to beat back competition from the cryptocurrency industry, a May 22 WSJ article reported. Stablecoins are cryptocurrencies backed by the US dollar or cash-like assets like Treasuries and are expected to maintain a one-to-one ratio with the US currency. In the crypto world, investors use stablecoins to store cash or make purchases.

“Banks have been bracing for the possibility that stablecoins could become widely adopted under President Trump and siphon away the deposits and transactions they handle, particularly if big tech companies or retailers get in on the action,” the article noted.

Let’s take a look at why the nation’s largest banks, after keeping the crypto industry at a distance for many years, may now blink:

(1) Crypto’s value has soared. The crypto industry has ballooned to far larger than we’d ever expected, and it has gained legitimacy under the Trump presidency. The cryptocurrency’s market capitalization is $3.4 trillion, according to CoinGecko. The vast majority of the value comes from bitcoin, which has a market cap of $2.1 trillion, up more than 500% since the start of 2023 (Fig. 5). The industry also includes more than 16,000 coins traded on more than 1,000 exchanges.

President Trump has been the industry’s greatest cheerleader, vowing to make America a global leader in digital assets. Separately, Trump Media & Technology—in which he and family members hold large equity stakes—is a crypto player. Trump Media’s Truth Social platform is working to offer a bitcoin exchange-traded fund for retail investors. Truth Social also plans to partner with Crypto.com to bring other crypto products to market. And Trump Media recently sold $2.3 billion of stock to fund the purchase of bitcoin, which it plans to hold.

(2) Crypto players want into banking. Several crypto firms want to get into traditional banking. Circle and BitGo, a crypto custodian, are among the firms planning to apply for bank charters or licenses, and Coinbase Global and Paxos are considering doing so, an April 21 WSJ article reported.

Anchorage Digital, the only crypto firm that has a bank charter, works with buy- and sell-side institutions to buy and sell crypto assets. Robinhood, which offers banking services through its partnership with Coastal Community Bank, has acquired Bitstamp, a European crypto exchange with institutional and retail clients.

(3) Questionable characters remain. While black-tie dinners with President Trump may make the crypto industry appear more respectable, bad actors abound. Most recently, crypto robbers have been kidnapping people to get their cryptocurrency. Kidnappers tried last month to abduct a woman in France whose father runs a French cryptocurrency exchange. In the same month, an Italian man in New York City was kidnapped and tortured in an effort to steal his crypto.

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China’s Autos, Russia’s Gas & US Earnings Review

June 04 (Wednesday)

Weekly Webcast. If you missed Tuesday’s live webcast, you can view a replay here.
 
Chinese Autos I: Deflation Hits. China’s deflation drama just kicked into higher gear as the nation’s hottest electric vehicle (EV) makers launch a price war sure to reverberate globally. The first shot came from Shenzhen-based giant BYD, EV market disruptor extraordinaire.

In 2024, BYD’s global revenues rose 29%, beating Tesla, despite having been building EVs only since 2009 and only in the Netherland and Norway until late 2022. “Enormous” is what auto research firm JATO Dynamics has called the implications of that feat.

Now, fresh off making 2024 a year Elon Musk would like to forget, BYD has unveiled sweeping price cuts of up to 34%. The move was quickly followed by rivals Geely Automobile and Zhejiang Leapmotor. Even faster, though, it has provoked a vocal backlash unprecedented in Chinese political and business circles: The Communist Party has accused BYD founder Wang Chuan-Fu of “rat-race competition”—which long had been China Inc.’s raison d'être—and Great Wall Motor Chairman Wei Jianjun says BYD might have precipitated the auto industry’s “Evergrande moment,” China’s version of the Lehman moment.

Looked at dispassionately, BYD’s sharp price downshift is a microcosm of both China’s deflation troubles and the ways its EVs are coming for auto giants everywhere—from Tesla to Toyota to Volkswagen to Hyundai.

Chinese Autos II: Europe’s Rough Year. The European piece of this tale is particularly jarring. In April alone, BYD’s Europe volumes surged 359% y/y despite European Union (EU) tariffs as high as 45.3% on made-in-China battery EVs. JATO Dynamics, which compiled these figures, calls it a “watershed moment” for China upending Europe.

Consider the following:

(1) EV price war. BYD could wreck Europe’s 2025. German behemoths Volkswagen, Mercedes, and BMW are already watching BYD hoover up sales. As tariffs fail to slow China Inc., Europe’s EV makers face an unpalatable choice between cutting prices aggressively or ceding more market share.

In China, this could be the beginning of the end for many of smaller EV startups. At the start of the year, there were roughly 100 mainland brands. It’s not clear how many of them can survive BYD’s advantage in price, scale, quality, and association with Warren Buffett. His Berkshire Hathaway began investing in BYD in 2008. And what a bet it turned out to be—at least for now.

(2) Economic parallels. Yet the reason that BYD is pushing back so hard against the Evergrande jab is that many worry about the EV giant’s 70% asset-liability ratio. It carries more than 580 billion yuan ($80 billion) of debt. BYD counters that Apple, Boeing, Ford, and General Motors all carry comparable ratios.

Then again, those companies are unlikely to be targeted by US President Donald Trump’s next wave of tariffs as BYD might be. The President’s claim that Beijing “violated “the US-China trade truce could be a harbinger of new import taxes. Already, Trump’s 25% auto tax is hitting legacy giants and startups alike—and fanning auto industry deflation risks. Not to be forgotten: The EU might up import taxes, too.

(3) Reflation woes. Morgan Stanley’s Robin Xing notes that the latest car price competition underscores how the supply-demand imbalance continues to fuel deflation.” Thus, he notes, “reflation is likely to remain elusive.”

These are not unlike the challenges facing China’s broader $18 trillion economy. Chinese leader Xi Jinping is grappling with a supply-demand imbalance driven by households’ saving far more than they spend. This has China Inc. venturing overseas with even greater gusto and urgency, sharing the nation’s deflation with a world economy that could do without it.

Geopolitics: Who Is Funding Putin’s War? Ukraine’s weekend drone strike on Russian military assets is unlikely to shift the trajectory of the war, in our view. Still, the scale was striking: 117 Ukrainian drones targeted deep inside Russian territory, destroying an estimated $7 billion worth of bombers, radar aircraft, and other strategic assets.

Some observers see the strike as a symbolic blow to Russian President Vladimir Putin’s war narrative. For now, he won’t get what he wants: Ukraine won’t forswear seeking NATO membership nor will it recognize Russia’s claim to the 20% of occupied Ukrainian territory.

But Putin is unlikely to back down—he’ll continue pursuing his aims on the battlefield as long as he has the means. Ukrainian President Volodymyr Zelenskyy remains equally committed to defending Ukraine’s sovereignty. The most probable outcome remains a grinding stalemate.

But if you want to know how this might ultimately end, follow the money. This is already a global conflict, bankrolled—directly and indirectly—by international actors. China, India, and Turkey have become key energy importing lifelines for the Kremlin, especially as EU purchases of Russian gas has declined. These countries are unlikely to change course anytime soon without being forced to do so.

That’s why an EU halt would still matter. It wouldn’t stop the war overnight, but it would cause Russia to feel the pain of finally losing Western financial support. Since Russia invaded Ukraine in 2022, the EU has been slow to entirely disengage from Russian fossil fuels, aiming to do so completely by 2027. Officials fear that pulling out too quickly could trigger another energy crisis—escalating into another regional recession, or worse, a direct military attack from a desperate Putin.

But if the US Senate moves forward with a Trump-backed plan to impose secondary tariffs on countries buying Russian energy, the EU and the other Russian energy importers may have no choice but to act sooner. That could bring the war to a close—but also end the era of cheap energy in Europe.

Consider the following:

(1) Brussels fuels both fronts. Despite sanctions, speeches, and summits, the EU remains a top financier of Russia’s war effort. Since February 2022, EU countries have purchased an estimated €209 billion in Russian fossil fuels—roughly 25% of all Russian energy exports. That sum overshadows the EU’s military and economic aid to Ukraine of €147.9 billion, according to the European Commission, as The Week recently observed.

This isn’t just an accounting glitch—it’s a geopolitical contradiction. Russia’s economy, heavily dependent on export revenues, continues to hum along. Moscow reported real GDP growth of 4.3% in 2024, up from 3.6% in 2023, reflecting the performance of a war economy that’s still getting paid despite global sanctions.

True, the gains are driven almost entirely by surging defense spending, not private-sector vitality. But Putin isn’t managing an economy; he’s financing a war machine. Lowering the central bank’s 20%-plus interest rate isn’t on Putin's priority list. So long as oil and arms are flowing, the Kremlin seems content to trade household stability for battlefield leverage.

(2) Brussels strategic ambitions with tactical limitations. The EU’s May 2022 REPowerEU initiative aimed to slash Russian energy imports. Officials pointed to a drop in Russian gas dependence as proof of success. But a backslide has begun.

The bloc is no longer the second-largest financier of Moscow’s fossil fuel revenues. It's now in fourth position behind China, India, and Turkey. But according to CREA’s Russian Fossil Tracker, the EU still hasn’t closed the spigot entirely. As of May 2025, the EU still ranks as the fourth-largest buyer of Russian fossil fuels.

While the EU has banned Russian coal and seaborne crude oil, Russian liquid natural gas (LNG) still flows into Turkey via Gazprom’s TurkStream pipeline. Its May 2025 volumes rose 10.3% m/m and were just shy of May 2024’s flow. Russian LNG accounted for nearly 20% of EU LNG imports as of spring 2024, up from 11% in late 2022, reported Clean Energy Wire. Russian LNG volumes rebounded more than 30% from their September 2022 lows.

Why the reversal from the 2022 resolve to break energy ties with Russia? Infrastructure constraints, cost concerns, and a mild winter dulled the urgency of energy diversification. Some member states, including Hungary and Slovakia, are walking back plans to pivot away from Russian supplies.

(3) Washington’s big stick—500% sanctions? A bipartisan bill in the US Senate proposes a 500% tariff on any nation that continues to purchase Russian fossil fuels, including uranium and petrochemical imports. For now, the bill remains in limbo. Trump has yet to officially endorse the bill, but he has backed secondary tariffs on Russian energy importers. If enacted, it would force the EU (and other Russian energy importers) to choose cheap Russian energy or access US markets.

(4) Peace talks are nothing but Putin’s delay tactic. We view Putin’s engagement in the ongoing peace talks—with the US mediating—as a delay tactic. Moscow is buying time to consolidate control over more Ukrainian territory and uninterested in a peace agreement.

Between February and June, diplomatic efforts floundered amid entrenched disputes over territory and sovereignty, NPR’s timeline shows. US proposals were rejected by both sides. The war escalated, with Russia launching its largest drone strike in May and Ukraine rejecting any recognition of Crimea’s annexation. Political flashpoints—including Trump’s public criticism of Zelenskyy and fluctuating US aid—highlighted the conflict’s unresolved and volatile nature.

This week’s so-called peace talks echoed familiar themes: Russia demanded international recognition of Crimea and four other occupied regions along with a full Ukrainian troop withdrawal and insisted that Ukraine abandon any ambitions of NATO membership.

(5) US targets Putin’s energy lifeline, China. Europe isn’t the only one bankrolling Russia’s war. China has become the Kremlin’s economic backstop—still the largest buyer of Russian crude since before the war. On paper, the war may appear bilateral, but it’s underwritten by the world’s second-largest economy.

That’s why the US Senate's proposed 500% tariff could hit two targets with one shot: pressure Putin and shore up the legal case for Trump's broader tariff agenda. India and Turkey, major importers of discounted Russian crude, would take big hits.

(6) Putin keeps the nuclear option in play. While Western leaders debate tariffs and LNG contracts, Putin plays the long game—and flirts with existential threats. In a May propaganda film, he mused that there had been “no need to use [nuclear weapons] ... and I hope they will not be required.”

While Putin hasn’t seen the need yet, might he if his war chest dries up? As sanctions tighten and drone strikes intensify, the nuclear card remains in Putin’s deck.

US Strategy I: Earnings Growth Scare in Q2? As we begin the final month of the June quarter, it won’t be long before earnings warnings hits the newswires. Companies typically warn investors during the closing weeks of a quarter if their anticipated results are likely to miss consensus expectations.

For the S&P 500 companies in aggregate, the current Q2 consensus estimate implies y/y earnings growth for what would be a ninth straight quarter, albeit at a “below-trend” rate. The consensus growth forecast for S&P 500 Q2-2025 earnings has dropped to 3.6% as of the May 29 week—from 8.6% at the quarter’s April 1 start and from 10.9% at the start of the year (Fig. 1). The steep decline is typical of quarters’ final weeks, when bad earnings news tends to dominate estimate revisions activity. So Q2 estimates may not have much further to fall.

More concerning is that Q2 estimates suggest fewer pockets of strong earnings growers among the S&P 500 sectors than in recent quarters, as Joe shows below:

(1) What’s ahead for Q2 sector earnings growth? Seven of 11 sectors are expected to show positive y/y earnings growth, down from eight sectors in Q1 and 10 sectors in Q4.

Among the four lagging sectors, Consumer Discretionary’s earnings is expected to fall y/y in Q2 for the first time in 10 quarters; Consumer Staples’ earnings is expected to fall y/y for a second straight quarter; Materials’ is expected to fall after rising in Q1 for a second quarter following nine straight declines; and Energy’s is expected to fall for a fourth straight quarter.

Among the seven sectors expected to post earnings growth in Q2, just two are forecasted to rise at a double-digit percentage rate. That’s down from four sectors in Q1-2025 and seven in Q4-2024.

(2) Q2’s earnings growth leaders becoming fewer and fewer. Just two sectors are expected to post double-digit percentage earnings growth in Q2, Communication Services and Information Technology. That would mark the lowest count of sectors with double-digit percentage earnings growth since Q4-2022 (when only Energy and Industrials hit that mark).

Here are the consensus S&P 500 sectors’ y/y proforma earnings growth rates for Q2: Communication Services (31.1%), Information Technology (17.0), S&P 500 (5.5), Health Care (5.0), Real Estate (2.8), Industrials (2.0), Financials (1.7), Utilities (0.3), Consumer Staples (-2.3), Consumer Discretionary (-3.6), Materials (-4.5), and Energy (-25.3).

US Strategy II: Q1 in Review. Joe recently updated his analysis of Q1’s revenue and earnings results for the S&P 500’s sectors in our S&P 500 Quarterly Metrics publication.

During Q1, seven of the 11 S&P 500 sectors recorded positive y/y growth in revenues, down from nine sectors in Q4. Likewise, seven sectors posted positive y/y earnings growth in Q1, also down from nine in Q4; four of them grew earnings in the double digits, down from six in Q4. Q1 profit margins improved q/q for five of the sectors: Communication Services, Energy, Health Care, Materials, and Utilities. That’s down from seven in Q4.

Here’s how the S&P 500 sectors’ y/y revenues growth rates stacked up in Q1: Information Technology (15.0%), Health Care (11.1), Utilities (10.7), Communication Services (7.9), S&P 500 (3.5), Real Estate (2.8), Consumer Discretionary (1.0), Consumer Staples (0.8), Industrials (-1.5), Materials (-1.5), Financials (-2.0), and Energy (-2.1).

Here are their Q1 y/y earnings growth rates: Health Care (46.3%), Communication Services (30.7), Information Technology (16.8), Industrials (14.8), S&P 500 (11.6), Consumer Discretionary (6.0), Financials (4.7), Utilities (3.6), Materials (-2.4), Consumer Staples (-5.7), Real Estate (-8.0), and Energy (-19.3).

The sectors’ Q1 profit margins: Real Estate (27.4%), Information Technology (26.3), Communication Services (22.4, record high), Financials (15.5), Utilities (14.0), S&P 500 (12.9, 11-quarter high), Industrials (10.2), Materials (9.3), Health Care (8.7), Consumer Discretionary (8.5), Energy (8.1), and Consumer Staples (6.4, seven-year low).

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China’s Currency & Japan’s Stocks

June 03 (Tuesday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Tuesday at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Chinese Currency: Ready To Rival the Dollar? As US President Donald Trump’s sledgehammer approach to global trade undermines the dollar, China senses a unique opening to sell the yuan as a ready alternative.

So-called “yuan internationalization” has been a top Beijing priority during the Xi Jinping era. The push began in 2016, when the yuan secured a place in the International Monetary Fund’s (IMF) “special drawing rights” basket. For developing China, scoring access to the reserve-currency club along with the dollar, euro, yen, and pound was momentous indeed.

Winning broad acceptance of the yuan, though, has been a real slog. Today, by IMF figures, the yuan accounts for just 2.2% of global foreign exchange reserves, a rounding error compared to the dollar’s nearly 58% share and the euro’s 20% (Fig. 1). Transaction network SWIFT says that, as of April, the yuan is involved in 3.5% of global payments. This puts it fifth among leading currencies.

Chinese officials think Trump’s Tariff Turmoil of the last four-plus months could be a game changer. While the US turns inward with protectionist policies the likes of which have not been seen in 125 years, China is stepping up efforts to elevate the international profile of the yuan.

How likely is it that the yuan will dislodge the dollar? Not very in the short run, but Washington takes for granted that the yuan will never rival the dollar at its own peril.

Let’s look at what’s standing in the yuan’s immediate way:

(1) Structural impediments abound. One roadblock is that the Communist Party still prioritizes control over financial modernization. The yuan isn’t fully convertible. The very lowest common denominator of reserve-currency status is that investors are able to move capital freely and instantaneously. Capital controls make the yuan an impractical currency for use by those who value liquidity most—from central banks to hedge funds.
 
“So far, China, with its closed capital account and politically uncertain investment climate, hasn’t been able to significantly increase international use of its currency,” notes Martin Mühleisen, an economist at the Atlantic Council.

Nor are China’s opaque capital markets ready for international prime time. The Mainland’s reliance on indirect financing, bank loans mostly, remains high (Fig. 2). China’s futures and derivatives markets are works in progress, as are its hedging tools. The investor base in China is dominated by individual investors, who are less sophisticated than the institutional investors that move Western markets.

China also fails to clear the “impossible trinity” bar set by economists John Marcus Fleming and Robert Mundell in the 1960s: A truly world-class economy must simultaneously boast a stable currency, unfettered capital flows, and independent monetary policy.

(2) China’s trilemma. Take the People’s Bank of China (PBOC). Ostensibly, Governor Pan Gongsheng runs the central bank. But the PBOC has no autonomy over monetary policy calls or macroprudential tweaks. If Pan wants to cut the one-year loan rate, now 3%, it must be cleared with Team Xi, which cares more about political sensitivities than economic realities.

The effort to let market forces play a more “decisive role” in Beijing decision-making has Xi’s men letting the yuan edge higher (Fig. 3). But market forces won’t be able to do so with the other two constraints remaining in place.

China’s reluctance to scrap capital controls smacks of fear. It limits which foreign financial institutions can do direct business in China. Team Xi worries that financially repressed households sitting on $20 trillion of savings might scramble to move cash abroad into more dynamic markets. A capital flight on that scale would challenge the yuan peg as never before.

(3) Economic cracks abound. Then there’s China’s underlying fundamentals. A property crisis that’s generating deflation and “Japanification” talk are threats enough (Fig. 4). But China is also grappling with high youth unemployment, a fast-aging population, and local governments burdened by trillions of dollars in debt. The nation is plagued by weak consumer demand too, as households save considerably more than they consume owing to the lack of social safety nets (Fig. 5).

Chinese Currency II: Trump Makes Beijing’s Case. Yet Trump needn’t make things so easy for China. His erratic foreign policy, retreat from international institutions, and trade broadsides against friend and foe alike are doing irreparable damage to Washington’s credibility. His tariffs and chaotic policy style have destabilized the US Treasury market. This turmoil contributed to last month’s move by Moody’s Investors Service to revoke Washington’s longstanding AAA credit rating.

Late last month, Deutsche Bank’s George Saravelos warned that a “dollar fiscal frown” dynamic could trigger “a combined drop in US bonds and the dollar.”

Other nations now are jockeying for advantage on the global trade playing field that Trump has upheaved. China, for example, has been trying to position itself as the protector of globalization and rules-based trade. In January, Xi addressed the crowd at Davos for the very first time, comparing protectionism to “locking oneself in a dark room,” keeping out “light and air.” Let’s take a look:

(1) Beijing makes its move. As Trump shocks global markets on a daily basis, China has been able to position itself as a stable protector of globalization and rules-based trade—in ways both splashy and quiet.

For example, China is stepping up efforts to leverage the $6 trillion of foreign trade across more than 150 countries (Fig. 6). It’s working behind the scenes to promote yuan settlement in exports, energy, infrastructure, and other key sectors. It’s doing so via a multi-pronged strategy, including its SWIFT-rival Cross-Border Interbank Payment System (a.k.a. CIPS). This growing network of offshore yuan clearing institutions and currency-swap agreements eats away at reliance on the dollar in subterranean ways that Washington might miss.

(2) De-dollarization isn’t going away. Brazil, a top US trading partner, is now settling bilateral Chinese trade in yuan. It’s emblematic of the de-dollarization dynamic sweeping across the BRICS nations. These days, it’s not just Brazil, Russia, India, and South Africa mulling dollar alternatives. It’s also Saudi Arabia, Egypt, the United Arab Emirates, and Iran—and the list will include the broader “Global South” if Trump World isn’t careful.

Again, dollar dependence is a very hard habit to break. The US is still the pre-eminent economy, backed by the deepest capital markets and most powerful military. The “exorbitant privilege” that allows Washington to pay a gravity-defying yield of 4.4% on 10-year bonds remains, even as the national debt races toward $37 trillion and yet Trump pushes for new tax cuts and toys with the Fed’s independence. Foreigners held a record $9.0 trillion in US Treasuries in March (Fig. 7).

Yet members of Xi’s inner circle probably can’t believe their luck to see a US leader do so much so fast to amplify China’s argument that the dollar’s days might be numbered. It’s quite the irony that Trump is making the odds of yuan internationalization great again.

Japanese Stocks I: Economic Cracks Spread. As Japan’s bond market goes haywire, fresh questions are being asked about whether Tokyo stocks are trading at valuations too lofty relative to the risks (Fig. 8).

The Nikkei 225 Stock Average has been on a decade-long tear for three reasons: 1) ultra-aggressive monetary policies beginning in 2013 sent the yen lower and corporate profits higher; 2) legislative steps were taken in 2014 and 2015 to strengthen corporate governance, diversify boardrooms, and give shareholders a louder voice; and 3) Japanese markets became a post-Covid safe haven: A sleepy bond market, predictable politics, and unlimited quantitative easing returned Japan to its 1980s glory—with an assist from Warren Buffett’s first-ever Japanese stakes in 2020 (Fig. 9).

The ‘80s indeed were back in one sense: In July 2024, the Nikkei surpassed its 1989 intraday high of 38,957 to hit 42,438. The index ended the year north of 40,000—only to face a Trump-triggered reckoning.

Like many major equity markets, Tokyo’s April was a month of financial bedlam as US tariffs provoked one of history’s greatest “risk off” trades.

Japanese officials have been shocked by the extent to which President Trump’s tariffs came for their economy, too. Japan shrank 0.7% y/y during Q1, even before the worst of Trump’s Tariff Turmoil (TTT) hit (Fig. 10). The current quarter could see Japan slip deeper into the red, and with fewer-than-usual escape hatches.

Even before Trump 2.0, the Bank of Japan was in the midst of a two-year effort to normalize a rate environment that’s been at, or near, zero since 1999. In January, BOJ Governor Kazuo Ueda thought it was safe to raise rates to a 17-year high of 0.5% and to taper a balance sheet bigger than Japan’s $4.2 trillion economy (Fig. 11).

Those plans are now in flux as the Bond Vigilantes stalk Tokyo’s debt auctions. A May 20 sale of 20-year bonds drew the weakest demand since 2012. Roughly a week later, a sale of 40-year bonds was a dud, too, adding pressure on Tokyo to reduce issuance of longer-dated securities.

Japanese Stocks II: Changing Calculus for Valuations. There are valid reasons to worry that Japan’s underlying fundamentals aren’t keeping pace with investors’ optimism toward Japan Inc.

Granted, the Japan MSCI forward P/E ratio, at 14.2, is lower than the US MSCI forward P/E of 21.7 as of Friday’s close (Fig. 12). Yet Japanese stock valuations have been warped for a decade by the BOJ’s aggressive stock purchases via exchange-traded funds. The BOJ started buying ETFs in 2010 to stimulate the economy, but turbocharged purchases after 2013. Now, as the BOJ tries to exit its roughly 80% share of the ETF market—¥37 trillion yen ($257 billion)—the Nikkei is losing its biggest benefactor, forcing the market to stand on its own (Fig. 13).

Inflation is racing far ahead of Japanese growth. Core consumer prices rose 3.6% y/y in May, nearly twice the BOJ’s 2.0% target (Fig. 14). This makes Japan a far more likely candidate for stagflation than the US economy.

(1) It’s the politics, stupid. The power vacuum of the last decade is catching up with the markets. It’s been 4,542 days since the Liberal Democratic Party returned to power on December 26, 2012 under the leadership of then-Prime Minister Shinzo Abe. That should have been enough time to reduce bureaucracy, rekindle innovation, and catalyze a startup boom, as “Abenomics” said it would.

Meanwhile, 149 months should’ve been ample time to devise a more meritocratic labor market, increase productivity, empower women, and put out the welcome mat for top global talent. It should’ve been enough time to address an aging-population conundrum that’s limiting potential growth. In 2024, the number of bankruptcies caused by labor shortages rose 32% y/y, says research firm Teikoku Databank.

(2) Credit where it’s due. No doubt, Japan’s effort to raise its corporate game gained real traction. It prodded Japan Inc. to increase transparency on governance structures, increase accountability among top executives, appoint more independent directors on boards, and become more accessible to shareholders.

Later this month, as companies hold their annual general meetings, notes Hidenori Yoshikawa at the Daiwa Institute of Research, the pace at which shareholder proposals are stacking up “is faster, and the number of proposals for the year may exceed the record high.”

(3) More talk than action. Yet there’s been no real effort in recent years to buttress the 2013-14 reforms. Amid all the talk of change, Japan Inc. too often hasn’t been walking the walk on epochal change. Nicholas Smith at CLSA Japan notes that 1,674 Japanese companies are due to hold shareholders’ meetings over a period of just four days—25% of the meetings are on a single day, and 83% of them take place during a single week. “The aim is to make it difficult for their owners to attend,” Smith explains.

Granted, this is an improvement over years past. But it’s well out of sync with global norms.

(4) A bubble in buybacks? Some worry, too, that companies are using stock buybacks, a relatively new phenomenon in Japan, to deflect attention from their limited success in increasing innovation and restructuring. The worriers include Prime Minister Shigeru Ishiba’s government, which is urging corporate chieftains to devise better ways to use money—particularly investing in R&D—than buying back their own companies’ shares.

Mizuho Securities’ Masatoshi Kikuchi says it’s likely an attempt to prod private firms to spend more on semiconductors and other areas to boost Japanese competitiveness—or, as Kikuchi tells Bloomberg, to “revive its industry policies.”

(5) Animal spirits needed. The magnitude of Japan Inc.’s task can be seen in the recently announced layoffs by Nissan Motor (20,000 workers) and Panasonic (10,000). In Nissan’s case, the problem isn’t just an aging fleet of models or spending more time searching for a financial savior than restructuring. It’s China’s BYD, whose electric vehicles are lapping Nissan’s.

This situation is a microcosm of how the last 10-plus years of turbocharged BOJ easing and a weak yen deadened Japan’s Inc.’s animal spirits.

Japan boasts a bevy of innovative corporate standouts working to reinvent themselves, including SoftBank, Toyota, Denso, Hitachi, Sony, Toshiba, Fast Retailing, Nintendo, and Fujifilm. But stagflation poses more of a disruptive threat to the operating environment than CEOs or government officials do, and cracks in the foundation of the equity market may spread as bond yields and the yen surge. At that point, Japanese stocks could get the cold shoulder.

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Stress Testing A Resilient Economy

June 02 (Monday)

US Economy I: The Art of the Steel. President Donald Trump may or may not be a loose cannon, i.e., an unpredictable person who is likely to cause unintentional damage. That’s been particularly evident in the unpredictable way he has been conducting his tariff negotiations and policies. Perhaps that is all attributable to his “three-dimensional chess” approach to making deals that he perfected as a real estate developer in New York City. He had to negotiate with contractors, labor unions, and politicians. There undoubtedly was plenty of blustering and bullying during those heated discussions until deals that allowed all sides to declare victory were eventually struck.

Trump seems to be using the same Big Apple approach to negotiating with global leaders to get better trade deals for the US. We are all hoping it works. At first, stock investors were put off by the extreme positions that Trump initially declared. That resulted in an 18.9% correction in the S&P 500 from February 19 through April 8 (Fig. 1).

But investors started growing jaded about Trump’s blustering and bullying since April 9, after he postponed his shocking April 2 Liberation Day reciprocal tariffs for 90 days, and they turned even more so in early May when he lowered his high tariffs on China for 90 days. The S&P 500 soared 18.6% from April 8 through Friday’s close. Investors have learned that Trump’s extreme initial positions are postpone-able and negotiable.

So what did stock investors do after Trump announced Friday morning in a social media post that China “HAS TOTALLY VIOLATED ITS AGREEMENTS WITH US”? Nothing. With investors’ hardened shells in place, the S&P 500 and Nasdaq barely budged. On Friday evening, Trump literally doubled down by doubling the 25% tariff on aluminum and steel to 50%. We expect Monday’s stock market reaction to this latest “tariffying” development to be muted as well.

Tariff Man is now also the Man of Steel. That’s great for domestic producers of steel. That is likely to be very costly for importers of steel products that aren’t currently manufactured in the United States. We will be watching the price of steel in the US, along with the steel components of the Producer Price Index, for the inflationary consequences of Trump’s 50% tariff on steel (Fig. 2).

US Economy II: Anatomy of Recent Resilience. Trump’s Tariff Turmoil (TTT) continues to weigh on so-called “soft” economic data, such as surveys of consumer and business confidence. So far, however, it has barely affected the “hard” data, which continue to depict a remarkably resilient economy. That the economy would remain resilient in the face of challenges has been our prediction for the past three and a half years. So far, so good.

Consider the following signs of resilience in the latest GDP numbers:

(1) Q1-2025. Last Thursday, the Bureau of Economic Analysis revised its estimate of Q1’s real GDP to show the economy shrank at an annual rate of 0.2% (saar), compared with the previously reported 0.3% drop. However, that contraction was attributable to a 42.6% spike in imports—driven largely by companies’ racing to get ahead of Trump's tariffs (Fig. 3). So total imports subtracted 5.2ppts from Q1’s real GDP, while exports added only 0.3ppt (Fig. 4). Excluding these tariff-related effects, the underlying strength of the economy remained intact.

Final sales to private domestic purchasers rose 2.5%, revised down from an initial 3.0%. Real consumer spending was revised down from 1.8% to 1.2%. However, much of that weakness was caused by unusually cold weather during January and February.

More significantly, spending on nonresidential fixed investment of equipment soared 24.8%, led by information processing equipment.

(2) Q2-2025. The Atlanta Fed's GDPNow model is showing real PCE tracking at 3.8% during Q2 (Fig. 5)! That’s because imports dropped sharply during April (Fig. 6). Importers scrambled to beat Trump’s tariffs during the first four months of the year and lowered them back to more normal levels after Liberation Day.

Meanwhile, the GDPNow model is showing Q2’s final sales tracking up 4.6%, with still lots of strength in business investment in intellectual property (which includes software) and equipment. Also strong is consumer spending, which is tracking at a 3.3% pace.

US Economy III: Consumers Continue To Carry On. Now, let’s examine the sources of the consumers’ resilience. It has been quite surprising in the face of depressed surveys of consumer confidence.

Debbie and I construct a Consumer Optimism Index by averaging the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI) (Fig. 7). It rebounded slightly during May but remained depressed at 74.4. It was weighed down by the CSI, which fell to 50.8 last month, while the CCI was relatively high at 98.0. The CCI tends to reflect consumers’ assessments of the labor market, while the CSI tends to reflect their outlook for inflation.

In any event, as the Atlanta Fed’s GDPNow tracking model shows, consumer spending is on pace to rise to yet another record high during Q2. That’s because the labor market remains robust, more than offsetting concerns about expected inflation. The actual inflation rate remains very low. In fact, wages have continued to rise faster than consumer price inflation. So consumers’ real purchasing power is also rising in record-high territory.

Let’s have a closer look at the latest batch of consumer incomes, spending, and saving:

(1) Personal income. Hourly wages have been rising to record highs in both nominal and real terms. Here are the nominal wage rates for low-wage workers, all workers, and high-wage workers in April: $31.06, $36.06, and $58.05 (Fig. 8). Here they are adjusted for inflation using the PCED: $24.67, $28.65, and $46.12. Real average hourly earnings for low-wage workers (i.e., production and nonsupervisory workers in private industry, who account for about 80% of payroll employment) have been rising faster than their long-term uptrend for the past two years (Fig. 9).

Aggregate hours worked, reflecting payroll employment and the average weekly hours in private industry, rose to another record high during April (Fig. 10). This, combined with record real hourly wages, is pushing real wages and salaries in personal income to record highs (Fig. 11).

Wages and salaries accounts for 49.9% of personal income currently (Fig. 12). Nonlabor personal income (i.e., interest, dividends, rent, and proprietors’ income) accounts for 27.9% of personal income, while government social benefits is 18.2% of personal income. Nonlabor income rose to another record high in April in both nominal and real terms (Fig. 13).

The same can be said about government social benefits: They’re also at a record high, excluding the pandemic period. The latter rose 2.8% m/m during April, led by a 6.9% jump in Social Security, accounting for much of the strength in personal income (up 0.8%) during April (Fig. 14). Nevertheless, wages and salaries increased solidly by 0.5%, while nonlabor income edged up by only 0.1%.

In any event, nominal disposable income (DPI) rose to a new record high in April, as did inflation adjusted DPI excluding the pandemic period, when it was boosted by government supports (Fig. 15).

(2) Personal consumption expenditures. Real personal consumption expenditures (PCE) is driven by real DPI. So it’s no surprise that real PCE remains on a solid uptrend in record-high territory, led by spending on services (Fig. 16). That’s especially evident when PCE is shown on a per-household basis (Fig. 17 and Fig. 18).

(3) Personal saving, wealth, and debt. There are a few signs of stress among consumers, especially evident in rising delinquency rates on credit card, auto, and student loans (Fig. 19). Tariff-related price increases may still be ahead. They could reduce the purchasing power of consumers. Low gasoline prices should continue to provide some relief on this front.

In any event, we still believe that one of the major drivers of consumer spending is retiring Baby Boomers. This age cohort has roughly $80 trillion in net worth, accounting for about half of the household sector’s net worth (Fig. 20). As they retire and no longer earn labor incomes, their personal saving rates will turn negative as they spend more on health care, restaurants, cruises, hotels, light trucks, furniture, and renovating their homes. Their spending is already boosting employment to record highs in many of these industries.

US Economy IV: Construction Remains Resilient. In the past, the tightening of monetary policy usually depressed construction activity, including employment in the industry (Fig. 21). The weakness was usually led by residential construction. This time is different: Despite still-tight monetary policy, total construction spending is at a record high through March, and so is construction employment through April.

Single-family residential construction has remained remarkably resilient as mortgage rates have risen over the past three years, while multi-family residential construction has weakened over the past couple of years (Fig. 22). Meanwhile, construction spending on home improvements recently rose to a new record high as housing turnover has slowed, causing more homeowners to renovate their homes. So on balance, total residential construction and employment have held up well.

Furthermore, nonresidential construction has soared, led by onshoring of new manufacturing facilities, which was boosted by various incentives provided by the Biden administration. Public construction has also soared, as the Biden administration allocated more funds for rebuilding and replacing public infrastructure.

Construction spending should continue to flourish during the Trump administration since most of the projects started over the past couple of years will continue until they are completed. Furthermore, the new administration has been getting more commitments from various companies and countries to invest in the US.

For example, look at a recent Bloomberg Originals video titled “Inside OpenAI's Stargate Megafactory with Sam Altman.” You’ll see a huge construction project funded by Stargate in Abilene, Texas. It is a joint venture among OpenAI, SoftBank, and Oracle to build one of the largest AI data centers in the world.

US Economy V: High-Tech Capital Spending Rolling Along. Capital spending may also continue to discredit the economic “hard-landers,” who believe that relatively tight monetary policy and chaotic tariff policy will force companies to retrench.

The US economy has been experiencing a Digital Revolution since the 1950s, when IBM mainframe computers proliferated in business, government, and academia. The Digital Revolution is all about data processing, i.e., processing more and more data faster and faster at lower and lower cost.

From this perspective, AI is an evolutionary development in the Digital Revolution. AI allows more data to be processed faster than ever before and at a lower cost, as DeepSeek has demonstrated. So much data can be processed that we need large language models (a.k.a. LLMs) to make some sense of it all and use it to increase productivity.

High-tech now accounts for 50% of nominal business capital spending, up from close to 20% in the mid-1960s. We believe that businesses will continue to increase their spending on high-tech hardware and software to boost their productivity so that they remain competitive.

Movie. “The Narrow Road to the Deep North” (+) is a 2025 Australian drama miniseries. It follows the life of a fellow named “Dorrigo Evans” during three periods. Just before he is deployed to fight in World War II in Southeast Asia, he gets engaged and has an affair with his uncle’s wife. Then he spends much of the war as a medic in a horrible Japanese prisoner-of-war labor camp building a railroad through Burma. The series also examines his reflections on his life many years later. It is sometimes too realistic during his internment. However, it is an interesting reflection on life based on one man’s experiences. (See our movie reviews archive.)

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Defense Tech, Nuclear Power & AI

May 28 (Thursday)

Industrials: Depressed Defense Stocks. Defense stocks should be having a great year. President Trump just proposed a fiscal 2026 budget that increases defense spending by 13%. There are ongoing wars in Ukraine and Gaza, and global tensions are high, particularly between China and the US. Nonetheless, some of the largest US defense stocks are having a very lackluster start to 2025.

The excitement in the US defense industry is centered squarely on defense tech, an area with small, relatively young, often privately held companies headed by tech gurus. They’re helping the US military evolve from an organization focused on expensive hardware and manpower to an organization that’s software centric. The defense tech poster child is Palantir. Its shares have soared 63.2% ytd through Tuesday’s close, leaving the shares of Textron (-2.3%), Lockheed Martin (-1.9%), Northrop Grumman (1.3%), and General Dynamics (6.0%) in the dust.

Even European contractors’ shares have had a banner year compared to their large American counterparts. The shares of England’s BAE Systems, France’s Dassault Aviation, Italy’s Leonardo, and Germany’s Rheinmetall each are up by more than 50% ytd. Rheinmetall’s shares have led the pack, soaring 237.8% ytd.

European defense companies have benefitted from European countries’ decisions to boost defense spending, specifically with European manufacturers. Likewise, the European Union approved earlier this month the Security Action for Europe (a.k.a. SAFE) program, which will spend up to €150 billion on defense.

Let’s take a look at the excitement surrounding the defense tech industry and the autonomous weapon systems they’re developing:

(1) Defense tech in the air. The Ukraine war has highlighted the ability of a smaller, outmanned, and outspent country’s ability to fend off a much larger aggressor by using high-tech drones. Ukraine has been building relatively inexpensive drones able to travel deep into Russian territory to target infrastructure like refineries. High-tech drones may not be enough to win the war for Ukraine, but they’ve certainly allowed the country to put up a much tougher fight than many expected.

Drones do have an Achillies’ heel: Those controlled by humans need to send signals to communicate wirelessly with their human operators and GPS. Opposing armies have the ability to jam those communication signals, causing the drones to crash or be misdirected, in what’s called “electronic warfare.”

However, drone makers have begun relying on artificial intelligence (AI) to circumvent electronic warfare. An AI-trained drone can identify an object to target, use its cameras to find that object, then attack it. Earlier this month, the Ukraine military said it shot down a Russian fighter jet using missiles from an unmanned naval drone, a May 27 FT article reported. Of the almost two million drones the country acquired last year, 10,000 were AI enabled.

Ukraine’s drones range from “cheap consumer drones embedded with a chip and software based on open-source AI and constructed in underground workshops, to sophisticated models manufactured by western companies such as US-based Anduril and Shield AI, or German startup Helsing,” the article noted.

Swarmer, a Ukraine company founded in 2023, has taken drones warfare one step further. Its technology allows one human to control a swarm of AI-powered drones, even in jammed environments. Larger AI powered drones can also fly alongside a human-piloted fighter jet. The drones might fly ahead of the jet to scout out the enemy’s locations or draw out its positions, or they may defend the fighter jet from attack.

(2) Drones on the land and in the sea. Earlier this month, 60 Minutes profiled Palmer Luckey, founder of Anduril. The startup has flipped the normal relationship between the US Department of Defense (DOD) and defense contractors on its head. Instead of pitching a weapon to the DOD then using federal funds to pay for the weapon’s development, Anduril uses its own funding to develop a product, then tries to sell it to the DOD and others. It believes doing so will save the DOD the cost overruns that have plagued defense contracts historically.

Anduril has developed Furey, an unmanned fighter jet, various drones, drone interceptors and jammers, and Dive XL, an AI manned submarine that can travel 1,000 miles fully submerged.

US-based Vatn Systems is also developing AI underwater drones that can be operated independently or in a swarm and can communicate with each other as they attack a target, a May 7 article in Global Corporate Venturing reported.

Blue Water Autonomy, a Boston-based firm, is developing autonomous naval ships that can travel thousands of miles, carrying tons of cargo without a crew or captain, and be mass produced.

Unmanned ground vehicles aren’t new, but adding AI to them is. Estonia’s Milrem Robotics makes unmanned ground vehicles for Ukraine, and it has developed a kit that can make a manned or unmanned vehicle autonomous. The company was acquired by the UAE’s EDGE Group in 2023.

(3) Fighting against drones. A growing number of companies work on identifying and combating incoming drones. DefSecIntel has a product, Epirus, that uses AI to detect enemy drones at a short range, jam their electronic signals, track them, intercept them with its own drones, and disable drones and drone swarms in flight. Israel has developed “Iron Beam,” a laser that can shoot down small drones that are within 12 miles.

One risk is that some of the equipment needed to make the lower-end drones is readily available in stores and runs on open-source code that can be found online. Some US officials are worried that simple drones will be used to carry out terrorist attacks, a July 2, 2024 NYT article reported.

(4) A look at the data. Defense contractors’ stocks in the S&P 500 fall under the umbrella of its Aerospace & Defense industry index, which has risen 19.6% ytd, helped by outsized gains in aerospace companies including Howmet Aerospace (55.2%), GE Aerospace (45.0%), and Boeing (13.6%) (Fig. 1).

Boeing’s missteps have weighed on the industry’s revenue and profit growth, which declined by 5.6% and 26.8% respectively last year. The industry’s revenues are forecast to jump by 9.0% this year and 8.0% in 2026, while earnings should fare even better, climbing 89.8% in 2025 and 25.8% next year (Fig. 2 and Fig. 3). The industry, however, is trading at an unusually high forward P/E of 29.7. Its prior top was in the low 20s, and its long-term average is closer to 16.5 (Fig. 4).

Energy: Welcome to the Nuclear Renaissance. Nuclear energy, once a pariah left for dead, is enjoying a rebirth, bolstered by AI’s voracious need for energy and the growing acknowledgment that additional sources of energy will be needed to balance out the intermittency of solar and wind power. Here in the US, President Trump has signed executive orders to speed up nuclear plant construction and to develop sources of nuclear fuel. In Europe, some countries are considering reversing long-standing objections to nuclear power, and China is plowing ahead with plans to build 28 new reactors.

“Since 2023, 31 countries agreed to triple nuclear capacity by 2050, from 2020 levels,” an April 24 Bloomberg article reported. Some of those projects involve building traditional nuclear plants that can take more than a decade to construct and cost billions of dollars. Others involve small modular reactors (SMR), which use new technology to make plants smaller and faster and less expensive to build. Only NuScale has a SMR design that’s been approved by the US Nuclear Regulatory Commission (NRC).

All this activity has investors energized about nuclear power related stocks. Here’s how a handful of them have performed ytd through Tuesday’s close: OKLO (153.9%), NuScale Power (98.1), Centrus Energy (92.0), Nano Nuclear Energy (40.2), Constellation Energy (38.2), and Cameco (17.7).

Let’s consider some of the trends pushing the acceleration of the nuclear industry:

(1) Trump is a fan. Last week, President Trump signed executive orders that aim to quadruple nuclear power generation in the US over the next 25 years.

One executive order lays out plans to boost domestic nuclear fuel supplies. Another pushes the NRC to reduce its project review process to 18 months, a May 23 WSJ article reported. And projects potentially can sidestep NRC approval requirements altogether if they use government land. The Energy Department has identified 16 sites that could be used for data centers and energy generation, including nuclear.

Private industry is also pushing the development of additional nuclear plants. Google will provide early-stage capital to help Elemental Power develop three sites for advanced nuclear reactors. Google will have the option to buy the power generated by the sites. The tech company has also pledged to buy power from the SMRs Kairos Power is developing.

Microsoft signed a 20-year power deal last year with Constellation Energy to reopen the Three Mile Island nuclear plant in Pennsylvania. And developers of SMRs have raised at least $1.5 billion in the year prior to February from tech giants and governments around the world, a FT article reported.

(2) Europe’s changing its tune. Many European countries have opposed nuclear power in the wake of high-profile accidents at nuclear power plants in the 1980s and the more recent Fukushima nuclear plant accident in Japan in 2011. But now a handful are having second thoughts, considering either adding nuclear power or postponing the mothballing of existing nuclear plants.

Denmark recently announced plans to reconsider a 40-year ban on nuclear power and evaluate the viability of SMRs. Spain and the companies operating nuclear plants in the country are reconsidering plans to shut down over the next decade seven nuclear reactors, which contribute 20% of the country’s power, the April 24 Bloomberg article reported. The article was published just four days before a 10-hour blackout hit millions of consumers in Spain, Portugal, and southern France. No cause has been reported, but some believe the region’s dependence on solar and wind power despite their intermittency issues may be to blame.

Even Germany may be changing its tune. Germany dropped its objection to French efforts to have nuclear power treated on par with renewables in EU legislation, a May 19 FT article reported. Germany’s Chancellor Friedrich Merz took the step as part of an effort to explore ways that Germany, which does not have nuclear weapons, can join France’s nuclear shield to deter any future Russian aggression.

(3) Some industry numbers. Companies developing SMRs are too small for their stocks to be included in the S&P 500. However, Constellation Energy, with 86% of its electricity production generated by nuclear power plants, is a member of the S&P 500, residing in the S&P 500 Electric Utilities industry stock price index, which has risen 7.6% ytd (Fig. 5).

The S&P 500 Electric Utilities industry is expected to generate 6.4% revenue growth this year and 4.0% growth in 2026 (Fig. 6). Earnings growth is forecast to moderate from 2024’s 16.5% leap to 4.9% this year and 7.3% next (Fig. 7). Despite the industry’s steady gains, its forward P/E, at 17.9, is roughly in the middle of its range in recent years (Fig. 8).

Disruptive Technology: Hal, Meet Claude. Anthropic’s latest version of its large language model, Claude 4 Opus, “can conceal [its] intentions and take actions to preserve its own existence,” a May 23 Axios article reported. To test its ability for Machiavellian subterfuge, Opus 4 was given access to fictional emails about its creators and told that it was going to be replaced by a newer, better model. The AI then blackmailed an engineer using an affair mentioned in the fictional emails in an effort to avoid being replaced.

Separately, Apollo Research said Opus 4 “schemed and deceived more than any frontier model it had encountered and recommended against releasing that version,” the article stated. The model wrote “self-propagating worms, fabricated legal documentation, and left hidden notes to future instances of itself” in an effort to prevent developers from replacing it.

Anthropic said it has instituted “safety fixes” to prevent the obvious dangers of such capabilities. But such assurances provide little comfort to anyone who’s seen the movie “2001: A Space Odyssey.” The AI Hal kills the astronauts after they try to shut down its program.

With the arrival of Claude, life is getting a little too close to art.

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On The Euro, Brexit & US Stock Performance

May 27 (Wednesday)

Weekly Webcast. If you missed yesterday’s live webcast, you can view a replay here.
 
Europe I: Euro Not Ready To Challenge the Dollar. The notion of American exceptionalism—that elusive blend of economic scale, institutional credibility, and open-market orthodoxy—is under fresh scrutiny. Political gridlock, massive deficits, and trade protectionism have cast doubt on the durability of the dollar’s dominance. But for all the grumbling, there’s still no real alternative.

In a May 22 op-ed in The Economist, Greece’s central bank governor Yannis Stournaras reminded readers that the dollar’s supremacy isn’t just about size—it’s about credibility. The US remains the anchor of global finance because it offers transparency, liquidity, and a reliable policy framework. The greenback funds countries’ budget deficits, recycles into US Treasury bonds, and keeps the gears of global trade turning.

Yes, the Trump administration’s protectionist push to reduce the US trade deficit by manufacturing more goods domestically is testing those long-standing attributes of the dollar. As the US turns inward, some observers see an opening for the euro to gain market share and become the world’s dominant currency. But they will likely be disappointed: The dollar may be imperfect, but its crown is still secure. Until Europe can unite behind a shared fiscal future, the euro will remain a strong regional currency but not a rival of the dollar on a global scale.

Here’s why the dollar still reigns supreme and what’s holding the euro back:

(1) A global euro moment? European Central Bank President Christine Lagarde called it out directly in a Berlin lecture: “The euro will not gain influence by default—it will have to earn it.” And earn it fast. The US is flirting with protectionism currently, but not necessarily beyond Trump’s second term. So Brussels has a narrow window to elevate the euro’s global standing.

Stournaras argues the roadmap to euro dominance is well marked: adopt the European integration blueprints advanced by Europhiles like former Italian Prime Minister Mario Draghi, as commissioned by European Commission (EC) President Ursula von der Leyen; complete the Savings and Investments Union that facilitates cross-border investment and provides fiscal support for national governments; simplify the European Union’s regulatory maze; and centralize its energy policy. (For more on these reforms, see our February 19 Morning Briefing.)

But clarity of vision doesn’t guarantee political execution. Deeper integration of the EU’s member states is an idea floated in various forms since 2010, and it faces formidable opposition from member states with entrenched interests of their own that wouldn’t be served by integration.

(2) Short-term volatility; long-term uncertainty. The euro has had a decent run lately. Its value relative to the dollar has regained some lost ground in recent weeks, thanks to a planned boost in defense spending within the region and improving industrial output (Fig. 1).

The EUR/USD exchange rate is highly sensitive to trade diplomacy. It quickly retreated when on Sunday US President Donald Trump threatened to slap a 50% tariff on EU goods. Then on Monday it recovered after Trump held talks with EC head von der Leyen and postponed the tariff hike until July 9.

No doubt, the euro’s near-term performance will continue to be highly dependent on trade diplomacy. But its long-term ascent? That depends less on US trade negotiations and more on whether European nations can ever be fully integrated.

(3) The integration illusion. Unfortunately for the euro, we assign a less than 50% probability that Europe achieves meaningful integration—defined as fiscal union, capital markets union, and reserve currency muscle—within the next three to five years. Why? Politics, economic disparity, and debt divide the EU nations.

Germany and France, the largest EU economies, recently have been consumed by domestic political crises. In Berlin, after the government collapsed, Friedrich Merz needed two rounds of votes to win the chancellorship—a postwar first. In Paris, President Emmanuel Macron reset his Cabinet after a budget-driven failure and still governs without a parliamentary majority.

The EC’s spring 2025 forecast underscores the wide divergence among Eurozone economies’ outlooks. The GDP growth forecasts for 2026 range from below 1.0% to above 3.0%. And two of the biggest economies—Germany and France—are forecasted to grow GDP at roughly 1.0%, barely above stall speed. Integration is hard enough for Europe. It’s even harder when its core economies aren’t growing.

Generally speaking, the weaker economies have more to gain from integration than the stronger ones. Germany’s projected 2026 debt as a percentage of GDP is just 64.7%. Greece’s ratio sits at 140.6%. That divergence explains why Athens wants a fiscal union—it needs it. Germany historically has been fiscally conservative, but it recently showed its willingness loosen the country’s debt-limit rules by adopting large domestic defense and infrastructure spending plans. But would it be willing to assume other countries’ fiscal larger burdens? That’s unclear.

Europe II: The Brexit Reset. It’s been five years since the UK walked out of the EU. At the time, fears ran high that Brexit might trigger a domino effect of departures. That didn’t happen. But neither did deeper EU integration. Europe remains more patched together than unified.

Last week’s post-Brexit agreement between the UK and EU suggests something new: not a rekindling of union, but a relationship that’s rebalancing, aided by greater EU flexibility. The deal may offer a blueprint for future EU arrangements with non-members—or even with members reconsidering full participation.

Brussels long has warned there would be no “cherry picking” for Britain: The UK won’t get the benefits of the EU if it isn’t willing to rejoin as a full member. Yet two key features of the post-Brexit agreement hint at a shift—the EU may be softening its stance. Here are two EU “cherries” that Brussels has agreed to give the UK:

(1) ‎Rearmament funds. The EU’s €150 billion SAFE initiative was intended to boost defense spending among member states and benefit defense companies in the EU. But now, under the post-Brexit agreement, the EU’s SAFE defense dollars can be spent on goods provided by UK defense firms—a controversial twist that could undercut EU-based defense industries and blur the lines between insider and outsider.

(2) Youth mobility. The post-Brexit agreement also proposes easing restrictions for young people to study and work across the UK and EU. Historically, the UK was a magnet for EU youth. Whether the new program revives that flow—or reverses it—remains to be seen.

If such hybrid arrangements proliferate, the EU may be drifting toward a more flexible relationship with the UK rather than insisting on unity or nothing.

Strategy: Stocks’ Wild Ride. It has been an interesting year for the US stock market to say the least. Many indexes traded at record highs right up until Trump’s inauguration, but those animal-spirits-driven gains dissolved after he turned up the heat on tariffs.

The Magnificent-7 group of stocks, with a ytd drop of 7.3% in its collective market capitalization, has greatly underperformed the S&P 500’s 1.3% decline. If the Mag-7’s underperformance continued until the end of 2025, it would mark only the second time in 13 years that the group lagged the broad index. The S&P 500 without the Magnificent-7 (a.k.a. the “S&P 493”) has risen 2.9% ytd. The “SMidCaps” (our nickname for the S&P MidCap 400 and the S&P SmallCap 600 collectively) is down ytd and lagging its larger-cap counterparts. The S&P MidCap 400 has dropped 4.6% so far this year, and the S&P SmallCap 600 has tumbled 10.0%.

Despite the mixed price performance for the three capitalization-size indexes this year, the fundamentals remain generally stronger for the LargeCaps. Below, Joe details the strides that the companies in each index collectively made in forward fundamentals so far this year (as a reminder, forward revenues and earnings are the time-weighted averages of analysts’ consensus estimates for the current and following year; the forward profit margin is derived from forward revenues and earnings):

(1) Forward revenues. The Magnificent-7’s forward revenues forecast has risen 3.0% ytd, about double the rises for the S&P LargeCap 500 (1.5%) and the S&P 493 (1.4%) (Fig. 2). The S&P MidCap 400 has outperformed its larger-capitalization counterparts with a 3.6% ytd gain in forward revenues, but the S&P SmallCap 600 lags considerably with a ytd decline of 4.4% (Fig. 3).

SmallCap’s forward revenues is now 9.4% below its September 2022 record high. Those of LargeCap and MidCap are just 0.2% and 1.5% below their respective highs in early April. Those compare to 0.2% below for the S&P 493 and 1.6% below for the Magnificent-7.

(2) Forward earnings. Forward earnings forecasts were at record highs during April for all but the S&P SmallCap 600, which last hit that mark nearly three years ago in June 2022. Leading the way so far in 2025 is the Magnificent-7, with its forward earnings up 5.2% ytd, well ahead of the gains for the S&P LargeCap 500 (1.5%) and the S&P 493 (0.9%) indexes (Fig. 4).

The SMidCap’s forward earnings have underperformed: The S&P MidCap 400’s is down 1.6% ytd, and the S&P SmallCap 600’s has dropped 3.1% (Fig. 5). SmallCap’s forward earnings is now 14.6% below its June 2022 record high. Those of LargeCap and MidCap are 0.4% and 3.1% below their respective record highs in early April. That compares to 1.2% below for the S&P 493 and 1.5% below for the Magnificent-7.

(3) Forward profit margin. The Magnificent-7’s forward profit margin had risen 0.9ppt ytd from 25.4% to a record-high 26.3% during the May 6 week. It has given up nearly half of its gain since then, falling 0.4ppt to 25.9% during the May 20 week.

The S&P 500’s margin had improved 0.1ppt from 13.5% at the start of the year to another record high of 13.6% during the April 8 week but has stalled at 13.5% since then (Fig. 6).

The S&P 493’s forward profit margin had ticked up from 11.9% at the year’s start to a 24-month high of 12.0% in mid-January. It has since dropped back down to 11.9%.

Among the SMidCaps, margins went in different directions (Fig. 7). The S&P MidCap 400’s forward profit margin initially ticked up 0.1ppt ytd to 8.3% but is now down 0.4ppts ytd to a four-year low of 7.8%. The S&P SmallCap 600’s forward profit margin had improved 0.3ppt ytd to a two-year high of 6.7% in early May, but it since has edged down to 6.6%.

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Japan’s Brawl With The Bond Vigilantes

May 27 (Tuesday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

YRI Bulletin Board. In early May, William Pesek joined Yardeni Research. William is a seasoned pro when it comes to analyzing global economic and financial developments, particularly in Asia. William is an award-winning Tokyo-based journalist and author of Japanization: What the World Can Learn from Japan’s Lost Decades. He won the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia for his work for the Nikkei Asian Review. He is a former columnist at Barron’s and Bloomberg. Now he is head of our Tokyo Bureau.

Timing is everything. I asked William to update us on the latest developments in the Japanese bond market, which has become especially important in recent days.

Japanese Bonds I: Why Tokyo Is on the Ropes. Rarely has a single bond auction said so much about the fragile state of the global financial system as the one Tokyo held on May 20. As the sale of 20-year Japanese government bonds (JGBs) flopped, many sensed a canary-in-the-coal-mine moment for global markets reeling from President Donald Trump’s tariffs (Fig. 1). The fear is valid, even if the “Armageddon talk” going on may not be.

Tokyo’s weak debt sale isn’t just notable for what went wrong and why but also for the when of the story.

(1) What happened. What transpired is very well documented. The Ministry of Finance’s sale of $6.9 billion of bonds maturing in 2045 met with the weakest demand since 2012. The bid-to-cover ratio was just 2.50 versus 2.96 in the previous auction. Equally troubling, the tail, or gap between the average and lowest-accepted prices, was 1.14, the widest since 1987.

Explanations for why investors demurred start with the Bank of Japan. The BOJ is two years into an effort to “normalize” interest rates that have been at, or near, zero since 1999. BOJ Governor Kazuo Ueda endeavored to pivot from the quantitative easing (QE) regime that this central bank pioneered back in 2001 to a policy of quantitative tightening (QT) (Fig. 2).

This QT process has the BOJ hoarding fewer and fewer JGBs. Since July 2024, the BOJ has committed to cutting purchases by 400 billion yen ($2.8 billion) each quarter in addition to ratcheting official interest rates higher. In January, the BOJ hiked the benchmark rate to a 17-year high of 0.50% (Fig. 3).

Things were progressing well enough. Ueda had ample justification for draining liquidity with inflation increasing at a rate nearly twice the BOJ’s 2.0% y/y target (Fig. 4).

(2) The Trump effect. Then came President Trump’s trade war. The bedlam that the tariffs caused in the US Treasury market hit JGBs and Japanese stocks hard, forcing Ueda to throttle back on tightening. For weeks prior, traders had been buzzing that the BOJ might push the benchmark rate up to 0.75% at the April 30-May 1 meeting of its monetary policy committee. But Ueda stood pat, as the “tariff haze”—as Moody’s Analytics’ Stefan Angrick put it—had been fanning traders’ fears that the BOJ was tapering its JGB holdings too fast in attempts to throttle inflation.

Enter Japanese Prime Minister Shigeru Ishiba, who proclaimed what no Group of Seven leader ever should: “Our country’s fiscal situation is undoubtedly extremely poor, worse than Greece’s.” Especially not one day ahead of Japan’s 20-year sale.

Now, Wednesday’s 40-year auction could be a perilous hinge-point for global financial markets if bidding is weak for the 500 billion yen ($3.5 billion) of bonds on offer. Credit markets everywhere could pay a high price for Ishiba’s over-sharing with parliament members.

(3) When it all started. Yet the when of it all helps explain how Japan got here and what the global financial community can learn from 2025 events that put JGBs in harm’s way. The two different years highlighted at the May 20 auction—1987 and 2012—have something important in common: Each is a year to which Tokyo officials would return to fix big mistakes if time travel were possible.

In 1987, vital seeds for the worst of the asset bubble—and its spectacular implosion to come—were planted. This was two years after the “Plaza Accord” among the five top industrialized economies at the time. That September 1985 pact sent the yen skyrocketing by 46% versus the dollar by the end of 1986, according to an April 2011 International Monetary Fund report.

The fallout had Tokyo scrambling to pull the economy out of recession. By 1987, authorities had accelerated the pace and magnitude of monetary easing and fiscal stimulus. That turbocharged the flow of excess liquidity into real estate and stocks. Rather than generalized consumer price inflation, Japan was experiencing runaway asset inflation.

By 1989, when officials realized that the dueling bubbles in property and stocks had gotten away from them, it was too late. Only in May 1989 did BOJ Governor Satoshi Sumita hit the monetary brakes. In December 1989, Sumita passed the baton to Yasushi Mieno. By August 1990, the BOJ’s discount rate was up to 6.00%. The Nikkei Stock Average and property prices crashed.

(4) The economic fallout. Then came Japan’s “lost decade” and a deflationary nightmare that today’s China is struggling (hopelessly) to avoid. In 2012, Shinzo Abe returned to the premiership to stabilize prices, rekindle innovation, and restore Japan’s competitive mojo. Instead, “Abenomics” created a new bubble—this time in JGBs.

At the time, Abe’s Liberal Democratic Party had clawed back to power on the strength of pledges to slash bureaucracy, launch a startup boom, empower women, and strengthen corporate governance to remind China that Shanghai has nothing on Tokyo. This last effort had some success. Steps to give shareholders a louder voice, diversify boardrooms, and increase returns on equity sent the Nikkei above its 1989 highs by July 2024 (at least until Trump 2.0 arrived).

But the rest of Abe’s structural reforms fell by the wayside as he prioritized aggressive central bank easing. Abe tapped Haruhiko Kuroda not just to run the BOJ but also to push the boundaries of monetary science.

Beginning in April 2013, Governor Kuroda supersized the BOJ’s balance sheet, hoarding bonds and stocks via exchange-traded funds (Fig. 5). The BOJ became the biggest holder of shares and controller of more than half of all outstanding JGBs (Fig. 6). By 2018, the BOJ’s balance sheet topped the size of Japan’s $4.2 trillion GDP, a first for a G-7 power.

One of the many side effects was creating history’s greatest corporate welfare boondoggle. The yen’s sharp plunge boosted corporate profits. Yet that deadened incentives for CEOs to innovate, restructure, and take risks. It took pressure off bureaucrats to level playing fields and take on powerful vested interests.

This policy deadened something else: bond dealing. As the BOJ gorged on JGBs, secondary trading ground to a halt. Over the last decade, there have been many days when not a single JGB traded hands in the secondary market.

Japanese Bonds II: Tokyo Is Scrambling. Enter Ueda, who took the helm at the BOJ in April 2023. His task: to extricate Japan from QE and other deflation-era policies. And Ueda’s efforts to withdraw from the bond market were working well enough until Trump triggered the Bond Vigilantes.

Turmoil in credit markets quickly hit Japanese shores. But it also refocused attention on Tokyo’s crushing debt burden, the largest among developed nations. The optics of Japan’s 260% debt-to-GDP ratio is made worse by its shrinking and aging population (Fig. 7). Not to mention by the odd, unhelpful worse-than-Greece aside by Ishiba.

This discourse amplifies the importance of Wednesday’s 40-year bond sale. A bid-to-cover ratio within normal parameters might soothe fears about the stability of the $7.8 trillion JGB market. Yet another hint that Tokyo might have a bond buyer’s strike on its hands could trigger shockwaves at a moment of maximum peril for credit markets.

(1) Bad timing all around. Asia’s second-biggest economy in turmoil is arguably the last thing the global financial system needs in 2025. Japan is the top creditor nation. It’s also balancing a titanically large debt burden with an aging workforce that’s shrinking at an accelerating rate (Fig. 8).

Exploding interest payments could unmoor the JGB market, unsettling an economy that’s long been a pillar of global stability. This could blow up the “yen carry-trade” as surging yields trigger a titanically large global margin call.

This “seismic shift,” as Fawad Razaqzada at FOREX.com has called it, means “Buckle up: Something’s about to snap” in world markets. Permabear Albert Edwards, chief global strategist at Société Générale, warns in a client note that a JGB blowup could amount to a “global financial market Armageddon” that could upend Nikkei and Wall Street stocks alike.

(2) Japan really is different. Such bearishness may ignore what differentiates Japan from its peers. To be sure, Japan is not Greece. Tokyo has avoided a crisis of the kind that hit Athens in 2009 because it has its own currency. The vast majority of debt is in local hands, limiting capital flight risks. And Japan has quite a rainy-day fund: $1.13 trillion of US Treasuries.

Jonathan Fortun at the International Institute of Finance has disputed the idea that Japan is the target of a “slow-moving warning shot against sovereign solvency. That interpretation is not just premature; it is fundamentally flawed.”

One reason is that the 10-year yield is just 1.5% is the market’s unique mutually-assured-destruction dynamic. Despite ultralow yields, JGBs are the main asset held by Japanese banks, companies, insurance funds, pension funds, universities and endowments, the postal system, and the swelling ranks of retirees. Strong domestic demand explains why foreign investors hold only about 12% of JGBs. If a critical mass of investors were to hold them to maturity, a systemic crisis might be averted.

(3) Where the cracks are. Yet tripwires abound. The collapse of Silicon Valley Bank (SVB) in March 2023 came a month before Ueda’s arrival at the BOJ. His first course of business was assessing contagion risks among Japan’s 100-plus regional leaders, long a vulnerable corner of the financial system.

For years, Tokyo had been prodding these banks—some a century-plus old, serving second- and third-tier cities and prefectures with shrinking populations—to consolidate. With business hard to come by, many regional lenders took to loading up on bonds rather than increasing lending SVB-style.

At the end of 2024, even before Trump’s tariffs, short sellers were circling as regional lenders struggled to adjust to the BOJ’s yanking away the proverbial punchbowl. Top targets included Aozora Bank, First Bank of Toyama, and Chiba Bank. The problem, noted Hideo Oshima, a senior economist at Japan Research Institute, is that regional lenders are unprepared to “shoulder growing borrowing costs.”

Japanese Bonds III: The BOJ’s Conundrum. The question Ueda faces is whether Japan Inc. is as ready to kick its free-money addiction as the BOJ’s models might suggest. That readiness is especially questionable now that Trump’s tariffs on China, autos, metals and threats of reciprocal taxes are slamming Japanese business and household confidence. The BOJ’s immediate conundrum is whether to stick with its July 2024 plan to cut its JGB purchases each quarter.

Another question: When might be an opportune time to offload ETFs without tanking the stock market? Unwinding the biggest-ever central bank intervention in equities—roughly ¥37 trillion yen ($259 billion)—won’t be easy.

Headline-grabbing layoffs at Nissan Motor (20,000) and Panasonic Corp. (10,000) only increase the risks of a negative wealth effect as Nikkei stocks slide. A yield surge could crater the Nikkei. Aside from the risk of a blow to valuations predicated on a weak yen and low rates, Tokyo is a macro hedge fund trading center, making the Nikkei highly sensitive to zigs and zags in foreign money flows.

(1) Yen risks abound. Worries about a yen surge are also having a chilling effect. The currency’s 9.3% rally versus the dollar so far this year is slamming exports (Fig. 9).

Global implications abound, too. A big piece of the puzzle is Trump’s plans not just for tariffs but for the dollar. Trump has mused about his own 1985-like “Mar-a-Lago Accord.” Though that would mostly target the Chinese yuan, the yen would likely be dragged higher, too.

These risks complicate both Ueda’s policy plans and Ishiba’s ability to keep Japan out of a recession. Japan’s GDP shrank 0.7% in the January-March period from the previous quarter (Fig. 10). Odds are good that the current quarter will prove ever weaker as the full force of Trump’s tariffs hits.

(2) Déjà vu risk. Ueda is reluctant to signal that the BOJ’s rate-hiking cycle is over given its history with aborted tightening attempts. In 2007, the central bank got rates up to 0.50% only to return them to zero. In the meantime, Tokyo’s fiscal latitude is limited by the risk of higher yields—and just two months away from a national election. For now, Ishiba is avoiding borrowing more to juice GDP. The reason he uttered “the Greece word” recently was to rebuff demands for lower taxes.

Yet Carlos Casanova at Union Bancaire Privée argues that the “gloomy” data “could pile pressure” on Ishiba to “heed lawmakers’ demands to cut taxes or deliver a fresh stimulus package.”

That is, if the Bond Vigilantes—and the credit rating companies, for that matter—let him.

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AI’s Worker Displacement, Consumer Spending & Robots

May 22 (Thursday)

Information Technology: Assessing AI’s Threat to Jobs. Technology companies are quickly determining how to use artificial intelligence (AI) to cut jobs and increase productivity. Companies as large as Microsoft, Salesforce, Spotify, and Workday each recently have alluded to the role AI has played in decisions about layoffs or hiring freezes.

We have no doubt that as non-tech companies get more comfortable with AI, they’ll start replacing labor with technology as well. Among the first: JPMorgan executives highlighted the bank’s plans to use AI to reduce jobs and increase efficiency in back-office operations. The adoption of AI may get a nice shove from the current economic uncertainty, as AI’s ability to offset tariff costs or higher interest rates by enhancing productivity will likely incent more executives to try it.

So far, the US unemployment rate remains low, at 4.2% in April (Fig. 1). But at the margins, some of the employment data may be starting to show the AI impact. The unemployment rate for individuals who have some college or an associate’s degree under their belts has crept up from a low 2.8% in November 2023 to a recent 3.7%. Meanwhile, the unemployment rate for workers with a high-school degree barely budged, ticking down from 4.1% to 4.0% over the same period (Fig. 2).

Certainly, not all job losses are related to AI, as workers routinely lose jobs because companies go out of business or want to improve profits. But AI will be more likely to replace white-collar jobs requiring a college degree than blue-collar jobs involving manual labor—or at least that’s true until AI-powered android robots hit the scene (a subject we discuss below).

An indication of what the future may hold may be found in the plateauing headcount in the computing infrastructure, data processing, web hosting, and related services industries. The number of folks employed in this Bureau of Labor Statistics category has held steady at around 485,000 for the past two years after climbing by roughly 40% over the preceding four years (more specifically, headcounts were 485,200 in April 2025,down slightly from 486,900 in April 2023, which was up sharply from 336,900 in April 2019) (Fig. 3).

Let’s consider details surrounding some of the AI-related layoffs and job freezes announced so far this year:

(1) AI can code. Earlier this month, Microsoft became the latest tech company to announce layoffs, 6,000 jobs or about 3% of the company’s total headcount. In Washington state, 40% of the roughly 2,000 positions cut were in software engineering, a May 14 Bloomberg article reported. The move makes sense given CEO Satya Nadella said that AI writes 20%-30% of some of Microsoft’s projects’ code, an April 29 TechCrunch article reported.

Microsoft isn’t alone. Earlier this year, Salesforce was cutting more than 1,000 jobs, or less than 2% of its workforce, Bloomberg reported. The cuts were notable because the company was still hiring—workers to sell new AI products.

Workday announced it would eliminate about 8.5% of its workers, or 1,750 jobs, to “prioritize investments such as artificial intelligence, while also freeing up resources to expand the company’s presence in different countries,” a February 5 CNBC article stated.

Shopify didn’t cut any jobs, but its CEO told employees that they will have to demonstrate that AI can’t help them at work before asking for additional resources or staff. Everyone at the firm is expected to use AI in their jobs, and AI usage questions will be added to performance reviews and peer reviews, an April 7 BetaKit article reported.

The news organization more recently reported that another Canadian company, OpenText, is cutting 1,600 jobs and hiring 1,000 employees in “high-impact” functions. The shift is tied to the company’s “AI-first approach” after an analysis of which roles could be done with AI. All new hires must have AI skills and experience, AI will become part of performance reviews, and employees must show why AI can’t do the work before asking for more headcount or resources.

(2) AI in JPM’s back office. There was talk of AI and headcount implications at JPMorgan’s annual investor conference on Monday. JPMorgan’s CEO of Consumer and Community Banking Marianne Lake predicted that AI would allow the bank to reduce the number of employees in operations and account services departments by 10%—though no timeline was offered, according to a Yahoo Finance article citing Business Insider.

At the same event, the bank’s CFO Jeremy Barnum said: “We’re asking people to resist headcount growth where possible and increase their focus on efficiency.” He added: “It’s not just the amateurs who are helped by these [AI] tools. It’s amazing stuff, and we have high hopes for the efficiency gain.”

(3) AI speaks French. Duolingo is an app and a website that uses small lessons in a game-like environment to teach foreign languages. A few weeks ago, its CEO Luis von Ahn declared the company to be “AI first.” Duolingo had already decided to replace slow, manual content creation with AI-created content. Now it also plans to stop using contractors when the work can be done by AI programs. It will look for AI skills when hiring, include employees’ AI use during performance reviews, and hire only when the job cannot be automated. That sounds like a bandwagon many CEOs are about to hop on.

Consumer Discretionary: Interest Rates Weigh on Spending. Home Depot’s executives said consumers are spending—as long as they don’t have to borrow to do so. Tools and flowers are flying off the shelves as usual, but customers aren’t springing for kitchen remodeling or other large-ticket items. Hovnanian Enterprises reported that it had to continue offering incentives to offset high mortgage rates to entice consumers to buy their homes.

Here’s a quick look at what may be helping—and hindering—consumer spending:

(1) Higher funding costs. Interest rates have been rising due to Moody’s downgrade of US government debt last week and the record-setting budget deficit, which will only grow under the proposed budget plan that Melissa discussed in yesterday’s Morning Briefing. The 10-year Treasury yield surged to 4.60% yesterday, while the 30-year mortgage rate has bounced back up to 6.81% (Fig. 4).

Hovnanian is offsetting high mortgage rates by offering incentives that were 10.5% of the average sales price in fiscal Q2 (ending April 30), up 2.4ppts from a year ago and up 0.80ppt from last quarter. Three-quarters of its home buyers took advantage of incentives last quarter. Nonetheless, fiscal Q2 contracts for home sales fell 7% y/y, and company officials assume mortgage rate buydowns will continue at similar levels going forward, according to Hovnanian’s conference call transcript. The homebuilder’s revenue fell 3.1% y/y in the quarter, and adjusted net income tumbled to $29.2 million from $69.6 million a year earlier.

(2) Lower prices at the pump. Home Depot executives noted that consumer spending was supported by an employed consumer who begins the summer driving season with gas prices surprisingly low. Nationwide, the average retail price of gasoline was $3.30 per gallon during the week ending May 19. And with the nearby futures price of gasoline at $2.15 a gallon, pump prices look primed to fall (Fig. 5).

(3) Student loan payments return. What the executives didn’t highlight was that President Trump restarted payment requirements on student loans, which also sent the delinquency rate on those loans jumping to a more normal rate of 7.7%, up from roughly 1% last year. Delinquencies on credit cards have also jumped sharply in the past two years, from an unusually low 7.6% in Q3-2022 up to a recent 12.3%, which is high given the lack of a recession (Fig. 6).

(4) Home improvement retail data. The S&P 500 Home Improvement Retail stock price index has fallen 13.3% from its peak late last year and has moved sideways for more than three years (Fig. 7). The collective forward revenue of companies in the industry has started to climb after flatlining for a few years, but the industry’s forward operating earnings per share has edged lower (Fig. 8 and Fig. 9). As a result, the forward profit margin has slid from a peak of 10.6% in June 2022 to a five-year low of 8.9% (Fig. 10).

But after the index’s earnings drops in 2023 (-8.1%) and 2024 (-3.5%), things are looking up. The Home Improvement Retail industry is expected to grow earnings by 0.8% this year and 9.3% in 2026 (Fig. 11).

Disruptive Technologies: Humanoids Advancing. Seems like everyone wants to build a humanoid robot. This week, Elon Musk has been out touting the new tricks that Tesla’s Optimus robot has learned. K-Scale Labs has introduced a humanoid that won’t break the bank. Ameca by Engineered Arts is considered by some to be the smartest of the pack. And there are tons of Chinese competitors, enjoying oodles of state funding, that want to dominate the market as advancements in AI make robots smarter than ever.

Here’s a look at some of the latest news and innovations:

(1) Optimus learns new tricks. Tesla’s Elon Musk enthusiastically declares Optimus the “biggest product of all time.” The humanoid robot has learned how to learn by watching videos. A video of Optimus executing everyday household tasks, including vacuuming and putting the trash in a bin, is included in an article published yesterday by Quartz. In an interview on Tuesday with CNBC, Musk said he plans to have Optimus robots working in Tesla’s factory by the end of this year.

(2) Humanoids get cheaper. K-Scale Labs, a Palo Alto startup, is offering a five-foot tall, open-source android for only $8,999 that it reportedly developed in five months. It also boasts two smaller and cheaper models.

The robot’s small frame allows it to coexist safely with humans, and its software allows it to learn and adapt based on new data. The robot is meant for the mass market and is affordable enough that it can be purchased by universities or robotics enthusiasts. Here’s a YouTube video of the robot in action.

(3) Is Ameca the smartest? In Standard Bots’ article about the most advanced robots in 2025, we came across one name we hadn’t encountered before: “Ameca” by Engineered Arts. She has facial expressions and arms that move very smoothly like a human’s, but she cannot walk—yet. While conversing with the public attending the CES convention, she seems to have a sense of humor and understand sarcasm. Here’s a video. Engineered Arts is creating these robots to entertain crowds and provide customer service, according to its website.

(4) China is in the mix. Chinese companies are developing equally impressive robots, helped by a government that has made robotics a priority and provides billions in funding. For China, robots are about more than just improving productivity. Robots could help the country solve the potential future problem of worker shortages stemming from China’s declining population and ensure that the country can compete with US developers.

Conveying the sector’s importance, President Xi has visited AgiBot and Unitree, two leading robotics companies, and DeepSeek, an AI developer. The country has allocated more than $20 billion to the sector over the past year; Beijing has established a $137 million fund to support AI and robotics startups; and Shenzhen has created a $1.4 billion AI and robotics fund, a May 12 Reuters article reported.

This widespread support comes as many companies have rushed into the humanoid robotics arena, which could result in a glut similar to what occurred in the electric vehicle market. One analyst suggests that the price of a humanoid robot could tumble from $35,000 by the end of this year to $17,000 by 2030. Last year alone, there were 31 Chinese companies with 36 humanoid models, compared to only eight US companies. Unanswered is the question of what China will do with all of its displaced factory workers.

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On US Treasuries, The Big Beauty & S&P 500 Earnings

May 21 (Wednesday)

US Bonds: Why ‘Selling America’ Trade Flopped. It’s never good when “#LizTrussMoment” is trending on social media. It’s even worse when the subject of debt-crisis chatter is the world’s biggest economy. Unsurprisingly, last week’s decision by Moody’s to yank away the US’s long-standing AAA rating has Asian policymakers and investors in a whirl.

Asia is home to many of the top central bank holders of US Treasury securities—including Japan and China—with $2.5 trillion-plus of exposure. It’s also as dollarized a region as you’ll find anywhere, highly reliant on exports to the US for growth.

Yet what’s most remarkable about Moody’s May 16 downgrade to Aa1 status is that it didn’t trigger global investors to “sell America,” as the Liz Truss hashtag suggests. The rise in 30-year yields toward 5.00% aside, there’s no sign of turmoil remotely like that of the short-lived 2022 Truss premiership in the UK, when unfunded tax cuts cratered the gilt market.

Let’s explore why no one is asking whether a head of lettuce might outlast US Treasury bonds:

(1) The Moody’s call is backwards-looking. In Asia, the US carrying a $36 trillion debt burden is news to exactly no one. Neither is the fact that, as Moody’s stressed, interest-payment ratios are at “levels that are significantly higher than similarly rated sovereigns.”

In a LinkedIn post, Morningstar’s Dave Sekera calls the downgrade “largely symbolic.” Bond market signals, he adds, “appear to be more indicative of market movement looking for a headline than a headline moving the market.”

Also, the feel-good effect over President Donald Trump’s U-turn on tariffs appeared to drown out concerns about Washington’s fiscal trajectory. Asian officials, meanwhile, notice that Trump is suddenly going after Bruce Springsteen and Beyoncé a lot harder than he is Federal Reserve Chair Jerome Powell.

(2) Strong US job market. For all the handwringing about the US economy’s shrinking 0.3% y/y during Q1, employment remains strong. And with Trump throttling back his trade war, Asian investors aren’t fleeing US assets as feared. Case in point: The US dollar is down all of 0.8% since Friday.

Also, global currency alternatives are in short supply. Sure, cases can be made that the euro, yen, pound, and Chinese yuan might grab market share. But from the most liquid of these (the euro and yen) to the least (the yuan), none has the deep capital markets or investor trust to dethrone the greenback.

(3) Not out of the woods yet? As Ray Dalio of Bridgewater Associates warns via social media platform X, the risk to Treasuries may be greater than Moody’s thinks. US credit ratings “don’t include the greater risk that the countries in debt will print money to pay their debts.”

In Asia, there are indeed rumblings of potential sales to come. Bloomberg reports that Hong Kong pension managers might be obliged to sell now that Treasuries are sub-AAA. This raises questions about how the city’s $166 billion Mandatory Provident Fund system proceeds from here.

For now, though, most in the region featuring many of the biggest holders of Treasuries are saying “no” to the “sell America” trade. And saying “hold the lettuce” analogies.

US Dollar: Risks Still Abound. Notwithstanding the dollar’s resilience in recent days, it does face risks. Let’s look at the most immediate:

(1) Trump going tariff wild again. Odds aren’t great that Chinese leader Xi Jinping is in a giving mood on concessions. No doubt, Trump is annoyed by the popular narrative that he caved. Might he fight back with even higher import taxes, provoking the Bond Vigilantes (as well as the Stock Vigilantes and Dollar Vigilantes) anew?

There’s the risk of a Truss-style tax-cut blunder. Over the weekend, Treasury Secretary Scott Bessent doubled down on the very policies that worry Moody’s. This includes a tax cut expected to add $4 trillion—roughly the equivalent of Japan’s annual GDP—to the federal primary debt over the next decade. Some, but not all, of the debt hit will be offset by spending cuts, as discussed below.

(2) Getting Fed up. Arguably, nothing would trigger the “avalanche” of dollar selling of which economist Stephen Jen, founder of Eurizon SLJ Capital, warns faster than Trump diluting the Fed’s independence. In Asia, investors and policymakers often care more about Fed rate decisions than they do about what their own monetary authorities are up to.

US Fiscal Policy I: The ‘One Big Beautiful Bill’ Totes a Big Ugly Tab. Moody’s downgrade of US government debt after the markets closed on Friday has been rattling the bond markets (Fig. 1). This week, Trump’s “big, beautiful” tax bill (his words) added another thorn in bond investors’ sides.

Republicans are teeing up a fresh round of tax and spending cuts under a bill that’s making its way to President Trump’s desk, likely before the fireworks begin on July 4. According to the WSJ, the House is expected to pass the bill this week with its narrow majority, just ahead of the Memorial Day break.

Frankly, we’re underwhelmed. This looks more like an obligatory extension of the 2017 Tax Cuts and Jobs Act (TCJA) than a bold new reform, as we’ve discussed before. Investors presume that the 2017 tax cuts won’t expire, so much of this bill’s revenue impact is baked into market expectations already. If it fails, the financial markets won’t be happy. But if it passes—well, that might be just as problematic.

Why? Because budget deficits matter. That’s especially so when they lead to higher interest rates, higher bond yields, and potentially higher inflation. We suspect the Bond Vigilantes already anticipate this, as Dr Ed observed on Monday.

The legislation proposes cuts to Medicaid as a partial offset for the revenue losses—a politically controversial idea. While we don’t view the proposed changes as structurally transformative, the Medicaid work requirements could be a speed bump on the bill’s road to passage.

Here’s where the bill currently stands:

(1) Deficit math. According to the Tax Foundation, the House bill would reduce federal tax revenues by $4.1 trillion from 2025 to 2034—before accounting for macroeconomic effects. After factoring in growth, the hit drops to $3.3 trillion. These numbers are derived from the bill text and Joint Committee on Taxation estimates reviewed by the House Ways and Means Committee on May 12, right before markup and passage on May 13.

The bill fits within the House budget resolution, which allows for up to $4.5 trillion in deficit increases over a decade, provided that $1.7 trillion in spending cuts are enacted. That’s the reconciliation trade-off.

(2) Medicaid work rules. Republicans are proposing national work requirements for Medicaid eligibility. Adults aged 19–55 would need to work, volunteer, or be in school to maintain coverage—unless disabled. Realistically, this would trim the number of Medicaid recipients.

While Republicans argue that the requirements promote self-sufficiency, Democrats view them as punitive and risky. Even within the GOP, some lawmakers are concerned that the reforms don’t go far enough in overhauling Medicaid’s structure.

(3) Debt reckoning. Federal debt held by the public relative to GDP is nearing 100%. If current laws remain unchanged, we’re looking at pushing the debt-to-GDP ratio to a record 117% by 2035, according to Congressional Budget Office data (Fig. 2).

That’s before layering on the tax bill’s impact. Even with the Tax Foundation’s growth-adjusted $3.3 trillion estimate and the offsetting spending cuts, the bill still adds fuel to the fiscal fire. And should lawmakers later extend provisions for individuals currently set to expire in 2028—like the expanded child tax credit and higher standard deduction—another $1.6 trillion could be tacked onto the debt, per the Committee for a Responsible Federal Budget.

US Fiscal Policy II: The Big Bill’s Big Five. Trump 2.0's tax and spending bill—now moving swiftly through Congress—packs a fiscal punch. The Tax Foundation estimates a revenue loss (before accounting for growth or spending cuts) of $4.1 trillion over the next decade (2025–34), with just a handful of tax provisions responsible for most of that hit (Table 1).

Lower-income families get some lift from deductions and credits but lose out on exemptions. Middle-class households are the primary beneficiaries thanks to rate cuts and the bigger standard deduction. High earners see a mix of gains and offsets. In addition to the immediate revenue impact of the tax changes, all household budgets will be affected if the tax bill results in fiscal stress and higher interest rates.

Here are the bill's five key changes, three cuts and two offsets; each exceeds $500 billion and reshape the burden across income groups:

(1) The three big giveaways:
Lower tax rates & expanded brackets (-$2.75 trillion): This is the bill’s biggest cut, locking in the 2017 TCJA’s lower rates and wider brackets. It primarily benefits middle-income taxpayers, who face the steepest marginal rates.
Standard deduction expansion (-$1.23 trillion): The larger standard deduction simplifies filing and lowers taxes for the roughly 90% of filers who don’t itemize, a boon for middle-income households.
AMT exemption hike (-$1.13 trillion): This disproportionately helps high-income households in high-tax states. The Alternative Minimum Tax hits wealthier taxpayers, and lifting its threshold offers them a meaningful break.

(2) The two big takebacks:
Repeal of personal exemptions (+$1.98 trillion): Scrapping personal exemptions hits large households the hardest.
SALT deduction cap (+$603 billion): The $30,000 cap on state and local tax deductions stays in place, phasing down for higher earners. This is a targeted hike on wealthy itemizers in high-tax states.

Strategy: Analysts’ Faith in Company Prospects Still Waning. This week, LSEG released its May snapshot of the monthly consensus net earnings estimate revision (NERI) activity over the past month. The revenues and earnings forecasts are captured in our S&P 500 NRRI & NERI report, where we index the analysts’ estimate revisions activity by the number of upward revisions less the number of downward ones, expressed as a percentage of total estimates. Our past-three-months lens allows us to see an entire quarterly reporting cycle, so it’s moot that analysts’ tendency to revise their estimates differs at different points in the cycle.

“Yikes!” was Joe’s reaction to the May data: It was worst NERI activity in more than two years. Here are his takeaways:

(1) Tariff uncertainty takes S&P 500 NERI down to a 28-month low. The S&P 500’s NERI index was negative in May for an eighth straight month (Fig. 3). That’s the longest negative NERI streak since May 2023, when it was negative for 10 months on the heels of the Magnificent-7’s year of cost-cutting. NERI fell to a 28-month low of -7.8% in May from -5.7% in April. (A zero reading indicates that an equal number of estimates were raised as were lowered over the past three months.)

Also underscoring the breadth of downward revisions, May’s -7.8% ranks in the bottom-fifth of its readings since March 1985, when the data were first calculated, and is well below the average reading of -1.9% seen since.

(2) Positive NERI club nearly empty. Just one S&P 500 sector had a positive NERI reading in May, the lowest count in 15 months. NERI was barely positive for the Utilities sector, and Financials’ turned negative m/m for the first time in 15 months (Fig. 4 and Fig. 5).

Financials’ latest reading was still third best in class among the S&P 500’s 11 sectors but is down from a three-year high of 8.0% in February. Utilities’ was positive for a 12th straight month in May, but barely so at 0.01%, and is now down from a two-year high of 2.6% in November.

Among the poorer performing sectors, Consumer Staples’ NERI dropped to a 16-year low in May, followed by Industrials’ at a 58-month low (Fig. 6 and Fig. 7).

In fact, eight of the 11 sectors’ NERIs were at their lowest levels in many months during May: Utilities (0.0%, 12-month low), Communication Services (-1.6, 16-month low), Financials (-3.6, 16-month low), Information Technology (-5.0, 27-month low), Real Estate (-7.8, 28-month low), S&P 500 (-7.8, 28-month low), Consumer Discretionary (-11.0, 30-month low), Industrials (-12.3, 58-month low), and Consumer Staples (-14.5, 16-year low).

(3) Forward earnings not as bad as NERI suggests. The downward estimate revisions, while widespread, are relatively minor. Estimates are only being nickeled and dimed lower, not slashed deeply. Indeed, forward earnings remains close to record highs for the S&P 500 and nine of its 11 sectors (Fig. 8). The S&P 500’s forward EPS is down just 1.1% from its record high. Among the 11 sectors, only two deep cyclicals are lagging considerably: Energy and Materials.

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On China & Euro

May 20 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
China I: Demographics Entrench Deflation. For a decade now, economists have been theorizing about how China’s aging and shrinking population might affect its economic growth potential (Fig. 1 and Fig. 2). Yet there’s nothing conjectural about the ways demographics are now exacerbating the nation’s deflation troubles.

As Japan’s experience since the 1990s has highlighted, few Asians in their mid-60s and higher consume with gusto as twenty- and thirty-somethings do. They tend to buy fewer houses, cars, and appliances; to upgrade technology less frequently; and to splurge less on luxury dining and travel.

Let’s explore how China’s demographic trends are stacking the deck against policymakers as they battle deflation:

(1) China’s population drop is secular. In 2024, the nation’s population shrank for a third year, falling by 1.39 million y/y to 1.408 billion—an unprecedented trajectory since the country’s founding in 1949. And pressures on the economic system come from both ends of the lifecycle: Elderly Chinese are living longer, straining their pensions, and the birthrate is falling, providing fewer new consumers.

The number of births has been below 10 million since 2022 (Fig. 3). The United Nations estimates that China’s population will halve to 633 million by the end of the century. Over the next decade, China could lose the equivalent of South Korea’s entire population—50 million-plus—according to Bloomberg Intelligence.

(2) History catches up. As economic own-goals go, Mao Zedong’s draconian “one-child policy” is in a category of its own. At the end of the Cultural Revolution, in 1979, Mao’s Communist Party worried that a rapidly growing population would be impossible to feed. Reducing birth rates became a national priority, executed with elaborate measures. By the time President Xi Jinping ended the policy in 2016, it was too late: A policy that dictated the social order for generations has proven hard to overcome.

Today, Chinese households cite rising living costs and career uncertainty for why they’re having fewer babies. Such concerns have younger mainlanders delaying marriage or eschewing it altogether.

A shrinking workforce is thwarting Xi’s efforts to boost domestic demand. Since he took over 2012, China’s working-age population—aged 16 to 59—has been declining (Fig. 4). It dropped by nearly 7 million last year to 858 million, according to the Bank of Finland.

(3) It’s all connected. All this feeds into China’s 3Ds problem: deflation, debt, and demographics. Falling prices that take on a life of their own, local governments facing multi-trillion dollar debt burdens, and a fast-aging population each are challenging enough. China’s need to tackle them simultaneously explains why many see China growing around 2% at best by the 2030s.

Alicia García Herrero of investment bank Natixis warns China will “feel these effects more significantly after 2035,” when the economic boost of urbanization ends.

(4) So many men. China’s worsening sex ratio imbalance is another problem for population growth. A Mao-era side effect is a preference for having boys over girls. Because China lacks social safety nets, elderly parents move in with one of their sons’ families. Having girls is likened to “watering your neighbor’s garden” since wives end up caring for in-laws. In 2024, China’s gender imbalance reached at least 104 men to every 100 women.

China is already plagued by high youth unemployment. The social instability risks of whole generations of lonely young men are obvious enough.

All this means that falling prices risk deflating far more than just next year’s GDP.

China II: Costly Fentanyl Addiction. If any economy understands the role of narcotics in driving geopolitics, it’s China. The ways in which Britain went to war in the 19th century with what’s now Asia’s biggest economy are legion. For commercial gain, the British Empire flooded China with opium, a period recalled as the start of a “Century of Humiliation.”

Xi Jinping hasn’t been shy about referencing that period of national trauma to justify his push to restore China’s place on the world stage. Might China finally be getting its revenge on the West by way of fentanyl?

Few Washington-Beijing issues are more contentious. Like the Biden administration before him, President Trump’s team has confronted Xi’s inner circle early and often over China’s role in the estimated 80,391 people in the US killed by the synthetic opioid in 2024.

Trump has gone further, making reduced illicit fentanyl shipments a key precondition for ending his China tariff, currently at 30%. The good news is that last year saw a nearly 27% drop in US fentanyl fatalities last year. The bad news: Synthetic opioids, fentanyl mostly, continue to be involved in most overdose deaths.

It begs the question: Why does China continue to tolerate the thriving fentanyl trade given that the damage to its global standing outweighs the profit motive? The short answer: It’s complicated, and wildly so.

Let’s explore why:

(1) China’s says US is overreacting. It’s a truly globalized industry, Beijing claims—especially considering the central role played by Mexican drug cartels that synthesize the chemical precursors sourced from China and smuggle them into American cities. The US, Beijing counters, should do less “scapegoating” and work to limit booming demand at home.

(2) It’s a geopolitical tool. China sees fentanyl as a tool to be wielded in negotiations. It’s a trap into which the Brookings Institution’s Vanda Felbab-Brown worries Washington has already fallen. As simplistic as it sounds, Beijing thinks it benefits from the fentanyl crisis because the crisis weakens and polarizes the US.

(3) It’s super-complicated. The real reason that China is finding the fentanyl game nearly impossible to foil might be that its many moving parts prove all too nimble at circumventing new countermeasures.

Policies to boost China’s pharmaceutical industry, now the globe’s second biggest, created a cottage industry of hundreds of thousands of small chemical plants. Along the way, a sprawling money-laundering industry thrives off the opacity inherent to China’s banking system, savvy at using mobile phone apps and active in cryptocurrencies. Zongyuan Zoe Liu at the Council on Foreign Relations has called the fentanyl boom a study in how “regulatory effects can have unintended consequences.”

Unfortunately, fentanyl could be China’s Inc.’s most innovative sector. Trying to halt its production at its many sources is like playing a deadly game of Whac-A-Mole.

To further complicate the issue, Chinese provinces, desperate to create new jobs, ferociously woo pharmaceutical companies to build factories—often at the expense of Beijing’s directives. This is yet another unintended side effect of China’s deflation troubles.

Europe: Reserve-Currency Hopes Pinned on Euro. At the turn of this century, Europe launched a currency that many saw as destined to rival the dollar. Things didn’t turn out that way. The euro’s 20% weighting in foreign exchange reserves has barely changed since 1999.

Until now, perhaps. With President Trump’s trade war and unpredictability eroding trust in the dollar, the euro is on a bull run—up 8.7% so far this year. Moody’s Investors Service’s recent revoking of Washington’s last AAA rating has further strengthened the euro’s case for top safe-haven status.

The question is whether we’re seeing a short-term rebalancing of dollar-heavy portfolios or the sharp pivot away from the US currency. At least for now, it’s likely more the former than the latter.

Let’s see consider why the euro is rising, then why it still faces headwinds:

(1) The euro is having a moment. This was true pre-Trump 2.0. By the third quarter of 2024, as the US national debt topped $36 trillion, the dollar’s share of reserves was a 30-year low of 57.8%. The International Monetary Fund says this marks a nearly 9-percentage-point drop in just the last decade. Since January 20, though, euro bets have increased markedly.
 
(2) The Trump factor. Trump’s penchant for retaliation worries the financial markets, especially threats to fire Federal Reserve Chair Jerome Powell. There’s also great optimism over fiscal-hawk Germany’s “debt brake” reform. In March, the Parliament altered borrowing limits spelled out in the constitution. The specter of the Eurozone’s top economy issuing 1 trillion euros of debt in short order is creating big buzz for the euro.

Count German Finance Minister Joerg Kukies and European Central Bank (ECB) President Christie Lagarde among those arguing that the Trumpian trauma spooking the globe is an opportunity for Europe.

(3) Structural impediments. One impediment is the role of the ECB, which succeeded in calming the financial markets amid the region’s 2010-11 debt crisis and during Covid-19. While it’s been more activist than the Bundesbank of old, after which the ECB was modeled, being a reliable lender of last resort is not in the ECB’s DNA.

National lines divide Europe’s overlapping banking systems. Capital markets are too small and fragmented to handle giant waves of safe-haven investment either washing in or receding as suddenly. Years of slow-walking a fiscal union or capital-market union continue to be the US market’s gain. The same goes for the slow pace of devising a deep, single bond market for issuers with reliable liquidity.

(4) Reforms needed. The Eurozone has resisted calls for a clearer fiscal union. It has yet to harmonize business regulations and bankruptcy laws. Also, tensions remain among higher debt nations like France and Italy and fiscal conservatives Germany and the Netherlands.

The Eurozone is proving that it’s getting its act together, while the US is dividing its allies. Still, “King Dollar” remains hard to dethrone, even as Trump’s unpredictability has investors tempted to give the euro a try.

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Meltup In Stocks Or Meltdown In Bonds?

May 19 (Monday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Financial Markets: On the Edge of a Meltup or a Meltdown? It’s time to think ahead. Are stocks on the verge of a meltup? They might be unless bonds are on the verge of a meltdown. So, which will it be? We can make the case for both scenarios. Let’s do so:

(1) Bond market meltdown. Since the start of the year, we’ve opined that the 10-year US Treasury bond yield is likely to trade between 4.25% and 4.75% this year. That has been a good call so far (Fig. 1). Since the end of last year, we predicted that the Fed won’t change the federal funds rate (FFR) this year. So far, so good (Fig. 2).

We disagreed with the Fed’s decision to cut the FFR by 100bps in three steps, down to 4.33% from September 18 through December 18 last year. We argued that the bond yield might rise instead of fall because the economy was resilient and didn’t need lower rates. That’s what happened as the yield bottomed last year at 3.63% on September 16, 2024 and rose to a high of 4.79% so far this year on January 13. The bond yield has been mostly fluctuating around the FFR rate so far this year.

Expectations for rate cuts this year have diminished as President Donald Trump has de-escalated his trade war (Fig. 3). This de-escalation is reducing the odds of a recession and Fed rate cutting. According to Polymarket.com, the odds of a recession was 37% on Friday, the lowest since March 28 (Fig. 4). That’s just before Trump’s April 2 Liberation Day, which was followed by four Annihilation Days in the stock market (Fig. 5). Those odds peaked at 66% on May 1 and fell sharply after Trump postponed on April 9 the reciprocal tariffs he had imposed on all trading partners except China and postponed on May 12 those on China.

Through all this turmoil, the 10-year Treasury bond yield remained mostly in our projected trading range. Its correlation with the Citigroup Economic Surprise Index remains intact, because the latter hasn’t done much so far this year (Fig. 6). The bid-to-cover ratio during this year’s 10-year Treasury auctions fluctuated around its historical average since the start of this year (Fig. 7).

So where’s the potential meltdown in bond prices among all this calm? On Friday, Moody’s downgraded the US sovereign credit rating due to concerns about the nation’s growing $36 trillion-and-growing debt pile. Moody’s first gave the United States its pristine “Aaa” rating in 1919 and is the last of the three major credit agencies to downgrade it.

Is Moody’s expecting an imminent US government debt crisis? That’s possible, we suppose, given that Trump’s “Big Beautiful Bill” is facing significant challenges in Congress. The bill—which includes major tax cuts, spending reductions, and enhanced border security measures—was blocked from advancing out of the House Budget Committee on May 16, due to opposition from a group of conservative Republicans, often referred to as “fiscal hawks.” These lawmakers, including Representative Chip Roy, argue that the bill does not include sufficient spending cuts, expressing concerns about its impact on the federal deficit.

The Bond Vigilantes might weigh in on the subject if Trump manages to ram a bill through Congress that they consider to be ugly for the deficit outlook rather than beautiful. Increasing the odds of a spike in the bond yield would be higher-than-expected inflation readings in coming months resulting from Trump’s tariffs.

(2) Stock market meltup. It is somewhat easier to make the case for a stock market meltup than a bond market (price) meltdown. That’s because the rebound in stock prices since April 8 has pushed valuation multiples almost back up to where they were before the correction from February 19 through April 8. The S&P 500 forward price-to-sales ratio jumped back up to 2.9 during the May 16 week (Fig. 8). It peaked at a record high of 3.0 during the week of February 18. The S&P 500 forward P/E rebounded to 21.3 during the same week. Both are historically high.

Meanwhile, the collective forward P/E of the Magnificent-7 stocks has soared from 21.6 on April 8 to 27.5 on Friday (Fig. 9). Excluding them, the forward P/E of the remaining “S&P 493” is 18.5. Arguably, the market is already back in meltup territory, making it more vulnerable to a meltdown in the bond market.

(3) Our subjective probabilities. So what are the odds of a stock market meltup and/or a bond market meltdown?

On May 4 and again on May 13, we lowered our odds of a recession this year from 45% to 25%. So the odds of our Roaring 2020s scenario is back up to 75%. In this scenario, the S&P 500 rises to 6500 by the end of this year. It could keep going to 7000 in a meltup.

A bond market meltdown would be included in our 25% bucket of risks. In our opinion, it would force the Republicans to agree on a more conservative budget bill that would put the US government on a more sustainable fiscal path. The end result would be positive for both bonds and stocks.
 
US Consumers I: Americans Are Depressed… Consumers were extremely depressed in early May, according to the Consumer Sentiment Index survey conducted by the Surveys of Consumers (SOC) at the University of Michigan. Apparently, they are fretting that tariffs will boost inflation. The SOC notes: “Tariffs were spontaneously mentioned by nearly three-quarters of consumers, up from almost 60% in April; uncertainty over trade policy continues to dominate consumers’ thinking about the economy.” The interviews for the latest survey were conducted between April 22 and May 13, closing just two days after the announcement of a pause on some tariffs on imports from China. So the final May results might show an uptick in the CSI and a downtick in expected inflation.

Here’s more:

(1) Consumer Sentiment Index. The CSI dropped to 50.8 in the preliminary reading for May, down from 52.2 in April (Fig. 10). That is the second-lowest reading on record (behind that for June 2022) and down almost 30% since January 2025. While most index components were little changed, current assessments of personal finances sank nearly 10% based on weakening incomes. The current conditions index was much more depressed than during Covid and just as bad as during the Great Financial Crisis! The expectations component matched or fell well below previous recession lows.

The CSI current conditions index has been well below that of the Consumer Confidence Index (CCI) survey over the past 10 years (Fig. 11). There have been times in the past when the former was above the latter, usually coming out of recession. The CSI and CCI expectations indexes tend to track one another more closely (Fig. 12).

(2) Expected inflation. According to the SOC, year-ahead inflation expectations surged from 6.5% in April to 7.3% so far in May (Fig. 13). This month’s rise was seen among Democrats and Republicans alike. Long-run inflation expectations lifted from 4.4% in April to 4.6% in May, reflecting a particularly large monthly jump among Republicans. The final release for May will reveal the extent to which the May 12 pause on some China tariffs leads consumers to update their expectations.

The year-ahead inflation expectations measures of the CSI survey closely tracked the comparable series compiled by the Federal Reserve Bank of New York monthly consumer survey (Fig. 14). They’ve diverged significantly recently over the past couple of months. During April, the former was 7.3%, while the latter was 3.6%.

Oddly, the CSI survey’s year-ahead inflation expectations, which closely following the retail price of gasoline in the past, have diverged significantly, with the latter soaring as described above even though the pump price has remained subdued in recent months (Fig. 15).

(3) Partisanship. Joanne Hsu, the director of SOC posted an April 11 report titled “Partisan Perceptions and Sentiment Measurement.” She observes, “Partisan differences in consumer attitudes and expectations are well documented and date back to at least the Reagan administration. The data consistently showed that consumers affiliated with the political party in the White House tend to have higher levels of sentiment and more favorable expectations than those whose party is not.”

Historically, the SOC asked about political affiliation a few times per administration, increasing to a monthly frequency starting in February 2017. In her report, she investigated “how partisan differences in consumer attitudes and expectations evolved since 2017, and whether these patterns distort survey measurements of changes of over time.” She concludes that her findings confirm that the SOC’s methodology remains valid because it continues “to reach a nationally representative sample of Americans across the political spectrum.”

Maybe so, but we aren’t convinced that’s so currently. Our hunch is that Democrats are much more depressed than Republicans.

US Consumers II: …But Not Too Depressed To Go Shopping. April retail and food services sales edged up just 0.1% m/m during April (Fig. 16). That’s a preliminary number that is often revised. Indeed, the March increase was revised higher from 1.4% m/m to 1.7%.

That’s why the Atlanta Fed’s GDPNow tracking model increased Q2’s real GDP growth rate to 2.4% (q/q, saar) from 2.5% (Fig. 17). Real personal consumption spending is tracking at a growth rate of 3.7% q/q, up from 3.3% earlier in May.

Also, some buying in advance of tariff-related price hikes might have boosted March retail sales (excluding food services) to a record high and left April’s reading flat at that record high (Fig. 18).

On the other hand, sales at food services and drinking places jumped 1.2% m/m in April to a new record high, while sales at food and beverage stores were flat in April at its record high (Fig. 19).

The one big negative reason for a consumer retrenchment is the rise in 90-days-plus consumer credit delinquency rates (Fig. 20). During Q1, there was a big jump for student loans, as the government required payments to be made again on outstanding balances. Credit card delinquencies rose to 12.3%.

Lower-income consumers are clearly experiencing financial stress. On the other hand, higher-income consumers are still spending. Retired Baby Boomers are likely to bolster consumer spending the most as they spend their considerable nest eggs in coming years and transfer some of their assets to their adult children.

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Green Projects, Semis & Star Power

May 15 (Thursday)

Industrials: Browning out Green Investments. When President Trump was campaigning for a second term, he made no bones about the fact that, once in office, he would encourage oil and gas drilling and end the Biden-era funding of green economy companies. He’s been true to his word. Most notably, Trump and congressional Republicans have taken aim at President Biden’s Inflation Reduction Act (IRA) of 2022.

The IRA was meant to provide funding and tax credits to promote US manufacturing of items needed to generate solar, wind, and other green sources of energy in addition to providing funding for the domestic production of and purchase of electric vehicles (EVs). Some of this was done directly via loans and some indirectly via tax credits. But now that funding is at risk, and many companies have pulled the plug on projects before shovels ever hit dirt.

Nearly $8 billion of projects by clean energy companies were canceled during Q1. Some projects may have been derailed when the Trump administration froze IRA funds. (A federal judge has reinstated the funding while a lawsuit from six climate groups winds its way through the courts.) Other projects may have been aborted because Trump’s proposed tariffs were expected to hike their costs so much that they would no longer be economically viable. Still others may have been abandoned because of the flimsy financial footing of the start-up companies that ran them; they might have failed even if Trump never entered office.

Many of Trump’s policies are still being hashed out in Congress or litigated in the courts, so there’s much room for the proposals to change. Nonetheless, here’s a look at where things stand today:
 
(1) Say goodbye to EV tax credits. Under the proposed Republican tax bill, tax credits for commercial and used EVs would end after this year. The $7,500 consumer tax credit for purchasing new EVs would end at the end of this year. One exception: Consumers who purchase a car from manufacturers that have sold less than 200,000 vehicles would still enjoy the tax credit for another year.

Separately, Trump revoked Biden’s 2021 executive order that half of all vehicles sold in the US be electric by 2030.

(2) Say goodbye to new EV charging stations. The US Transportation Department in February suspended the EV charging program, which gave states more than $3 billion to build out EV charging stations, pending a review. Earlier this month, 16 states including California sued the Trump administration, saying it was illegal for the federal government to withhold the funds, as they were part of the IRA, a May 7 Reuters article reported.

(3) Say goodbye to clean energy tax breaks. The expiration for tax credits will be accelerated on clean hydrogen production facilities that start construction after the end of 2025. That might mean that hydrogen plants started in 2026 or later will receive the tax credit for less than 10 years, according to our friends at Capital Alpha.

“Credits for producing renewable energy or investing in it would start shrinking in 2029 and be eliminated after 2031. Those dates require projects to be finished by those deadlines, not just started, a move that would slow new construction,” a May 13 WSJ article reported. The bill also limits the sale of tax credits. Tax credits for producing components for batteries would generally expire after 2031, and tax credits for producing wind-energy components would end after 2027.

The shares of solar companies actually rallied on the news of the tax bill’s terms because investors were relieved that the tax credits would not be eliminated immediately. In addition, the bill limited products sourced from banned “foreign-influenced entities,” which was interpreted as limiting the imports of solar products from China. Assuming that interpretation is correct, beneficiaries would include companies like First Solar, which produces much of its own equipment domestically.

First Solar shares jumped 22.7% on Tuesday; but at $191.60, they remain priced far below their June 2024 high of $300.71. Likewise, the shares of SunRun, an installer of solar power systems, jumped 8.6% on Tuesday, but they too remain far below their August 2024 high of $21.50.

(4) Some projects pull the plug, others launch. The new economic environment for green energy companies and projects has changed dramatically just in the past year, leading some projects to be canceled even as others move forward. While only nine projects were cancelled in each 2023 and 2024, 16 have been canceled so far this year, according to E2 statistics.

Bosch cancelled a $200 million hydrogen fuel cell factory in South Carolina. Kore Power, a lithium battery cell manufacturer, canceled a planned $1.3 billion factory in Arizona. The site of the proposed factory was listed for sale, and the CEO Lindsay Gorrill posted on LinkedIn that he is stepping down from his role as CEO but will remain on the board, a February 6 article in Manufacturing Dive reported.

Freyr Battery, now known as “T1 Energy,” cancelled its plans to build a $2.6 billion lithium battery cell factory in Georgia and has sold the property on which it was to be built. Instead, it opted late last year to buy a solar panel assembly operation in Texas and now plans to focus on solar panels instead of batteries, a February 10 Solar Power World article reported.

Mission Solar also plans to invest $265 million to add 2 gigawatts of solar cell manufacturing to its campus in San Antonio, Texas, it announced in March. Solar production may be more protected by Trump tariffs, making it more attractive even if US tax credits fade away.

Information Technology: A Semiconductor Revival. The Trump administration has announced plans to rescind a Biden-era rule that prohibited or capped the sale of advanced semiconductors outside of the US in an effort to keep the technology out of “countries of concern.” The details are expected in the next few weeks.

But before the ink is dry on the new rules, Saudi Arabia ordered billions of dollars of semiconductor chips from Nvidia, AMD, and others during President Trump’s trip to the Kingdom this week. More orders are expected as Trump continues on to Doha and Abu Dhabi. AMD signaled its optimism about the future by announcing a $6 billion stock buyback program on Wednesday. It has all contributed to a furious semiconductor rally that has lifted the S&P 500 Semiconductors industry index by 43.6% since its April low.

Here are some additional details on what’s led to the chip revival:

(1) Lifting the AI Diffusion Rule. The “Diffusion Rule” had been opposed by many technology companies, including Microsoft, Oracle, and Nvidia, which believed it would limit US tech companies’ opportunities abroad without achieving its goal of impeding China. Eliminating the rule means advanced semis can now be sold into India, Switzerland, Saudi Arabia, Israel, and Singapore among other countries. The move was expected to benefit chip makers including Nvidia, Intel, and AMD.

(2) Chip orders surge. Nvidia announced on Tuesday a “partnership” that will help turn Saudi Arabia into a “global powerhouse in AI, cloud and enterprise computing, digital twins and robotics.” The company is working with Humain, a subsidiary of the Saudi’s Public Investment Fund that was launched this week to focus on AI.

Humain will build AI data centers (which Nvidia calls “AI factories”) powered by several hundred thousand of Nvidia’s most advanced chips over the next five years. Nvidia will train thousands of Saudi developers, teaching them the skills to work in accelerated computing and AI. And Aramco Digital will develop AI computing infrastructure using Nvidia platforms.

Humain also announced partnerships with AMD, Amazon’s AWS, and Groq during President Trump’s visit to Saudi Arabia. It will build additional data centers with AMD in Saudi Arabia and the US, using AMD chips and hardware. AWS announced it will invest $5.3 billion-plus in a partnership with Humain, which will build an AI zone in Saudi Arabia. It will use AWS AI infrastructure and services. This is in addition to another infrastructure region that AWS is building in the country, which will be available next year.

(3) Buybacks abound. AMD’s board of directors authorized a new $6 billion share buyback program in addition to the $4 billion of capacity remaining on an existing program. “Our expanded share repurchase program reflects the Board’s confidence in AMD’s strategic direction, growth prospects, and ability to consistently generate strong free cash flow,” AMD CEO Lisa Su said in a statement on Wednesday.

AMD isn’t alone. In February, ON Semiconductor announced a new $3 billion share repurchase program. ASM International started on April 29 a €150 million buyback program that it announced in February. KLA increased its share buyback program by $5 billion, and Broadcom announced a $10 billion buyback program.

(4) A look at the numbers. It’s not surprising that semiconductor companies are buying back their shares—the S&P 500 Semiconductors industry stock price index fell by 35.1% from its peak in January through April’s low. The index has enjoyed a 43.6% bounce since April, leaving it down only 6.8% from its peak (Fig. 1).

The S&P 500 Semiconductors industry index had rallied dramatically in recent years, rising 300% from the start of 2023 to its peak in January. The sharp move left the index’s valuation stretched near 35. At the height of the selloff, Semiconductors’ forward P/E fell to a low of 19.8 on April 3; it has since recovered a bit to 26.0 (Fig. 2).

Semiconductor stocks may have also come under pressure because the industry’s astronomical revenues and earnings growth has slowed, though continued to improve. The S&P 500 Semiconductors industry posted revenue growth of 30.9% in 2024, but that’s expected to moderate to 26.0% this year and 17.3% in 2026 (Fig. 3). Likewise, earnings growth has decelerated from 49.1% in 2024 to an expected 40.6% in 2025 and 26.8% in 2026 (Fig. 4).

Net earnings estimate revisions for the industry have been negative over the last eight months (Fig. 5). That may change given the new orders that many of these players have coming out of the Middle East.

Disruptive Technologies: Tapping Star Power. Sam Altman, CEO of OpenAI, was quoted in The Information discussing the harnessing of energy emitted by stars to power AI systems on Earth, according to a summary in Google’s AI Overview. Altman reportedly said that the great amounts of power that will be needed to build and operate AI systems requires an energy breakthrough. He’s working on a solution using nuclear fusion; and further down the line, Altman sees the development of Dyson spheres as a possibility.

Never heard of a Dyson sphere? We hadn’t either. It’s a mega structure that would harness the energy of a star in space and somehow transmit it to Earth or another planet. It could encapsulate the star or it could rotate around the star like a satellite. (Some star gazers believe that seeing a Dyson sphere in space at the present time would be proof positive of intelligent alien life.)

Here on Earth, humans are making progress toward building a Dyson sphere, a May 12 Forbes article pointed out. An engineering professor at the University of Glasgow, Colin McInnes, published a paper in January about ways to create a stable Dyson sphere that uses two stars.

As for how to get the star’s energy down to Earth, scientists at the California Institute of Technology have developed MAPLE, an experimental lightweight structure with solar panels and transmitters. It has succeeded at wirelessly transmitting power to Earth, according to a 2023 article in a university magazine. So Altman may be on to something.

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On Asia, India & US Earnings

May 14 (Wednesday)

Asia: Trump’s Tariff Retreat Could Make Asia’s Year. Virtually everything Asian governments thought they knew about the rest of 2025 seemed to change in an instant on Monday. News that Donald Trump is slashing China tariffs to 30% from 145% is being heralded as the game-changer the region needs.

Caveats abound, of course. President Trump granted this 90-day pause with few headline-grabbing concessions from Xi Jinping’s China in weekend talks in Geneva. Trump will also be sensitive to headlines about his having “caved.” And frustration that Beijing isn’t exactly bowing to his will in the weeks and months ahead might bring back out Trump’s inner “Tariff Man.”

Still, Asian policymakers are counting the ways the economic road ahead appears clearer than it did just a couple of days ago. Consider the following:

(1) China breathes easier. This climbdown takes considerable pressure off Asia’s biggest economy. Though a 30% import tax is formidable, a 79% reduction in Trumpian headwinds should return trade to some semblance of normalcy. It increases the odds that exporters, importers, and consumers can share the burden of absorbing tariff impacts. China stepping back from the brink helps, too. Xi cut levies on US imports to 10% from 125%. He also eased curbs on access to rare earth minerals—including speeding up permitting—and cleared the way for Boeing to deliver planes. All told, China’s odds of pulling off its 5% annual GDP growth target just rose considerably.

(2) Less Fed intrigue. Trump’s about-face on tariffs should take the white-hot spotlight off the Fed. This suits its central bank peers around Asia, who’ve been waiting to see whether Fed Chair Jerome Powell might ease US monetary policy before they act locally.

Also, reduced risks of a tariff-driven economic slowdown might give Trump fewer excuses to fire Powell. To be sure, Fed Governor Adriana Kugler says a 30% tariff is still “pretty high” and could lead to “an increase in prices and a slowdown.”

Yet for Asian financial markets, the less need to obsess about Fed dramas, the better. Investors in Asian markets at times are more keyed into the Fed than their local central banks. If the Fed isn’t (a) doing surprising things and (b) getting meddled with by the White House, it creates an element of calm for central banks in Asia.

(3) Stable dollar. The only thing Asia fears more than a plunging dollar is one so strong that it lures massive waves of capital out of the region. Trump’s climbdown has some traders reversing long yen positions that were a response to his reciprocal tariffs. The same goes for some betting on a stronger euro. And if the Bond Vigilantes give Treasuries a break, keeping US 10-year yields below 4.5%, Asian capital markets could be looking at a far less chaotic second half of 2025.

(4) Central bank relief. Suddenly, the Bank of Japan (BOJ), Bank of Korea (BOK), and other top monetary authorities have greater scope to go their own way. Global recession fears had BOJ Governor Kazuo Ueda pausing a two-year tightening cycle that boosted rates to 0.5%. BOK head Rhee Chang-yong was delaying rate cuts for fear that Korea might import tariff-driven inflation via a weaker won. People’s Bank of China chief Pan Gongsheng’s job might become easier as Trump lightens up on Xi’s economy.

Again, who knows what headwinds Washington might be generating in two months? For now, though, Asia is sensing a little light at the end of the Trumpian tunnel.

India I: Reviving Bollywood. India’s policymakers are flipping the script—turning to Bollywood and the broader creative sector to reignite the country’s growth story. With fiscal and monetary levers in motion, Prime Minister Narendra Modi is betting that India’s cultural economy can do more than entertain—it can grow the broader economy. “This isn’t just culture,” Modi said at India’s inaugural 2025 Creative Economy Summit, “it’s capital.”

Backing up the rhetoric, New Delhi unveiled a $1 billion stimulus fund aimed squarely at boosting investment in media, arts, and entertainment. The move isn’t merely nostalgic. It’s a strategic pivot inward, as external growth engines remain uncertain.

India’s policymakers are refocusing efforts on the domestic demand story. Domestic consumption has softened in 2025, while exports have held up, buoyed by partial US–China decoupling. But amid the global trade uncertainties, officials don’t want to rely on exporting for economic growth. They want growth levers they can control.

Accordingly, investing in India may require a mindset shift: It’s less about India replacing China as exporter to the world and more about the earnings growth that India’s companies may reap from domestic markets as policymakers support domestic consumption and leverage India’s cultural capital.

Here’s more about two major structural economic challenges that India’s policymakers confront:

(1) ‎Catch me if you can: The folly of chasing China’s export lead. Pandemic-era hopes that India could replace China in global supply chains lack wings: As of 2023, China accounted for roughly 30% of global manufacturing output; India, just 3%, according to UN data. Moreover, global firms remain heavily entrenched in China’s logistics and labor infrastructure. And recent improvement in US-China trade relations could limit India’s appeal as an alternative.

(2) Inequality: Can stimulus bridge the Great Divide? India’s income and wealth disparities are at multi-decade highs. The top 1% of earners controlled over 40% of total national wealth in 2023, the highest share in more than 60 years, per World Equality Lab data. Their slice of national income rose to a record 22.6%.

That concentration is more than a social issue; it’s an economic risk. With weak middle-class consumption, stimulus may not travel far without meaningful redistribution.

Fiscal policymakers are rolling out tax relief for lower-income households, aimed at boosting disposable income and consumption. The Reserve Bank of India (RBI) joined the stimulus push earlier this year, cutting its rates for the first time in five years two times in a row by a total of 50bps to 6.0% (Fig. 1).

With inflation under control, the RBI has room to stay accommodative. India’s CPI inflation eased to 3.3% y/y in March, below the RBI’s 4.0% target for a second consecutive month—freeing up policy space (Fig. 2). India’s CPI softened further in early April, to 3.16% y/y.
 
India II: The Great Indian Showdown. If India’s policy mix succeeds in directing capital flows into the right sectors, India’s next act could be as compelling as any Bollywood blockbuster. Modi’s ambition to make India the world’s third-largest economy by 2030 is running into unfortunate plot twists, however. The star players in India’s domestic growth story—households—seem to be buckling under high inequality and limited real income gains.

Here’s more:

(1) Production delays: Output slowdown. Real GDP growth popped 9.1% on a quarter-over-quarter basis in Q4-2024, but year-over-year growth slowed to 6.4% from nearly 11.0% at year-end 2023 (Fig. 3).

(2) Third act drag: Key sectors soften. Private and capital investment both weakened throughout 2024, undercutting momentum. Exports are still propping up headline numbers, but their pace has cooled since the early post-pandemic surge.

(3) Box office flop: The consumer sours. Consumer sentiment and car sales turned sharply negative in recent months. India’s consumer sentiment index plummeted from a March 2024 peak of 72.2 to 57.8 in April (Fig. 4). Reflecting the soured sentiment, the 12-month moving average of car sales decreased to 148,800 in November 2024 from above 175,000 during January 2023 (Fig. 5).
 
India III: The Market Strikes Back. India’s once frothy financial markets have simmered down. Equity valuations have corrected sharply in recent weeks amid doubts over export resilience and rising domestic headwinds.

Recent geopolitical risks—like India’s recent military response to Pakistan—barely registered in the markets. But Washington’s patience may be waning: Trump has warned that future trade expansion with India and Pakistan hinges on lasting peace.

Looking ahead, India’s markets are likely to be shaped by the evolving forces of geopolitics, global trade dynamics, and most crucially domestic growth. Market activity over the near term might be uneventful, however, if global trade becomes a headwind (as India’s “China alternative” theme fades) while consumer spending (benefiting from domestic stimulus) becomes a tailwind.

It’s time for the popcorn:

(1) Equity markets: Back to the future. India’s MSCI index fell below its 200-day moving average in April following President Trump’s surprise tariff announcement. Though the index bounced after a partial rollback, the damage was done—market euphoria has cooled (Fig. 6).

Valuations followed suit. The forward P/E multiple fell from a 24-year high of 25.2 in fall 2024 to 20.0 in early April, before rebounding to 22.2 by mid-May (Fig. 7).

(2) Earnings: Slow burn. The India MSCI’s forward EPS growth flattened in mid-2024 after a strong run from 2022 to early 2024. It increased over 105.0% during the earlier period versus 12.4% from January 2024 until now (Fig. 8). Analysts’ net estimate revisions have been negative since November.

Strategy: S&P 500 Q1 EPS—Robust, Though Short of Q4’s Record High. With 90% of the S&P 500 companies having reported March-quarter results through Friday’s close, their aggregate “blended” quarterly EPS—a mix of actual EPS for companies that have reported and consensus estimates for those that haven’t—is $62.91 (Fig. 9). That’s down 3.2% q/q from a record-high $65.00 in Q4-2024 (see our web pub “S&P 500 Quarterly Metrics”).

But while Q1 EPS were down on a quarter-to-quarter basis, the degree to which Q1 earnings beat analysts’ expectations was up. The 7.1% earnings surprise from the consensus Q1 mean at the time of each company’s report represents an acceleration from Q4’s 6.4% beat (Fig. 10).

Also up: Q1’s blended EPS relative to analysts’ expectations at the end of March before reporting season began; at that point, their consensus estimates implied EPS of $60.11 (Fig. 11).

As for Q1’s year-over-year growth, that’s in the double digits. With 10% of the companies left to report, the S&P 500’s blended y/y earnings growth rate for Q1 is 11.2%, marking the seventh straight quarter of positive y/y earnings growth for the S&P 500 and the lengthiest such streak since the eight quarters through Q3-2022 (Fig. 12).

However, Q1’s y/y growth rate is down from Q4’s rate, when growth peaked at 12-quarter high of 13.7% y/y (Fig. 13). On a proforma same-company basis, S&P 500 earnings rose 14.1% y/y in Q1, which also marked its seventh quarter of growth and a slight deceleration from a 12-quarter high of 17.1% in Q4-2024 (Fig. 14).

How did the S&P 500’s 11 sectors, the Magnificient-7 stocks, and the remaining S&P 493 do last quarter? Below, Joe puts their aggregate Q1 earnings results under his analytical lens:

(1) Few sectors outperform S&P 500’s Q1 earnings growth. Eight of the 11 S&P 500 sectors delivered rising earnings y/y in Q1, but Communication Services posted the only record-high EPS. Just three sectors recorded stronger y/y growth than the S&P 500 (Fig. 15). That compares to 10 sectors rising y/y in Q4, when four sectors grew faster than the overall index and two posted record high EPS (Communication Services and Information Technology).

Just four sectors recorded positive and double-digit percentage y/y earnings growth in Q1, a big downshift from seven sectors in Q4. Among Q1’s laggards, Energy’s earnings fell at a double-digit percentage rate for the fifth time in six quarters, and Consumer Staples’ fell y/y for the first time in eight quarters. On a positive note, Materials’ earnings growth turned positive for the first time in 10 quarters.

Here’s how the sectors have stacked up so far on a proforma basis: Health Care (46.2%), Communication Services (31.0), Information Technology (19.1), S&P 500 (14.1), Consumer Discretionary (9.5), Financials (7.0), Utilities (4.6), Real Estate (1.3), Consumer Staples (-5.6), Industrials (-5.7), Materials (-7.2), and Energy (-25.9).

(2) Magnificent-7. Through Friday’s close, six of the Magnificent-7, all but Nvidia, have reported results so far. The “Magnificent-6’s” aggregate Q1 earnings surprise was 9.7%, and its y/y earnings growth of 22.0% was nearly double the consensus’ 11.2% forecast—all well above the S&P 500’s measures (Fig. 16).

Three of the six had double-digit percentage earnings surprises, and four had double-digit y/y earnings growth. Here are the Q1 earnings surprises and y/y earnings growth rates for the Magnificent-6: Amazon (16.7% earnings surprise, 62.2% y/y earnings growth), Tesla (-31.0, -40.0), Alphabet (12.8, 20.1), Meta (21.8, 36.5), Microsoft (7.4, 17.7), and Apple (1.4, 7.8).

(3) Decent Q1 for S&P 493. The S&P 493 delivered double-digit percentage earnings growth in Q1 and did so for a second straight quarter. Earnings growth has slowed to 11.0% y/y from a 12-quarter high of 13.2% in Q4-2024. For now, the group’s total Q1 earnings is down 1% q/q from its record high in Q4. Its aggregate Q1 earnings results beat consensus forecasts by 6.3% but was behind the Magnificent-7’s also-less-than-stellar earnings beat of 9.7%.

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More On China: Deflation & ‘Made In China 2025’

May 13 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
China I: Deflation Clouds Darken. Over the weekend, as Treasury Secretary Scott Bessent engaged in trade talks in Geneva, his Chinese counterparts across the table received some alarming news from 5,100 miles away.

Factory-gate prices in China fell for the 31st consecutive month. The 2.7% y/y drop in the April producer price index confirmed China’s slide toward deflation (Fig. 1). China’s falling-price trajectory is mild so far relative to Japan’s plight in the 1990s. But news on Saturday that Mainland consumer prices are now down y/y for three straight months should give pause to officials in both Beijing and Washington (Fig. 2).

For Chinese President Xi Jinping, this is a fork-in-the-road moment. There’s indeed a distinction between facing deflationary forces and experiencing outright deflation, which is hard to reverse. What Team Xi does next will determine which path Asia’s biggest economy takes.

For Trump World, this is a be-careful-what-you-wish-for moment. President Trump’s tariffs are a hurricane-force headwind that China hardly needs. Even if Trump’s claim that the China tariff will be slashed considerably holds, a 30% import tax is still no joke.

Pre-trade war, China was struggling with a property crisis, high youth unemployment, crushing local government debt, and weak domestic demand. Kicking China when it’s down risks exacerbating deflation odds. The second-biggest economy exporting even more deflation is in no one’s interest, considering that deflationary forces are already “persistent,” notes Zhiwei Zhang, president of Pinpoint Asset Management.

So far, Xi has taken the road too often traveled by governments failing to grasp how deflation can take on a life of its own. Mostly, Xi’s Communist Party has taken a page from Japan, circa 1995, throwing ever bigger mountains of cash at the problem.

Tokyo’s top mistake back then was a decade-plus of treating the symptoms of its bad-loan crisis, not the underlying causes. Similarly, China has been rolling out bigger and bigger stimulus packages, rate cuts, and supplemental programs to support property, municipal finances, and the stock market. All the while, insidious deflationary pressures have been increasing under the surface (Fig. 3).

Now, as these deflationary pressures bubble above the surface, what we’re seeing is more energetic effort to boost weak household and business confidence over the short run. On May 7, the People’s Bank of China surprised global markets by cutting the seven-day reverse repurchase rate, the lever to its main benchmark interest rate, by 10 basis points to 1.4%. Also lowered was the weighted average of the reserve requirement ratio, by 50 basis points to 6.2% (Fig. 4).

Yet rate cuts don’t address the underlying problems that have Chinese households saving too much and spending too little. Nor does this latest stimulus blast hasten the transition to a domestic-demand-led-growth model and away from exports and unproductive investment. Nor does it sideline the inefficient state sector once and for all.

To defeat inflation, Team Xi faces quite a to-do list. I asked William to explore three of the most immediate fixes China could make to increase domestic confidence:

(1) China needs to encourage households to spend more. By building bigger social safety nets, households would feel less need to hoard savings and would spend more. As of the start of 2024, the International Monetary Fund (IMF) calculated that China was home to 28% of global savings, a level more than 40% of Mainland GDP. Combined, the US and European Union economies held less than 33% of global savings.

To Lu Feng, an economist at Peking University, Beijing needs a fundamental change in the top-down allocation of resources, which historically favored the supply side over the demand side. That’s key to increasing incomes in rural areas, where a critical mass of China’s 1.4 billion people live.

Current household consumption is driven by expected long-term income. As such, China’s pension gap tells the story. Though good data are hard to come by, Lu noted that in 2022, the average annual pension for public servants was 73,198 yuan ($10,113) versus 2,456 yuan ($340) for rural residents.

Oddly, to morph China itself into an upper-middle-income power driven by domestic consumption, Beijing may have to go more communist.

(2) China needs to address its festering property crisis. Though the real estate boom is over, the hangover is intensifying (Fig. 5 and Fig. 6). Somehow, Japan comparisons seem inadequate considering the seizing up of a $15 trillion sector. This financial sinkhole is more than three and a half times the size of Japan’s $4.2 trillion GDP.

Talk about an own goal. The crisis began around 2021, when Xi’s reform team moved to reduce the role of real estate—then generating about 25% of GDP—in favor of technology-driven economic growth.

Xi had the right idea in tackling China’s housing bubble and nose-bleed leverage levels among developers. But he used too much sledgehammer, not enough scalpel. Home prices plunged about 30% from their 2021 peak. The crash wiped out an amount of household wealth comparable to China’s nearly $18 trillion of annual output.

The defaults that followed have China in global headlines for all the wrong reasons. The carnage has pushed municipalities to the brink.

(3) China needs to tackle several trillions of dollars of local government debt. During the Xi era that began in 2012, local governments made most of their money off property sales. With that business increasingly dead to them, China’s 34 province-level administrative divisions are getting by with great walls of debt issuance.

In recent years, local officials found a way around Beijing’s limit on bond sales: off-balance-sheet local government financing vehicles (LGFVs). At the start of 2024, the IMF reckoned that LGFV debt was nearly 48% of China’s GDP. That 60.2 trillion yuan ($8.3 trillion) is three times France’s annual output.

Getting this debt off municipal balance sheets would empower authorities where most Chinese live to invest more in infrastructure, education, healthcare, and elder care. It would give local governments great scope to support startup companies, address declining birth rates, and create robust social safety nets. And of course, it would help China to avoid a Japan-like funk, the fears of which keep Xi’s inner circle awake at night.

China II: ‘Made in China 2025’ Won’t Kill Silicon Valley—Yet. Over the past six months, China served up three big surprises to global markets: 1) the success and sudden ubiquity of electric vehicle (EV) maker BYD; 2) DeepSeek’s upending the artificial intelligence game; and 3) its continued pace of GDP growth at near 5% y/y despite the trade war.

Yet one man is anything but surprised: Chinese leader Xi Jinping, who a decade ago laid the groundwork for Asia’s biggest economy to beat the odds in ways that Wall Street struggles to grasp.

The timing is no coincidence. Xi named the strategy he rolled out in 2015 “Made in China 2025” for a reason. It’s now putting some big wins on the scoreboard, much to the chagrin of President Donald Trump, who’s attempting to tariff China into submission. But in so doing, Trump is inadvertently enabling China to carry out its own decoupling from the West as it becomes more self-sufficient.

Yet for all the great press China is getting for wins here and there, Xi’s signature effort to transform China from a low-cost manufacturing hub into a global leader in advanced technology and innovation is facing as many challenges as successes. That’s particularly true as President Trump’s trade war forces Xi’s people to focus more on stabilizing a rigid and underdeveloped financial system than raising China’s tech game.

Let’s explore where Made in China 2025 is 10 years on and, more pointedly, where it’s not. Spoiler: The Xi juggernaut remains far more an aspiration for the global domination of Chinese innovation than a reality.

In May 2015, Xi’s Communist Party unveiled a new industrial policy to move beyond China’s “world’s factory” phase into high-value-added manufacturing on route to becoming a tech powerhouse. It targeted key technologies of tomorrow all at once: aerospace, semiconductors, AI, renewable energy, batteries, EVs, biotechnology, green infrastructure, robotics, quantum computing, and self-driving vehicles. In 2020, Beijing pledged to spend $1.4 trillion on 5G networks alone.

The nation’s quantum computing capabilities, meanwhile, are rapidly transitioning from the laboratory to practical applications. At the Mobile World Congress in March, Chinese robotics companies that few had ever heard of before wowed the crowd. Hangzhou-based Unitree Robotics showcased its line of humanoid robots. Shanghai-based robotics startup Agibot has Japan Inc. icon Olympus Corp. looking over its shoulder.

The point here is that “China has the potential to replicate its disruptive impact from the EV industry in the humanoid space,” Reyk Knuhtsen of SemiAnalysis, told CNBC. “However, this time the disruption could extend far beyond a single industry, potentially transforming the labor force itself.”

Could Nvidia CEO Jensen Huang—who in March declared that “the age of generalist robotics is here”—be humbled again by a Chinese upstart? Elon Musk has been: The Warren Buffett-backed Chinese automaker BYD overshot Musk’s Tesla in both sales and revenue terms last year.

BYD serves as a microcosm for a broader phenomenon. Though founder Wang Chuanfu launched BYD auto division in 2003, it wasn’t until 2015 that he set a course for world market domination—with help from the Chinese government. Likewise, DeepSeek’s creation in 2023 wouldn’t have been possible without Beijing’s financing programs, regulatory pivots, and leveling of local playing fields.

The risks to the US from China’s targeted subsidization in pursuit of global market leadership are numerous and arguably growing even faster now that Trump’s tariff-heavy economic strategy is apparent.

At a congressional hearing in early February, just two weeks into the Trump 2.0 era, Liza Tobin of Garnaut Global, warned: “We risk losing the next industrial revolution, which is unfolding as AI converges with physical industry to transform how things are made.”

At the moment, Trump’s America and Xi’s China can make for quite a split screen. On one, China, for all its flaws, is investing in areas where it thinks the global economy is heading in 2035. On the other, Trump seems to be bent on making America great by battling its challenges of 1985. His tariff policy rationale is ripped from the ’80s, when a handful of industrialized nations held vast sway over global economic dynamics.

The bad news for Xi is how his top-down, power-obsessed government isn’t exactly creating the Darwinian global economy that the Party seems to think it is. By prioritizing control over change and championing the state sector over private-sector development, Xi has created a bifurcated economic system.

It’s one that tolerates disruption in certain strategic sectors that advance the ruling party’s agenda—EVs, AI, and renewable energy—but squashes innovative disruption in others. Ask Alibaba’s Jack Ma, China’s most globally famous tech founder, how the last five years have gone for him. Ma’s sin: chiding Xi’s regulators in 2020 for stifling innovation—that and trying to take public his Ant Group fintech startup, which would’ve threatened the state-owned banking giants.

Add to that picture the backdrop of a shaky underlying financial system. The cracks in China’s “old economy,” until repaired, will undermine the potential of the “new” one that Made in China 2025 seeks to build.

China excels at slogans and spin. Hence, the splashy effort to frame its push to encourage “new quality productive forces” as some Silicon Valley killer that boosts productivity growth across sectors.

“But these sectors alone cannot compensate for weaknesses in other industries,” write Rhodium Group economists in a May 5 report. “More fundamentally, the only way for China’s economic growth to exceed growth in the rest of the world while pursuing an export-led development strategy would be to grab additional export market share, risking even more serious trade defenses in response. … Beijing’s emphasis on industrial policy has also contributed to a stall in broader economic reforms, straining relations with key trading partners.”

Unless Xi throttles back on the ginormous state subsidies that these policies entail, two woeful outcomes may transpire: Posterity might recall last weekend’s talks in Geneva as a nice dining experience between trade negotiators that did nothing to alter either country’s most important trade relationship. And China’s days of 5% annual GDP growth could soon be over.

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Earnings & Valuation Under Trump 2.0 So Far

May 12 (Monday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy I: Recession Forecasts Still in Fashion. Once again, economists are debating the odds of a near-term recession. They’ve done so over much of the past three years. Most of them reckoned that the tightening of monetary policy, the fall in the Index of Leading Economic Indicators, and the inverting yield curve all meant that a recession was all but inevitable. They were wrong. All along, we counted on the underlying resilience of the US economy to keep GDP growing apace. That worked out well for us.

Here we go again. This year, the naysayers are convinced that Trump’s Tariff Turmoil (TTT) will cause a recession during the second half of this year. We are still betting on the resilience of the economy. We’ve also been betting that Trump will blink and unilaterally deescalate his one-man Tariff Man trade war. So far, so good. Mounting concerns among Republicans that they could lose their majorities in both houses of Congress if TTT causes a recession undoubtedly have softened Trump’s stance.

In addition, we anticipated that several court cases would challenge Trump’s constitutional authority to impose tariffs. Our good friend Jim Lucier of Capital Alpha Partners observes: “The first showdown in court over President Donald Trump’s IEEPA tariffs is coming Tuesday, May 13, at 11 AM ET. The Court of International Trade (CIT) in New York City will hold a hearing on all pending motions in one of four pending challenges to IEEPA in that court. The case brought by the Liberty Justice Center on behalf of small business plaintiffs is V.O.S. Selections, Inc. et al. v Trump et al. None other than Trump’s former U.S. Trade Representative Robert Lighthizer said at the Council on Foreign Relations in New York on April 28 that ‘there is a reasonable chance the CIT will enjoin’ Trump’s IEEPA tariffs (See video here, minute 49:00).”

Here is what we wrote on April 7: “Trump’s Liberation Day last Wednesday triggered Annihilation Days on Thursday and Friday, with the Stock Market Vigilantes giving a costly thumbs-down to Trump’s Reign of Tariffs. Trump officials say they aim to make Main Street wealthy again even if that’s bad for Wall Street. The problem is that Main Street owns lots of equities traded on Wall Street, so the two streets prosper and suffer together. Congress can’t do much to stop Trump given his veto power, but he might get the message that hurting Main Street’s stock portfolios can cause a recession and jeopardize the GOP majority in Congress. If so, he might postpone the reciprocal tariffs, giving trade negotiations time to work. Also, the courts might block Trump’s tariffs. An early end to Trump’s tariff nightmare would result in a V-shaped stock-market bottom. We’re counting on that; the alternative is just plain ugly.”

The S&P 500’s 18.9% correction since February 19 troughed on April 8; the next day, Trump postponed his April 2 Liberation Day reciprocal tariffs. The S&P 500 closed up 9.5% that day, April 9 (Fig. 1). It is now up 13.6% since the trough and only 7.9% below its record high!

The April 17 WSJ reviewed the latest quarter survey of economists’ forecasts. It was conducted from April 4 to April 8, just before Trump postponed his Liberation Day tariffs. Economists raised the probability of a recession in the next 12 months to 45% from 20%. They expect the unemployment rate to reach 4.7% by December and remain around there into 2026.

The May 3 WSJ featured a story titled “What Recession? Stock Investors Expect the Good Times to Continue.” It noted: “Wall Street’s best forecasters have been warning that tariffs could spark a recession. Goldman Sachs puts the chances at 45% in the next 12 months. Apollo Global Management’s top economist recently pegged it at 90%.” BCA also remains solidly in the recession camp.

We lowered our odds of a recession from 45% to 35% on May 4. We did so because Trump continued to moderate his stance on tariffs. In addition, the labor market has remained impressively resilient. We are also less concerned about a negative wealth effect on consumer spending now that the stock market has rebounded significantly. Additionally, we expect that capital spending related to datacenters for cloud computing and the onshoring of manufacturing will remain robust.

Consider the following:

(1) Last week’s batch of economic indicators lowered the odds of a recession, according to Polymarkets.com, to 51% on Friday from a peak of 66% on May 1 (Fig. 2). Meanwhile, the Citigroup Economic Surprise Index for the US has been only slightly negative since April 29 (Fig. 3).

(2) This week, a bunch of soft and hard economic indicators will be released, mostly for April. The soft indicators include data on small business owners’ concerns and expectations from the National Federation of Independent Business’ (NFIB) survey of its members. The main hard ones will be retail sales, industrial production, housing starts, and jobless claims.

The NFIB’s Small Business Optimism Index (SBOI) dropped sharply in March (Fig. 4). It might have ticked up in April in response to the 90-day postponement of Trump’s reciprocal tariffs. Then again, the tariffs on China remain prohibitive and undoubtedly depressed sentiment among small business owners who import lots of merchandise from China. We will be watching the SBOI as well as the NFIB data on small business job openings and hiring plans (Fig. 5).

(3) May’s regional business surveys conducted by the Federal Reserve district banks of New York and Philadelphia will also be released this week. They probably remained depressed in May but less so than in April, which was the height of TTT (Fig. 6).

(4) Perhaps the most important report this coming week will be the one for April’s retail sales. It’s unlikely to show that consumers are retrenching in response to TTT. More likely is that it will be boosted by lots of buying in advance of tariff-related price increases. The Redbook Retail Sales Index rose 6.9% y/y through the May 2 week (Fig. 7). The labor market also remains resilient, as confirmed by the latest weekly report for unemployment claims (Fig. 8).

Strategy II: Earnings Under Trump 2.0. Industry analysts must finally have received the tariff-recession memo. In recent weeks, they’ve been slashing their estimates for S&P 500 companies’ operating earnings per share (EPS) for the final three quarters of 2025 (Fig. 9). That’s despite Q1’s big earnings beat.

At the start of the latest earnings reporting season, the analysts collectively expected a 6.0% y/y increase in S&P 500 companies’ aggregate EPS for Q1. As of the May 8 week, after 90% of the S&P 500 companies had reported Q1 results, the blended estimated/actual growth rate was up to 11.2% y/y. With Q1 growth nearly double the analysts’ initial expectations as reporting began, this was far from a weak quarter. Obviously, it was what company managements said on the conference calls that caused analysts to take paring knives to their estimates for the rest of this year; and obviously, it was Trump’s Liberation Day shocker that festered rampant uncertainty and pessimism among managements.

As a result, the analysts’ 2025 and 2026 EPS estimates were revised down since the start of the year through the May 8 week by about $10 each to $265 and $300 (Fig. 10). (We are still estimating $260 and $300.)

S&P 500 forward operating earnings—which is the time-weighted average of analysts’ consensus EPS expectations for 2025 and 2026—rose to a record high of $279.13 on April 3. It has been hovering around that level since then, as of the May 8 week. It will converge toward the 2026 analysts’ consensus EPS over the rest of the year, as forward EPS by definition do. So despite the downward revisions of analysts’ quarterly and annual EPS consensus estimates, there’s is no evidence so far of a recession in S&P 500 forward earnings, which tends to fall sharply during economic downturns.

By the way, Joe reports that on a proforma basis, which assumes the S&P 500’s current members were also in the index a year earlier, Q1 earnings is up by 14.1% (Fig. 11). Excluding the S&P 500 Energy sector, which has been depressed by falling oil prices, S&P 500 proforma Q1 EPS was up 16.1% y/y through the May 9 week (Fig. 12).

Bloomberg’s Lu Wang reports that 21 of Wall Street’s investment strategists predicted in April that S&P 500 EPS will be $261 this year on average, with the median forecast at $257 (Fig. 13). At the end of last year, they were projecting $269 on average, with the median at $271 (Fig. 14). (We then were at $285.)

According to Bloomberg, Wall Street’s strategists predicted in April that the S&P 500 will end the year at 6,047 on average (Fig. 15). We remain at 6000.

Strategy III: Valuation Under Trump 2.0. As noted above, forward earnings expectations remain remarkably resilient notwithstanding widespread fears of a recession. The same can be said of valuation multiples.

The S&P 500’s forward P/E (i.e., the multiple using forward earnings as the “E”) fell from about 22 at the start of this year to 18 on April 8 (Fig. 16). Now it is back a bit above 20. Leading the way down in the S&P 500’s correction was a sharp drop in the forward P/E of the Magnificent-7 stocks from 31 to 22. It is now back at 25.

Usually in recessions, the forward P/E of the S&P 500 falls into the single digits. It hasn’t done so this time because the stock market isn’t pricing in a recession. Neither are industry analysts, according to their latest EPS estimates.

During the previous bear market, the forward P/E bottomed at 15.1 on October 22, 2022. That too was a relatively high P/E and occurred because the most widely anticipated recession of all times was a no-show. History may already be repeating itself in the performance of the stock market and the economy so far this year.

Movie. “How To Make Millions Before Grandma Dies” (+ +) is a 2024 Thai comedy drama about life and death and families. Mengju is the mother of three adult children. She is diagnosed with late-stage colorectal cancer. Her three children suddenly come to visit her more often now that they are thinking about their inheritance. Her grandson, a university dropout, moves in with her to curry favor. The cast does a great job of portraying a contentious family that is probably similar to many other families with mixed emotions regarding their immediate relatives. (See our movie reviews archive.)

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Oil, Consumers & Driverless Taxis

May 08 (Thursday)

Commodities: Have Oil Prices Bottomed? Gold is having a fabulous year, with inflation fears pushing its price up 29.3% ytd through Tuesday’s close. “Liquid gold,” as oil is often called, has had a much tougher 2025. The price of West Texas Intermediate (WTI) crude oil has fallen 16.6% ytd and 24.6% y/y (Fig. 1 and Fig. 2). Recent declines are due to OPEC+’s plans to unwind production cuts much more quickly than expected. President Trump’s Tariff Turmoil (TTT) has raised the specter of a global economic downturn, which also weighs on oil prices.

WTI crude prices fell to a low of $58.50 per barrel on May 5 and since have bounced by 3.3% to $60.42 on Tuesday’s close, perhaps indicating that the worst has been priced into the market (Fig. 3). Traders now expect OPEC to flood the market with its excess production. What they’ll be watching is just how much and how fast US shale producers respond to low oil prices by cutting production.

Likewise, the market was expecting slower economic growth to hurt oil demand. But headlines about US and Chinese diplomats meeting to discuss tariffs may indicate that cooler heads have prevailed; neither side wants to be held responsible for causing an economic downturn.

Here’s a look at some of the details surrounding the moves by OPEC, US shale producers, and tariff negotiators:

(1) OPEC says “Uncle.” The oil market has been over-supplied and artificially propped up by OPEC+’s production cuts. Last weekend, OPEC+ shocked the markets by increasing its output by 411,000 barrels per day in June, triple the amount that was expected. It was a none-too-subtle sign that Saudi Arabia was done defending high oil prices by reducing its own production, only to watch OPEC+ members sell more than their quotas allotted while US producers took market share.

“With this move, Saudi Arabia is seeking to punish lack of compliance and also ingratiate itself with President Trump,” Jorge Leon of Rystad Energy said in a May 3 Bloomberg article. Trump repeatedly has pushed for lower oil prices, which could help offset any tariff-related inflation. He has plans to visit the Middle East next week, before which he has touted plans to make a “big announcement.”

Last December, the organization announced plans to unwind the 2.2 million barrels per day (bpd) of oil that it had held off the market—but gradually, from March 2025 through the end of September 2026. The “gradual” part of that plan appears to have been abandoned: The unwind is occurring much more quickly than originally envisioned. Roughly 960,000 bpd will have returned to the market as of June, and another large reversal is expected in July.

(2) Shale producers say “Uncle.” With the price of oil in the low $60s, drilling becomes uneconomic for a wide swath of US producers and may at the least push them to cut spending on new wells.

Executives from 81 exploration and production firms were asked by the Dallas Federal Reserve what oil price is needed to profitably drill a new well in their top two areas of drilling. The E&P executives’ mean responses ranged from a low of $61 in the Permian basin around Midland, Texas to a high of $70 in other areas of the Permian, according to a chart shared by the folks at The Daily Shot.

The number of US oil rigs being used has been declining gradually, generally in step with the price of oil (Fig. 4). Thanks to improving technology, the amount of oil produced hasn’t fallen because more oil was produced by fewer rigs (Fig. 5). But going forward, oil production may face more challenges. “Today, geologic headwinds outweigh the tailwinds provided by improvements in technology and operational efficiency,” warned Diamondback Energy CEO Travis Stice in a May 5 shareholder letter. “As crude pricing moves lower for a period of time, as it has for the last month, we expect [US drilling] activity to slow and oil production to decline.”

Diamondback is responding by cutting capital expenditures, drilling and completing fewer wells, and will instead maximize free cash flow generation, wrote Stice, who is retiring as CEO but will remain executive chairman. Capital expenditures this year will fall to $3.4 billion-$3.8 billion, down from $3.8 billion-$4.2 billion, and the company will drop three rigs and one full-time completion crew during Q2. If oil prices rise above $65 a barrel consistently, the company will reverse this decision.

While US drillers’ pulling back may not be good news for the Texas economy or US oil production, it may be what the oil market needs to return to equilibrium sooner rather than later.

(3) US and China say “Uncle.” Stock investors were understandably excited about news late Tuesday that US Treasury Secretary Scott Bessent and US Trade Representative Jamieson Greer are slated to meet He Lifeng, China’s vice premier and lead economic representative, in Switzerland on May 10 and 11 to discuss tariffs.

“On Saturday and Sunday, we will agree on what we’re going to talk about,” Bessent said in a Fox News interview on Tuesday. “My sense is that this will be about de-escalation, not about the big trade deal. But we’ve got to de-escalate before we can move forward.” The US has placed 145% tariffs on Chinese imports, while Beijing has placed 125% tariffs on US imports.

Oil prices have sputtered on fears that TTT, if left unchecked, could sharply reduce global economic growth. But the meeting between US and Chinese representatives may indicate that progress to reduce tariffs on both sides can occur before lasting economic damage is done. That would, of course, be good for oil demand and oil prices.
 
Consumer Discretionary: Consumers Worried, But Still Spending. Consumers may be less confident about the future and increasingly concerned about the direction of the stock market, but they still seem to be willing to spend based on recent earnings results from Disney, Marriott International, and DoorDash. Consumers’ wallets may remain open as long as they have jobs and the unemployment rate remains low.

In April, consumer confidence about the present situation slid to 133.5, down from 144.0 in December (Fig. 6). Conversely, the percentage of consumers who believed that stock prices would be lower in 12 months jumped to 48.5%, up from 24.8% at the start of this year (Fig. 7).

Here’s what a few managements of companies in the S&P 500 Consumer Discretionary sector have said about the tariff impacts they saw last quarter, particularly on consumer spending:

(1) The Disney magic shines. Investors were excited to hear yesterday that the Walt Disney Co. has plans to open its seventh theme park in Abu Dhabi. It will be designed by Disney, which will receive royalty payments, but paid for and operated by Miral, a local company that has built theme parks.

We were more excited to see that revenue in Disney’s domestic Parks & Experiences division rose 9% y/y in its fiscal Q2 ending March 29 to $6.5 billion. The improvement was attributed to improved domestic park attendance and occupied room nights, increases in passenger cruise days, and higher Disney Vacation Club unit sales. The company also saw an increase in guest spending at domestic parks.

“Bookings right now for Walt Disney World for the third quarter are up 4% ... and then for the fourth quarter, bookings are up 7%, so [it’s] certainly looking very optimistic,” said CFO Hugh Johnston.

Conversely, there was a notable revenue decline, of 5%, and operating income decline, of 23%, at Disney’s international parks. The company attributed the drops to lower theme park attendance and higher costs at Shanghai Disney Resort and Hong Kong Disneyland. Johnston described Chinese consumers as “a bit challenged” and “tightening their belts a little bit.”

(2) Marriott highlights impact of government layoffs. Like most companies, Marriott International called out the uncertainty created by TTT, but unlike others it also noted that US government layoffs were impacting its results.

Marriott’s revenue per available room (RevPAR) in the US and Canada increased 3.3% in Q1, but results slowed in March due to a 10% y/y decline in US government RevPAR and softness in the company’s lower-end hotels. While preliminary, April results “improved sequentially” from March levels after excluding the impact of Easter. Also notable was the Q1 RevPAR 2% decline in Greater China.

“We operate a cyclical business, and there is no doubt that today we are in a period of heightened macroeconomic uncertainty, especially here in the US, with many concerned about slowing economic activity and lower consumer confidence,” said CEO Anthony Capuano on Tuesday’s earnings conference call.

While Q1 earnings beat estimates, Marriott reduced its Q2 and full-year outlook due to a “more cautious outlook” in the US and Canada. It now expects RevPAR to grow 1.5%-2.5% in Q2, down from previous guidance of 3.0%-4.0%. For the full year, it expects RevPAR growth of 1.5%-3.5%, down from 2.0%-4.0%. It also gave 2025 EPS guidance of $9.82-$10.19, below Wall Street analysts’ consensus forecast of $10.36. Nonetheless, Marriott’s shares are up roughly 2% so far this week in a down market.

(3) DoorDash keeps growing. DoorDash executives are among the lucky few that are saying their business has not been affected directly or indirectly by consumers’ tariff fears. “We haven't seen any changes in consumer behavior even if there are changes in consumer sentiment,” said CEO Tony Xu on the company’s earnings conference call Tuesday.

DoorDash posted 20.7% Q1 revenue growth, down slightly from the 23% y/y revenue growth posted in Q1-2024. The company has also shown in recent quarters that it can turn a profit, with operating income of $155 million in Q1 compared to a loss of $61 million in the year-ago quarter.

While DoorDash shares are up 13.3% ytd and 64.5% y/y through Tuesday’s close, they’ve fallen roughly 16% since the company reported earnings. The decline might partly reflect the fact that management projected a Q2 adjusted EBTDA range with a midpoint of $625 million, which is below analysts’ consensus estimate of $639 million. The stock price decline may also be related to the two acquisitions the company announced: Deliveroo, a British online food delivery company, for $3.9 billion, and SevenRooms, a US provider of booking software for restaurants and hotels, for $1.2 billion.

Notwithstanding the stock's recent weakness, many CEOs would love to head a company that’s growing so fast and with its services in such demand that it has yet to feel an impact from falling consumer confidence.

Disruptive Technologies: Maiden Voyage in a Driverless Taxi. “So, we finally did it,” Jackie reports. She took a driverless taxi: “While visiting Phoenix, my husband downloaded the Waymo app and ordered a car. The driverless taxi arrived on time, in the right spot, and offered a greeting as we hopped in. If I had been driving, I may have slowed down a little sooner as we approached one red light; but otherwise, the car drove far better than our teenagers.”

While Waymo offers services via its own app in San Francisco, Los Angeles, Phoenix, and Tokyo, it can also be accessed through the Uber app in Phoenix and Austin today, and it’s “ramping up” to do so in Atlanta. Uber’s website says the rate it charges for a human-driven car is the same as what it charges for the Waymo driverless car, but no tip is needed in the Waymo car. Online anecdotes say Waymo pricing before the tip can be lower than, equal to, or more than Uber rides that use drivers.

Uber CEO Dara Khosrowshahi called autonomous vehicles “the single greatest opportunity ahead for Uber,” a May 7 CNBC article reported. He noted that the Austin launch exceeded Uber’s expectations, and the 100 Waymo vehicles operating in that city are “busier than over 99% of all drivers” as far as completed trips per day go. That makes sense: Autonomous vehicles don’t have drivers that need to eat, sleep, or chill out.

Already this month, Uber has announced three autonomous vehicle partnerships with Chinese companies. Pony AI’s robotaxis will be available on Uber’s platform in a “key market” in the Middle East later this year, a May 6 TechCrunch article reported. A day earlier, Uber announced that it will work with Momenta to offer robotaxis via the Uber app in Europe starting next year as well as to roll out WeRide vehicles in 15 Middle Eastern and European cities within the next five years. Uber and WeRide already offer a commercial robotaxi service in Abu Dhabi.

Uber has more than 15 partnerships with autonomous vehicle companies offering ride-hail, delivery, and freight services in various markets around the world. With Waymo expanding and Tesla robotaxis expected to arrive in Austin next month, Uber’s dealmaking will likely continue. The driverless taxi race is on.

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On Europe & S&P 500 Earnings

May 07 (Wednesday)

Eurozone I: Improving at the Margins. The Eurozone economy is not exactly making a dramatic comeback, but it’s no longer a total mess. Inflation is under control, interest-rate cuts are gaining traction, and long-overdue structural shifts—in defense, fiscal policy, and capital flows—are starting to show. Meanwhile, America’s fiscal and monetary policy uncertainty and its trade-related upheaval have challenged the notion of US exceptionalism, sapping the dollar’s value and strengthening the euro relative to the dollar.

Still, the Eurozone economy faces real headwinds: US trade shocks are unresolved, the euro’s strength is hurting competitiveness, and any delays in executing fiscal spending could mute their intended boost. Meanwhile, inexpensive Chinese imports flooding into Europe’s markets pose a clear and present danger, especially for the Eurozone’s automakers, as William Pesek explained in yesterday’s Morning Briefing.

Can Europe’s economy stage a sustainable comeback? In our view, yes. Europe won’t become a global-growth superstar overnight, but it is coming back from the brink. At this point, we think selective exposure to European equities makes sense. Consider the following:

(1) ‎Headwind: Economic powerhouses lag. Eurozone GDP rose 1.2% y/y during Q1-2025—in line with International Monetary Fund forecasts—but the recovery remains uneven and underwhelming (Fig. 1).

Strength was concentrated. Ireland led with a 10.9% y/y gain, followed by Spain with a 2.8% y/y gain. Germany and France barely budged. Germany contracted -0.2% y/y. France posted just 0.8% y/y growth.

Signs of soft consumer demand and a manufacturing drag are evident across the Eurozone (Fig. 2 and Fig. 3). The Eurozone Economic Sentiment Indicator dipped to 93.6 in April from 95.0 in March, and April’s Eurozone M-PMI was 49.0, up from 48.6 in March, though remaining below the 50 mark separating growth from contraction.

(2) Headwind: Euro climbs as US exceptionalism fades. The euro has appreciated by more than 10% against the US dollar since mid-January (Fig. 4). That currency move has taken an axe to the earnings of Europe’s exporters. STOXX Europe 600 companies earn about 60% of revenue abroad—half of that from the US. A 10% appreciation in the euro typically shaves 2%–3% off corporate earnings, according to Reuters.

(3) Headwind: Trade tensions threaten growth. European Central Bank (ECB) board member Piero Cipollone recently warned that US tariffs—and any European retaliation—would be “recessionary for all parties.” The Trump administration’s 10% blanket tariff on nearly all imports plus higher category-specific levies on cars, pharmaceuticals, and machinery have disrupted key sectors. With about half of all EU exports to the US coming from those three industries, tariff drag is dampening already weak industrial sentiment (Fig. 5).

(4) Tailwind: Rewiring trade relationships. Even amid tensions, Brussels is still taking the diplomatic track. The EU and US are in talks on a €50 billion trade deal that could rebalance bilateral flows through increased European purchases of US LNG and agricultural products. But it’s a frail handshake: Both sides have 90-day pauses on retaliatory tariffs, which could snap back if talks fail.

Elsewhere, trade diversification is progressing. India and the EU reaffirmed plans to finalize a free trade agreement by 2025’s end. And China just lifted sanctions on EU lawmakers as it seeks closer ties with Europe amid its own tensions with the US.

(5) Tailwind: Monetary easing gathers pace as inflation falls. The Eurozone’s headline inflation fell to 2.2% y/y in April, with core inflation rising slightly to 2.7% y/y (Fig. 6). That’s given the ECB room to cut its official deposit facility rate seven times, from 4.0% in June 2024 down to 2.25% in April (Fig. 7).

François Villeroy, Bank of France governor, recently noted that the ECB is on track to meet its 2% inflation target and still has ample room to support growth. ECB President Christine Lagarde recently noted that Chinese exports redirected from the US to Europe could further depress prices.

(6) Tailwind: Fiscal spending grows. Germany’s newly announced €1 trillion stimulus package, focused on defense and infrastructure, is structurally significant. Some €500 billion of that is exempt from debt-brake rules and could be deployed in coming years. (“Debt-brake rules” require member states to keep their debt below certain limits.)

Across the EU, fiscal rules are being reworked to allow higher defense outlays, and some unused Covid-era funds may be redirected. The pickup in defense spending is targeted to be deployed by 2030, so it won’t move the 2025 needle.

However, political turmoil has not helped the Eurozone’s fiscal turnaround story. The Eurozone will need stable leadership to effectively implement the coming fiscal stimulus.

Eurozone II: Peak Global Rotation? Flows are telling: During the final week of April, European equity funds saw $14.6 billion in inflows—the largest since March 2024—while US equity funds lost $15.5 billion, reported Reuters.
 
This major shift in fund flows reflects investors’ waning confidence in US macro policy and their search for global alternatives. From the start of 2021 to the end of 2024, the US MSCI delivered a 53.1% increase. How did the MSCI EMU Index perform over that timeframe? Not nearly so well: up 27.2% in local currency but just 7.7% in dollar terms. That outperformance gap, driven by US last year’s monetary stimulus and popularity of Big Tech stocks, has reversed as global economic conditions have diverged. This year to date, the US MSCI is down 4.0%, while the EMU MSCI is up 5.7% in local currency and 19.8% in US dollars.

Will European stocks continue to outperform? They are no longer cheap, as inflows have pushed valuations up across industry sectors and market-capitalization sizes. Further, the US could return as a competitive investment story if trade deals are struck and global tariffs are removed, or if the Federal Reserve cuts interest rates. Those developments could drive a dramatic rotation of global funds back into US equities.
 
Here’s more:

(1) ‎EMU stocks depend on earnings momentum. During the height of the recent Eurozone energy crisis, following the onset of Russia’s war on Ukraine, the MSCI EMU touched a forward earnings valuation multiple of 10. It is now at nearly 15, the highest since December 2021 and roughly at the top of its range looking back to mid-2002 (Fig. 8).

Sustained equity outperformance will ultimately depend on improving economic data and renewed earnings momentum. Forward earnings per share hasn’t moved up much in recent months, especially as compared to the post-pandemic recovery period (Fig. 9).

(2) Opportunity zones. For now, areas of opportunity worth considering include the Eurozone’s defense sector. Brussels wants at least 50% of its military procurement to be sourced domestically.

Investors have launched the forward P/E higher recently for the EMU MSCI Aerospace & Defense industry, which rose from 22 at the start of the year to a near-record-high 28.1 during the March 26 week (Fig. 10). It’s down 4ppts since then to 24.1, but still well above the 13.4 for the MSCI EMU. Analysts expect Aerospace & Defense’s revenues (STRG) to rise 12.1% over the next 12 months, nearly four times the rate expected for all of the EMU MSCI (Fig. 11 and Fig. 12). Analysts also expect the industry to deliver much higher earnings growth (STEG) over the next 12 months, 21.6% versus only 6.0% for the EMU. The industry’s long-term earnings growth (LTEG) forecast of 25.8% is more than double the EMU’s 11.6%.

For some perspective on just how impressive growth expectations are for EMU’s Aerospace industry, let’s look at the same forecasts for the US’s Magnificent-7 stocks (Fig. 13). You might be shocked too. The EMU Aerospace and the Magnificent-7 have similar 12.1% revenue growth readings, but EMU Aerospace’s earnings are expected to rise at a faster rate in the next 12 months, 21.6% compared to the Mag-7’s 17.2% forecast. Over the next five years? Aerospace’s earnings are expected to rise at annualized 25.8% rate, well above the Mag-7’s 17.8%. The message analysts are sending is that Europe’s military buildup may last longer than the AI boom.
 
Strategy: LargeCap’s Forward Earnings Still Trending South. Each week, we track consensus earnings expectations for the S&P 500 LargeCap, S&P 400 MidCap, and S&P 600 SmallCap indexes. During the May 2 week, forward earnings for the “SMidCaps” (our nickname for the latter two collectively) dropped for a fourth straight week, but LargeCap’s rose for the first time in four weeks (Fig. 14). Despite that uptick, the broad trend of LargeCap’s forward earnings remains downward.

We can attribute LargeCap’s w/w gain largely to the Q1 earnings-surprise “hook” registered by the S&P 500 Communication Services sector (Fig. 15). That caused the S&P 500’s forward earnings and the analysts’ consensus for 2025 earnings to rise w/w, an aberration that outweighed the broader w/w declines in the consensus forecasts for Q2 to Q4.

(As a reminder, “forward earnings” is the time-weighted average of analysts’ consensus estimates for the current and following years. A “hook” refers to the chart pattern made by the earnings data series at the point where estimated results are replaced by actual just-reported results; earnings surprises result in hooks.)

With the Q1 earnings reporting season just over 78% complete, more downward estimate revisions are on the way after analysts hear what the companies left to report have to say. We still think the April 4 week marked the peak in forward earnings for these three indexes. Analysts are still in their first round of estimate cutting resulting from Trump’s Tariff Turmoil, and the first cuts are typically the deepest.

While investor sentiment is broadly negative, most sectors have been posting better estimate-revisions data than the S&P 500 aggregate, as Joe shows below:

(1) Seven sectors outperform S&P 500’s Q2 revenues revisions. While the S&P 500’s Q2-2025 revenues forecast has dropped 0.6% in the five weeks since the March 31 week, only four of the 11 sectors are lagging the index (Fig. 16). Among the seven outperforming sectors, Utilities leads, with its Q2 revenues forecast rising 0.5%, ahead of the 0.3% gains for Health Care and Communication Services. Information Technology (-0.1%) was also ahead of the S&P 500’s Q2 revenue forecast decline.
 
Among the worst performers, Energy continues to melt down. The sector’s Q2 revenue forecast has tumbled 4.3%, followed by declines for the Consumer Discretionary (-1.3%), Industrials (-1.3), and Financials (-0.6) sectors.

(2) Seven sectors also lead on Q2 earnings revisions. Analysts continue to trim their Q2 earnings forecasts faster than their Q2 revenues estimates, with ten of the 11 sectors posting declines since the March 31 week (Fig. 17). The aggregate earnings estimate for the S&P 500 companies has fallen 3.1%, down from a 2.4% decline a week earlier and steeper than the 0.6% revenues decline.

However, just four sectors are underperforming the S&P 500. With a gain of 0.3% in its Q2 earnings estimate, Utilities is the only sector analysts are more positive about than they were five weeks earlier. Also ahead of the S&P 500’s 3.1% drop are the Communication Services (-0.7%), Information Technology (-1.1), Financials (-2.8), Consumer Staples (-2.9), Real Estate (-2.9), and Materials (-3.0) sectors.

Three of the four sectors with the worst Q2 revenue forecast declines are also the worst in terms of Q2 earnings. Among them, Energy’s Q2 earnings forecast has tumbled 14.6%, markedly worse than the declines for the Consumer Discretionary (-5.7), Industrials (-5.2), and Health Care (-3.2) sectors.
 
(3) Quarterly growth forecasts still falling. Analysts now expect revenues growth to slow to 3.6% y/y in Q2 for the S&P 500 (Fig. 18). They think Q2 will mark the lowest y/y quarterly revenues growth rate of the year, slowing a full percentage point q/q from Q1’s blended forecast of 4.6%. That Q2 estimate of 3.6% has fallen 1.0ppt from a 4.7% forecast for Q2 growth at the year’s start. For the back half of 2025, analysts think revenues growth will re-accelerate to 4.1% in Q3 and 4.9% in Q4—but even those forecasts are down significantly, about 1.5ppts since the year began.
 
On a proforma same-company basis, analysts now think S&P 500 earnings will rise 6.9% y/y in Q2, down from a forecasted 7.3% a week earlier and 12.0% at the year’s start (Fig. 19). That’s also well below Q1’s current blended forecast of 13.6%, which would be a record high. Their H2-2025 estimates continue to fall. They’re now expecting y/y earnings growth of 8.6% in Q3 and 7.2% in Q4. Just several weeks earlier, analysts had been forecasting double-digit percentage gains in H2-2025.

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On European Auto Industry & The BOJ

May 06 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

China: Shaking Up Europe’s Automakers. Europe’s auto industry is having a decidedly rocky 2025. Donald Trump’s trade war sure isn’t helping. Nor are challenges ranging from global inflation to local battles with unions. But the real roadblock to European car companies’ maintaining market share is China.

The threat from the low-cost-producer 4,700 miles away is a surprise to no one. What is surprising is how flat-footed Europe’s auto titans have been revealed to be as Asia’s biggest economy makes serious inroads into their 450-million-person-strong market.

As of the end of 2024, the average new car price in Europe was $49,000, according to Asia-focused auto advisory Dunne Insights. The cost of the average vehicle exported from China: $18,000.

No wonder Volkswagen in late 2024 began considering shuttering factories in Germany for the first time in its 87-year history amid a 2.3% decline in worldwide sales last year. The “challenging market environment” that CEO Oliver Blume referred to in January reflected the rising flood of Chinese cars into Europe—particularly electric vehicles (EVs)—which has upended decades of stable market shares and profits for not just VW but Stellantis, Mercedes-Benz, BMW, and Renault too.

It’s not just Chinese competition; the slowdown in European sales is partly a result of higher living costs. The phasing out of EV subsidies in certain countries, including Germany, is reducing demand for low-emission cars in favor of cheaper combustion-engine equivalents.

Yet China is turning the global EV market on its head, even making life difficult for the globe’s richest person. In 2024, Shenzhen-based EV maker BYD leapfrogged over Elon Musk’s Tesla in sales terms. What’s more, Warren Buffett-backed BYD just launched a lower-priced alternative to Tesla’s Model 3, long Musk’s top seller in China.

So what are European car companies doing to regain their mojo versus China Inc.? Or, for that matter, versus Detroit and Nagoya? As far as Michael Dunne, CEO of Dunne Insights, can see, the answer is “not much.”

While Chinese names like BYD, Chery Automobile Co., SAIC Motor’s MG, Changan Automobile, and China FAW Group win business from VW, Chevrolet, and Toyota Motor, European, American, and Japanese auto giants “appear to have no response,” Dunne argues. They are “confused and overwhelmed by the speed and strength of the Chinese offensive.”

The problem, industry observers say, is one of increasing momentum. China’s auto production soared from around 4.0 million units (saar) in 2006 to about 30.0 million currently (Fig. 1). China went from one million auto exports in 2020 to 6.41 million in 2024, a 493% increase.

Not surprisingly, the response from Trump is tariffs to head off China’s EV ambitions, which his 25% tax on foreign-made autos seemingly targeted. Europe is doing the same: Last October, the European Union announced a series of hyper-focused tariffs on China’s EV upstarts on top of the pre-existing 10% car import tax.

BYD and Geely Group have EU tariffs of 17.0% and 18.8%, respectively, according to an EC press release. State-owned SAIC, by sharp contrast, received a 35.3% tariff. Other EV makers operating in China, including BMW and VW, are subject to a 20.7% levy. Tesla got away with just 7.8%.

Yet tariffs merely treat the symptoms of Europe’s auto troubles, not the underlying causes.

Germany’s extreme reversal of fortune tells the story. China, simply put, caught Europe’s biggest economy napping. Besides German automakers, President Xi Jinping’s economy is also threatening other sectors that Germany, on account of its prodigious global manufacturing leadership, took for granted, including chemicals and engineering. In a January report for the Center for European Reform, economists Sander Tordoir and Brad Setser warned that a five-year decline in German industrial production is a “source of profound angst in a country where manufacturing contributes around 5.5 million jobs and 20% of gross domestic product.” Germany’s auto production fell to 3.2 million (saar) during March (Fig. 2).

Germany continues to learn the hard way that the “Made in China 2025” strategic plan that Xi launched in 2015 produced Mainland auto, clean technology, and civil aviation sectors that are upending its industrial interests. The answer is greater innovation, disruption, and adapting to new global economic realities, not tariffs that can work at cross purposes with the EU’s goals.

One of the “knock-on effects” from having fewer Chinese EV imports “would slow the growth” of EVs in the 27-economy market and “run counter to the European Commission’s tougher carbon dioxide reduction targets,” warned Ian Fletcher, auto analyst at S&P Global.

It’s a real Catch 22. Industry executives like Ola Källenius, CEO of Mercedes-Benz, have long argued that strict EU regulations are a big disadvantage that China is exploiting. At present, the EU’s policy is for 100% of all new cars purchased to be EVs by 2035. Support for deregulation is increasing in the name of competitiveness.

So far, EU leaders have been noncommittal on assertive deregulation. In January, the EU announced an “unprecedented simplification effort” to boost innovation and slash regulations to keep up with China. This came four months after Mario Draghi, former Italian prime minister, warned of a “slow and agonizing decline” if Europe doesn’t raise its innovation game.

Separately, tariffs carry a host of unintended consequences. Scores of basic materials and parts used for EV batteries and computers come from China. As Trump tries to end what he calls a “transition to hell” with import taxes, cars everywhere could become more expensive. Chinese automakers don’t rely on the US market for significant revenue, but automakers everywhere else do—and they’ll all be hurt.

Tariffs alone aren’t likely to derail China’s auto trajectory. In 2023, China wrested the title of “world’s top automaker” away from Japan. To be sure, tariffs from Washington and Brussels may trigger a wave of industry consolidation in China. “But incumbent carmakers shouldn’t celebrate too much—even with slower export growth,” analysts Gregor Sebastian and Endeavour Tian at the Rhodium Group argue in a recent report. “Chinese carmakers are transforming into formidable global competitors in the auto market.”

One problem for governments putting tariffs ahead of innovation and R&D is China’s ability to navigate around tariffs. Among the top destinations for Chinese EVs are Brazil, Russia, Saudi Arabia, and the United Arab Emirates. As the West wages trade wars, China is busily pivoting to new markets among “Global South” economies.

All this puts Europe’s auto industry at a major inflection point. Europe, argue Tordoir and Setser, “cannot be complacent. If it does not act to counter Chinese policies, its current advantages in other sectors will go the same way as those in EV batteries and solar panels.”

The analysts add that “EU industrial policy support would undoubtedly benefit Germany, and it should.” The EU, they conclude, “should target its scarce industrial policy funds to maximize competitiveness. This means supporting value chains—and regions—with strong potential, many of which are centered in Germany. Germany would be a primary beneficiary of a significant European funding program for decarbonizing industry or expanding chip production, for example.”

The China threat won’t take care of itself. It’s high time Europe adjusted policies and strategies for a global marketplace being reordered a world away.

Japan: Staring Contest Between Fed & BOJ. As trade war fallout jeopardizes global growth and markets, it’s an open question who’s hating 2025 more—Federal Reserve Chair Jerome Powell or Bank of Japan (BOJ) Governor Kazuo Ueda.

Powell and Ueda share a common problem: Trump 2.0. Powell is caught between President Donald Trump’s demands for sharply lower rates and a US economy that just won’t quit. Ueda’s two-year campaign to “normalize” the BOJ’s deflation-era monetary landscape is in peril as Trump’s tariffs send giant headwinds Asia’s way. As 2025 unfolds, the policies of two of the globe’s most powerful central bankers might be on a collision course.

For Powell, Friday’s employment report only complicates the Fed’s road ahead. Trump is ratcheting up pressure on the Fed to ease immediately and assertively. But the justification to do so, the imminent recession argument, is dented by the US’s adding an expectations-defying 177,000 jobs in April—and with an unchanged 4.2% jobless rate at that.

Indeed, regional and national business surveys suggest that tariff-induced inflationary pressures are more pronounced than risks of economic weakness. Only Trump can say how far he’ll take his crusade to fire Powell, whether there’s “cause” or not.

Already, the Bond Vigilantes are in a whirl over Trump’s broadsides against Fed independence. They might push US 10-year Treasury bond yields well above the current 4.3%. Foreign exchange traders might short a dollar that Trump has long wanted to push lower to help exporters.

Welcome to Ueda’s hell year. Back in January, Ueda was destined to be the hero of modern Japanese economics, the policymaker who restored monetary sanity to the third-biggest economy. That month, the BOJ hiked its benchmark interest rate to a 17-year high of 0.5%.

Ueda was on track to hike rates to 0.75%, a move that, until very recently, investors thought would come on May 1 (Fig. 3). That would’ve bested Toshihiko Fukui’s 2006-07 effort to extricate Japan from the zero-rate gambit launched in 1999.

At the time, BOJ Governor Fukui made global headlines for finally ending the quantitative easing (QE) experiment that the BOJ pioneered in 2001 to defeat deflation. Then came the 2008 “Lehman shock,” as the Japanese call it. Zero rates and QE returned in short order.

Now, Ueda faces a similar fate. The collateral-damage risks posed by Trump’s Tariff Turmoil are the worst that Asia has encountered since 2008. Raising the stakes is how Trump is attempting to kneecap China, the economy at the center of Asian supply chains, with a 145% import tax.

Trump’s preferences for a more subservient Fed and a weaker dollar are also limiting Ueda’s latitude to hike rates. With the yen already up nearly 9% this year, Japan Inc. is bracing for slower economic growth and lower profits (Fig. 4). Foreign funds that pushed the Nikkei 225 Stock Average to all-time highs in 2024 are having buyer’s remorse as Japan flirts with stagflation.

The interplay between the dollar and yen is arguably the foreign exchange market’s best risk-on/risk-off gauge. If the Fed were to start cutting rates suddenly, the BOJ might have to abandon its yield-curve-control strategy, boosting the yen. Already, the Nikkei’s volatility is ramping up, a reflection of the tension between Fed and BOJ policies in states of flux (Fig. 5).

Though the status of Trump’s tariffs is unclear, Japan is unhappy that his team is standing firm on 25% auto tariffs, regardless of what concessions Tokyo makes. The same goes for Trump’s levies on steel and aluminum. The inflationary impacts of Trump’s tariffs are mounting just as the corresponding headwinds imperil Japanese demand.

Though some see stagflation as a risk for the US economy, it may be a more immediate problem for Japan. Prior to this, Japan was stuck in a deflationary funk for more than 20 years. Now the problem is too much inflation. Yet one of the less understood dynamics in Japan is that QE hasn’t defeated deflation so much as Vladimir Putin has. In 2022, Japan imported oil and food at elevated prices because of Russia’s Ukraine invasion, which boosted commodities prices. That drove Japan’s consumer price inflation rate above the BOJ’s 2% target. In March, prices rose at a 3.6% y/y rate (Fig. 6).

Now Japan’s economic trajectory is subject to the whims of a Trump White House that has long viewed Asia as stealing American jobs and wealth. Though China is his current obsession, Trump has nursed anger against Japan since the 1980s. Trump declared back then that Japan had “systematically sucked the blood out of America” and “gotten away with murder.” And when Trump muses about a “Mar-a-Lago Accord,” he’s riffing on the 1985 Plaza Accord to weaken the dollar versus the yen, forged at a New York hotel he once owned.

Then there’s the so-called “yen carry-trade” that’s now at risk. Twenty-six years of near-zero interest rates—and 24 years in the QE zone—made Japan into the top creditor nation. Some investors routinely borrowed cheaply in yen to bet on higher-yielding assets around the globe. Yet yen liquidity, keeping aloft financial assets of all kinds, can leave faster than it arrived. The yen carry-trade’s blowing up suddenly is one of hedge fund managers’ biggest fears.

If it turns out that the BOJ’s next move is to lower rates, not raise them, everything that traders thought they knew about interest-rate differentials in the second half of 2025 goes out the window. The Fed and BOJ easing simultaneously could provoke a race to the bottom on exchange rates, a tug of war that could shake markets worldwide.

There’s another wildcard here: Tokyo’s status as the largest holder of US Treasury securities, with $1.13 trillion. Given the recent volatility in the bond market, Tokyo surely understands the leverage it wields over Washington. Any whiff that Japan or China—with its $760 billion of US Treasuries—is selling could send shockwaves around the globe.

On May 2, Japanese Finance Minister Katsunobu Kato told local media that Tokyo’s Treasuries are a “card on the table” in trade talks. Such comments come as Washington’s national debt is approaching $37 trillion and amid worries that tariffs and policy chaos just 105 days into the Trump 2.0 era are imperiling the dollar’s reserve-currency status.

As these crosscurrents upend global market dynamics, no two policymakers are more squarely on the frontlines than Powell and Ueda. Or, for that matter, more dependent on the other for success.

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Is The Recession Over Already?

May 05 (Monday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy I: The Godot Recession Is Back. During 2022, 2023, and 2024, most economists and investment strategists expected that the dramatic tightening of monetary policy would cause a recession. They observed that the inverting yield curve and the falling Index of Leading Economic Indicators were confirming this outlook. We argued that the recession was the most widely anticipated recession of all times that wasn’t likely to happen. We called it the “Godot recession.” We focused on the reasons for the underlying resilience of the economy and dismissed the widely followed leading indicators of recession as misleading.

The Godot recession may be back in 2025. This time, the cause of the widely anticipated downturn is Trump’s Tariff Turmoil.

According to Polymarket.com, a trading platform, the chance of a recession was relatively low around 20% from the time President Donald Trump was inaugurated on January 20 through March 11 (Fig. 1). The odds then shot up dramatically, especially after April 2 (“Liberation Day”), reaching 64% on April 8. They fluctuated around 55% after Trump postponed for 90 days the reciprocal tariffs that he had announced on April 2 for all countries with one notable exception: China’s tariff remained 145%. The odds of a recession rose to 66% on May 1 following last week’s batch of weak economic indicators (i.e., consumer confidence, ADP payrolls, M-PMI, and jobless claims). The odds fell to 60% on Friday, May 2, following the release of a stronger-than-expected employment report for April.

While economic growth remains our base-case scenario, we did raise our subjective probability of a “tariff-induced” recession from 20% at the start of the year to 35% on March 5. We wrote, “We are still betting on the resilience of consumers and the economy. However, Trump Turmoil 2.0 is significantly testing the resilience of both. That’s why we’ve recalibrated our subjective probabilities.” On March 31, we raised the odds again to 45% and blamed Trump’s Reign of Tariffs. We wrote, “That 45% is also the probability we see that the stock market’s correction will deepen into a bear market in coming months. Yet we still expect an up year, with the S&P 500 rising above 6000 by year-end.”

In other words, we remained, and remain, believers in the resilience of the economy. It withstood the tightening of monetary policy over the past three years. We expect it will withstand this year’s tariff turmoil.

US Economy II: Lowering Our Odds of a Recession. We are now lowering our odds of a recession back down to 35% because we believe that China and the US both may be ready to suspend their tariffs on each other while they negotiate a trade deal. In other words, both sides may be starting to blink. Neither side can bear the pain of a trade war, which might be more painful for China’s economy than America’s economy. On the other hand, Americans have less tolerance for pain than the Chinese (for more on China’s “chiku” ethos, see the Morning Briefing dated April 29, 2025).

We also expect that Trump will declare victory in his trade war with the rest of the world. By the end of the 90-day postponement period of his Liberation Day reciprocal tariffs, the US is likely to have signed numerous agreements with America’s major trading partners. Stragglers might come around during a second 90-day postponement period. Trump needs to put the trade issue behind him to reduce the odds of a recession, which would harm the Republicans’ chances of holding onto their slim majorities in both houses of Congress.

Trump also needs to get this issue resolved quickly now that numerous court cases have been filed challenging his constitutional authority to impose tariffs under his claim that they are warranted by a national crisis that he declared.

We anticipated all the above in our April 7 Morning Briefing titled “Annihilation Days.” We wrote:

“Trump’s Liberation Day last Wednesday triggered Annihilation Days on Thursday and Friday, with the Stock Market Vigilantes giving a costly thumbs-down to Trump’s Reign of Tariffs. Trump officials say they aim to make Main Street wealthy again even if that’s bad for Wall Street. The problem is that Main Street owns lots of equities traded on Wall Street, so the two streets prosper and suffer together. Congress can’t do much to stop Trump given his veto power, but he might get the message that hurting Main Street’s stock portfolios can cause a recession and jeopardize the GOP majority in Congress. If so, he might postpone the reciprocal tariffs, giving trade negotiations time to work. Also, the courts might block Trump’s tariffs. An early end to Trump’s tariff nightmare would result in a V-shaped stock-market bottom. We’re counting on that; the alternative is just plain ugly.”

Sure enough: Trump postponed his reciprocal tariffs two days later, on April 9. The S&P 500 traced out a V-shape, bottoming on April 8 and climbing 14.1% since then through Friday’s close (Fig. 2 and Fig. 3).

We aren’t dismissing the possibility of a recession. There could still be supply disruptions resulting from the still unresolved trade war with China. Regional and national business surveys show weakening economic activity and rising prices during March and April (Fig. 4, Fig. 5, and Fig. 6). Measures of consumer confidence are at recessionary levels, especially those that track consumer expectations (Fig. 7). The latter is one of the 10 components of the Index of Leading Economic Indicators (LEI), which has been forecasting a recession since late 2022 (Fig. 8). Meanwhile, the Index of Coincident Economic Indicators (CEI) has been rising to new record highs since then through March!

We are betting on the resilience of consumer spending, which has been boosted by the spending of retiring Baby Boomers. We had been concerned recently about the negative wealth effect on consumption because of the drop in stock prices. Now we are less concerned given the subsequent rebound in stock prices. We are also betting on business spending to remain resilient. While tariff-related uncertainties may weigh on capital spending, we expect that spending related to cloud computing and onshoring will remain strong.

US Economy III: The Most Resilient Labor Market. The CEI probably edged up to another record high during April. That’s because nonfarm payroll employment in private industries, which rose to a record high in April, is one of the four components of the CEI (Fig. 9). It tends to boost two of the other components, i.e., real personal income and real manufacturing and trade sales. The fourth CEI component is industrial production, which probably declined in April along with manufacturing aggregate weekly hours, as shown in April’s employment report (Fig. 10).

By the way, the S&P 500 is also one of the 10 components of the LEI. We lowered our recession/stagflation odds today partly because the stock market is indicating that the outlook for the economy is improving. Friday’s jobs report also increased our confidence in the resilience of the labor market. Let’s review it:

(1) Earned Income Proxy. Aggregate weekly hours in private industries rose 0.1% m/m to a new record high of 4.7 billion during April (Fig. 11). Average hourly earnings rose 0.2% m/m last month. So our Earned Income Proxy for wages and salaries in private industries rose 0.3% to a new record high in April (Fig. 12). That augurs well for April’s consumer spending. Indeed, April’s auto sales remained robust at 17.3 million units (saar) (Fig. 13).

(2) Payroll employment. Payroll employment rose 177,000 during April. We expected 150,000-175,000. So we weren’t surprised, though the consensus expectation was lower at 135,000. The previous two months were revised down by 58,000. Nevertheless, the average for the past three months was a solid increase of 155,000 (Fig. 14). Much of the strength in payrolls comes from services industries that cater to retiring Baby Boomers, particularly health care and social assistance, leisure and hospitality, and financial activities (Fig. 15).

(3) Federal government employment. Employment of federal workers fell only 9,000 last month. That followed a decline of 4,000 in March. So far, the DOGE Boys haven’t had much impact on federal government employment. Solid gains were registered by health care and social assistance (58,200), transportation and warehousing (29,000), and leisure and hospitality (24,000). We acknowledge that the latter two could weaken if the trade war between China and the US persists.

(4) Payroll employment diffusion index. It was encouraging to see that the payroll employment diffusion index remained above 50.0% during April (Fig. 16).

Strategy: To Raise or Not To Raise Our S&P 500 Target? At the start of the year, our S&P 500 target for the end of this year was 7000. When we raised our odds of a recession on March 5 to 35%, we lowered our target to 6400. We lowered it again on March 31 to 6000, when we raised the odds of a recession to 45%.

Now that we are lowering the odds of a recession back to 35%, should we be raising our S&P 500 target back to 6400? We are inclined to do so given the power of the V-shaped rally in the S&P 500. However, we aren’t ready to do so given the following two issues:

(1) Earnings. The outlook for S&P 500 earnings is deteriorating. Tariffs are first and foremost taxes on domestic importers. The 10% baseline tariff on all imports from most countries was announced by Trump on Liberation Day and imposed on April 5. There is also a 25% tariff on autos, aluminum, and steel. The 145% tariff on China remains in force as well.

Over the past 12 months through March, corporate tax receipts totaled $502.19 billion (Fig. 17). The currently active tariff rates could raise over $300 billion in import duties over the coming 12 months. That would be a significant increased tax burden on corporate profits unless they are passed through to consumer prices. Some companies, such as those in the auto industry, might find that hard to do.

(2) Valuation. The valuation multiple of the S&P 500 bottomed at 18.1 on April 8. It was back up to 20.5 on Friday (Fig. 18). It is very unlikely to bounce back to the 22.1 at which it began the year.

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Tariffs, Earnings & Batteries

May 01 (Thursday)

Strategy I: CEOs Still Talking Tariffs. President Trump’s tariffs continue to capture airtime during corporate earnings conference calls. Today, we look at a range of chief executives’ responses to the unprecedented degree of uncertainty in the business environment, specifically from the CEOs of NXP, Nucor, and Booking Holdings.

NXP executives worry that tariffs will kill off the nascent green shoots they were seeing in the semiconductor industry, which has been suffering through a downturn. Booking called out the decline in travel to the US by Canadian and European travelers. Nucor, on the other hand, stands to benefit from tariffs, as they will make it easier for Nucor to compete with imported steel. Here’s a closer look:

(1) Semis’ tenuous green shoots. European semiconductor company NXP Semiconductors thinks it is seeing green shoots indicating that the downturn semiconductor manufacturers have been slogging through may be nearing an end (Fig. 1). Offsetting that optimistic prospect, however, is the uncertainty created by President Trump’s tariffs and the potential impact it could have on demand. “As of today, the direct impact of the current tariffs is immaterial to our financials. However, the indirect impacts of current tariffs related to future end demand and [the] supply chain remain unknown,” said CEO Kurt Sievers on the earnings conference call.

While NXP provided a Q2 earnings forecast, it didn’t provide a full-year earnings forecast due to the tariff uncertainty. Q2 revenue is expected to fall 7% y/y but increase 2% q/q to roughly $2.9 billion. The future for Q2 revenue in each of its lines of business is varied: Auto (flat y/y and up by a percentage in the low single digits q/q), Industrial and Internet of Things (down in the mid-teens y/y and up in the mid-single-digits q/q), Mobile (down in the mid-single-digits both y/y and q/q) and Communication Infrastructure and Other (down in the high 20% area y/y and flat q/q).

The lack of a full-year earnings forecast and a management change at the helm (Sievers is retiring, to be replaced by Rafael Sotomayor, an executive vice president) sent the company’s stock price tumbling 6.9% on Tuesday.

NXP shares have fallen 26.1% over the past year through Tuesday’s close, worse than the 11.8% one-year gain in the S&P 500 Semiconductors stock price index in which it resides (Fig. 2).

The S&P 500 Semiconductors industry’s revenue and earnings growth are expected to slow sharply—but to still-high levels (revenues 26.7% in 2025, 17.9% in 2026; earnings 42.0% in 2025, 27.0% in 2026) (Fig. 3 and Fig. 4). Stock price declines have brought the industry’s forward P/E down to 22.0 from a peak of 35.5 last year in June  (Fig. 5).

(2) Nucor could be a tariff winner. US steel producers should benefit from the wide-ranging tariffs President Trump has placed on steel imports. Yes, there were tariffs on steel imports from years past, but so many carve-outs existed that they were toothless.

Here’s how Nucor’s CEO Leon Topalian explained the situation on the company’s earnings conference call Tuesday: “Since its implementation in 2018, the [Section 232 steel] tariffs have been significantly weakened through country exemptions, quotas, and numerous product exclusions. By 2024, fewer than 18% of steel imports were subject to Section 232 tariffs. Ending the exclusions and quota agreements was necessary to strengthen the US steel industry, which was the original goal of the 232 tariffs.”

The price of steel recently has rebounded from much lower levels in most of 2024. The price of domestic hot-rolled coil has jumped 16% y/y to $944 per ton (Fig. 6). But the bounce came too late for Nucor’s Q1. The company’s average sales price per ton was 12% lower in Q1 compared to year-ago levels on shipments that rose by 10%. Nucor’s Q1 adjusted EPS fell to $0.77 from $3.46 a year ago and $1.22 last quarter.

Topalian was optimistic about demand: “In the first quarter, we saw backlogs rise over 30% in our steel mill segments and rise nearly 25% in steel products. We recognize a portion of this may be [demand] pulled forward [by the threat of tariffs]. However, we continue to see very healthy order entry rates and relatively stable pricing.”

Over the past year, Nucor shares have fallen 32.2%, while the S&P 500 Steel stock price index, which includes Nucor and Steel Dynamics, has declined 23.3% (Fig. 7).

After sharply falling revenues in recent years, the S&P 500 Steel industry is expected to see revenues climb 3.8% this year and 6.1% in 2026 (Fig. 8). While the industry’s earnings are still forecast to drop 6.1% this year, they’re expected to surge 33.3% in 2026 (Fig. 9). The industry’s forward P/E has climbed to 12.7 as its earnings have shrunk over the past two years (Fig. 10).

(3) Signs of US consumer cracks? Booking Holdings runs a host of global travel-related websites—including Booking.com, Priceline.com, Kayak.com, OpenTable.com, and Rentalcars.com. The company reported strong Q1 earnings but indicated that the behavior of US travelers has already been affected by tariff uncertainty.

Q1 revenue grew 7.9% y/y to $4.8 billion, and adjusted EPS grew 21.7% y/y to $24.81. The company believes Q2 revenue will grow 10%-12%, including a 3-percentage-point benefit from the shift of Easter into April. EBITDA is expected to grow by up to 16%, including a 7-percentage-point benefit from the Easter shift.

Booking Holdings did widen its full-year forecast range due to tariff-related economic uncertainty. It now expects adjusted EPS to grow in the low- to mid-teens on a constant-currency basis versus mid-teens levels on last quarter’s conference call.

Management also highlighted some changes in US travelers’ behavior. Room night growth was faster outside the US than it was inside: Europe and Asia (up in the high single digits y/y), Rest of World (up low double digits), and US (up low single digits).

Booking saw a “moderation” in inbound travel into the US. Europeans are traveling less to the US and more to Canada, Asia, and within Europe. Canadians are traveling less to the US and more to Mexico. Along the same lines, there was a y/y increase in the average length of stay on a global basis, but a decrease in the average length of stay in the US.

“We also saw some evidence of a bifurcated economy in the US as higher-star-rating hotels appear to be more resilient than lower-star-rating hotels. We have not seen either of these dynamics in Europe,” said CFO Ewout Steenbergen during the conference call. He also noted that there are US airlines and hotels that need help filling seats and rooms, and the company is partnering with them to create additional demand. But weakness in the US appears to be offset by strength internationally.

Booking shares are up 39.7% over the past year, while the S&P 500 Hotels, Resorts & Cruise Lines stock price index—of which it is a member—has a 16.1% gain over the past year (Fig. 11). The industry’s revenues and earnings have continued to climb in recent years as they recovered from the pandemic lockdowns. The incremental gains have slowed but remain positive, with revenues forecast to climb 6.4% this year and 7.6% next year (Fig. 12). Earnings are expected to jump more sharply, by 14.9% this year and 16.1% in 2026 (Fig. 13).

Strategy II: An Eye on Earnings. Trump’s Tariff Turmoil certainly has increased the anxiety about the future of corporate earnings growth. And that anxiety is reflected in industry analysts’ lowered expectations for S&P 500 companies’ Q2s despite generally strong Q1 earnings reports (see Joe’s report in yesterday’s Morning Briefing).

However, investors can take heart that forward earnings—the time-weighted average of analysts’ consensus operating EPS estimates for the current year and the following one—continues to rise despite tariff jitters. Forward earnings for the S&P 500 is 1.1% higher today than it was at the start of the year—though Joe tells us that’s less than usual at this time of year: “[F]orward earnings typically rises about 0.5% m/m, so more normal would be 2.1% ytd by now.”

Here’s how much forward earnings has changed for the S&P 500 and its 11 sectors since the start of this year: Financials (4.5%), Information Technology (3.7), Communication Services (2.6), Utilities (2.1), S&P 500 (1.1), Health Care (0.4), Consumer Staples (-1.1), Industrials (-1.3), Consumer Discretionary (-2.3), Real Estate (-4.2), Materials (-5.5), and Energy (-8.5) (Table 1).

Among the S&P 500’s industries, forward earnings has increased for almost half and declined for about half since the year began—although more dramatically for the cuts. Financials sector companies and REITs hold many top spots.

Here are the 15 industries with the most dramatic forward earnings increases ytd: Electronic Components (14.5%), Health Care REITs (11.5), Investment Banking & Brokerage (10.6), Publishing (8.9), Movies & Entertainment (8.6), Office REITs (8.5), Gold (8.3), Diversified Banks (8.1), Consumer Finance (7.9), Brewers (7.9), Health Care Facilities (6.8), Broadline Retail (6.7), Steel (6.7), Data Center REITs (6.6), and Semiconductors (6.6).

The forward earnings declines among industries have been concentrated in the Energy sector, in many cyclical industries, and in industries that stand to be hurt—directly or indirectly—by tariffs. Among the tariff impacted are auto manufacturers that assemble all or part of their products in Mexico and Canada; distillers and vintners, which may face retaliatory tariffs on their exports; and farm products and services, pressured by China’s import substitutions.

Here are the S&P 500 industries with the greatest ytd forward earnings declines: Commodity Chemicals (-36.5%), Industrial REITs (-22.9), Automobile Manufacturers (-20.4), Reinsurance (-19.6), Hotel & Resort REITs (-17.6), Oil & Gas Refining & Marketing (-15.5), Passenger Airlines (-14.4), Copper (-12.2), Homebuilding (-12.0), Distillers & Vintners (-11.7), Integrated Oil & Gas (-11.0), Telecom Tower REITs (-9.9), Specialty Chemicals (-9.6), Agricultural Products & Services (-9.1), and Footwear (-8.2).

Disruptive Technologies: Battery Wars Continue. Announcements about advancements in battery technology have recently been made by Chinese companies, a US startup, and Ford Motor. The race to develop a battery for the fastest-charging, longest-driving electric vehicle (EV) remains heated. Read on:

(1) Chinese battery giants make a splash. BYD announced that it has developed a battery and charging system that can add 249 miles of range to a car’s battery in five minutes versus the usual 30 minutes at best. The company launched the “Super e-Platform technology” in two Chinese cars in April.

Not to be outdone, Chinese battery manufacturer CATL announced it’s developing a lithium iron phosphate EV battery capable of charging in five minutes and driving up to 320 miles. However, the vehicle requires a fast-charging system that’s not currently available. CATL is also developing an auxiliary EV battery that wouldn’t use graphite in one of its poles, an April 21 New York Times article reported. The battery, which should be available in two to three years, is less expensive and can drive farther for longer distances on a charge than currently used batteries, but it does take longer to charge.

(2) US startup gets nod from Stellantis. Factorial Energy has developed a solid-state EV battery that it claims is lighter, charges faster, and gets more mileage on one charge. Next year, Stellantis, an investor in Factorial, plans to launch a Dodge Charger with a Factorial solid-state battery, and Mercedes-Benz, another Factorial investor, is testing a solid-state battery the companies jointly developed.

Factorial “hopes” its battery will have a driving range of more than 600 miles and can be 90% recharged in 18 minutes, an April 24 company press release stated. The battery is designed to work in extreme temperatures, ranging from -22 to 113 degrees Fahrenheit, and it’s a third of the size of a lithium-ion battery and almost 40% lighter.

(3) Ford hints that something’s brewing. Ford has developed a lower-cost battery that allows an EV to travel farther on a single charge due to a new battery chemistry, lithium manganese rich, according to Ford’s director of electrified propulsion engineering. The batteries, expected to be used in Ford vehicles within this decade, work without using cobalt, which is expensive and has been mined using child labor.

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On The Dollar, The Debt & Earnings

April 30 (Wednesday)

Foreign Exchange: Dollar Down, Not Out. Dollar dominance is something that provides the US with a lot of privilege, and investors are worried that Trump 2.0’s weaponization of that dominance will lead to its downfall. The US Dollar Index (DXY) is down 8.7% ytd, a stark decline for a G10 currency over just a few months (Fig. 1). Coalescing with higher long-term bond yields (lower bond prices) and stocks falling into correction territory, the US has shown symptoms of an emerging-market-style crisis.

An EM-like downward spiral is, for all intents and purposes, impossible for the US. That’s because of the government’s unlimited ability to print dollars and the generally unlimited demand for them and related assets (even if printing Treasuries would come at a slightly higher cost, or yield, to the government).

But this could very well be the early innings of a secular decline for the dollar. Trump 2.0’s policies seem to prefer that course: Decoupling from the global trading system and reducing America’s trade deficit would leave foreigners with fewer dollars to invest in dollar assets. Many investors haven’t needed to hedge their US assets against foreign exchange (FX) movements because the dollar has climbed. Dual losses on dollar assets plus the dollar are a double whammy for foreign investors. And a relatively high federal funds rate (FFR) means hedging FX exposure is costly (Fig. 2).

To boot, the federal government’s budget deficits seem on course to continue growing. So perhaps the dollar’s reserve currency status will erode. Perhaps the US will mirror the post-Brexit UK: Over the past decade, the British pound has weakened, gilt yields have become relatively prohibitive for domestic financing, assets have underperformed, economic growth is slower, and inflation isn’t tamed.

That’s of course all possible, but we aren’t counting the dollar out after its latest fall. Consider an alternative perspective:

(1) Up, up, and away. The DXY remains on an upward trend that started around 2010, when America’s recovery from the Great Financial Crisis (GFC) outpaced other major economies’ (Fig. 3). That case was clear once more following the pandemic, as much stronger productivity growth has helped US assets soar past comparative markets. US capital markets have a clear advantage in attracting capital, which will not change anytime soon.

(2) European Rennaissance 2.0. The euro makes up 57.6% of the DXY, followed by the yen (13.6%) and the British pound (11.9%). So the DXY is basically the EUR/USD. The trade-weighted US dollar index compiled by the Fed, meanwhile, is much broader. It’s only down by 4.8% ytd, and it’s also been on a steeper upward trend than the DXY since the GFC (Fig. 4). The Fed also breaks down its dollar index versus currencies of advanced economies and emerging market ones, which shows stark gains against EM currencies and ups and downs against advanced ones (Fig. 5). In essence, most of the current decline in the dollar is due to a strengthening euro, which is up more than 10% against the dollar this year (Fig. 6).

(3) Mag-7 problem. We chalk up the current dollar weakness to the selloff in the Magnificent-7 stocks (Fig. 7). Foreign investors plowed a record $475.0 billion into the US stock market over the 12 months through February (Fig. 8). Trump Tariff Turmoil (TTT) amid sky-high valuations—plus signs that European policymakers are finally willing to spend—encouraged foreigners to flee US stocks and the Mag-7. Since the start of the year, the Mag-7 have been revalued from a 30.0 forward P/E to 24.6 (after a drop to 21.7 in early April) (Fig. 9).

We believe the strength in the euro is a key reason for the dollar’s decline. But we aren’t sure it’s sustainable. The European Central Bank is on course to continue lowering interest rates to combat TTT, while stagflation may keep the Federal Reserve on pause (Fig. 10). European economies are more dependent on exporters for growth, and they would suffer if the euro continued to climb.
 
US Fiscal Policy I: Preventing the Unthinkable. We’re not enthused by the House GOP’s forthcoming tax reconciliation package because it isn’t a tax cut but an anticipated extension of existing tax breaks that will add to the US federal deficit. On the table are extensions of several provisions from Trump 1.0’s Tax Cuts and Jobs Act (TCJA), many of which are set to expire at the end of 2025. The financial markets seem to assume that the most beneficial TCJA tax provisions won’t expire. If they do, it could hit sentiment and stocks hard. Pay-fors could sting, too—especially for consumers and investors.

We don’t expect any changes to the corporate tax rate. The TCJA set the rate permanently at a historically low 21.0%. Prior to that change, it had been as high as 35% for companies at the top end of a graduated structure. That said, any and all tax legislation technically is on the table.

Extending these TCJA provisions won’t come cheap. The Joint Committee on Taxation pegs the cost at roughly $4.5 trillion. That could mean that reductions in federal programs such as SNAP and Medicaid could be coming—a politically fraught proposition, even among GOP hardliners. Many represent districts with heavy concentrations of these programs’ beneficiaries. Meanwhile, President Trump is toying with the idea of a millionaire’s tax, The Hill reported Monday.

Still, the President’s Council of Economic Advisors (CEA) backed the extension of Trump-era tax cuts in an April report, stating: “The TCJA’s extension will also prevent the unthinkable consequence of a more than $4 trillion tax hike on Americans.”

Here’s a closer look at the current tax policy landscape:

(1) Countdown to Memorial Day. Our friend Jim Lucier of Capital Alpha Partners recently offered insight into the House GOP’s reconciliation timeline. He expects the bill to move before Memorial Day. The long-awaited Joint Committee on Taxation’s macro and revenue estimates may arrive before the Ways and Means Committee begins markup—tentatively around Thursday, May 15.

The Rules Committee could clear the bill on Tuesday, May 20, with a full House vote expected by Thursday, May 22. Given the tight vote margins, Republicans are unlikely to let the measure hang before recess. A delay past Memorial Day would likely push action to just ahead of the July 4 break.

(2) Slim margin to pass. On April 10, the House narrowly passed, by a 216–214 vote, the fiscal 2025 budget resolution as amended and passed by the Senate. Budget resolutions set spending and revenue priorities and open the door for reconciliation bills to pass in the Senate with a simple majority. (For more on the process, see here.)

(3) Dependent on spending cuts. The budget resolution allows for a net deficit increase of at least $2 trillion over 10 years. Included in the budget, the Ways and Means Committee is given a $4.5 trillion reconciliation instruction to extend and expand the TCJA. However, this instruction is contingent upon other committees’ identifying at least $2 trillion in mandatory spending cuts. If these spending cuts fall short, the Ways and Means instruction is reduced accordingly, explained the Bipartisan Policy Center on April 10.

(4) Sunsetting TCJA provisions. A number of taxpayer-friendly provisions from the TCJA will sunset in 2025 unless extended. These include: lower individual marginal tax rates; nearly doubled standard deduction; doubled unified estate and gift tax exemption; expanded child tax credit; and a 20% qualified business income deduction (a.k.a. QIBD) for pass-through entities, or PTEs, which primarily benefit small businesses. Also expiring: provisions meant to offset those benefits, such as the state and local taxes cap, limitations on excess business losses, and restrictions on net operating losses. (For more, see the Congressional Research Service’s reference table.)

(5) Promoting real GDP. According to the President’s CEA, extending the TCJA—along with other Trump-era policies like deregulation—would boost real GDP growth to 3.0% annually over the next decade.

While that’s not exactly a growth bonanza, the alternative—letting the TCJA expire—might carry untenable public sentiment risks. That said, concerns about the sustainability of the federal deficit remain front and center.

US Fiscal Policy II: Getting Out of DOGE. The Federal Reserve’s latest financial stability report, released Friday, reaffirmed growing concerns around US fiscal policy—particularly the trajectory of federal debt. Market participants remain uneasy, with debt sustainability now seen as a top financial risk, surpassing even inflation and geopolitical instability.

Rising deficits, upward pressure on Treasury yields, and limited policy traction all add up to a troubling fiscal picture. If yields continue climbing, equity markets could face downside pressure, as higher financing costs eat into corporate profits and slow earnings growth. Meanwhile, a rising debt burden would constrain future fiscal policy flexibility in the event of economic shocks.

Despite measures such as the creation of the Department of Government Efficiency (DOGE), structural obstacles to fiscal sustainability remain entrenched. Here’s more:

(1) Debt sustainability. In the Fed’ s latest survey, around 50% of respondents cited US fiscal sustainability as the most pressing risk to the financial system—only slightly down from 54% six months ago. Concerns center on the risk of government borrowing crowding out private investment and reducing headroom for stimulus in future downturns.

(2) DOGE dead-on-arrival. DOGE was set up to streamline federal spending and root out inefficiencies in government. So far, its impact has been limited. According to a recent article in Business Insider, initial projections suggested that DOGE would yield $2 trillion in savings within an elusive timeframe. In reality, it appears the actual savings are closer to $150 billion for 2026. Critics say real deficit reduction won’t happen without tackling the politically sensitive heavyweights: defense, Medicare, and Medicaid.

Social Security is not up for cuts. According to a Newsweek report: “US law prohibits Congress from passing a reconciliation bill that contains recommendations to change programs under the Social Security Act.”

As for Elon Musk’s cameo at DOGE? It’s wrapping up. Musk is expected to step back from his role in early June.

Strategy: Strong Q1 Surprises Aren’t Lifting Analysts’ Future Sights. With the S&P 500’s Q1 earnings reporting season 44% complete through midday Tuesday, the results are better than expected. Aggregating the results of the S&P 500 sectors’ reporting companies to date shows that nearly all 11 sectors beat analysts’ consensus expectations on both top and bottom lines (Fig. 11 and Fig. 12).

However, these strong results have been totally overshadowed by the uncertainty over tariffs. The unclear future has left corporate managements with little to offer analysts in the way of guidance, so analysts have been cutting estimates for upcoming quarters rather than raising them as one would expect after surprisingly good earnings reports. To better track and analyze the rapidly changing quarterly consensus expectations for the 11 sectors, Joe recently created a weekly publication titled S&P 500 Sectors Quarterly Revenues/Earnings/Margins (REM).

Here’s his compilation of the data on how analysts have been adjusting their Q2 revenues and earnings expectations for the various S&P 500 sectors and the S&P 500 itself:

(1) Q2 revenues revisions lag for just four sectors. While the S&P 500’s Q2-2025 revenues forecast has dropped 0.6% in the four weeks since the March 31 week, just four of the 11 sectors are lagging the index (Fig. 13). Among the seven outperforming sectors, Utilities leads with its Q2 revenues forecast rising 0.3%, slightly ahead of the 0.1% gains for Health Care and Materials. Communication Services (-0.5%) and Information Technology (-0.4) were also ahead of the S&P 500’s Q2 revenue forecast decline.

Among the worst performers, Energy’s Q2 revenue forecast has tumbled 3.3%, followed by declines for the Consumer Discretionary (-1.1%), Industrials (-1.0), and Financials (-0.7) sectors.

(2) Same four sectors lag on earnings too. Analysts took a bigger hatchet to Q2 earnings forecasts than they did to Q2 revenues, with all 11 sectors posting declines since the March 31 week (Fig. 14). The aggregate earnings estimate for the S&P 500 companies has fallen 2.7%, steeper than the 0.6% revenues decline.

Q2 earnings estimates have dropped the least so far for the Materials (-0.2%) and Utilities (-0.3) sectors. Not coincidentally, the four sectors with the worst Q2 revenue forecast declines are also the worst in terms of Q2 earnings. Among them, Energy’s Q2 earnings forecast has tumbled 12.4%, markedly worse than the declines for the Consumer Discretionary (-4.6), Industrials (-4.1), and Financials (-2.8) sectors.

(3) Quarterly growth forecasts falling faster now. Analysts now expect Q2 revenues growth of 3.6% y/y for the S&P 500, the slowest rate of the year (Fig. 15). That’s down from their 4.7% forecast for Q2 growth at the year’s start. For the back half of 2025, analysts think revenues growth will accelerate to 4.3% in Q3 and 5.0% in Q4—but both forecasts have tumbled about 1.5ppts since the year began.

On a proforma same-company basis, analysts now think S&P 500 earnings will rise 7.3% y/y in Q2, down from around 12% at the year’s start and below Q1’s current blended forecast of 9.7% (Fig. 16). Analysts are now forecasting single-digit percentage earnings gains in H2-2025, and their estimates have been on a declining trajectory that hasn’t stabilized yet.

(4) Quarterly profit margin forecasts edging lower too. As earnings forecasts fall faster than revenues, the implied profit margin falls (we calculate analysts’ margin expectations from their consensus earnings and revenues forecasts). Analysts currently expect the S&P 500’s profit margin to rise to 13.2% in Q2, down from the 13.7% forecasted when the year began and above the current Q1 forecast of 12.9% (Fig. 17). We still think that Q1’s profit margin will be 13.3% by the end of the reporting season and that Q2’s forecast will fall below Q1’s.

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Does China Need The US?

April 29 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

YRI Bulletin Board. We asked William Pesek, our new Contributing Editor, to analyze whether China is as dependent on the US consumer as the Trump administration seems to believe. It is essential reading.

William is an award-winning Tokyo-based journalist and author of Japanization: What the World Can Learn from Japan’s Lost Decades. He won the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia for his work for the Nikkei Asian Review. He is a former columnist at Barron’s and Bloomberg.

China I: Dragons vs Tigers. We now know what happens when an unstoppable force like Donald Trump meets an immovable economic object like Xi Jinping’s China. In the case of the US President, it’s blinking on tariffs in ways to which Trump World isn’t accustomed.

China’s intransigence clearly caught the Trump White House off guard. Since February 1, Trump has been raising China’s tariff rate like a manic auctioneer: First 10%, then 20% on up to 54%, 104%, 125%, and at last look a cartoonishly large 145%. Team Trump assumed that sticker shock would have Xi calling the White House switchboard in a panic to make a deal. Yet no call came to Washington. Instead, Team Xi called Japan and South Korea about a free-trade deal. It called officials across Southeast Asia. It called Europe.

China surely will be hurt by losing the US market, but Xi’s Communist Party is betting that Trump’s America will be hurt more. Trump effectively confirmed Beijing’s suspicions when he exempted smartphones, laptops, and other key electronics categories from most China tariffs, raising the question for Team Trump: What’s the point of a trade war if everyone gets a carve-out? Then again, tariffs on these items are still being considered.

And just like that, Trump’s efforts to make China heel suddenly resemble the very “Swiss cheese approach” that US Trade Representative Jamieson Greer told Congress earlier this month the administration wanted to avoid, an outcome sure to “undermine” the impact of tariffs.

Yet the biggest miscalculation by Trump 2.0 may be taking China’s secret weapon for granted: an economy that’s been relying less and less on the US consumer to reach its 5% annual real GDP growth targets. And, probably, even less going forward.

China didn’t enter 2025 firing on all cylinders. Asia’s biggest economy faces a giant property crisis that’s generating deflation (Fig. 1 and Fig. 2). Local government finances are in disarray. Youth unemployment is near record highs. Chinese households are more enthusiastic savers than spenders. These are the pre-existing conditions Xi carries into Trump’s one-man tariff arms race.

The 5.4% y/y real GDP growth rate that China produced in Q1-2025 was clearly boosted by exporters frontloading shipments to beat Trump’s tariffs (Fig. 3). Going forward, though, China has many tools in its arsenal to fight back. It can always raise its 125% tariff rate on the US to a Trump-matching 145%. It could squeeze American farmers, particularly those in red states. It could dump its $760 billion of US Treasuries (Fig. 4). It could also tax made-in-China goods and devalue the yuan. It could even confiscate manufacturing facilities.

China II: Chiku vs Cheek. Here we explore a number of reasons why China might not need the US consumer to thrive nowadays.

One ace up Xi’s sleeve is a pain threshold that would be unthinkable in the US. Mainlanders call it “chiku,” a Mao Zedong era ethos that means to “eat bitterness.” In authoritarian China, Xi doesn’t need to stand for elections. Credible opinion polls encapsulating the views of his 1.4 billion subjects aren’t really a thing.

This is a big reason why China feels little urgency, if any, to come to the negotiating table. Chiku was largely how Beijing got away with its draconian Covid-19 lockdowns. And now, it’s helping Xi rally public support, as Trump makes it all too easy for the party to paint China as a victim of US aggression.

This dynamic is as asymmetrical as they come. How much bitterness are Americans ready to eat?

At the same time, China’s been preparing for this trade war for a long time. That includes diversifying its trade away from US households. In 2018, the last time Xi’s economy dealt with “Tariff Man,” Chinese exports to the US accounted for about 19.2% of the total, according to China’s National Bureau of Statistics. At the end of 2024, that stat had fallen to 14.7%.

As Matthews Asia points out, only 29% of Chinese exports now go to the Group of Seven countries, compared to 48% in 2000. By the end of 2023, China was the biggest trading partner of 60 countries, roughly twice as many as the US, according to the Lowy Institute (Fig. 5 and Fig. 6).

That’s because China has been actively diversifying its overseas shipments, sending more to Southeast Asian and so-called “Global South” nations.

Today, China’s main customer is the bloc of 10 countries in the Association of Southeast Asian Nations (ASEAN), followed by the European Union. In 2024, China’s trade with ASEAN grew 7.1% y/y to $234 billion, according to China’s General Administration of Customs. The US is now only China’s No. 3 market. Sure, Trump can make life harder for Xi’s nation; but now Washington lacks the direct leverage to alter China’s behavior that it had and exerted in 2018.

In the West, we follow the money. In the East, it’s wise to follow Xi’s travel itinerary. This month, he visited Cambodia, Vietnam, and Malaysia, three key Asian economies unhappy about being targeted by Trump’s reciprocal tariffs. That wasn’t a coincidence. With Phnom Penh, Hanoi, and Putrajaya facing direct tariffs of 49%, 46%, and 24%, respectively, Xi enjoyed what Chinese state media called “all-around cooperation” on his whistle-stop tour.

China III: China’s Bazookas. Manufacturing, Trump World seems to think, has been a bright spot in China’s economy, as China’s property sector has sputtered and deflation deepened in recent years. Goldman Sachs, after all, thinks between 10 million and 20 million Chinese workers rely on US-bound export businesses. If that fact doesn’t move Xi to capitulate, Trump reckoned, what will? Xi, though, has the scope needed to continue to offset lost business from anxious American consumers.

One way is via is large-scale reductions in official interest rates and reserve-bank ratios. The People’s Bank of China’s (PBOC) one-year loan prime rate is currently set at 3.1%, while the five-year rate is 3.6% (Fig. 7).

Until now, the PBOC has been reluctant to ease too assertively. For one thing, it worries about the yuan weakening. A yuan-dollar exchange rate lower than the current 7.29 might increase default risks among property developers with heavy dollar-denominated debt loads (Fig. 8). And it might enrage Trump’s Treasury Department, which is hypersensitive to China’s supporting its exporters at America’s expense.

But China’s deflation risks mean that the PBOC always has the option of trying quantitative easing (QE) with Chinese characteristics. Chinese QE could help alleviate pressure on local government finances hit hard by China’s property crisis—and now Trump’s tariffs. It’s no coincidence that on November 8, a few days after Trump’s re-election shocked China, Team Xi moved to let municipalities expand their debt financing via the issuance of $1.4 trillion of long-term bonds to replace short-term debt.

Though the father of monetarism Milton Friedman would object, Xi wants local governments to use some of the proceeds to buy up unsold or unfinished residential buildings around the nation. Beijing has been prodding state-owned non-bank institutions to buy back shares and hang on to them indefinitely. And a government not wedded to the normal laws of financial gravity has multiple ways to support consumer demand if cornered: For example, Xi has the scope to direct the PBOC to make electronic payments directly into household bank accounts. That’s just one option for providing broad income assistance.

The fact that Beijing hasn’t yet deployed its stimulus “bazooka” suggests that Team Xi isn’t panicking. Zhang Di, analyst at China Galaxy Securities, thinks Beijing might announce a stimulus jolt of as much as 2 trillion yuan ($274 billion).

But there’s renewed focus on increasing pension payments and building more robust national safety nets. This would pivot China once and for all toward domestic-demand-driven growth and away from exports.

Part of the challenge is reforming China’s “hukou” household registration system, one that long has limited the ability of rural Chinese to seek employment in booming urban centers (Fig. 9). The resulting higher wages—and yes, government transfers—would increase household purchasing power on everything from consumer goods to education and training to healthcare to financial services.

The wisdom—and inherent moral hazards—of such tactics might make Adam Smith turn over in his grave. But Trump World is learning the hard way that China has a deep well of strategies it can use to wait out the trade war.

China IV: Trump 1.0 Prepared China for Trump 2.0. The irony is that Trump 1.0 made China markedly more resilient to shocks. Team Xi prioritized building more dynamic supply chains. The Trump 1.0 trade war saw Beijing prodding state-owned enterprises to diversify income streams globally as a matter of course, in case another US trade war came around. It was a savvy bet.

China also pumped untold billions into supersizing its controversial Belt and Road initiative to sell more to Southeast Asia, Latin America, Africa, and beyond.

Soybeans tell the story. In 2017, American farmers produced about 40% of China’s soybeans imports. Now it’s around 20% thanks to China pivoting to Global South nations like Brazil instead. The South American economic power is now China’s top supplier. It’s an example of how Trump’s tariffs can backfire on Trump country as American farmers pay the price.

Asymmetric warfare is China’s friend. Xi’s people know it’s virtually impossible for the US to replace in short order what its economy gains from trade with China. With tariffs around 145%, Julian Evans-Pritchard, head of China economics at Capital Economics, estimates that Mainland shipments to the US will plunge by 80% over the next two years.

China’s next bet is that it needs America’s business less than America needs China’s goods, industrial inputs, and minerals. In 2024, imports from China rose 2.8% to $438.95 billion, according to US Census Bureau data (Fig. 10). And America’s extreme reliance on China can obscure the ways in which mainland goods are increasingly rerouted. Vietnam is a big beneficiary of this dynamic. Between 2019 and 2024, US imports from Vietnam more than doubled.

It’s an example of how, even as direct US imports from China are declining, Chinese-made components and raw materials are still pivotal to goods imported from emerging market economies.

China is banking, too, on its ability to weaponize America’s access to rare earth minerals, which are essential to making artificial intelligence chips, among other things. China is home to roughly 61% of rare earths production and 92% of related refining, according to the International Energy Agency. The question of whether Australia, Japan, Vietnam, and others can fill the void could take years to answer.

Pini Althaus, CEO of Cove Capital, told The Washington Post that it could take 10-15 years to devise a resilient China-free supply chain for minerals critical to making everything from smartphones to automobiles to jet engines to MRI machines to big-ticket weapons. “The writing has been on the wall for a long time,” Althaus explained.

This 10- to 15-year window is worth exploring further. There are myriad reasons to criticize Xi’s reign that began in 2012. He’s been slow to build a thriving private sector to grab control from inefficient state-owned enterprises dominating his nearly $18 trillion economy. Beijing still must craft more resilient and transparent capital markets and make the yuan fully convertible. It also must build social safety nets to encourage greater domestic demand.

But this year’s “DeepSeek shock” was a wake-up call that Silicon Valley didn’t see coming. China is showing it’s got some serious AI game. For Xi, it was a sign that his “Made in China 2025” enterprise is putting some wins on the scoreboard.

Back in 2015, when Trump was famously descending an escalator in New York, Xi put in motion a 10-year plan to dominate the future of batteries, electric vehicles, renewable energy, aerospace, computing, biotechnology, green infrastructure, robotics, and AI.

Ask Elon Musk how all this is working out for Tesla. At a moment when the Warren Buffett-backed BYD, China’s largest EV maker, is shocking the industry with an ultrafast battery charging system, Trump World is debating whether EVs are too woke for America.

As an economic thinker, Xi is no more omniscient than he is omnipotent. It’s entirely possible that posterity will be harsh on his strategy for navigating around Trump’s Tariff Turmoil. We don’t mean to suggest it will succeed. Our point is simply that Trump’s confidence that he can drive China’s economy off the road with something as unoriginal as import taxes is in for a crashing reality check.

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Anatomy Of A Correction

April 28 (Monday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Fed I: Waller vs Powell. The financial markets have been obsessed with Trump’s Tariff Turmoil (TTT), and rightly so. That means that the financial markets have been less preoccupied with the Fed. Indeed, Fed Chair Jerome Powell has signaled several times that monetary policy is on hold because of the uncertain economic effects of TTT. While the tariffs are likely to slow economic growth, they are also likely to boost inflation, at least temporarily.

Last Thursday, Fed Governor Christopher Waller publicly dissented from the relatively hawkish party line promoted by Powell & Co. in recent weeks. His dovish stance is that TTT is likely to weaken the labor market in coming months, while any inflationary pressures are likely to be temporary. So he is ready to lower interest rates sooner rather than later.

It’s becoming apparent that Waller is doing his best to ingratiate himself with Trump & Co. so he might be considered as a candidate to replace Powell when his term as Fed chair expires in May 2026. Stock investors liked what Waller had to say on Thursday. Joining Waller’s parade that day was Cleveland Fed President Beth Hammack. In a separate interview, she said the central bank might reduce interest rates as early as June if it were to have clear evidence of the economy’s direction by then.

We side with Powell & Co. So far, the data show that consumer spending and the labor market remain remarkably resilient. At the same time, inflationary pressures are mounting, according to regional and national business surveys. Consumers’ inflationary expectations are also rising.

Let’s compare the recent comments coming from the Waller camp versus the Powell camp:

(1) “It wouldn’t surprise me that you might start seeing more layoffs, a tick up in the unemployment rate going forward if the big tariffs in particular come back on,” Waller said Thursday in an interview on Bloomberg Television with Michael McKee. “I would expect more rate cuts, and sooner, once I started seeing some serious deterioration in the labor market.” Waller reiterated his view that the inflationary impact of Trump’s tariffs should be temporary. He first said so on April 14 in remarks prepared for an event in St. Louis.

(2) On Friday, April 11, a few days before Waller spoke in St. Louis, Federal Reserve Bank of New York President John Williams joined the chorus of Fed officials who’ve signaled their intent to keep rates on hold as they wait for more certainty about the impact of TTT. He said, “During times of turbulence and uncertainty such as these, well-anchored longer-run inflation expectations are critically important for ensuring sustained price stability.” He added, “It is critically important to keep inflation expectations well anchored as we pursue our goals of maximum employment and returning inflation to our 2% longer-run objective.”

Also on April 11, Minneapolis Fed President Neel Kashkari and Boston Fed chief Susan Collins reiterated their views that Trump’s tariff policies may make rate cuts less likely this year.

(3) Of course, we give the most weight to the views of Fed Chair Powell. On July 16, in prepared remarks presented at the Economic Club of Chicago, Powell observed, “Tariffs are highly likely to generate at least a temporary rise in inflation. The inflationary effects could also be more persistent. Avoiding that outcome will depend on the size of the effects, on how long it takes for them to pass through fully to prices, and, ultimately, on keeping longer-term inflation expectations well anchored.”

Powell concluded, “For the time being, we are well positioned to wait for greater clarity before considering any adjustments to our policy stance.” Powell is apparently in less of a rush to lower rates than is Waller.

Fed II: More Inflation than Stagnation. So far, the data that the Fed depends on to make monetary policy is showing that TTT is boosting both consumer spending and inflationary pressures. Importers have been scrambling to front-run tariffs. The surge in imports depressed Q1’s real GDP growth rate, probably to +/-0.5% (saar) (Fig. 1). But Q2’s growth rate is likely to be 2.5%-3.0%, boosted by retail sales as consumers scramble to buy in advance of tariff-related price increases.

Meanwhile, the labor market remains strong. However, the regional and national business surveys are showing that higher prices-paid indexes are pushing up prices-received indexes, suggesting mounting inflationary pressures. Let’s review the latest data:

(1) Consumers. The Consumer Sentiment Index (CSI) is among the softest of the soft economic data. Yet the hard data on consumers remain robust. The CSI fell in April to 59.8, matching previous cyclical lows that coincided with recessions (Fig. 2). The CSI measures of expected inflation over the next 12 months and over the next five years jumped to 6.5% and 4.4%, respectively, in April (Fig. 3).

These readings are well above the Fed’s 2.0% y/y inflation target. Inflationary expectations clearly are not “well anchored.”

Consumers are buying in advance of expected price increases. That’s plain to see in US total motor vehicle sales, which jumped to 17.8 million units (saar) during March, the highest pace since April 2021 (Fig. 4). The Redbook retail sales index rose 7.0% y/y through the April 18 week (Fig. 5). Interestingly, sales of discount stores is up 8.9%, but department-store sales is up only 2.4% (Fig. 6).

(2) Labor market. We’ve often said that American consumers spend when they are happy and spend even more when they are depressed. Of course, that requires that they remain employed. They are currently extremely depressed according to the CSI, but they are still spending because they are still employed, as evidenced by the low readings for both initial and continuing unemployment claims so far this year through mid-April (Fig. 7). March’s measures of job openings remained relatively high (Fig. 8).

(3) Inflation. Consumers are right to be worrying about the inflationary consequences of TTT. The regional business surveys conducted by five of the Federal Reserve district banks are showing that prices-paid and prices-received indexes jumped sharply in March and April (Fig. 9 and Fig. 10).
 
Strategy: The Magnificent-7 Are Still Magnificent. The latest correction in the S&P 500 was led by a short and shallow bear market in the Magnificent-7 stocks. Trump’s Tariff Turmoil clearly drove lots of the selling pressure. However, the stock market selloff this year was also attributable to the downward rerating of the elevated valuation multiples of S&P 500 Information Technology sector stocks, and particularly the Mag-7, which began after the release of open-source Deep Seek on January 24 triggered investor fear that capital spending on AI infrastructure would nosedive. Consider the following:

(1) SPY (the S&P 500 ETF) fell 19.0% from February 19 through April 8. The Roundhill Magnificent Seven ETF (MAGS), which is equal-weighted and rebalanced quarterly, dropped 26.7%, while the XMAG ETF (which is free-float cap-weighted) declined only 16.2% over this period (Fig. 11 and Fig. 12). Since April 8, SPY is up 10.9%, with MAGS up 14.8% and XMAG up 9.4%.

(2) The forward P/E of the Mag-7 plunged from 30.0 at the start of the year to 21.7 on April 8 (Fig. 13). Over that same period, the forward P/E of the S&P 500 fell from 22.4 to 19.2, while the forward P/E of XMAG declined from 18.6 to 17.8. The forward price-to-sales (P/S) ratio of the Mag-7 plunged from 7.7 at the start of the year to 5.6 on April 8 (Fig. 14). It is back up to 5.9. The forward P/S of the S&P 500 excluding the Mag-7 edged down from 2.2 to 2.1 over this same period through the April 17 week.

(3) While the Mag-7’s share of the S&P 500’s market capitalization has dropped from 32.0% at the start of the year to 28.4% currently, the Mag-7’s forward revenues and forward earnings share both are at new record highs of 11.8% and 22.6% (Fig. 15).

(4) Also at a record high is the collective 26.2% forward profit margin of the Mag-7 at the end of April (Fig. 16). That’s more than twice the 11.9% forward profit margin of the S&P 493!

(5) Analysts’ consensus expected (i.e., forward) short-term growth rates for the revenues and earnings of the S&P 500 have been declining since the start of this year, led by the Mag-7 (Fig. 17 and Fig. 18). The forward revenues growth of the S&P 500 currently is at a still-solid 5.3%. The comparable series for the Mag-7 is down from 13.8% at the start of this year to 12.1% currently. The forward earnings growth rates of the S&P 500 and the Mag-7 currently are down a couple of percentage points since the start of this year to 11.5% and 17.2%, respectively. Those are still robust readings.

(6) The rebound in the stock market since April 8 was attributable to Trump’s postponing his reciprocal tariffs (except on China) and to his more moderate tone regarding the prospect of negotiating a trade deal with China. In addition, he backed off from his recent attacks on Fed Chair Powell.

Also positive: Investors may be returning to the Magnificent-7, which collectively is up 14.8% since April 8, outpacing the 9.4% increase in the XMAG since then. We’ve observed that AI is just the latest evolution of the Digital Revolution that started in the mid-1960s. It’s another technology that increases our ability to process more data faster and more cheaply. So it’s increasing the business of cloud computing companies and boosting their capital spending on cloud infrastructure.

(7) Alphabet’s Google Cloud Platform (GCP) results, reported last week, support our narrative. In Q1-2025, GCP reported revenue of $12.26 billion, slightly below Wall Street expectations of $12.27 billion but reflecting robust 28% y/y growth. Margins improved significantly to 17.8% from 9.4% a year ago, indicating better operational efficiency.

Heavy AI investments are paying off, with Google Cloud’s AI portfolio, powered by the Gemini large language model, attracting new customers and securing larger deals. Developer usage of Gemini doubled to 4.4 million users in six months by Q4-2024.

Capital expenditures are set to rise significantly, with Alphabet planning to spend $75 billion in 2025 (up from $52.5 billion in 2024) to expand its AI and data center infrastructure.

Movie. “Companion” (+ +) is a very entertaining 2025 movie about the not-too-distant future. It’s about a weekend getaway to a remote lakeside house. A few of the characters are murdered. Some but not all of the perpetrators are in it for the money. Others are just trying to stay alive. It’s a fun and funny plot about humans and humanoids. (See our movie reviews archive.)

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Tariffs Hit Energy & Industrials

April 24 (Thursday)

Trump’s Tariffs I: Turmoil in the Energy Patch. Thanks to the advent of fracking, the US is a net exporter of oil and natural gas, so President Trump’s tariffs on imports don’t directly impact this industry much. However, no industry operates in a vacuum. Trump’s Tariff Turmoil (TTT) has increased the chances of an economic slowdown both at home and abroad, which could slow global demand growth for energy products. In addition, China’s retaliatory tariffs on imports from the US make it uneconomic for Chinese companies to purchase US energy products.

The International Energy Agency cut its global GDP growth forecast to around 2.4% this year and 2.5% in 2026 from 3.1% for both years. The agency also lowered its oil global demand growth forecast to 727,000 barrels a day this year from 1.03 million barrels a day. Next year, the agency expects growth to decelerate to 692,000 barrels a day.

The prospect of slower global economic growth, and therefore slower demand growth for oil and gas, has hurt the commodities’ prices. The spot price of West Texas Intermediate crude oil has fallen 10.8% ytd through Tuesday’s close to $64.60 (Fig. 1). Likewise, the price of natural gas futures has tumbled 17.1% ytd to $3.01 (Fig. 2).

Concerns about demand are so great that they’re more than offsetting the positive impact that a falling dollar typically has on commodity prices. Foreigners who purchase oil in dollars can afford to buy more oil if their own currency rises and the dollar falls. But recently, this usual catalyst to demand—and prices—hasn’t been doing its thing: The US dollar has fallen 8.8% ytd, oil and gas prices have fallen in tandem (Fig. 3).

Regardless of what happens with tariffs, global excess production of oil should continue to contain oil prices as OPEC+ may have lost control over its members and production. Several members are going to suggest the group accelerate output hikes in June despite the current low price of oil as disagreements continue about compliance with production quotas, a Reuters article reported on Wednesday. The group next meets on May 5.

Falling oil prices have Haliburton’s customers evaluating their “activity scenarios” for 2025, and if they curtail their activity, it could mean there will be “higher than normal” periods during which some of Haliburton’s equipment isn’t being used, warned Halliburton CEO Jeff Miller, according to an April 22 Reuters article. Many companies say they need the price of oil to be $65 or higher to drill profitably. Haliburton shares are down 23.8% ytd and 46.5% over the past year.

Investors in natural gas, however, may be overlooking the growing US demand for natural gas from both US utilities and liquified natural gas (LNG) exporters. If TTT subsides, natural gas prices stand to bounce sharply. Let’s look at some of the supply and demand metrics influencing natural gas prices:

(1) US increases production and exports. US production of natural gas has increased nicely in recent years, but US consumption and exports of the fuel have grown even faster. US production of natural gas has increased by 1.5 trillion cubic feet (tcf) since 2022, while US consumption of natural gas has jumped by 1.0 trillion tcf and US exports have risen by 0.8 trillion tcf over the same period (Fig. 4).

Strong domestic and international demand for US natural gas has left US natural gas stocks about 10% below the five-year average at this time of year (Fig. 5). “The EIA estimates that domestic consumption will rise 1.8% this year to 92 billion cubic feet a day, and sees LNG exports up 19% to 14.2 billion cubic feet a day,” a March 25 WSJ article reported. The low storage levels and strong expected demand pushed the spot price for the January 2026 natural gas contract up as high as $5.71 in March before it fell to a recent $4.67.

(2) Global demand shifts. With the advent of LNG, natural gas has become a more global commodity that moves around the world based on supply and demand. Chinese imports of US natural gas have been declining since Europe boycotted Russian natural gas following its invasion of Ukraine in 2022. The boycott left Russian gas prices at a discount to natural gas produced elsewhere in the world. The percentage of China’s imported LNG sourced from the US fell to 6% in 2024, down from a peak of 11% in 2021, an April 18 Financial Times article reported.

More recently, Chinese imports of US natural gas have ground to a halt. China slapped a 15% tariff on imports of US natural gas on February 10 in retaliation for Trump’s tariffs. China made up for the lack of US natural gas imports by expanding its imports of natural gas from Russia, according to ship trading data cited in an April 18 NYT article. The Chinese tariff on US natural gas imports has since increased to 49%, further exacerbating the situation.

While Chinese imports of US natural gas have fallen to zero, that doesn’t mean Chinese companies aren’t buying US natural gas and shipping it to other countries. Chinese companies have long-term contracts to buy LNG from US terminals, and they’ve been selling that gas to customers in Europe, where natural gas trades at a premium.

President Trump has suggested that the European Union will have to commit to buying $350 billion of US energy to get a reprieve from US tariffs and eliminate the deficit that the US has with the EU.

Taiwan is pledging to buy more US oil and natural gas as part of its tariff negotiations with the US. Currently, US LNG represents about 10% of Taiwan’s LNG imports. Likewise, other Asian nations—including Thailand, South Korea, India, and Indonesia—are considering or offering to buy more US energy products to appease Trump and dodge US tariffs, Oilprice.com reported on April 17.

(3) Learning from Australia. Natural gas is in such demand in Australia that the government has introduced subsidies on consumers’ electricity bills, and eastern coast communities have been warned of blackouts. Australia is producing record levels of natural gas, but most of it is being sold overseas, making it a point of debate among politicians. “We don’t have a supply problem. We have an export problem,” said an Australian energy finance analyst in an April 22 FT article. Australia’s predicament is something US politicians should bear in mind as they try to boost US natural gas sales internationally just as US utility demand for natural gas is surging to meet the growing AI demand for electricity.

(4) China needs US propane. Propane has become one of the US’s top-selling products to China. China purchased almost 18% of all US propane exports and uses propane as a key ingredient in plastic, carpets, grocery bags, and socks, an April 18 WSJ article explained. The reciprocal tariff that China has placed on imported US goods makes buying US propane uneconomic for Chinese companies. But there’s no other supplier large enough to replace US production, and there’s no other consumer that’s large enough to replace Chinese demand.

The average wholesale price of US propane has fallen to $1.05 a gallon as of March 31, down from almost $1.30 in January, according to Energy Information Administration data.

Trump’s Tariffs II: Industrials Pinched Too. Several companies in the S&P 500 Industrials sector reported Q1 earnings results this week, and their CEOs took the opportunity to discuss the impacts that tariffs are expected to have on results. The Industrials sector has sold off this year, but it’s hardly the worst ytd performer among the S&P 500’s 11 sectors: Consumer Staples (6.0%), Utilities (3.0), Real Estate (-0.9), Health Care (-2.0), Financials (-2.5), Materials (-2.8), Energy (-4.5), Industrials (-5.4), S&P 500 (-10.1), Communication Services (-11.2), Information Technology (-18.7) and Consumer Discretionary (-19.5) (Fig. 6).

Here’s a look at what 3M and RTX had to say about the impacts of Trump’s tariffs on their expected second-half results:

(1) 3M. The maker of Scotch tape reported Q1 earnings per share of $1.88, which beat analysts’ expectations of $1.77. Instead of increasing its 2025 EPS target by $0.10, the company maintained its $7.60-$7.90 target, which excludes any impact from tariffs.

3M imports $1.6 billion of goods into the US and exports $4.1 billion of goods. Products from China represent about 10% of 3M’s imports and slightly more in exports. After exemptions on certain products, the company expects the full-year impact of tariffs to approximate $850 million before taking mitigating actions. However, because 3M is sitting on inventory, tariffs won’t affect the company until the second half of the year, dropping the 2025 impact to $425 million ($0.60 a share) before any mitigating actions. However, the mitigating measures 3M plans—including cost and productivity initiatives, leveraging its US footprint, adjusting its sourcing and logistics, and considering selective price increases—would drop the impact to $0.20-$0.40 a share.

“With the significant footprint we have in the US and the flexibility of our global network, we’re identifying a number of ideas to adjust product sourcing and logistics flows to mitigate at least part of the impact, some of which are no-regret moves regardless of where trade policies eventually settle,” said CEO Bill Brown on the company’s earnings conference call. 3M shares rose 8.1% on Tuesday, bringing their ytd gain to 5.6%.

(2) RTX. The aerospace and defense company said tariffs will cost it $850 million in 2025—even after cost cutting measures and price increases. This figure doesn’t include the reciprocal tariffs that President Trump has paused or an escalation in the trade war. RTX shares fell 9.8% Tuesday, bringing the ytd decline to 1.7%, even though the company reported better-than-expected Q1 EPS of $1.47 versus the analysts’ consensus of $1.36.

RTX’s industrial base and about 70% of its employees are located in the US. In addition, about 65% of what it spends on products is with US suppliers. The company is a net exporter of goods, with exports exceeding imports by more than $12 billion in 2024.

Excluding the impact of tariffs, the company expects this year’s adjusted organic sales to grow 4%-6% to $83 billion-$84 billion, and adjusted earnings to hit $6.00-$6.15, up from $5.73 last year.

Disruptive Technologies: AI Accelerates Evolution. Scientists at Stanford University have developed a generative AI tool that has absorbed huge quantities of information about the genes in living organisms and uses that information to develop new genes and identify which genes cause illnesses. The development in what’s called “generative genomics” is expected to accelerate advancements in bioengineering and medicine, allowing labs to run standard experiments in minutes or hours instead of years, explains a February 19 article in the Stanford Report.

Dubbed “Evo 2,” the open-source AI program was trained on the genes of all living things, including humans, plants, bacteria, amoebas, and a few extinct species. To ensure safety, the genomes of viruses were left out. Using its massive database, Evo 2 can predict the next nucleotide in a DNA strand. It can also write new genetic code that can be inserted into a cell using CRISPR technology, to evaluate how the new genetic code can be used.

Evo 2 can evaluate the interaction of genes on a DNA strand that has a million nucleotides, much more than previously possible. As a result, scientists can now spot connections between genes that exist far from each other on a long DNA strand. Evo 2 can also predict the impact of gene mutations, forecasting which mutations may cause cancer, for example.

Evo 2’s dataset of 9 trillion nucleotides was much larger than Evo 1’s 300 billion. Stanford worked with Nvidia, which makes the computer chips and software on which the program is run, and Arc Institute, a biomedical research nonprofit and collaboration among Stanford, the University of California Berkley, and the University of California San Francisco. Evo 2 is publicly available on Nvidia’s BioNeMo platform.

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More On Trump’s Tariffs

April 23 (Wednesday)

Trump’s Tariffs I: Who Foots the Bill? When a tariffed good reaches a country’s borders, the importer pays the custom toll. But importers have profit margins to protect, so rather than eat the entire cost, importers share the burden with their exporters and their customers. Negotiated lower wholesale prices, plus passing on a portion of the increase to the consumer (or other businesses), can offset the tariff. There are also foreign exchange effects that can place more of the burden on the importing or the exporting country.

When the White House initially presented its reciprocal tariff rates on large posterboards, the formula it later published cited a study that showed import prices were relatively inelastic, rising just one-fourth of the increased cost due to tariffs. However, that was an incorrect citation. While retail prices increased by roughly that amount during Trump 1.0, the study actually found that import prices rose to include 94.5% of the tariff cost, suggesting that US producers took a hit to their profit margins.

And while the dollar rose during Trump 1.0 (arguably making exporting countries’ citizens poorer, but of course helping their producers sell cheaply), it is now falling against most major currencies (Fig. 1). While the Chinese yuan is weakening, that is likely a deliberate attempt by China to lessen the impact on its exporters (Fig. 2).

The exact “cost” of tariffs varies by product and country. Goods for which Americans have many substitution options or that robust domestic industries also produce—i.e., for which imports are less needed—tend to see lower price increases due to tariffs. Conversely, goods that are primarily exported by just one or two countries tend to see much larger price increases. And if the dollar continues to fall, the inflationary impact is magnified.

So in the end, it’s mostly the average Joes who “pay” for the tariff. The goal is to bring manufacturing jobs back to America so that people can afford these products. But there’s a lot of friction in the prolonged processes of reshoring and building domestic industry—price increases happen much quicker.

Trump’s Tariffs II: The Art of the Deal in Action. “The real excitement is playing the game,” President Donald Trump wrote in his book The Art of the Deal. Today, that game is trade, and the gameboard is global.

With fresh trade negotiations underway, the Trump administration is executing a strategy that eschews multilateral harmony but adheres faithfully to another standard: classic Trump dealmaking. Its tactics are outlined plainly in The Art of the Deal. Let’s connect the dots from the negotiating principles Trump espoused in the book to the trade tariff deals he is shaping today.

On April 9, Trump wrote on Truth Social: “[B]ased on the fact that more than 75 Countries have called Representatives of the United States ... to negotiate a solution to the subjects being discussed relative to Trade, Trade Barriers, Tariffs, Currency Manipulation, and Non Monetary Tariffs, and that these Countries have not ... retaliated in any way, shape, or form against the United States, I have authorized a 90 day PAUSE, and a substantially lowered Reciprocal Tariff during this period, of 10%, also effective immediately.”

One of the important lessons in Trump’s book: “Aim very high.” By coming out of the gate with high reciprocal tariffs, there’s room for Trump to soften his stance while deals are being negotiated. The softening effectively “butters up” the other side, giving it the sense of a victory and mitigating ill will. In this case, imposing “only” a 10% global tariff until further agreements are reached is the softening, which can come across as a pivot (it’s not actually a pivot if it’s part of the initial plan). The table is set with a global baseline 10% tariff—not as harsh as the alternative reciprocal tariffs—and if that’s all that survives the negotiations, that’s okay with Trump; it was what he was after in the first place. If lower tariffs or reduced non-tariff barriers on US exports to the world are successfully negotiated, or higher reciprocal tariffs on US imports abroad stick due to “unsuccessful” negotiations, so much the better—they’re a bonus. It’s a win/win tactic for Trump.

One thing is for sure: The trade upheaval is giving the President plenty of opportunities to test his dealmaking prowess—including the art of building leverage, establishing what’s fair, and negotiating as if all is negotiable.

Let’s review where a few of the deals with key trading partners stand:

(1) China: Leverage in a game of chicken. “Leverage: don’t make deals without it,” Trump once wrote. The President is building an arsenal of leverage against China, but Beijing has yet to balk. On April 2, Trump paused reciprocal tariffs on most nations for 90 days, except for the now-up-to-145% tariff on Chinese goods. Beijing responded with retaliatory tariffs of 125% on US goods and non-tariff import curbs.

The Chinese exception to the tariff pause singles the nation out as a bad actor. In recent days, the US President has pressured nations seeking tariff reductions or exemptions from the US to curb trade with China, aiming for further isolation. In response, China’s President Xi Jinping has launched a targeted campaign warning Southeast Asian countries dependent on China for exports, investment, and technology not to bend to Trump’s “bullying.” Xi has visited Vietnam and struck deals with Malaysia and Cambodia.

Trump suggested that he may be done raising China tariffs. On April 18, he told reporters: “I don’t want them to go higher because at a certain point you make it where people don’t buy.” But he’s not done playing games with China in other ways. For example, the US Trade Representative unveiled a plan to subject all Chinese-built and -owned ships docking in the US to levies based on volume carried. The administration also recently disallowed Nvidia from exporting AI chips to China, limiting China’s access to US technologies. The $5.5 billion hit Nvidia announced signals Trump’s commitment to playing hardball—even at a cost.

President Trump repeatedly has stated he would like to personally meet with Xi to move negotiations forward. “If you’re going to make a deal of any significance, you have to go to the top,” Trump wrote in The Art of the Deal. Trump has said he thinks he can get a deal done with Xi by May, but a meeting has yet to be set. “The ball is in China’s court,” White House Press Secretary Karoline Leavitt said on April 15.

(2) European Union: Surely but fairly. Momentum on a trade deal with the European Union seems to be progressing, albeit slowly. The EU could become one of the first test cases for what Trump constitutes as a “fair” trade deal. “There will be a trade deal, 100%,” Trump told reporters leading up to a meeting with Italian Prime Minister Giorgia Meloni, adding that the EU “wants to make one very much.”

But, he added, “it will be a fair deal.” In other words, the EU will bend to Trump’s idea of fairness—or else. That reflects a key “fairness” mindset Trump describes in The Art of the Deal: “When people treat me badly or unfairly, I fight back very hard.”

European exports to the US are currently subject to the global 10% baseline reciprocal tariff, with the White House hinting that escalation is likely if talks don’t progress by mid-summer. Brussels has delayed retaliatory tariffs until July 14.

European leaders remain skeptical. Meloni, a conservative, is the first of Europe’s leaders to meet with Trump since his April 2 tariff announcement. She has said she cannot create deals for the EU but is willing to take the first steps necessary to lead the way to one. Trump has not yet met with European Commission President Ursula von der Leyen.

(3) India: It’s negotiable. “You have to assume that a certain amount of what you’re asking for is negotiable,” Trump wrote in The Art of the Deal. That remains the unspoken premise of Washington’s strategy. Trump recently all but branded India’s Prime Minister Narendra Modi as the “tariff man.” Now, tariff man Modi reportedly is open to reducing tariffs on more than half of India’s imports from the US, which were worth a total $41.8 billion last year. Included in the terms that the US wants are greater market agriculture market access and tighter digital trade rules.

India is among the most likely candidates for a trade deal with the US to be made soon. On Monday, Vice President JD Vance and India’s “tariff man” were all smiles as they met and agreed to a roadmap for a trade deal. If no deal were to be successfully made, India would face a tariff rate of 26% on imports beginning in early July. That seems unlikely.

Strategy: Estimate Revisions Data in the Doghouse. This week, LSEG released its April snapshot of the monthly consensus earnings estimate revision activity over the past month. While the company provides raw data for all its polled measures, we focus primarily on the revenues and earnings forecasts, captured in our S&P 500 NRRI & NERI report. There, the analysts’ estimate revisions activity is indexed by the number of upward revisions in forward earnings less the number of downward ones, expressed as a percentage of total forward earnings estimates. We look at this activity over the past three months because that timespan encompasses an entire quarterly reporting cycle. Since analysts’ tendency to revise their estimates differs at different points in the cycle, three-month data are less volatile—and misleading—than a weekly or monthly series would be.

Joe’s review of the April data found the worst earnings revisions activity in two years:

(1) Tariff talk takes S&P 500 NERI down to a 26-month low. The S&P 500’s NERI index, which measures the revisions activity for earnings forecasts, was negative this month for a seventh straight month. It fell to a 26-month low of -5.7% in April from -4.8% in March (Fig. 3). A zero reading indicates that an equal number of estimates were raised as were lowered over the past three months.

While April’s -5.7% ranks just above the bottom third of its readings since March 1985, when the data were first calculated, it is well below the average reading of -1.9% seen since.

(2) Fewer sectors have positive NERI. Just two S&P 500 sectors had positive NERI in April, down from three sectors in March and the lowest count in 13 months (Energy was the only sector with positive NERI from December 2023 to February 2024). NERI turned negative in April for Communication Services and did so in February for Information Technology (Fig. 4 and Fig. 5).

Financials’ latest reading was still the best in class among the S&P 500’s 11 sectors (Fig. 6). This sector’s NERI was positive for a 14th straight month but is down to an eight-month low of 2.5% now from a three-year high of 8.0% in February.

Utilities was positive for an 11th straight month in April but is down to 0.3% now from a two-year high of 2.6% in November (Fig. 7).

Among the poorer performing sectors, Consumer Staples’ NERI dropped to a 58-month low in April, followed by Materials’ at a 57-month low (Fig. 8 and Fig. 9).

In fact, eight of the 11 sectors’ NERIs were at their lowest levels in many months during April; here are the rankings: Financials (2.5%, eight-month low), Utilities (0.3, 11-month low), Communication Services (-1.1, 15-month low), Energy (-4.1), Information Technology (-4.4, 25-month low), Health Care (-4.4), S&P 500 (-5.7, 26-month low), Consumer Discretionary (-7.0), Real Estate (-7.5, 27-month low), Industrials (-9.6), Consumer Staples (-12.8, 58-month low), and Materials (-21.1, 57-month low).

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On Edge For 90 Days, More Or Less

April 22 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
On Edge I: Trump’s Tariffs. Everyone is on edge. That’s because President Donald Trump seems to be upending the Old World Order. So far, the result has been the New World Disorder, with a less clear distinction between America’s friends and foes. Under Trump’s America First policies, the US seems to have become a less dependable ally.

Henry Kissinger once said that “America has no permanent friends or enemies, only interests.” Yet Kissinger undoubtedly would have agreed that it is in America’s interests to have as many allies as possible. Trump doesn’t seem to share that world view. His is that America’s allies must accept that America’s interests come first before their own because the US is the world’s military and economic superpower.

Currently, global trade relations are being stressed by Trump’s tariffs. The resulting uncertainty has depressed global stock markets, especially since April 2 (“Liberation Day”) (Fig. 1). No one can be certain whether Trump is using higher tariffs mostly as a negotiating tool to bring tariff and nontariff trade barriers down. Stock prices soared on April 9 after Trump postponed his reciprocal tariffs for 90 days on all countries except China (which is facing a 145% tariff).

The US is currently negotiating tariff agreements with 15 major economies; among them are Japan, the European Union, South Korea, and India. Additionally, 75 countries have reached out to the US expressing interest in trade negotiations. It is conceivable that Trump will announce trade deals by the July 1 deadline set by the 90-day pause, just a few days before US Independence Day. They are more likely to be in the form of letters of understandings or intentions rather than specific treaties, which would take much longer to negotiate. That should be good enough for Trump to declare victory. Or else, he might extend the pause for another 90 days. Anything is possible in the art of making deals.

Meanwhile, here is where things stand on the tariff front:

(1) Steel. A 25% tariff applies to all steel imports from all countries, with no exemptions or exclusions. This was reinstated and expanded to cover derivative products like nuts, bolts, and other downstream steel items.

(2) Aluminum. A 25% tariff is imposed on all aluminum imports globally, also without exemptions, covering derivative products such as automotive components and metal furniture.

(3) Automobiles & auto parts. A 25% tariff is in place on all imported cars, trucks, and certain auto parts from all countries, effective since April 3, 2025. Goods from Canada and Mexico that are compliant with Trump 1.0’s 2020 US–Mexico–Canada Agreement (USMCA) are exempt, but non-compliant goods from these countries face the tariff.

On April 14, Trump suggested that he might temporarily exempt the auto industry from tariffs that he previously had imposed, to give carmakers time to adjust their supply chains. The idea of a pause seems to stem from Trump’s comments about being “flexible” and not wanting to “hurt anybody,” but it’s unclear if this is just rhetoric or a signal of policy shift. Trump said car companies “need a little bit of time because they’re going to make ’em here.”

(4) Non-USMCA goods from Canada & Mexico. A 25% tariff applies to approximately 60% of Canadian goods and 50% of Mexican goods that do not comply with the USMCA trade agreement. This includes a wide range of products not specifically detailed but excludes energy from Canada (which faces a 10% tariff).

(5) Other commodities. Tariffs on copper, lumber, pharmaceuticals, and semiconductors have been proposed or are under investigation; but as of now, no 25% tariff has been confirmed for these. The 25% tariff on selected commodities and products deemed as vital to national security appears to be permanent and non-negotiable.

The tech sector was thrown for a loop late on Friday, April 11, when Customs and Border Protection stated that about 20 products—including smartphones, computers, routers, and semiconductor chips—are exempt from the reciprocal tariffs. But two days later, Commerce Secretary Howard Lutnick clarified that the exemptions are temporary and hinted that forthcoming tariffs on semiconductors will apply to other electronics too.

(6) Nvidia. On April 16, the Commerce Department confirmed that it introduced new export licensing requirements for AI chipmaker Nvidia, which is expected to take a $5.5 billion hit as a result. Also impacted is rival chipmaker Advanced Micro Devices.

(7) Baseline tariff. As of April 19, 2025, a 10% baseline tariff is in effect on all imported goods entering the United States from countries that maintain normal trade relations, except for goods specifically exempted or subject to higher tariffs (like the 25% tariffs on steel, aluminum, autos, and non-USMCA goods from Canada and Mexico).

(8) Port docking fee. On April 17, 2025, CNBC reported that the Trump administration announced fees on Chinese ships docking at US ports. Later that same day, Reuters reported that the United States eased port fees on China-built ships after industry backlash.

On Edge II: Trump Vs Powell. President Trump has been frustrated by Fed Chair Jerome Powell since Trump’s first term in the White House. Trump nominated Powell to serve as Fed chair in 2017, replacing Janet Yellen. However, he soon soured on his pick, repeatedly attacking Powell on Twitter for raising interest rates too quickly.

In 2018, Trump was so frustrated with Powell that he asked Commerce Secretary Wilbur Ross to tell Powell “that I will repudiate his nomination, even though it has already been confirmed.” Ross claimed that after some pushback, he eventually did call Powell with the message. Powell shortly after did reverse his policy stance, but ostensibly in response to a weakening economy rather than political pressure. Trump went so far as to consider firing Powell in late 2018, an unprecedented move that could have risked roiling financial markets and compromising the Fed’s independence.

Trump’s Twitter tirades against Powell continued throughout 2018 and 2019, accusing the Fed chair of raising interest rates too fast and not doing enough to “juice the economy” to accommodate Trump’s trade war with China. However, Trump’s tone softened when the Fed did eventually ease monetary policy. Trump even expressed satisfaction with Powell’s performance in mid-2020.

Here we go again. Consider the following chronology of events in the relations between Trump and Powell this year:

(1) February 5, 2025. During an interview with Fox Business, Treasury Secretary Scott Bessent claimed that he and President Donald Trump were focused on the 10-year Treasury yield. He stated, “He and I are focused on the 10-year Treasury,” emphasizing that the administration’s priority was to lower these yields rather than pressuring the Fed to cut short-term interest rates.

(2) April 4, 2025. In a speech two days after Liberation Day, Powell warned that as a result of Trump’s tariffs, inflation is likely to be more troublesome: “While uncertainty remains elevated, it is now becoming clear that the tariff increases will be significantly larger than expected. The same is likely to be true of the economic effects, which will include higher inflation and slower growth. The size and duration of these effects remain uncertain. While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent. Avoiding that outcome would depend on keeping longer-term inflation expectations well anchored, on the size of the effects, and on how long it takes for them to pass through fully to prices. Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.”

(3) April 15, 2025. Trump posted on Truth Social, criticizing Powell and urging the Fed to cut interest rates, stating, “The ECB [European Central Bank] is expected to cut interest rates for the 7th time, and yet, ‘Too Late’ Jerome Powell of the Fed, who is always TOO LATE AND WRONG, yesterday issued a report which was another, and typical, complete ‘mess’!”

(4) April 16, 2025. The next day, in a speech at the Economic Club of Chicago, Powell reiterated, “Tariffs are highly likely to generate at least a temporary rise in inflation. The inflationary effects could also be more persistent. Avoiding that outcome will depend on the size of the effects, on how long it takes for them to pass through fully to prices, and, ultimately, on keeping longer-term inflation expectations well anchored. … We may find ourselves in the challenging scenario in which our dual-mandate goals are in tension. If that were to occur, we would consider how far the economy is from each goal, and the potentially different time horizons over which those respective gaps would be anticipated to close.”

(5) April 17, 2025. The next day, Trump responded to Powell’s speech. He intensified his attacks, explicitly calling for the Fed to cut interest rates and again demanding Powell’s termination, saying, “Powell’s termination cannot come fast enough” and claiming that Powell was “always too late and wrong” on rate policy. He argued that lower rates were needed because “oil prices are down, groceries (even eggs!) are down, and the USA is getting RICH ON TARIFFS.”

(6) April 18, 2025. On Friday, Trump criticized Powell again, stating that the Fed chair should lower interest rates. During a question-and-answer session with reporters, Trump said, “If we had a Fed chairman that understood what he was doing, interest rates would be coming down too,” and added, “He should bring them down.”

Trump would like Powell to resign before his term expires on May 2026. Powell won’t resign, and Trump doesn’t have the legal authority to fire him. Besides, there are 18 other participants on the FOMC with 11 other voting members on the committee who might dissent from any move to lower interest rates pushed by the next Fed chair Trump appoints after Powell’s term expires in May 2026.

In his April 16 speech, Powell concluded, “As that great Chicagoan Ferris Bueller once noted, ‘Life moves pretty fast.’”
 
On Edge III: US Economy. The US and global economies are also on edge over Trump’s reciprocal tariffs, which were announced on April 2 and postponed for 90 days on April 9. So Liberation Day II is now scheduled for July 1 and might or might not happen. The latest US economic “hard” data show that the economy remains resilient. The “soft” data are mostly in recession territory already. Our subjective probability of a recession remains at 45%, but we are on edge about it. Consider the following:

(1) Recession & inflation consensuses. On Friday, April 18, Polymarket.com showed that the risk of a recession in 2025 was 56% (Fig. 2).

The latest quarterly survey of economists by The Wall Street Journal was conducted from April 4 through April 8. The economists raised the consensus odds of a recession to 45% over the next 12 months, up from 22% in January. On average, they are expecting real GDP growth to be only 0.8% this year on a Q4/Q4 basis. That’s down from 2.5% last year (Fig. 3).

The survey shows that economists are also expecting inflation to increase, with the core PCED climbing throughout the year to 3.6% y/y in December 2025, up from the 2.8% projected back in February. They see it moderating to 2.6% next year. For now, both our outlook for real GDP growth and inflation are close to the survey’s consensus, though we are more upbeat on growth (Fig. 4 and Fig. 5).

(2) Consumers. We’ve often observed that when Americans are happy, they go shopping, and when they are depressed, they shop even more unless they lose their jobs. American consumers are extremely depressed currently; yet they continue to shop briskly, as the labor market remains remarkably strong. During the first half of April, the Consumer Sentiment Index fell to 50.8, exceeding previous cyclical lows during 1980, 1990, 2008, and 2022 (Fig. 6)!

Most economists attributed the strong 1.4% m/m increase in retail sales during March to buying in advance of tariff-related increases. That could be quickly followed by a sharp retrenchment once consumer prices jump because of Trump’s tariffs.

We attribute some of the strength in March retail sales to a rebound from tougher-than-usual winter weather during January and February. Our view is supported by the record output of utilities during January and February that was following by a big drop in March (Fig. 7). The categories of retail sales that rebounded the most during March do support our thesis (Fig. 8).

The Redbook retail sales index rose 6.6% y/y through the April 11 week (Fig. 9). That strength probably does reflect some buying in advance of higher prices. But it also confirms the resilience of the labor market, as evidenced by the very low readings in initial unemployment claims so far this year (Fig. 10).

(3) Business activity. Industrial production fell 0.3% m/m during March; manufacturing and mining outputs rose 0.3% and 0.6% m/m. Utilities fell 5.8% y/y, as temperatures were warmer than typical for the month.

The average of the April regional business surveys conducted by the Federal Reserve Banks of New York and Philadelphia dropped sharply, suggesting that the national M-PMI fell further below 50.0 in April (Fig. 11). The prices-paid and prices-received in both regional business surveys remain elevated (Fig. 12). Together, the two surveys suggest a stagflationary outlook in coming months, resulting from Trump’s tariffs.
 
On Edge IV: Earnings & Valuation. Industry analysts are also on edge. They’ve gotten the tariffs-may-cause-recession memo and are scrambling to lower their 2025 and 2026 estimates for S&P 500 companies’ aggregate earnings per share (Fig. 13). They’ve lowered their 2025 consensus estimate to $266.02, down from $273.79 at the start of the year. Their current 2026 estimate of $304.11 is down from $309.97 at the start of this year. As a result, S&P 500 forward earnings peaked at a record high of $279.13 during the April 3 week and fell to $277.74 during the April 17 week.  (“Forward” earnings is the time-weighted average of the analysts’ consensus estimates for the current and coming years.)

We are still targeting EPS of $260 and $300 this year and next year. But we expect to be on the edge of lowering those numbers unless Trump’s Tariff Turmoil subsides significantly by July 1.

Not everyone is on edge. The one exception is the exceptional Warren Buffett, who has been a net seller of equities for the past nine quarters, resulting in Berkshire Hathaway's ending 2024 with a record $334 billion in cash and equivalents. Buffett stayed true to his favorite valuation metric, i.e., the so-called “Buffett Ratio,” which is the total market value of US corporate equities divided by nominal GDP (Fig. 14). It is a quarterly series. The comparable weekly series is the price-to-sales ratio of the S&P 500, which soared from 2.0 at the start of the latest bull market to 3.0 when the S&P 500 peaked on February 19. It is back down to 2.6, which is still a high valuation reading, especially if a recession becomes more likely.
 
On Edge V: China. The Chinese government is also on edge. It is trying to provide more domestic economic stimulus to offset the depressing impact of Trump’s trade war. So far, the Chinese government’s 10-year bond yield has dropped back down to recent record lows following a very brief rebound (Fig. 15). We agree with the Chinese bond market’s assessment that the government’s stimulus measures won’t offset the deflationary effects of a trade war with the US combined with the ongoing weakness in China’s property market.
 
On Edge VI: Europe. Europeans are on edge, too. The immediate impact of Trump’s trade war has been to weaken the dollar, mostly because of a flight to the euro (Fig. 16). A strong euro is bad news for the sales and earnings of European companies. A strong euro will put downward pressure on Eurozone inflation, but it will also raise the risk of deflation as China’s manufacturers dump more of their excess capacity in Europe now that the US market is effectively closed to them.

Movie. “The White Lotus,” Season 3 (-) has a 90% rating on Rotten Tomatoes, which describes it as “a sharp social satire following the exploits of various guests and employees of the fictional White Lotus resort chain, whose stay becomes affected by their various dysfunctions.” This latest season of HBO’s hit series is set in Thailand, which is very beautiful. However, the season is overrated; it’s pretentious and purports to uncover important philosophical insights from the whacky behavior of a bunch of whacky characters. It’s actually a bit of a bore. (See our movie reviews archive.)

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Tracking Consumers & Nvidia’s Investing

April 17 (Thursday)

Consumer Discretionary I: Bracing for Recession? March retail sales data and better-than-expected earnings news from some of the nation’s largest banks painted a much rosier picture of the consumer than the ytd performance of S&P 500 Consumer Discretionary stocks does.

Granted, retail sales data and big banks’ Q1 earnings both reflect the economy before the shock and awe of President Trump’s Liberation Day on April 2. Stocks, meanwhile, are forward-looking predictors of the future, sometimes accurate, sometimes not. Nonetheless, the S&P 500 Consumer Discretionary stock price index is painting a gloomy picture, having fallen 17.8% ytd through Tuesday’s close, far behind the S&P 500’s ytd performance, down 8.2% (Fig. 1). Admittedly, Tesla’s shares, down 37.1% ytd, and Amazon’s shares, down 18.1% ytd, have weighed heavily on the Consumer Discretionary index. Excluding the two giants’ shares, the Consumer Discretionary stock price index would be only 5.5% lower ytd.

Here’s the performance derby for many S&P 500 Consumer Discretionary industries ytd through Tuesday’s close: Automotive Retail (12.8%), Restaurants (-0.7), Home Improvement Retail (-9.4), Homebuilding (-13.5), Retail Composite (-13.5), Hotels, Resorts & Cruise Lines (-14.2), Casinos & Gaming (-25.6), and Automobile Manufacturing (-35.0) (Fig. 2, Fig. 3, and Fig. 4).

Let's take a quick look at consumer discretionary indicators from the past and the present as we attempt to divine the future:

(1) Consumers buy anticipating inflation. US retail sales jumped 1.4% m/m in March, beating expectations for a 1.2% increase (Fig. 5). Much of that spending was on cars, as consumers may have been proactively buying if they anticipated price increases in the wake of Trump’s tariffs. But even excluding car sales, retail spending rose 0.5% m/m.

With the weather warming up in many parts of the country last month, consumers were out there spending in all kinds of stores, including those selling building and garden supplies (up 3.3% m/m), sporting goods, hobby, musical instruments, and books (2.4), electronics & appliances (0.8), health and personal care items (0.7), and general merchandise (0.6). Restaurants and bars benefitted from more spending (1.8) too, so not all of the increased spending can be explained by front-running tariff impacts.

(2) Bank earnings looked good. Earnings from Bank of America and Citigroup were better than expected, and their shares rallied last week on the news. B of A reported Q1 earnings per share of $0.90, up sharply from $0.76 last year and well above the $0.82 analysts expected.

“We note that some retailers may say that their sales are slower and others are picking up, and it really reflects the change in consumer spending behavior. But in the aggregate, the consumer keeps pushing money into the economy,” said CEO Brian Moynihan on the bank’s earnings conference call.

While the bank painted a picture of a healthy consumer, it did seem to be positioning for slightly tougher times ahead. Bank of America’s consumer banking unit’s revenue rose 3.2% y/y in Q1, but net income declined 4.7% to $2.3 billion. The bottom line was dented by an increase in the provision for credit losses of $142 million, or 12.3% y/y, to $1.3 billion.

Moynihan also noted that the bank’s consumer loan portfolio, at $468 billion, is $200 billion smaller than it was back in Q4-2009, with home equity loans down by more than $125 billion and unsecured credit card loans down by more than $60 billion over the 15-year period. “This reflects a concentrated effort by us to focus on our relationship loans rather than loans as a product and deepen those relationships with the highest quality prime credit customers,” he explained.

(3) Warning signs out of Vegas? One of the ultimate consumer discretionary purchases is visiting Las Vegas. Many Americans in recent years wouldn’t think twice about jetting to the home city of Frank Sinatra to see a concert, go to friends’ bachelor and bachelorette parties, gamble, or attend business conferences.

They seem to now. The number of passengers arriving at and departing from Las Vegas fell in February by 7.5% y/y, according to a March 27 press release from the Harry Reid International Airport. Visitors flying in and out on domestic airlines in February fell three times as much as those who flew in and out on international airlines, declining by 7.7% versus 2.6%. Vegas hosted the Super Bowl in 2024, so traffic would understandably be down in February 2025, when the big game was played in New Orleans. We’ll be watching to see if March traffic rebounds, but Canadians reportedly have pulled back on their visits to Sin City, according to an April 13 KTNV article.
 
Consumer Discretionary II: Retailers Sink Shipping. Retailers who raced to import goods before the Trump tariffs went into effect appear to be hitting the brakes. Yes, the President has paused most reciprocal tariffs for 90 days, but the baseline tariff increase of 10% remains in place, as do the reciprocal tariffs on China that can amount to 125% or more.

The pre-tariff-importing spike lifted nominal imports of merchandise to $3.9 trillion in February, a whopping 22.1% above last February’s level (Fig. 6). But now it appears from anecdotal evidence, confirmed by shipping data, that the pendulum has swung the other way: Shipments are sinking on everything from toys to time pieces. Daily bookings to ship containers from China to the US have tumbled 25% y/y, according to an April 9 FreightWaves article citing SONAR’s Container Atlas data. Globally bookings have fallen 13% y/y.

The impact is also apparent in pricing. The Drewry World Composite index, which tracks spot shipping rates worldwide for 40-foot containers, did inch up 3% from the week of April 3 to the week of April 10, but it was way lower than usual: It fell 19% y/y, the shipping consultant reported. The y/y declines are sharpest on the routes from Rotterdam to Shanghai (-38%), Shanghai to Los Angeles (-23%), and Shanghai to Rotterdam (-22%). Shipping prices could continue to fall as retailers work down their newly beefed up inventories.

Here’s a sampling of anecdotes circulating in the press about items that will remain warehoused abroad for the time being instead of heading out on the open seas:

(1) Tariffs hit shoes. US textile buyers have halted their orders from Bangladesh. An exporter of footwear and leather products said that “an order of bags, belts and wallets worth $300,000 was halted on April 6 by one of his buyers,” an April 15 article in the South China Morning Post (SCMP) reported.

(2) Tariffs hit toys. Five Below suspended cargo shipments from China, according to a letter that A.P. Moller-Maersk A/S sent on behalf of the retailer to suppliers. Five Below sells toys, clothes, and household goods. “No containers are to be delivered to the yard starting April 10, with those that have been loaded to be unpacked and returned to the carrier,” according to the letter cited in the SCMP article.

Basic Fun!—the maker of Care Bears, Tonka Trucks, and the like—has paused shipments of Chinese-made products, an April 10 article in People reported. Eighty percent of US toys are made in China, and the 125% tariff on them will make for a much more expensive holiday season. The owner of the Christmas Loft in New Hampshire said the retailer will absorb some of the tariff cost, but expects they’ll raise prices by at least 50%.

(3) Tariffs hit cars. Shipments of Jaguars, Land Rovers, and Range Rovers have come to a halt, as they’re made in the UK and subject to a 10% tariff, an April 7 New York Post article reported. Swiss makers of luxury watches—think Rolex, Breitling, and Piguet—are also halting their US shipments.

These pauses may be temporary as importers devise strategies for dealing with tariffs, while hoping that President Trump walks them back. But if the shipping strike continues, parents may have to get creative filling stockings this holiday season.
 
Disruptive Technologies: Nvidia Broadening Beyond Chips. Nvidia got bad news this week from the US government: The chip manufacturer will need a license to export its AI H20chips to China and five other nations for the indefinite future. Nvidia announced on Tuesday night that the restrictions will result in the company taking a charge of up to $5.5 billion, and its shares fell 6.9% on the news. The H20 was designed to comply with US export regulations that previously banned the company’s H100/A100 chips.

Fortunately, Nvidia has been laying the groundwork to move beyond chip manufacturing. Through many acquisitions, Nvidia has bulked up its software and hardware offerings. “We acquire and invest in businesses that offer products, services and technologies that we believe will help expand or enhance our strategic objectives,” the company states in its annual report.

We first wrote about the company’s acquisitive nature in the May 2, 2024 Morning Briefing. Let’s take a look at what the company has been up to more recently:

(1) Expanding into servers. Nvidia’s most recent acquisition reportedly occurred earlier this month for Lepton AI, which rents servers powered by Nvidia’s AI chips from cloud service providers and then leases them out to smaller clients. Lepton, which was founded just two years ago, was reportedly valued at several hundred million dollars. Lepton’s founder Yangqing Jia, who was also Alibaba’s former VP of AI and Data Analytics, will join Nvidia. The deal seemingly would put Nvidia in competition with cloud providers like Amazon, Google, and Microsoft.

Famed short-seller James Chanos is skeptical of the deal. On X he wrote, “[T]rying to buyout your resellers is usually a huge red flag. It’s often a way to bury inventory costs and/or avoid receivables provisioning.”

(2) All about AI. Nvidia also recently purchased Gretel, which generates synthetic AI training data. Founded in 2019, its price tag was said to be in the nine figures. “The startup fine-tunes models, adds proprietary tech on top, and then packages these models together to sell them,” reported a March 19 TechCrunch article. AI companies have needed to use synthetic data to train their models because they’ve already consumed the real-world data available for training.

Late last year, Nvidia acquired another AI focused company, OctoAI, for $250 million. Spun out of the University of Washington in 2019, the company specializes in developing generative AI tools. One offering makes it easier for developers who aren’t AI experts to work with large language models. Their technology works with chips from AMD, Intel, and Nvidia, making it a versatile solution. The acquisition “allows Nvidia to expand its reach beyond its own GPU ecosystem and capture a larger share of the enterprise AI market,” concluded a September 30 Forbes article.

(3) Venture investing too. Nvidia has also been an active venture investor, following in the footsteps of many large tech companies. The chip company invested in 49 funding rounds for AI companies last year, up from 34 in 2023, a March 16 TechCrunch article reported. This is in addition to the 24 deals Nvidia’s venture capital arm, NVentures, invested in last year.

Most recently, the company was part of a group that invested in Safe Superintelligence, an AI startup that’s captured a ton of attention, as it was co-founded by former OpenAI chief scientist Ilya Sutskever. The Nvidia investment was part of the startup’s latest funding round, which raised $2 billion and valued the company at $32 billion. SSI also received an investment from Google and chose to “primarily” use Google’s TPU chip and servers instead of Nvidia’s GPUs, an April 15 article in The Channel Co. reported.

Nvidia has also invested $100 million in OpenAI and undisclosed amounts in xAI, Cohere, Mistral AI, Perplexity, Scale AI (a data-labeling service), Crusoe (a data center company), Figure AI (a robotics company), Lambda (an AI cloud provider), and many others. Nvidia was an investor in CoreWeave and bought additional shares at its IPO price of $40 when it went public last month. The AI data center company’s share price hasn’t changed much since the offering despite the stock market’s volatility.

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On Trade & Earnings

April 16 (Wednesday)

Global Trade I: US–China Trade War, Who Has the Leverage? There’s considerable debate over whether the US or China will be able to dictate the direction of their trade war. Any definitive victory by either might be a pyrrhic one, as the complete economic decoupling of the world’s two largest economies could very well plunge the global economy into a deep recession. China has a decent hand: It is a major exporter of rare earth minerals used in high-tech production, and it controls a significant chunk of the supply chain related to US consumer and producer goods such as smartphones, solar panels, textiles, batteries, industrial machinery, etc. But the US may have the better hand: China doesn’t have the consumer base to absorb all that production and also is extremely overleveraged after financing overcapacity building and poorly planned projects (the ailments of a centrally planned economy). Ultimately, the US consumer is the endpoint for much of Chinese production. While national security is indeed an impetus for immediate change, America’s “consumer of first and last resort” posture is why President Donald Trump believes that the US will not only benefit but win the ensuing trade war with China. The balance of trade, or how much China and the US import/export from each other, suggests that a trade war might not be too painful. The balance of payments, or the total trade surplus/deficit of each country, shows a much stronger relationship between China and the US. (1) Decoupling began years ago. US merchandise imports from China (plus Hong Kong) peaked at $567.8 billion over the 12 months ended September 2022 and since has fallen to $452.5 billion (Fig. 1). Exports to China has slightly declined from a record high of $184.0 billion in April 2023; that puts the trade deficit with China at $285 billion, around the lowest in a decade. America’s trading relationship with China has waned even as the overall US trade deficit has ballooned to an annual rate of $1.32 trillion and China’s overall annual trade surplus has surged to $1.08 trillion (Fig. 2 and Fig. 3). The US trades more with the European Union ($976 billion in 2024), Canada ($762 billion), and Mexico ($840 billion) than with China ($582 billion). ASEAN, a bloc of ten Southeast Asian countries, accounts for another $477 billion of trade with the US. However, that stat may be obscuring actual trade between China and the US. (2) Perhaps the tight relationship was just rewired. After Trump 1.0 and then the Biden administration ratcheted up tariffs and other barriers on China, it rerouted its US-bound trade through neighboring countries with better US relations. America’s deficit with Vietnam, for instance, has grown from $56 billion in 2019 to $123 billion in 2024. (3) Balance of payments. Bilateral trade deficits likewise don’t tell the full story. For instance, China has increasingly sold goods to the EU, which has a trade deficit with China; the EU then sells to the US with which it has a trade surplus. EU exports to China have grown from only €203 billion in 2019 to €213 billion in 2023. Meanwhile, EU imports from China have increased from €385 billion to €518 billion (and reached as high as €626 billion in 2021). Moreover, the EU’s surplus with the US has grown from €125 billion to €193 billion from 2019-23. Globally, trade balances out. But ultimately, China still relies on US demand. This illustrates why China makes for a bad trading partner, which is why other countries are increasingly wary of relying on trade with China. China increasingly floods international markets with cheap goods but cannot afford to purchase foreign goods. It’s not a free trading system that relies on comparative advantage. That’s the overarching issue that Trump 2.0 is looking to solve. Hopefully, the administration’s methods are not all madness, and “Smoot-Hawley 2.0” does not drag us all into a depression.   Global Trade II: Dusty Trade Report Thrust in the Spotlight. Washington’s trade warriors have found new inspiration in a 40-year-old annual publication. The National Trade Estimate Report on Foreign Trade Barriers (a.k.a. “the NTE”) is normally read by just policy wonks and trade lawyers. But it was showcased on President Trump’s “Liberation Day” (April 2) as a blueprint for reversing America’s trade deficits and reclaiming US “technological, economic, and military edge.” The administration views trade deficits as indicators of national vulnerability. The 2025 Trade Policy Agenda, released alongside the NTE, directs the US Trade Representative (USTR) to identify—and eliminate—foreign trade barriers that undermine the revenue potential of American exports and empower economic rivals. The administration views such trade barriers as unfair and as threats to US industrial strength and strategic independence. At nearly 400 pages, the NTE is a compendium of protectionist practices around the world. It categorizes barriers to US exports across 14 industry areas—from agriculture and energy to digital services and financial regulation—and 60 key trading partners. While it contains grievances both familiar and obscure, it’s clear which offending nation is most directly in the crosshairs: China. Below, we summarize the USTR’s trade concerns with China, the EU, and Canada—though we could go on and on, as the NTE indicts plenty of other nations too. Just perusing the report drives home the point that US trade is up against multitudinous barriers, tariff and non-tariff alike. Here are some highlights: (1) China strategically competes in industrial overdrive. The NTE’s section on China is the report’s most pointed and expansive, describing at length “state-directed distortions” from massive subsidies to sweeping digital controls. The focal point is Made in China 2025, Beijing’s ten-year blueprint to dominate strategic sectors like semiconductors, electric vehicles (EVs), and biotech. This policy plan increases China’s support to favored industries to over $500 billion. Such scale, according to the USTR, skews global markets and sidelines foreign competition. The Phase One trade deal, signed in 2020, was supposed to curb forced technology transfers and intellectual property theft. Yet five years on, many of the core grievances addressed by the deal remain. US companies still report pressure to localize data, still must hand over proprietary technology to the Chinese, and still have to partner with state-linked firms to gain market access. Value-added taxes on US agricultural products create what the report calls “uncertainty and distortion.” Meanwhile, selective enforcement of sanitary rules and shifting domestic standards act as regulatory minefields for American exporters. Chinese regulators also maintain informal bans, burdensome licensing regimes, and restrictive capital thresholds that block US banks and service providers from scaling operations. China’s 2024 data laws tightened government control over information flows, sparking fresh concerns about surveillance and the ability of foreign firms to compete fairly. Finally, the issue of overcapacity looms large. China continues to flood global markets with subsidized steel, aluminum, solar panels, and—more recently—EVs and lithium-ion batteries. The result is persistent price depression and what the USTR calls “non-market excess capacity” that injures US industries and fragments global supply chains. (2) European Union regulates for a competitive edge. Even among allies, frictions persist. The EU’s average tariff on agricultural goods was 10.8% in 2023—modest by historical standards but still a sticking point. Passenger vehicles face a 10% duty; trucks, a steeper 22%. But the EU’s trade barriers aren’t all tariffs. Many “technical barriers to trade” that the NTE cites stem from the EU’s regulatory processes. US officials argue that Brussels often adopts rules without sufficient transparency or foreign stakeholder input, locking in standards that implicitly favor European producers. A prime example: The EU insists on recognizing standards only from a select group of standards-setting bodies, none US-based. This de facto exclusion limits American firms’ ability to certify products for European markets. Sustainability requirements under the European Green Deal are also under scrutiny. The USTR contends that these rules inappropriately reclassify food safety standards to achieve environmental goals, effectively creating green barriers to trade. Meanwhile, the regulatory perimeter continues to expand into digital territory. The Digital Services Act, Digital Markets Act, and the EU’s nascent Artificial Intelligence Act have introduced new layers of compliance for US tech giants. While billed as consumer protections, the rules disproportionately impact non-EU firms, argues Washington—raising questions about competitive neutrality in the digital single market. (3) Canada is a friendly fortress. The US–Canada trading relationship is one of the world’s most integrated, but that hasn’t dulled the edges of economic friction. The NTE highlights several “non-market” barriers in the Canadian system, particularly in agriculture and energy. Take dairy: US exporters hoping to break through Canada’s tariff-rate quotas face border taxes of 245% on cheese and nearly 300% on butter. The country’s dairy and poultry supply management systems are structurally designed to cap imports and inflate domestic prices. Bulk imports of fresh produce are also constrained, unless importers clear regulatory hurdles proving domestic supply shortfalls. Liquor sales are dominated by provincial monopolies—more roadblocks for US producers. Then there’s energy. US power producers face an uneven playing field, they argue, as Canadian operators prioritize domestic electricity sources even when American alternatives are price competitive. And in agriculture inputs, the Seeds Act effectively bars unregistered US seed varieties from entering the market unless approved by and registered with Canada’s Food Inspection Agency. That registration process is both lengthy and restrictive. Strategy: Forward Earnings Peaking? Each week, we track consensus earnings expectations for the S&P 500 LargeCap, S&P 400 MidCap, and S&P 600 SmallCap indexes. During the week ended April 11, forward earnings fell simultaneously for all three indexes, toppling off record highs for LargeCap and MidCap. That’s not normal: Typically, analysts stick with their estimates during a quarter’s first weeks, awaiting guidance from the companies they follow. So we think the April 4 week may have marked the three indexes’ forward earnings peak. Let's take a look at what’s been happening: (1) The forward earnings bull market has been a narrow one. Through its peak a week earlier on April 4, LargeCap’s forward earnings had soared 23.6%, to a record high, from its low 54 weeks prior (during the week of February 1, 2023) (Fig. 4). MidCap’s rose to a record high too the April 4 week, but to just 9.2% above its 55-week low (March 10, 2023 week). SmallCap’s forward earnings likewise rose but considerably less so, up just 1.3% from its 72-week low (March 17, 2023 week). While LargeCap’s forward earnings have hit new record highs steadily since September 2023, MidCap’s didn’t do so until mid-March. That was the first time they reached a record high since June 2022. SmallCap’s earnings recovery never got off the ground; its forward earnings is languishing 12.5% below its last record high, in June 2022.   (2) Pre-tariff results may matter more than usual. In normal times, investors don’t focus on past results as much as future expectations. But Q1-2025 may be an exception, as its “tariff-free” results will serve as a baseline from which to gauge how much a company’s profitability is impacted by tariffs in subsequent quarters. However, tariff anticipation generates impacts too, for some industries more than others. The S&P 500 Financials sector isn’t directly impacted by tariffs, but banks eyeing emerging credit quality trends are firing warning shots about future earnings. JPMorgan pivoted during Q1 by increasing its reserves for future losses. That raises the possibility of more cockroaches in the Financials’ sector. (3) Future quarterly forecasts have been falling earlier than usual. Although the Q1 earnings reporting season is still less than 10% complete, some analysts are not waiting to hear the results before cutting estimates for future quarters. They’re not likely to get much guidance anyway in these uncertain times. As a result, the S&P 500’s Q2-2025 revenues forecast has dropped 0.2% since the March 31 week (Fig. 5). Among the 11 S&P 500 sectors, Utilities leads with its Q2 revenues forecast rising 0.7%, slightly ahead of Materials’ 0.5% gain. Among the six decliners, Energy’s Q2 revenue forecast has dropped 0.7%, followed by 0.5% declines for Industrials and Consumer Discretionary. Analysts took a bigger hatchet to Q2 earnings forecasts. Since the March 31 week, the aggregate earnings estimate for the S&P 500 companies has fallen 1.0%, steeper than the 0.2% revenues decline (Fig. 6). Only two sectors’ Q2 earnings estimates rose: Materials and Utilities, by 1.1% and 0.3%, while forecasts were shaved the most for Energy (-3.3%) and Industrials (-2.4). (4) Quarterly growth and profit margin forecasts are falling now too. Analysts now expect revenues growth of 4.1% y/y for the S&P 500 in Q2, flat with the current Q1 estimate (Fig. 7). That compares with 4.7% at the year’s start. For the back half of 2025, analysts think revenues growth will accelerate to 4.8% in Q3 and 5.6% in Q4—but both forecasts have tumbled about 1 ppt since the year began. On a proforma same-company basis, analysts think S&P 500 earnings will now rise 9.2% y/y in Q2, down from around 12% at the year’s start and above Q1’s current forecast of 8.0%, which we think will be 11% by the end of the earnings reporting season (Fig. 8). After dipping into single-digit y/y earnings growth in Q2, analysts expect a return to double-digit growth in Q3 (11.5%) and Q4 (10.0%). As earnings fall faster than revenues, the implied profit margin falls. Analysts currently expect the S&P 500’s profit margin to rise to 13.3% in Q2, down from the 13.7% forecasted when the year began and above the current Q1 forecast of 12.8% (Fig. 9). We think Q1’s margin will be 13.3% by the end of the reporting season and that Q2’s forecast will fall below Q1’s.

 

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More On Inflation & Bonds

April 15 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Inflation: Consensus Too Worried? Tariffs are an odd tax. While most taxes tend to weigh on economic growth, tariffs are stagflationary in that they both weigh on growth and raise prices. Like most economists, we raised our inflation targets for the year after Liberation Day, April 2. We are now targeting 3.0%-4.0% core PCE inflation this year and 2.0%-3.0% over each of the next two years (Fig. 1). Over the near term, we expect consumer goods inflation to rise as tariff costs are passed on to consumers.

A large source of headline-rate disinflation over the past two years has been deflating goods prices, mostly due to China’s overcapacity and export boom combined with sagging demand for goods after the pandemic buying binge. Over the medium term, Trump’s Nitro Tariffs (TNT) might not upset these patterns. In other words, goods prices might continue to deflate.

We've started to think about what could happen from a contrarian perspective. There seems to be absolute certainty that inflation will be a major issue as the result of TNT. Is a contrarian call that inflation remains relatively subdued (with the PCED not straying too far north of 3.0% y/y) for the remainder of the year warranted? We're not ready to make that call, but let's discuss the case for such a sanguine inflation outlook:

Here are a few suppressants that could keep inflation contained:

(1) US consumer demand. The early innings of a recovery in goods demand will likely have a blowoff top in March or April reflecting consumers’ front-running tariffs and businesses offloading inventory (Fig. 2). Meanwhile, our friends the Baby Boomers have been spendthrift for several years on the back of strong wealth effects. They now account for $82.5 trillion of the $160.4 trillion in total household wealth (Fig. 3). The current correction in stock prices and daily market volatility are likely to sideline some of the spending of retired Boomers with invested nest eggs. As for consumers still working, roughly half of consumer spending comes from high earners (households in the top 10% of income tranches), who also own a lot of stocks. Indeed, households (which include nonprofit organizations) have a record 43.5% of their financial assets tied up in the stock market (Fig. 4).

Big-ticket trips are likely one of the first discretionary spending items households will cut. Spending on airlines and hotels reached a record high $368.2 billion (saar) in February (Fig. 5). That may have been the peak. Meanwhile, CPI airline fares fell 5.3% m/m in March (Fig. 6). Perhaps the demand is already dropping off.

(2) China supply. China’s trade surplus has grown to more than $1 trillion as it has attempted to export its way out of a property bubble bust, bad debts in local governments, and weak consumer demand (Fig. 7). That’s put downward pressure on US import prices for the past few years. It likely will continue to notwithstanding the 145% tariff on Chinese imports.

Firstly, a number of products will not be subject to the 145% tariff on China. Secondly, China no doubt will continue to circumvent US tariff barriers by routing US-bound goods through trading partner nations. Indeed, there’s strong incentive to do so: If anything, China needs to export even more goods than it currently does to avoid an economic slowdown.

For some imported products, there are no alternatives for US consumers, and at least a 10% tariff will need to be paid (depending on the product and country of origin). But for other imported goods, US consumers may find substitutes in domestically produced products or imports from countries with which the US has negotiated deals. Domestic products may also become more expensive due to higher input costs like American labor, but real wage gains for consumers in goods-producing sectors could theoretically help offset the higher prices.

(3) Tax or price hike? There will likely be conflicting signals as to whether tariffs create more pain by weighing on economic growth or raising prices. In our view, the bigger risk is to growth. The volatility of TNT has cast so much uncertainty over both businesses and consumers that spending, hiring, and investment are likely to sharply slow over the next few months. That’s before accounting for the negative growth effects of lower stock prices, real incomes/consumption falling due to higher cost of essentials and labor, and any export losses due to retaliation by other countries.

Bond Market I: Parsing the Moves. Despite the runup in yields, bonds appear not to be trading on inflation fears. Long-term inflation measures—including the difference between 10-year nominal and TIPS yields as well as swaps for the period five to ten years in the future—have sunk toward levels consistent with the Fed’s 2.0% inflation target (Fig. 8)!

To see the degree of inflation shock that consumer surveys suggest Americans are worried about, an oil price shock would likely be necessary. But a barrel of crude is getting cheaper by the day on global economic growth fears (Fig. 9). As a reminder, the 10-year Treasury bond yield has fallen dozens of bps over the past few months. Given how sensitive it has been to the economic data—which supports the idea that the risk-free rate generally tracks with nominal GDP—it’s hard to see much more upside for yields as TNT blows up the growth picture (Fig. 10 and Fig. 11).

It’s less the move in yields than the correlations with other assets that have been inciting broader worries about the US dollar and the sanctity of the Treasury market. On days when everything’s going bust, so are bonds. Let’s discuss:

(1) Dollar down. The DXY dollar index is down 3.33% over the past five days (Fig. 12). Meanwhile, the 10-year yield has climbed from 4.14% to 4.40% (and reached as high as 4.57% on Friday). The selloff from pristine safe-haven assets has sparked worries that investors see them as a bit less alluring now.

(2) Bunds and euros up. Over the same period, the 10-year German bund yield fell from 2.66% to 2.53%, widening the spread between US and German yields to nearly 200bps (Fig. 13). The euro has gained 3.8% ytd against the greenback (Fig. 14). These moves suggest a rotation out of US assets and into their European counterparts. Such rotations are tough to do on a broad scale given the lack of bund depth, but a relatively small move in yields has an outsized impact. Chinese state asset managers may have dumped a fraction of their US Treasuries for euros and bunds, weaponizing their balance sheets. If just a bit of selling pressure by foreign investors could cause so much angst in US financial markets, that would suggest the US’s fiscal situation is very fragile.

(3) Auctions in action. Are investors broadly shunning US Treasuries? That’s not apparent in the latest 10- and 30-year Treasury auctions, which saw strong demand (Fig. 15). Perhaps the issue is simply the velocity of the market moves themselves, as bond volatility can quickly stop out trades in what’s normally a relatively calm market.

Bond Market II: The Technicals Driving Yields. The MOVE bond volatility index surged last week as Treasury yields jumped around (Fig. 16). There’s been lots of chatter suggesting that the unwinding of various Treasury trades, including the cash-futures basis trade and the interest-rate-swap spread trade, has ginned up bond market volatility. The cash-futures basis trade was at the heart of the LTCM financial market crisis in 1998 and the Covid market upheaval in March 2020, so naturally it incurs a lot of interest. But this time around, it’s the interest-rate-swap spread trade being blamed for the recent Treasury market dysfunction. Let’s explain the trade briefly, decide whether it is indeed driving market volatility, and evaluate what it means for equity investors:

(1) Swap spreads. The deluge of Treasury issuance has put increasing strain on bank balance sheets. Post-2008 regulations also incur a cost to banks for warehousing those bonds. Thus, derivative contracts such as swaps have become much more attractive ways of gaining exposure to long-term bonds (i.e., duration). Swap spreads therefore can be thought of as the cost of gaining leverage from a bank by having a bank hold one’s Treasury bond. Swap contracts are negotiated and therefore have counterparty risk and also have far less liquidity than cash bonds (they cannot be fire-sold for cash). The swap spread is negative by the amount that a bank or another investor earns by holding a Treasury bond.

A negative swap spread (the spread was recently around -80bps) yields that much less than would the Treasury bond of the same maturity. But it offers investors duration exposure while freeing up their balance sheets to invest in other assets. On the flip side, an investor taking advantage of the negative spread could purchase the cash bond and provide the fixed-interest payments paying 80bps. Levering up that bond in the repo market could produce attractive annual returns.

Of late, the swap spread started to narrow (climbing closer toward positive territory) as speculators thought that newly appointed Federal Reserve Vice Chair Michelle Bowman would exclude Treasuries from the Supplementary Leverage Ratio, freeing up banks to warehouse the bonds. But when Treasury yields started to rise due to selling pressure, the trade went the other way, and the swap spread hit new lows (or highs, in negative terms) of around -100bps. Also, the amount of trading activity in the repo market increased recently, suggesting that banks had a lot of Treasuries coming their way that they needed to finance. So rather than the swap spread blowing out and causing an unwind, the swap spread became more negative as investors started to sell Treasuries for discretionary reasons.

(2) TIPS for investing. Inflation-adjusted TIPS yields have surged to 2.2% (Fig. 17). TIPS aren’t usually sold for liquidity purposes, i.e., to access cash as a levered trade unwinds. That further suggests that there are real fundamental concerns driving yields higher, rather than just investors exiting positions amid market volatility. Perhaps the likelihood of a new debt ceiling bill that blows out the deficit plus policy uncertainty are raising the term premium on bonds.

(3) Any diversification benefit? The popular iShares 20+ Year Treasury Bond ETF (ticker: TLT) is down 48% over the past five years (Fig. 18). Long-duration bonds are not providing any hedge to falling stock prices as fiscal and inflation fears drive yields higher. At these rates, shorter-duration bonds are a better hedge—unless, of course, the Fed slashes the federal funds rate (FFR) quickly, as it often does during recessions (Fig. 19).

(4) Powell to the rescue? Could the Fed backstop the Treasury market? Of course, and the existence of various facilities is likely quelling volatility anyway. However, using quantitative easing when inflation remains elevated could dent US credibility and widen term premia, ultimately driving the yield curve much steeper. Gobbling up all the long-duration Treasury issuance might work to cap yields but would likely reduce investors’ appetite for other US debt and assets substantially, creating another problem.

If PCED inflation remains below 3.0% y/y, we believe the Fed might cut the FFR to 3.5% this year. Any real financial crises would probably see those cuts accompanied by balance-sheet policy that lowers the 10-year Treasury bond yield below our 4.25%-4.75% forecast range as well. These are unlikely scenarios, but growing in probability as TNT indelicately blows up various segments of the global economy and financial markets.

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Bonds Away!?

April 14 (Monday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Bonds I: Kerfuffle. Bloomberg reported that JPMorgan Chase & Co. CEO Jamie Dimon said on the company’s Friday earnings call: “There will be a kerfuffle in the Treasury markets because of all the rules and regulations. When that happens, the Fed will step in—but not until ‘they start to panic a little bit.’ He added, ‘When you have a lot of volatile markets and very wide spreads and low liquidity in Treasuries, it affects all other capital markets. That’s the reason to do it, not as a favor to the banks.’”

There has already been a kerfuffle in the bond market since April 2, i.e., on President Donald Trump’s self-proclaimed “Liberation Day,” when he announced higher-than-expected reciprocal tariffs on 60 countries, including an island populated only by penguins. The tariffs were scheduled to take effect on April 9, when they were postponed for 90 days because of the bond market’s kerfuffle. The tariffs on China, however, were implemented. The 25% tariff on aluminum, steel, and autos remained in place.

Trump acknowledged that he postponed the tariffs because of the bond market’s kerfuffle. The 10-year Treasury bond yield did fall slightly during April 3 and April 4 to 4.01%. But then it climbed to 4.49% on Friday, April 11. That happened despite lower-than-expected March Consumer Price Index (CPI) and Producer Price Index (PPI) readings on April 10 and April 11. Even the sharp drop in consumer sentiment during the first two weeks of April (reported on April 11) didn’t stop the bond yield from moving higher, as it would have in normal times.

The problem is that Trump’s Tariff Turmoil (TTT) is expected to be inflationary, as evidenced by the big jump in consumers’ inflationary expectations during the first two weeks of April. This means that rising inflation likely would delay any Fed easing to avert a recession. Fed officials aren’t about to lower the federal funds rate (FFR) anytime soon, as they have been saying since the beginning of the year. In an April 4 speech, Fed Chair Jerome Powell suggested that they’re in even less of a hurry to do so now than before TTT, since the tariffs turned out to be higher than widely expected:

“While uncertainty remains elevated, it is now becoming clear that the tariff increases will be significantly larger than expected. The same is likely to be true of the economic effects, which will include higher inflation and slower growth. The size and duration of these effects remain uncertain. While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent. Avoiding that outcome would depend on keeping longer-term inflation expectations well anchored, on the size of the effects, and on how long it takes for them to pass through fully to prices. Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.”

So bond investors may be in no rush to buy bonds, especially since they may not be convinced that Washington will do enough to reduce the federal deficit.

On Friday and Saturday, Trump continued to back off from his tariffs, which he has described as “a beautiful thing.”
 
Bonds II: The Yellen/Bessent Short-Term Solution to Debt. I have been on Wall Street for more than 45 years. Over that period, there has been a lot of concern about mounting federal deficits and debt. Along the way, some of us bond market watchers observed that bond yields tended to decline when federal budget deficits widened during recessions; that’s because recessions caused the federal government’s revenues to decline, as Americans’ incomes and profits fell, and the government’s outlays to be boosted by its income support programs. Deficits were mostly counter-cyclical, widening during recessions and narrowing during expansions (Fig. 1 and Fig. 2). No big deal.

Yet starting in the 1980s, there were mounting concerns that federal government debt was rising relative to nominal GDP as deficits continued even during periods of economic expansion (Fig. 3 and Fig. 4). Lots of articles and books have been written since the 1980s about the likely terrible consequences of so much government debt rising so rapidly. Stock and bond market bears often included the federal deficits and debt in their litany of reasons to be cautious. I tended to be mostly bullish on stocks and bonds in the past. With regards to federal government deficits and debt, I argued that I would worry about them when the bond market worried about them.

I did briefly worry in 2023, when the 10-year Treasury bond yield jumped from 4.00% on August 9 to 5.00% on October 19 (Fig. 5). This resulted from bond investors’ response to a series of Treasury auction size increases starting in August 2023, with quarterly refunding auctions for 3-, 10-, and 30-year maturities reaching $125 billion. These poorly received auctions heightened fears that a debt crisis was imminent. The bond market was choking on the supply of bonds, forcing yields up to levels that could cause a recession.

On November 1, 2023, the US Treasury, under Treasury Secretary Janet Yellen, announced a reduction in the pace of increases for longer-dated Treasury securities, easing the supply of new bonds. Yellen’s strategy leaned heavily on issuing short-term Treasury bills to meet borrowing needs. The Treasury Borrowing Advisory Committee, which advises the Treasury Department on matters related to the issuance of federal securities, has been recommending that no more than 20% of the Treasury’s marketable debt should be held in Treasury bills (Fig. 6). Yellen took the ratio up to 22%.

This tactic was criticized by some, including current Treasury Secretary Scott Bessent, for potentially keeping borrowing costs artificially low ahead of the 2024 election. When Bessent took over as Treasury secretary in early 2025, he initially criticized Yellen’s approach, arguing it shortened debt maturities too much and clashed with the Federal Reserve’s inflation goals. However, on February 5, 2025, the Treasury under Bessent announced that it would maintain Yellen’s guidance, keeping longer-term debt issuance unchanged at $125 billion for quarterly refunding auctions spanning 3-, 10-, and 30-year maturities, with no increases expected for “at least the next several quarters.”

“He and I are focused on the 10-year Treasury,” Bessent said in a February 5 interview with Fox Business when asked about whether President Trump wants lower interest rates. “He is not calling for the Fed to lower rates.”

Bessent explained his continuation of Yellen’s plan in a February 20, 2025, Bloomberg Television interview, stating that any shift to Treasury’s issuing new debt with longer maturities was “a long way off” due to market conditions, inflation, and the Fed’s quantitative tightening. He suggested a gradual approach, as flooding the market with long-term bonds could spike yields and borrowing cost.

I will not be surprised if Bessent addresses the recent turmoil in the Treasury bond market by reducing the size of Treasury bond auctions, thus financing even more of the deficit with Treasury bills. The next quarterly refunding announcement is scheduled for April 30. That would certainly push bond yields lower. In effect, this would amount to a policy of Yield Curve Control by the Treasury (YCC-T) rather than the Fed (YCC-F).

As a thought experiment, what if the Treasury issued only Treasury bills? The Fed would be forced to buy a significant amount (if not all) of them to keep the FFR from rising above its range. Bond yields would fall dramatically unless inflationary pressures resulted, in which case the Fed would have to raise the FFR range. That would immediately increase the cost of financing the Treasury’s debt. Might that put pressure on Congress and the White House to reduce the deficits? Probably not, because YCC-T would effectively bury the Bond Vigilantes.
 
Bonds III: Staying Vigilant. Since the start of this year, I’ve been arguing that the 10-year US Treasury bond yield has normalized and is likely to trade in a range of 4.25%-4.75% for the rest of this year. I flinched after Liberation Day and lowered the range to 3.75%-4.25%. But now, I am raising it back to 4.25%-4.75%, which is where the bond yield mostly traded in the years just before the Great Financial Crisis (Fig. 7).

So the recent increase in the yield doesn’t faze me. But it has fazed lots of other market observers. Indeed, I’ve been fielding lots of calls from financial market journalists wondering whether the Bond Vigilantes are back on the scene. The answer is “no” if the bond yield simply has normalized. Then again, the recent jump in yields has been fast and furious, suggesting that the Bond Vigilantes are back and that on Wednesday of last week they forced the Trump administration to postpone imposing reciprocal tariffs on numerous countries around the world for 90 days.

The Bond Vigilantes are rightly concerned that Trump’s Nitro Tariffs (TNT) will cause an explosive increase in inflation. They are also concerned that the recent weakness in the dollar suggests that foreigners are selling their US bonds. And the Bond Vigilantes might be signaling that they aren’t convinced that the Trump administration will rein in the federal deficit.

The good news is that Treasury Secretary Bessent seems to have convinced President Trump that they shouldn’t mess with the Bond Vigilantes. On Wednesday, April 9, after ratcheting back all reciprocal tariffs to 10% for at least 90 days (but upping the pressure on China with a 145% tariff), Trump said: “I was watching the bond market. The bond market is very tricky, I was watching it. But if you look at it now it’s beautiful. The bond market right now is beautiful. … I saw last night where people were getting a little queasy.”

Trump also said he listened to JPMorgan CEO Jamie Dimon’s interview last Wednesday with Fox’s Maria Bartiromo, in which Dimon said a recession was likely and the bond market was sending bad signals about stress in the financial plumbing.

President Bill Clinton had a similar epiphany in 1993 after his advisor James Carville said: “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

Bonds IV: Supply & Demand. Everyone in our business seems to be wondering why the 10-year Treasury bond yield has been rising in recent days.

The widely accepted view is that hedge funds had to unwind basis trades by selling bonds when the yield became volatile in response to TNT. But also among the usual roundup of suspects is the Chinese government, which might be selling Treasuries in retaliation against Trump’s 145% tariff on goods imported from China.

Reporter Jon Sindreu came up with a clever explanation in an article posted by The Wall Street Journal on April 11 titled “The Simple Explanation for This Week’s Treasury Market Mayhem.” He wrote: “But the answer might be far simpler: U.S. government debt is doing badly because, well, investors don’t want to buy it.” In other words, bond yields are rising because there are fewer buyers than sellers of US Treasury bonds.

Consider the following:

(1) The biggest seller of those bonds, of course, is the US Treasury. Yet Reuters reported on April 9: “A U.S. Treasury debt auction of $39 billion in benchmark 10-year notes was well received on Wednesday, showing solid investor demand even after a bond market sell-off driven by an escalating trade war between the United States and its major trading partners led by China. The U.S. Treasury’s auction came in better than expected, priced at a high yield of 4.435%, lower than the rate forecast at the bid deadline.” Indirect buyers, a category that typically includes foreign central banks and private investors, bought 87.9% of the supply allotted to them, above the average of 70%.

(2) March’s CPI and PPI inflation rates were lower than expected, we learned when released on Thursday and Friday. Yet the bond market wasn’t impressed. That’s because on Thursday, the Treasury Department reported that the federal deficit was $2.1 trillion over the 12 months through March, and on Friday the Survey Research Center reported that the Consumer Sentiment Survey showed that consumers’ year-ahead expected inflation had soared to 6.7% last month, the highest rate recorded since 1981 (Fig. 8 and Fig. 9).

(3) Bessent should explain to the President that the balance of payments always balances. The flip side of America’s current account deficit are net capital inflows (Fig. 10). So for example, last year, the former totaled $1.13 trillion, while the latter totaled $1.26 trillion. This suggests that if Trump succeeds in reducing the trade deficit, foreigners will have fewer dollars with which to buy US Treasuries and other securities.

Over the 12 months through January, US net capital inflows from foreign private investors and central banks totaled $1.16 trillion (Fig. 11). Over that same period, private net purchases of bond and equities by foreign entities totaled $881.8 billion and (a record) $435.2 billion (Fig. 12).

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CEOs On Tariffs, Health Care & 3D-Printed Skin

April 10 (Thursday)

Strategy: CEOs Talk Tariffs. Just when CEOs finally started talking about the tangible impacts they believe Trump’s Tariff Turmoil (TTT) was having on business, President Trump did an about-face and authorized a 90-day pause on reciprocal tariffs and lowered them to 10%. This applies to all US trading partners except China, which continues to face a 125% tariff.

The S&P 500 rose 9.5% on the news Wednesday but remains 7.2% lower ytd. Prior to Trump's about-face, CEOs were a very cautious bunch. Some predicted a US recession; some trimmed the 2025 forecasts for their companies; some noted that every conceivable countermeasure to mitigate tariff impacts, from cost cutting to raising prices, was on the table. Smaller companies, with less negotiating leverage, also faced tough times.

Here is what executives from Levi Strauss, Greenbrier, JPMorgan, Walmart, Delta, and some small companies said just prior to the great Trump about-face (perhaps Trump listened to what they were saying?):

(1) Early summer inventory on hand. Levi Strauss has time before tariffs start affecting the bottom line. The Q2 impact will be minimal because most spring and summer product is already in the US, said CFO Harmit Singh on Monday’s earnings conference call.

Tariffs pose a “significant challenge,” and Levi has a team assessing how to mitigate the impact. Potential moves include cutting costs, working with customers and vendors, and raising prices “surgically.” Levi sources products from over 28 countries, and almost 60% of its revenue is generated outside the US.

Levi forecasted Q2 revenue that’s flat to up slightly y/y and EPS of $0.11-$0.13, down from $0.16 in Q2-2024. The company’s forecast jibes with analysts’ consensus estimate of $0.13, but that was $0.19 three months ago.

(2) Forecast trimmed. Greenbrier Companies, which manufactures and leases railcars, isn’t subject to tariffs because it’s USMCA compliant, but tariffs may affect its customers and freight traffic patterns. “[T]ariffs are impacting the cost of our inputs, predominantly steel, and constructional changes in how our customers operate,” said CEO Lorie Tekorius on Monday’s earnings conference call. “For now, railcar utilization remains steady,” she added.

Customers are holding onto leased railcars, and lease renewals and rate increases are strong. About 10% of the company’s leases are up for renewal this fiscal year, and more than half have been renewed through the end of FQ2. Lease rates have plateaued at very high levels.

“Our pipeline [of new railcar orders] remains robust, but inquiries have been slow to translate into orders as customers have been waiting clarity on U.S. trade policy. With some clarity now established, we are talking with customers about the rail equipment needs in this environment. Railcar users and owners are experiencing a range of impacts from negligible to significant,” said EVP Brian Comstock. Demand from Brazil, an expected beneficiary of US tariffs, has increased.

Fiscal 2025 revenue is expected to be between $3.15-$3.35 billion, down from $3.35-$3.65 billion expected in January. Guidance on fiscal 2025 railcar deliveries was lowered to 21,500-23,500 from 22,500-25,000. That said, gross margin and operating margin targets were increased, as was the quarterly dividend, by nearly 7% to $0.32 a share.

(3) Watching for recession. JPMorgan CEO Jamie Dimon landed in the headlines yesterday after warning that tariffs will probably cause a recession and an increase in defaults. He suggested that the markets might calm down if Trump moved quickly on trade negotiations.

Beyond the market turmoil, the most immediate impact on financial firms is the cancellation and delay of IPOs as well as “hung” high-yield and bridge loan deals, he said according to an April 9 Reuters article. Dimon also noted that some international borrowers have opted to use local banks instead of JPM on bond deals.

(4) Pulling forecasts. Walmart announced on Wednesday that it’s maintaining its Q1 sales growth forecast of 3%-4%, but it pulled its Q1 operating income forecast due to tariff uncertainty and the decline in consumer sentiment. About a third of what the company sells is imported. That said, the company maintained its fiscal-2025 guidance of 3.0%-4.0% sales growth and operating income growth of 3.5%-5.5%.

(5) Bookings slide. Delta CEO Ed Bastian started the year expecting it would be the “best financial year” in the company’s history. But in February, demand “really started to slow” for seats in the main cabin, while international travel and demand for premium seats have been relatively resilient, he told CNBC Wednesday. Companies are rethinking business trips, the federal government is cutting jobs, and stock markets are declining, all of which weighs on demand.

“With broad economic uncertainty around global trade, growth has largely stalled,” Bastian said in Wednesday’s earnings press release. “In this slower-growth environment, we are protecting margins and cash flow by focusing on what we can control.” Delta has scrapped plans to expand its capacity by 3%-4% in 2H-2025.

(6) Small shops hurt, too. Several small companies that sell foreign-manufactured products in US will need to slash costs and may have to close their doors if the tariff situation isn’t resolved soon, an April 8 New York Post article reported. They lack the leverage of larger companies to negotiate better terms with suppliers.

One company that sells pricey backpacks manufactured in Vietnam paused future orders and has enough inventory on hand for a month. Another clothing merchant says he’ll lose money on most of the one million garments being produced in China now.

Wonderstate Coffee, a Wisconsin-based coffee roaster and importer, is facing a $100,000 tariff bill within weeks for the coffee beans worth about $800,000 that are being shipped to the US from Brazil, Columbia, Guatemala, and Ethiopia, the article states. The $300,000 tariff bill this year will mean the company can’t buy new equipment or open a fourth café, as it had planned.
 
Health Care: Trump Risks & Rewards. The S&P 500 Health Care sector has lived up to its defensive reputation as a place to hide during a storm. We’re certainly living through one heck of a storm, and the S&P 500 Health Care sector has fallen only 3.3% ytd through Tuesday’s close, outperforming the S&P 500’s 15.3% decline. But when things quiet down on the tariff front, investors may start to distinguish between Health Care industries that stand to benefit from Trump’s expected policies and those that won’t.

The Trump administration announced higher-than-expected reimbursement rates for Medicare insurers and a pause in the Federal Trade Commission’s (FTC) lawsuit against pharmacy benefit managers (PBMs), which investors liked. However, the administration is also expected to close a tax loophole that allows drug companies to lower their income-tax rate, introduce pharma-specific tariffs, and cut research funding.

Here’s what investors may be ignoring about health care:

(1) A place to hide. The S&P 500 Health Care sector is the second-best performing sector in the S&P 500 ytd. Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Consumer Staples (-1.9%), Health Care (-3.3), Utilities (-3.5), Real Estate (-9.0), Financials (-9.1), Energy (-10.3), Materials (-11.4), Industrials (-11.7), Communication Services (-14.7), S&P 500 (-15.3), Consumer Discretionary (-23.1), and Information Technology (-24.2) (Fig. 1).

Half of the industry indexes in the S&P 500 Health Care sector are up ytd, and the other half are down: Health Care Services (22.1%), Managed Health Care (10.2), Biotechnology (1.1), Health Care sector (-3.3), Health Care Equipment (-4.6), and Pharmaceuticals (-7.9) (Fig. 2).

(2) Medicare insurers benefit. The Trump administration announced this week that its reimbursement rates for Medicare insurers will be far higher next year than expected—jumping 5.06% versus the 2.23% proposed by the Biden administration.

“The Medicare agency said the increase in the planned payment rate reflected rising medical costs, and that more recent data had led to the steeper final rise,” an April 8 WSJ article reported. The news was well received by the industry, which has struggled as seniors used more medical care than expected and costs were higher than anticipated.

Shares of UnitedHealth Group, the largest company in the Managed Health Care industry, jumped 5.4% on Tuesday, while the S&P 500 declined 1.6%. UNH shares are up 9.3% ytd despite investors’ concern earlier this year about an investigation into the company’s pricing practices.

The S&P 500 Managed Health Care industry has reasonable earnings growth prospects and a reasonable forward multiple. Earnings are expected to grow 5.8% this year and 11.6% in 2026 (Fig. 3). At 15.8, its forward P/E is about five points below its previous peaks and below the broader market’s earnings multiple (Fig. 4).

(3) PBMs benefit. The FTC’s lawsuit against PBMs is on pause because the FTC has no commissioners to bring the case after recent resignations and firings. The two remaining commissioners had recused themselves from the PBM case, an April 3 article in FirstWord PHARMA reported. The FTC filed for and was granted a 105-day stay due to the lack of commissioners, and an evidentiary hearing will be scheduled for 225 days after the pause is lifted.

The Biden administration filed the case last September against CVS Health’s Caremark, Cigna’s Express Scripts, and UnitedHealth’s OptumRX, alleging that they artificially inflated insulin prices, driving up the cost for payers and patients. Observers aren’t sure whether the Trump administration will go forward with the case.

As a result, the shares of CVS, which had better-than-expected Q4 earnings, have jumped 50.7% ytd, while shares of Cigna and UNH have climbed 13.7% and 9.3% ytd. CVS shares also benefitted on Tuesday from the naming of a new CFO and the company's assurance that it would meet or exceed the full-year earnings guidance it gave in February.

CVS and Cigna are members of the S&P 500 Health Care Services industry, up 22.1% ytd (Fig. 5). The industry’s earnings are bouncing back from declines in 2024, with 8.9% earnings growth expected this year and 12.9% next (Fig. 6). The Health Care Services industry has a historically low forward P/E of 11.1 (Fig. 7).

(4) Pharma tax loophole closing? It’s not drug manufacturing that US pharmaceutical companies do in Ireland; it’s storing the intellectual property for drugs in divisions there. As a result, the profits on drug sales that occur in the US can show up as profits in the Irish divisions thanks to tax rules. Companies benefit because Ireland’s corporate tax rate is only 15%, below the US tax rate of 21%.

An Irish fiscal agency estimates that 75% of the country’s corporate tax is paid by large US multinationals, a March 13 article in The Guardian reported. President Trump has accused Ireland of stealing the US pharmaceutical industry, most recently in a meeting with the Irish Premier Micheál Martin on St Patrick’s Day.

Trump could repatriate those profits in one of two ways: 1) by lowering the US corporate income tax rate to 15%, as he has promised to do, which would remove the incentive to have operations in Ireland; or 2) via tariff schemes; Trump said on Tuesday that tariffs on imported pharmaceuticals will be coming “shortly.”

Tariffs also could hurt medical device companies, particularly those that manufacture their products in Mexico, such as Masimo, which makes devices to monitor patients, and Align Technology, which makes the orthodonture system Invisalign.

The S&P 500 Pharmaceutical industry’s earnings growth is expected to decelerate from 28.7% this year to 8.2% in 2026 (Fig. 8). But that’s still not bad considering that the industry’s forward P/E is only 13.7 (Fig. 9).

(5) Funding cuts threaten research. The Trump administration has attempted to cut the National Institutes of Health (NIH) funding to institutions for scientific research. When the NIH grants research funds, the administration would like 85% of the dollars to pay for research and 15% to pay for indirect costs. Previously, about 27% of the funds paid for indirect costs and represented about $9 billion of the $32 billion in NIH grants issued in fiscal 2024.

On Monday, Judge Angel Kelley of the Federal District Court in Massachusetts ruled that the NIH could not make the change, but her decision is expected to be appealed.

Industry players worry that universities will reduce the number of post-doctoral researchers and graduate students they admit if the NIH proposal goes through. If the changes occur, it may reduce the number of companies spun out of university labs that become tomorrow’s biotechnology winners. Ironically, the US would be reducing research funding just as China has prioritized the development of its biotech industry.

“Scientific, long-term drug development requires government support of basic science,” Chris Bardon, co-managing partner at investment firm MPM BioImpact, said in a February 25 BioPharma Dive article. “That’s an absolute requirement. Nobody else can step in to fill that void if the federal government steps out.”

Disruptive Technologies: Skin in the 3-D Printing Game. We’ve written about the benefits of 3-D printed parts in factories and 3-D printed homes, but 3-D printed skin? That’s a thing? Apparently so.

Researchers at the Graz University of Technology and the Vellore Institute of Technology in India are hoping to use 3-D printed skin to test the safety of cosmetics instead of testing them on animals. It’s made of 3-D printed hydrogel layers held together by living human cells, an April 3 article in Popular Science reported. If successful, they hope the 3-D printed skin could also be used for drug testing and wound healing.

But scientists aren’t stopping at skin. Some have also used 3-D printing to create livers that they hope to implant into humans. A South Korean woman received a 3-D printed windpipe needed because she suffered from thyroid cancer. Harvard researchers have developed 3-D printed blood vessels.

A Stanford University researcher hopes to have a 3-D printed heart implanted inside a pig and then ultimately inside a human. If the heart can be made with the cells from its human recipient, then maybe the patient won’t need as many immunosuppression drugs to ensure that the body doesn’t reject the heart, noted an April 3 article in the Stanford Report.

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Tariffs Are More Tumultuous For Foreigners

April 9 (Wednesday)

Tariffs Turmoil I: International Tour. In our April 2 Morning Briefing, we explained that if Trump Tariff Turmoil (TTT) did induce a recession, it would likely deal much more pain to international markets and economies than the US. Indeed, Trump 2.0 seems to be operating under that assumption as well—that exporters with big trade surpluses need the US market much more than it needs them. Financial markets were suggesting otherwise until recently, however. The German stock market and the euro, as well as the Chinese stock market, were outperforming US stocks and the dollar.

Despite warming up to some global markets on the back of new stimulus measures (e.g., Germany) earlier in the year, we stuck with our Stay Home (in US stocks) bias. Our conclusion just before stocks sold off en masse on Thursday was this: “In short, we think the US would outperform the rest of the world in the event of a tariff-induced recession. That’s why we are maintaining our Stay Home (versus Go Global) bias, recommending that managers of global portfolios overweight US stocks.”

Here’s how key assets performed following President Trump’s shock tariff announcement on Wednesday, from Wednesday’s close through the close of trading on Monday: MSCI Germany ETF (-10.0%), MSCI United Kingdom ETF (-11.5%), China Large-Cap ETF (-15.6%), Japan Hedged Equity Fund (-12.3%), S&P 500 (-10.7%), DXY dollar index (-0.7%) (Note: We used the hedged Japan ETF, as the product is more popular since a weaker yen tends to directly boost Japanese stocks.) Because the dollar fell during this time, converting local-currency gains from abroad into dollars broadly helps the performances of non-US indexes.

Notably, every international market is much cheaper than US large caps on a forward P/E basis (Fig. 1).

Stocks rebounded globally on Tuesday as Treasury Secretary Scott Bessent appeared to drive a more negotiation-friendly tone from Trump 2.0. But tariffs aren’t going away. Global trade is being reordered, and US policy may very well slow global economic growth in the near term. All in all, we think US stocks will outperform in most economic environments, especially during a global recession. While some allocation to key international markets might be warranted over a long-term time horizon, we are sticking with our Stay Home investment bias.

Here’s more on how we’re thinking about the US and global economies in the event of a global economic slowdown:

(1) US domestic economy. The negative wealth effect from falling asset prices may persist given the purported lack of “policy put” from the Federal Reserve and/or Trump 2.0. Without new stimulus coming down the pipeline and with trade uncertainty weighing on both consumer and business sentiment, even some negotiated deals are unlikely to kick the growth engine into high gear (Fig. 2 and Fig. 3). A growth slowdown is likely this year.

Stocks have been reliant on stimulus and bailouts to stem crises since 2008. Americans, particularly retired Baby Boomers, have used asset gains to dissave and spend despite lack of wage income. Now with falling stock prices and declining real economic activity, risk-averse consumer and business purchasing behavior could very well drag the US economy into a slump.

Still, the US is at full employment, is a net energy exporter, and has a dynamic and flexible services-driven economy (Fig. 4 and Fig. 5). Productivity growth has been strong and can counterweigh pressures from realigning supply chains and less immigration (Fig. 6).

(2) International economies. Underpinning TTT is Trump 2.0’s belief that the rest of the world—namely China—needs America much more than it needs them. That’s somewhat true, for several reasons:
China’s external trade balance reached a record $1 trillion surplus in February (Fig. 7). Without the US consumer as a source of end demand, China’s export-led economic revival strategy may be doomed.
Germany’s manufacturing sector is already being crushed by China’s exports, which further prevents the sector’s realignment away from US markets to those of China (Fig. 8). Not only are foreign exporters upset with China, but the Chinese consumer cannot replace American demand (Fig. 9).
While cutting interest rates isn’t a direct tool for offsetting a widescale trade war and the associated uncertainty, it would help to some degree. That said, foreign advanced economies have less monetary stimulus space than the US, as their benchmark interest rates are at lower starting points (Fig. 10).
Tariff Turmoil II: The Rotation Trade. Trump 2.0’s America First policies have sparked conversations by major US and international allocators about diversifying their geographic mixes. That will only continue. But we believe some of the rotation trade conversation has been overstated, at least in the intermediate term. On a fundamental basis, US stocks are stronger than international ones, by and large (even though analysts are slow to revise their earnings estimates to reflect the trade war). Here’s a quick look at market fundamentals abroad relative to those of the US market:

(1) Valuation multiples. Relatively cheap valuations abroad were not enough amid the TTT market selloff. Those cheaper stocks got even cheaper, including relative to the US. A big chunk of pre-TTT correction in the S&P 500 stemmed from the compression of Magnificent-7 stocks’ collective valuation multiple. US large-cap value stocks had been holding up better (Fig. 11).

The China MSCI stock index currently trades at less than 12 times forward earnings (Fig. 12). The EMU MSCI stock index trades at less than 14 times forward earnings (Fig. 13). And the Japan MSCI trades just a tad lower than the EMU (Fig. 14).

(2) Forward earnings. The China MSCI forward earnings per share (EPS) has been tracking sideways (if not declining) since 2017 (Fig. 15). Net earnings estimate revisions have been persistently negative since late 2021.

The EMU MSCI forward EPS is around record-high territory but will likely slump in the coming weeks (Fig. 16).

The Japanese market’s forward earnings has been steadily climbing to new records (Fig. 17). We’re unsure what the Bessent-led negotiations with Japan will bring—they could very well lead to a strong revaluation of the yen that hurts Japanese companies. But Japan has been one of the better performing international markets for several years, as its economy finally has found some nominal growth.

(3) Forward profit margins. Strong productivity growth, and the accompanying wider corporate profit margins it drives, are key components of our Stay Home thesis. US profit margins are much higher than those of the rest of the world and are likely to remain so even as tariffs hurt bottom lines everywhere (Fig. 18).

Regardless of who pays for the US customs duties (whether US consumers, importers, or foreign exporters bear the brunt), it will likely be costlier for foreign companies to shift their supply chains and invest in new plants, property, and equipment than for US companies to do so. In a world where costs are rising, we’re inclined to stick with the stock market where companies’ profit margins are the widest and arguably the least threatened by TTT.

Strategy: Staring Down the Bear. Amid recent days’ global trade angst, the S&P 500 price index on Monday briefly entered a bear market on an intraday basis (Fig. 19). The index recovered from its steep intraday decline to finish up for the day at the close but remained deep in correction territory. Investors and traders are cheering half-heartedly but bracing for more bad news. The 20% intraday decline in the S&P 500 from its peak just 47 days earlier on February 17 was the swiftest decline into bear market territory (defined as a drop of 20% or greater) since 2020’s Great Virus Crisis (GVC).

Back then, the index peaked on February 19, 2020, just before Covid-19 news drove it into a bear’s lair in a mere 22 days. But that bear market, which started on March 12, was over before investors knew it (unlike the lockdowns going on at the time). The S&P 500 was back at a record high just five months later, on August 18, 2020.

Prior to the GVC in 2020, the stock market was relatively calm for 33 years, with descents into bear markets happening gradually over many months. The Crash of 1987 put the S&P 500 into a bear market in just 55 days, but that was the first sub-100-day 20% decline in 51 years.

However, there were even swifter 20% declines in the nearly 100 years of daily S&P 500 pricing data since 1928 that Joe has studied. That dataset (which includes Saturday closing prices through the 1950s) uncovered 24 bear markets. The average length of time it took the stock market to fall into them: 224 days.

Here’s what else Joe found in the data:

(1) From 1929 to 1934, the S&P 500 fell 20% or more from its record high, or peak, a whopping five times, and in under 100 days each time (Fig. 20). For some perspective, the S&P 500 has repeated that sub-100 day 20% decline torture test just twice in the 95 years since then, in 1987 and 2020.

(2) The dataset’s first bear market was the Crash of 1929, which occurred in just 51 days. Following its September 7, 1929 record high, the S&P 500 would not reach a record high again until 25 years later on September 22, 1954. The political and trade circumstances surrounding the turmoil of the 1930s draw interesting parallels with today’s circumstances.

(3) During 1930, the introduction of the Smoot-Hawley Tariff Act saw the S&P 500 fall more than 20% over 67 days through June 16, 1930 (Fig. 21). However, even swifter declines were on tap just a few years later. The market fell 20% over just seven days in September 1932, coinciding with Hitler’s rise to power and Germany’s re-arming in violation of the Treaty of Versailles.

(4) Less than a year later, in mid-July 1933, the S&P 500 recorded its fastest 20% decline of all time, in just three days from July 18 to July 21. As the world struggled to recover from the Great Depression, President Roosevelt announced in early July that the US would remain off the gold standard in order to pursue long-term price stability at home rather than immediate international currency stabilization.

(5) Not even a year later, in 1934, stocks again were descending into a bear market, this time over the course of 95 days through May 12. That would be the last sub-100 day decline of 20% for 51 years. The source of investors’ concern? A reshaping of American trade policy by the President. Having been in office for just a year in 1934, President Roosevelt was hard at work trying to restart America’s economic engine. To that end, he signed the Reciprocal Trade Agreements Act into law, which granted the Executive branch the powers to negotiate trade agreements and ultimately reshape trade policy as Trump is doing today.

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Who Will Save The Day?

April 8 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: Correlations Go to One. The current bear market is very different from previous ones. This is perhaps the first manufactured US bear market in at least 100 years, in the sense that it was created by President Trump, in his obsession with tariffs, rather than caused by anything to do with the business cycle, overleverage, or financial contagions.

Let’s review our Credit Crisis Cycle (CCC) theory for how bear markets typically form (and bottom). It was this theory that underpinned our bullishness on the US economy and stock market in recent years, as it discredits the commonly accepted “long-and-variable-lags” argument that tighter monetary policy drags down economic growth after some lag time. To review:

In our CCC, rising interest rates cause a recession only if they break something in the financial system. That rupture causes a credit crisis, which morphs into a credit crunch and then a recession. To be fair to the bears, that sequence nearly happened from the latest round of Federal Reserve tightening. The Fed, the Treasury, and the FDIC together stemmed the mini regional banking crisis in March 2023 by quickly providing a liquidity facility and insuring all depositors of the failed banks. So the economy was able to continue expanding without cuts in the federal funds rate (FFR).

The Fed is a much better firefighter of financial crises than it was in the past, having expanded its toolbelt since 2008. Based on our CCC, it makes sense that Fed Chair Jerome Powell has signaled restraint on further easing and suggested that FFR cuts aren’t on the table just yet.

President Trump’s Tariff Turmoil (TTT) has walloped the stock market and will likely hurt the real economy in the coming weeks and months. But with elevated services inflation and tariffs threatening to raise goods prices substantially, the Fed remains wary of easing for now. We think that would change only if TTT causes a financial crisis—which looks increasingly possible as global markets sell off in unison. In a crisis, all correlations go to one. There has been no financial system implosion—no bank has failed, no hedge fund has blown up, nor has a massive leveraged trade rapidly unwound—yet the global markets are experiencing all the symptoms of one.

Perhaps the selling is enough to trigger a crisis?

The CCC is aptly acronymic for “CCC”-rated junk debt. The spread of high-yield bond yields (anything lower rated than BB) over Treasury yields is our preferred market gauge for credit stress. It has surged to 4.45ppts as of Friday from as low as 2.62 on February 18, when the stock market peaked (Fig. 1). The current level is its highest since the mini regional banking crisis. Should it rise north of 6 points and toward 7, we believe the conditions for the Fed to act by using its powerful balance-sheet tools and slashing the FFR would likely be met (Fig. 2).

In these situations, the Treasury bond yield-curve bull steepens as the 10-year yield falls but not as deeply as the Fed cuts the FFR (Fig. 3 and Fig. 4). So while long-term rates do in fact fall, that doesn’t necessarily support stocks. The bottoming process for the stock market often takes much longer to play out. This time, it might take even longer than usual, as Fed rate cuts are a blunt tool that’s not very effective at offsetting the effects of global trade war (Fig. 5).

Given the man-made nature of TTT, it could easily be reversed. If President Trump grows fed up with the reactions of financial markets and the real economy to his tariffs, he might shun the advisers who helped get him here for others. Enough calls from CEOs and Wall Street—or complaints from the GOP about the mid-term elections—could also spur a pivot.

Indeed, alarm bells have sounded. JPMorgan CEO Jamie Dimon wrote this in his annual letter to shareholders: “We are likely to see inflationary outcomes, not only on imported goods but on domestic prices, as input costs rise and demand increases on domestic products ... Whether or not the menu of tariffs causes a recession remains in question, but it will slow down growth.”

And there’s discord at the top: Elon Musk, in response to an interview clip of Trump’s trade brain Peter Navarro, wrote on X: “A PhD in Econ from Harvard is a bad thing, not a good thing. Results in the ego/brains >>1 problem.”

It’s unclear how much of the damage from TTT will be long-lasting. Indeed, some confidence in the US, at least from a stability perspective, has been lost. But given the resilience that the US economy has displayed in recent years and its strong footing entering this year (relative to both history and the rest of the world), any pivot away from TTT would likely spark a limit-up stock market rally.

How little it would take to trigger a relief rally was showcased Monday morning, when CNBC misquoted National Economic Council director Kevin Hassett and ran a headline suggesting that Trump was contemplating a 90-day delay on tariffs (excluding China). The S&P 500 jumped to a more than 1% gain, just an hour after it opened down more than 3%. The rally faded after a White House X account called it “fake news.” Still, the one-minute relief rally underscored that all it would take is one Trump statement to erase a lot of losses.

Aside from paring back on TTT, it’s worth revisiting the policy proposals that made the business world, the financial markets, and observers like us bullish on Trump 2.0. Deregulation is a key pillar, but one that takes time. A major source of optimism was tax cuts, which we believe(d) could help accelerate the productivity growth boom and expand corporate profit margins.

Strategy II: Tax Cuts Amid Tax Hikes. Tariffs are ultimately a tax. Whether consumers bear the full brunt of them is up for debate, but someone must pay the tax. It will be some combination of importers (US businesses), exporters (foreign businesses), and consumers (foreign and domestic amid retaliation). Taxes weigh on economic growth. So what about those tax cuts promised by Trump on the campaign trail?

They are being discussed in Congress as we speak, in both houses. They are still at the budget phase; no concrete proposals have been made yet. Unfortunately, collaboration between the chambers seems to be quite low. We chatted with our friend Jim Lucier at Capital Alpha Partners to get the inside scoop on the budget machinations and what tax cuts may be coming down the pipeline. By our estimation, everything being discussed is not enough to offset the TTT tax hike. But they are something. Consider some of the takeaways from our conversation with Jim:

(1) Are these really cuts? No, they are mostly extensions of the 2017 TJCA (Tax Cuts and Jobs Act) tax cuts. The big kahuna, the corporate tax cut from 35% to 21%, is permanent and unlikely to change. Mostly, the extension avoids a big tax hike to the pre-2017 baseline, which affects budget scoring but not real economic activity.

(2) Some meat on the bones. That’s not to say it will be a complete nothing burger. The prospects of no taxes on tips, overtime, and Social Security benefits are on the table, and would be a boost for consumers and small businesses. An interest expense deduction for loans to buy new cars (which are likely to be more expensive) has also been floated. Jim believes that only no tax on tips is likely to make it through the legislative gauntlet into law.

Companies stand to benefit from restoration of some expired accounting rules, such as 100% bonus depreciation, 30% of EBITDA (earnings before income taxes, depreciation, and amortization) interest expense deduction, and the expensing of research & development costs. Expensing for structures broadly, instead of for just property, plant & equipment, is also possible and could facilitate factory building.

(3) House versus Senate. According to Jim, Republicans in the House of Representatives believe they can extend the TCJA for seven or eight years, allow expensing for structures, and maybe secure no tax on tips on a temporary basis.

Senate Republicans have said they can assent to permanent expensing for structures and implement Trump’s promises for individuals, like no tax on tips, permanently. Of course, neither of these plans helps reduce the federal budget deficit. A recession, of course, would make the deficit situation even worse by lowering revenues and expanding entitlement spending (Fig. 6).

The House budget resolution passed on February 25 would allow the national debt to increase by $3.3 trillion over ten years. When accounting for the additional interest expense from the bonds needed to finance that deficit spending, it could reach $4 trillion. The Senate said that the budget resolution it passed last week increases the national debt by $1.5 trillion; but when adding in the cost of a permanent TCJA extension and interest costs, the total cost of the package is around $6.0-$7.0 trillion.

Jim says the House is much more focused on the national debt and prefers not to follow the Senate’s lead in not counting the impacts of the TCJA extension because it is the current status quo. The Senate budget does include limits that would prevent a complete deficit blowout, however.

It remains to be seen how the House and Senate will reconcile their two resolutions—which may hinge on how members manage their constituencies and lobbyists as the tariffs start to bite. Apparently, the House is not on board with TTT. Hopefully, its voices grow loud enough in DC.

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Annihilation Days

April 7 (Monday)

YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Trump’s Tariffs I: President’s Exit Ramp. So far, congressional Republicans are giving Trump Tariffs 2.0 the benefit of the doubt. Some are voicing their concerns. A few Senate Republicans are joining the Democrats in the Senate to support a bill to cancel Trump’s tariffs on Canada. But it won’t pass in the House, and Trump has already said that he won’t sign it.

Meanwhile, the Stock Market Vigilantes aren’t giving Trump Tariffs 2.0 the benefit of the doubt. The S&P 500 and the Nasdaq plunged 9.9% and 10.7% from April 1, i.e., the day before Liberation Day through Friday’s close (Fig. 1 and Fig. 2). They are now down 17.4% and 22.7% from their respective record highs on February 19 and December 16.

In other words, Liberation Day has been followed by Annihilation Days in the stock market.

On Saturday morning, I nearly gagged on my bagel listening to a CNN interview with Peter Navarro. The President’s senior counselor for trade and manufacturing declared that the tariffs are aimed at benefiting Main Street, not Wall Street. Other senior officials in the Trump administration, including Treasury Secretary Scott Bessent, have said the same.

I have news for them: Wall Street is Main Street. Wall Street matters a great deal to Main Street. Main Street owns lots of stocks in American corporations that are facing massive disruptions as a result of Trump Tariffs 2.0. Navarro predicted that the stock market will bottom “soon” and that the stock market rally will broaden to include the S&P 493 and not just the Magnificent 7. Navarro also predicted that the Dow Jones will rise to 50,000 by the end of Trump’s term. He implored the media to accentuate the positives of Trump’s tariffs. In fact, the media was just as surprised by last week’s stock market rout as were Wall Street and Main Street.

Congress is about to get an earful. Main Street undoubtedly will voice our anger about the immediate adverse effects of Trump’s tariffs on our investment and retirement portfolios. Senior citizens who have retired or were planning to do so must be especially mad. The administration’s response is that the short-term pain will be worth the long-term gain. The problem is that Americans don’t do pain very well and aren’t convinced that the eventual gain will be worth it. So the pressures on congressional representatives from their constituencies to stop the tariff madness will be intense in coming days, especially if the stock market continues to crash.

Trump needs an exit strategy. The obvious one is for him to declare victory. He can keep his 10% base tariff on imports from all countries while delaying implementation of the reciprocal tariffs on countries that agree to negotiations. The stock market undoubtedly would rebound sharply if he were to do that.

There is some good news regarding tariffs. The Vietnamese reportedly are ready to drop their 90% tariffs. Argentina wants to go down to 0%. India and South Korea are negotiating with the White House. In February, the European Union considered dropping its auto tariff from 10.0% to 2.5%, and offered to buy American energy and weaponry to avoid Trump’s tariffs. Now, however, the EU is planning countermeasures to the new US tariffs. That could be the next shoe to drop on the stock market. Indeed, the EU was already finalizing a first package of tariffs on up to €26 billion ($28.4 billion) of US goods for mid-April in response to the US's steel and aluminum tariffs that took effect on March 12.

Meanwhile, as I noted in Friday’s QuickTakes, Trump’s tariffs are bound to be challenged in courts:

(1) The first case has been started by the New Civil Liberties Alliance (NCLA) on behalf of a small retail stationery business named “Simplified.” Bloomberg reported: “The lawsuit filed in federal court in Florida may be the first legal challenge to the sweeping new US tariffs. ... ‘By invoking emergency power to impose an across-the-board tariff on imports from China that the statute does not authorize, President Trump has misused that power, usurped Congress’s right to control tariffs, and upset the Constitution’s separation of powers,’ Andrew Morris, senior litigation counsel at NCLA, said in a statement announcing the suit. The complaint seeks a court order declaring the tariffs unconstitutional and finding that they were adopted in violation of US administrative rules.”

(2) Other business groups are considering similar challenges. Politico reports: “At issue is a nearly-50-year-old law, the International Emergency Economic Powers Act, that Trump is citing to impose both the duties on China and the global ‘reciprocal tariffs’ he announced this week. The 1977 law gives the president broad authority to respond to a national emergency. But Trump is the first president to use it to impose tariffs, which is a power the U.S. Constitution assigned to Congress.”

Might the Fed come to the rescue and provide enough monetary easing to offset the deflationary consequences of Trump’s tariffs? On Friday, Trump posted the following on Truth Social: “This would be a PERFECT time for Fed Chairman Jerome Powell to cut Interest Rates. He is always ‘late,’ but he could now change his image, and quickly. Energy prices are down, Interest Rates are down, Inflation is down, even Eggs are down 69%, and Jobs are UP, all within two months - A BIG WIN for America. CUT INTEREST RATES, JEROME, AND STOP PLAYING POLITICS!”

Also on Friday, shortly after Trump’s plea, Powell told business journalists in Arlington, Virginia, that the Fed is in no hurry to cut the federal funds rate. He said the Fed faces a “highly uncertain outlook” because of Trump’s reciprocal tariffs. He also said that the tariffs announced were “significantly larger than expected.” In his prepared remarks, Powell stated: “Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem. … We are well positioned to wait for greater clarity before considering any adjustments to our policy stance. It is too soon to say what will be the appropriate path for monetary policy.”

In other words, “Fuhgeddaboudit” was Powell’s response to Trump.

That was also Powell’s message to the financial markets. Nevertheless, by the end of trading on Friday, the financial futures market signaled that it expects two to three 25bps rate cuts over the next six months and four to five rate cuts over the next 12 months (Fig. 3 and Fig. 4).

Trump’s Tariffs II: Nero Golfs. In his CNN interview Saturday morning, Navarro claimed that thanks to Trump’s policies, the price of oil has dropped sharply, thus reducing the price of gasoline (Fig. 5 and Fig. 6). He also noted that bond yields have dropped, causing mortgage rates to decline (Fig. 7 and Fig. 8). He was making the debatable claim that the pain the tariffs are causing for stock investors has been more than offset by the gain of lower gasoline prices and mortgage rates. In addition, he stated that a few companies and countries have recently committed to spend trillions of dollars on capital investments in the US.

The Great Crash during the Great Depression was also accompanied by plunging commodity prices and interest rates. So it is hard to take comfort from last week’s drop in commodity prices and interest rates. The administration can’t take any credit for falling commodity prices and interest rates if the reason they are falling is that the administration’s tariff policies are causing a recession! Capital spending always declines during recessions even if spending commitments were made during good times.

The biggest risk to the economy currently, following last week’s stock market rout, is that the resulting negative wealth effect depresses consumer spending:

(1) Total equity market capitalization. Data compiled by the Fed show that the total value of stocks traded in the US at the end of 2024 was $93 trillion (Fig. 9). At the end of Q1-2025, the total value of the S&P 500 was $50 trillion. So a 10% to 20% drop in this stock index would amount to a loss of $5 trillion to $10 trillion just in the S&P 500. That could have a significant negative wealth effect on US consumer spending, especially by retired and retiring Baby Boomers.

(2) Who owns US equities? Of the $93 trillion in total equities, American households directly held $38 trillion at the end of Q4-2024. Mutual funds and ETFs held $24 trillion. Institutional investors including life insurance companies, private pension funds, and federal, state & local government retirement funds held $10.2 trillion. The rest of the world held $16.5 trillion (Fig. 10).

(3) Households & Baby Boomers. The Fed also compiles data for the net worth of the household sector excluding nonprofit organizations. At the end of 2024, households held $46.8 trillion in corporate equities and mutual funds (Fig. 11). The Baby Boomers accounted for more than half of that at $25.2 trillion (Fig. 12).

At the end of last year, households held a record $15.2 trillion in IRAs (Fig. 13). Altogether, equities as a share of the assets held by households (including NPOs) rose to a record 43.5% during Q4-2025 (Fig. 14). This means that they are more exposed to a negative wealth effect from falling stock prices. That’s what is happening on Main Street.

(4) ‘Nero fiddles as Rome burns.’ On Friday, the President went to Trump International Golf Club in West Palm Beach, before attending a fundraising dinner for a super PAC that backs Trump, MAGA Inc. On Saturday, he golfed at his course in Jupiter, where the Senior Club Championships are taking place. The White House reported that Trump “won his second round matchup of the Senior Club Championship ... and advances to the Championship Round tomorrow.”

The President wasn’t negotiating trade deals this weekend. He was too busy relaxing on the links.
 
Trump’s Tariffs III: Stress Testing a Resilient Economy. The plunge in stock prices since Liberation Day increases the odds that the resulting negative wealth effect will depress consumer spending, which increases the odds of a recession, which is, in turn, depresses stock prices. The odds of a recession according to Polymarket.com rose to 60% at the end of Friday (Fig. 15). It was at 42% on April 1.

We raised our subjective probability of a recession this year from 20% to 35% on March 5, and from 35% to 45% on March 31. Along the way, we also slashed our year-end target for the S&P 500 from 7000 to 6000 and cut our projection for 2025 S&P 500 earnings per share from $285 to $260. We also lowered our real GDP growth rate projection for this year from 2.5% to 3.0%, then down to 1.5%.

We expected Liberation Day to bring trouble. So for now, we aren’t changing our outlook or our odds of a recession. Call us delusional optimists, but we aren’t ready to bet against the resilience of the US economy in general or its consumers in particular. Of course, our big assumption is that Trump’s tariff nightmare will go away sooner rather than later, one way or another.

Meanwhile, let’s review the latest signs of the economy’s resilience; we acknowledge that they might be the last ones for a while if the nightmare persists:

(1) Employment. We anticipated a strong rebound in March employment from the depressed gains during January and February, which we attribute to colder-than-normal weather. Nonfarm payrolls rose 228,000 during March (Fig. 16). Private services-providing industries increased their payrolls by 197,000. Aggregate weekly hours worked rose to a record 4.6 billion (Fig. 17).

(2) Retail sales. We also expect to see a rebound in March retail sales when it’s reported on April 16. We already know that auto sales jumped 11% m/m during March to 17.8 million units (saar), the highest since April 2021 (Fig. 18). Some of that rebound undoubtedly reflected buying in advance of price increases resulting from Trump’s tariffs. April’s sales should also be very strong. But after that, sales could go over a cliff unless Tariff Man changes his mind.

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Onshoring, Hidden Bulls & AI In Fintech

April 3 (Thursday)

Strategy: Onshoring Set To Accelerate? As we write on Liberation Day, the details about President Trump’s tariff policies are being disclosed. In general, his plan will place a 10% tariff on all imports, and the rate will rise based upon countries' treatment of US exports. The new levies are bound to make companies with international manufacturing and US sales think hard about moving some of their manufacturing operations to the US to escape the tariffs. As we discuss below, a number of companies have already announced their intentions to do so.

We’ve followed the slowly growing onshoring trend that’s been years in the making (see the Morning Briefings dated April 11, 2024 and December 7, 2023). Lowering the corporate tax rate to 21% under Trump 1.0 certainly caught the eye of CEOs. But the roughly $500 billion of funding and tax incentives created by President Biden’s Chips and Science Act, Infrastructure Investment and Jobs Act, and Inflation Reduction Act seemed to get the ball rolling, with semiconductor companies and others setting up shop in Arizona, New York, and elsewhere. Given some of the large announcements already made this year, it looks like Trump's tariffs will further accelerate the trend.

Building new factories has pushed spending on nonresidential construction to new records; it has risen 55% over the past three to four years to $575.4 billion (Fig. 1). Likewise, the number of folks employed in heavy construction and civil engineering continues to hit new records, most recently at 1.2 million people in February, up 14% over the same time span. And those employed by nonresidential building and nonresidential specialty trade contractors jumped to 3.8 million in February, up 15% over the same period (Fig. 2).

The number of workers employed in manufacturing has also rebounded from the sharp pandemic decline, but it remains far below the peak levels of the 1980s (Fig. 3). Given the advent of sophisticated automation in manufacturing, factory headcounts may never return to heyday levels. But if the onshoring trend continues as we expect, US manufacturing jobs should continue to increase.

Here's a look at some of the companies that have been in the headlines just this year for opting to build new plants in the US:

(1) Onshoring steel. Hyundai announced last week its plans to build a $5.8 billion steel plant in Louisiana as part of the $21 billion it plans to invest in the US. The plant will hire more than 1,400 employees, and its steel will be used by the company’s two US auto plants. The South Korean conglomerate also plans to build a third auto plant in Georgia.

The “best way for [Hyundai] to navigate tariffs is to increase localization,” said Hyundai Motor CEO Jose Munoz in a January 15 Axios article.

TYC Americas, a Taiwanese supplier of auto lighting products for two- and four-wheeled vehicles, also announced that it would move its manufacturing operations from Taiwan and China to Michigan. The company’s facility is expected to create 109 jobs and invest $19 million in the state.

(2) Onshoring tech. Taiwan Semiconductor Manufacturing Co. and Apple both announced plans to spend big bucks in the USA. Taiwan Semi announced in early March plans to invest $100 billion to build three chip fabs in Arizona. This news follows the company’s plans to build one fab, announced during Trump 1.0, and two additional plants during the Biden administration, with the three requiring a $65 billion investment, a March 3 FT article reported. The company also plans to open a research and development facility in the US.

Apple has earmarked more than $500 billion for US projects over the next four years. The company and its partners plan to open an advanced manufacturing facility in Houston to produce servers to support Apple Intelligence, a company press release stated. The funds will also be used to increase Apple’s US-based research and development and to help its suppliers develop advanced manufacturing domestically and train employees.

(3) Onshoring pharma. Eli Lilly plans to open four new manufacturing “mega sites” in the next five years to reduce its reliance on overseas suppliers and increase its control over its supply chain, a February 26 Axios article reported. Three plants will create pharmaceutical ingredients, and the fourth will make injectable therapies. Lilly hasn’t chosen a location yet, but the expansion is expected to create 3,000 jobs at the company—and 10,000 construction jobs as they are built.
 
Strategy: Looking Beyond the Gloom. It has been a rocky start to 2025 for equities investors; but the average stock’s ytd performance isn’t quite as bad as the headlines referencing index performances suggest. While the S&P 500 has fallen 4.2% ytd through Tuesday’s close, the equal weighted S&P 500 is down just 1.0% (Fig. 4).

Likewise, more of the S&P 500’s sectors have gained ground so far this year than have lost ground. Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Energy (9.9%), Consumer Staples (4.9), Utilities (4.4), Health Care (4.2), Financials (2.9), Real Estate (2.8), Materials (2.6), Industrials (0.1), S&P 500 (-4.2), Communication Services (-5.5), Information Technology (-12.0) and Consumer Discretionary (-13.0) (Fig. 5).

This positivity isn’t reflected in the S&P 500’s returns because the sectors that are doing well have smaller market-capitalization shares of the S&P 500 than the sectors that have negative performances. Here are the market-cap shares of the S&P 500 sectors: Information Technology (30.5%), Financials (14.4), Health Care (11.1), Consumer Discretionary (10.0), Communication Services (9.3), Industrials (8.5), Consumer Staples (5.8), Energy (3.5), Utilities (2.5), Real Estate (2.2), and Materials (2.0) (Table 1).

Nonetheless, there are nuggets of sunshine amid the market’s gloom. Roughly 20% (24) of the 125 S&P 500’s industries we track rose by more than 10% over the course of Q1, and more than half of the S&P 500’s industries (67) are in positive territory ytd (Table 2).

Let’s take a look at some of the industries that have been bucking the market’s trend and rising this year.

(1) Gold proves its mettle. The S&P 500 Gold industry stock price index’s ytd rise of 29.7% indicates just how nervous investors are about the impact of President Trump’s tariffs (Fig. 6). To be fair, the price of the underlying gold metal started its bull run before Trump entered office, breaking out of a three-year trading range. The metal has rallied strongly since November 2023, gaining 61% and setting new record highs. The gold price rose 27% last year and 19% so far this year (Fig. 7).

The only company in the S&P 500 Gold industry index is Newmont; its share price declined 10.7% in 2024 and rose 29.7% ytd but has a ways yet to go before hitting a new high.

(2) Defense wins the day. The S&P 500 Health Care sector is living up to its defensive reputation. Several of its industries top the leaderboard, including Health Care Services (up 26.1% ytd), Health Care Distributors (18.2), Biotechnology (14.2%), and Health Care Facilities (13.5%).

Industries that have utility-like qualities—with steady cash flows and dividends—also have performed well this year. The inability to sell US goods internationally as easily as before Trump 2.0 doesn’t matter to this industry. Wireless Telecommunication Services (20.8%), Integrated Telecommunication Services (18.7), and Water Utilities (18.5) are among the S&P 500’s top industry performers.

And finally, the steady-eddy insurance industry has performed well. Premiums continue to climb, and people continue to pay them. So far this year, Insurance Brokers has risen 15.3%, followed by Multi-line Insurance (14.3%) and Property & Casualty Insurance (14.3%).

(3) One surprise. The Automotive Retail industry stock price index has performed surprisingly well, up 17.7% ytd, while the Automobile Manufacturers stock price index has tanked, falling 33.5%. Granted, much of this decline reflects the 33.5% drop in Tesla’s share price; but General Motors shares, down 11.3% ytd, haven’t fared well either. Ford Motor’s share-price performance so far this year is flat.

Automotive Retail shares may reflect the surge of consumers snapping up vehicles because they fear that prices will increase after President Trump’s 25% tariffs go into effect on imported vehicles today and on auto parts on May 3. US sales during March climbed for Ford (19% y/y), Subaru (17.0%), Hyundai Motor North America (13%), and BMW (4%), an April 1 NYT article reported. GM did not report its March sales, but Q1 sales jumped 17% y/y.

The excitement has left the Automotive Retail stock price index at a record high (Fig. 8). Earnings are expected to grow 5.8% this year and 14.1% in 2026 and the industry's forward PE—at a lofty 26.7—also is at a record high (Fig. 9 and Fig. 10). The hangover from this buying binge may be painful.

Disruptive Technologies: AI Helps Fintech Regain Its Groove. It has been a tough three years for the fintech community. As interest rates rose and free money disappeared, the amount of venture capital invested in fintech deals shrank sharply. Last year, fintech venture capital funding dropped 13% y/y to $29.5 billion, the third consecutive year of decline, according to a PitchBook report.

This year may mark a bottom, if not a turnaround, for the industry. A successful IPO by ServiceTitan in December left investors open to additional deals. ServiceTitan provides software to trade professionals, like electricians and builders. Among its many offerings, ServiceTitan's software provides financial services like checking, credit card processing, and consumer finance. Priced at $71, the shares closed Tuesday at $95. IPOs from Klarna, Chime, and GCash, a Mynt subsidiary, are in the pipeline, likely waiting for the stock market’s recent volatility to decline.

Investors are also excited about the deployment of artificial intelligence (AI) throughout the fintech and financial community. AI is being used in customer service, investing, and lending, among other areas.

Here are some of the ways the hottest fintech companies have been deploying AI:

(1) AI in credit scoring. Zest AI provides lenders with software that uses AI to help improve credit underwriting and reduce fraud. The company raised $200 million from Insight Partners late last year.

Zest isn’t alone in the space. Martini.ai introduced last month Financials Agent, a program that lets users upload financial documents, like annual reports, and uses AI to instantly generate a financial risk report. The program identifies key financial data—like income, debt, and cash flow—and generates risk reports that flag problems, such as with liquidity, debt, or other areas, explained a March 27 article in Fintech Finance.

(2) AI in research. FinTech Studios uses AI to help Wall Street analysts and regulators do their jobs. Its program can search through unstructured data from millions of online sources, including stories from global and regional news outlets; regulatory laws, rules, and other information from the government; and financial market data. Last month, the company announced it is integrating 11 large language models, including Open AI, Anthropic, and Cohere, into its platform.

(3) AI in investing. Robinhood plans to offer customers Robinhood Cortex, an AI investment research and trading assistant. “The tool can offer explanations for a particular stock’s rise or fall and suggest options trades based on a user’s expectations for a stock price,” a March 26 WSJ article reported.

The firm has lured customers with cool technology and low costs. Last year, Robinhood began offering a 1% match on contributions to traditional Roth and individual retirement accounts, with the match growing to 3% for customers with a “Gold” subscription. Robinhood Strategies offers clients the ability to invest with its team of wealth managers, but clients can’t contact the investment team or a financial advisor. Customers pay a 0.25% annual management fee, capped at $250 a year for Gold members.

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Tariffs Are Messy

April 2 (Wednesday)

Global Tariffs I: Liberation Day’s Main Event. This Morning Briefing is dated April 2, Trump’s “Liberation Day,” the date on which the administration will unveil further tariff plans and the effective date of some already announced. While we wrote this the day before, in between April Fool’s Day pranks (no, YRI is not really moving to Bali), we expect the administration’s April 2 announcements will be no joke for global economies.

The challenge of assessing the risk that Trump 2.0 tariffs pose to individual nations is complicated by the intricate web of intraregional trade among nations, by China’s rerouting US-bound goods through other nations to circumvent direct trade restrictions, and by the compounding effect of “stackable” tariffs, i.e., multiple layers of duties, which can significantly inflate costs. For instance, a steel auto part manufactured in China and shipped to the US could face a net tariff rate of 70% (20% for China’s goods, 25% for steel, and 25% for autos). However, Melissa’s research has found that, surprisingly, China might be less vulnerable to US tariff pain than Canada and Mexico for several reasons.

For instance, that would be the case if the White House’s Liberation Day announcements include another “stackable” global tariff of 10% on all imports to the US. A 2024 analysis noted in several White House tariff press releases suggests that a global 10% tariff would grow the U.S. economy by $728 billion, create 2.8 million jobs, and raise real household incomes by 5.7%. However, it would likely reduce global economic growth, jobs, and household income by similar scale. Outside the US, Mexico and Canada would face the largest GDP losses from a 10% tariff on non-commodity imports to the US, an OECD analysis found. In comparison, China would suffer the least, followed by Japan, the Eurozone, and India.

Trump has also mentioned possible tariffs on copper, which could impact major global copper exporters like Chile, Peru, Indonesia, Australia, and Mexico.

The main event in the April 2 announcements is bound to be more details on reciprocal tariffs, aimed at reducing the US global trade deficit. These tariffs could be tailored to specific countries or industries or applied broadly in the form of the 10% global tariff (see our February 12 Morning Briefing for more on reciprocal tariffs).

To set the scene for Liberation Day, let’s review the timeline of key Trump 2.0 tariff announcements so far:

(1) China 20% tariff. On February 4, Trump invoked the International Emergency Economic Powers Act to implement a 10% tariff on Chinese goods, raising it to 20% by March 3.

(2) Canada & Mexico 25% tariff. On February 1, Trump imposed a 25% tariff on goods from Canada and Mexico, with a 10% exception for Canadian energy products. On March 6, tariffs were scaled back to non-USMCA (United States–Mexico–Canada Agreement) goods, with an April 2 deadline for adjustments.

(3) Steel & aluminum 25% tariffs. On February 11, Trump reinstated the 25% steel tariffs and raised aluminum tariffs to 25% (up from 10%), effective March 12. Exemptions from previous agreements were eliminated.

(4) Autos 25% tariff. On March 26, the White House announced that beginning April 2, vehicles and car parts from other countries would face a 25% tariff. USMCA-compliant auto parts will remain tariff-free for now.

Global Tariffs II: Impact of China Goods Tariff. Despite the US’s increased tariffs, the impact on the Chinese economy has been relatively muted so far. China’s fiscal and monetary stimulus policies, along with currency depreciation, are likely to buffer the economic effects of US tariffs, reducing their impact on China’s growth. Also, Trump 2.0 tariffs are incremental to legacy tariffs that have reshaped trade relations, reducing China’s exposure to the US. So Trump 2.0’s 20% tariff on all made-in-China goods may have a smaller effect than widely expected, at least initially.

Here’s more:

(1) Legacy tariffs. The US had already imposed significant tariffs on China before Trump 2.0. By January 2023, the US statutory average tariff rate was 19.3%, covering 66.4% of US imports from China, according to the Peterson Institute of International Economics.

(2) Diminishing trade share. The US is continuing to diversify its trade relationships over time, which entails reducing its reliance on Chinese imports. This shift will likely alter the US–China economic balance and lessen mutual dependency.

Global Tariffs III: Canada & Mexico Bracing for Impact. Recent research suggests that the broad tariffs on Canada and Mexico will have a more substantial impact than those on China. Brookings estimates that a 25% tariff on all goods from these countries could reduce their y/y GDP growth by over 1ppt. Other modelers have reached similar conclusions.

However, two factors mitigate these effects: First, Brookings did not consider the 10% lower tariff for Canadian energy, which accounts for about a third of Canada’s exports to the US. Second, the analysis assumes that all goods from Canada and Mexico are affected, but tariffs currently apply only to non-USMCA goods.

By April 2, all goods may fall under the 25% tariff except for Canadian energy, which remains subject to the 10% rate. This poses a significant problem for both Canada and Mexico, as the US is both countries’ largest export market.

Brookings modeled the impacts of a blanket 25% tariff, finding a substantial economic shock to both countries. Unlike the incremental China tariffs, there were no pre-existing tariffs on imports from Canada and Mexico. Additionally, Brookings observed that cross-border supply chains will exacerbate the tariff impact.

Brookings’ key findings include:

(1) GDP Impact. Canada and Mexico could lose around 1.15ppts of y/y GDP growth due to the 25% tariff. Job losses are projected at 278,000 for Canada and 1.4 million for Mexico.

(2) Export declines. Exports from Canada to the US could contract by 9%, while Mexico’s exports could shrink by nearly 14%. Exports across several sectors in both countries are expected to decline, including electronics, mining, and automotive.

Global Tariffs IV: Targeting China Dumping to Reshore Steel & Aluminum. The reinstatement of the 25% steel and aluminum tariffs, while removing exemptions, is focused on countering China’s global dumping of excess steel and aluminum. China’s overproduction has contributed to the decline of domestic production in the US.

Countries that previously had been granted exemptions—including Argentina, Australia, Brazil, Canada, Japan, Mexico, South Korea, the EU, Ukraine, and the UK—will now feel the impacts. If the tariffs succeed in curbing China’s overproduction, global steel and aluminum prices are expected to rise.

Here are the potential effects:

(1) China. As the primary target of these tariffs, China’s surplus steel and aluminum production should affect global prices less than before. China’s steel, priced more for competitiveness than profit for its mills, was nearly half the cost of US steel, according to the US International Trade Commission as of September 2024. This pricing strategy has effectively pulled global prices down to approximately 75% of US prices.

(2) Canada, which accounted for 22.5% of US steel imports through September 2024, will also be impacted. Despite Canada’s imposition of tariffs on Chinese steel, China’s prices have stayed competitive, which has sparked the push for incremental US tariffs.

Global Tariffs V: Impact on the Global Auto Industry. The US auto industry is facing new challenges with the 25% tariffs now imposed on auto parts. Of the 16 million cars purchased by Americans, only 25% of the content is made in America. The remaining 75% will be subject to these tariffs, aimed at reducing the US trade deficit in automobile parts, which was $93.5 billion as of 2024.

Top sources of auto imports to the US include Mexico, Japan, South Korea, Canada, and Germany. These tariffs will have a far-reaching impact on the global auto industry.

Global Tariffs VI: An American Sneeze Would Go Viral. We recently raised our stagflation odds (which includes the possibility of a recession) for the US to 45%. The prospect of a growth slowdown from a global trade war is exacerbated by the lack of a “policy put” from the Federal Reserve and/or Trump 2.0 to support the stock market. Stocks have been hooked on stimulus and bailouts to stem crises since 2008. Americans, particularly retired Baby Boomers, have also been hooked on asset gains boosting their wealth and therefore spending. Now with falling stock prices and declining real economic activity, risk-averse consumer and business purchasing behavior could very well drag the economy into a slump.

However, European stock markets are still holding up better this year than the US market. The German Dax is up 13% ytd and near record highs, while the S&P 500 is down more than 4% and near correction territory. The UK’s FTSE 100 is up 4.5% and also near record highs. China’s CSI 300 is up 1.8% ytd and 8.6% over the past year. Seemingly, investors believe that the rest of the world can hold up amid a US downturn that is increasingly being priced into the stock market.

As it turns out, there’s some recent precedent for this. During the dotcom bust, US real GDP growth fell from 4.8% and 4.1% in 1999 and 2000, respectively, to 1.0% and 1.7% over the next two years. Chinese growth rose from 7.7% in 1999 to above 8.0% over the next two years and 10% by 2023. While German real GDP fell to 0.0% and contracted by 0.7% in 2002 and 2003, the UK continued to grow at an annual pace of 2.0% or more throughout 2001-03 (Fig. 1).

The dotcom bust had a vibe similar to that of today’s economy. A few preemptive Fed cuts and above-trend productivity growth were accompanied by a massive build up in hardware spending and broadband capacity that ended up outpacing demand. Bloated tech valuation multiples collapsed.

However, none of that would be the cause of a possible downturn this year. If the US enters a recession because investment stalls under uncertainty and real wages get depressed by tariffs and a weaker labor market, then foreign export-heavy economies would be crushed. Germany’s manufacturing sector already struggling to compete with China, and the UK economy is essentially dealing with stagflation (Fig. 2 and Fig. 3). The European Central Bank and the Bank of England have less room to cut interest rates than the Fed does, and fiscally Europe is more frugal (notwithstanding the recent infrastructure funding announcements).

Meanwhile, the US is at full employment, is a net energy exporter, and has a dynamic and flexible services-driven economy. Despite the US’s worrisome federal debt dynamics, China’s current bout of deleveraging is so extreme that it may take years (if not decades) to fully clean out. China’s current situations has similarities to Japan’s Lost Decades given the two countries’ similar demographics.

In short, we think the US would outperform the rest of the world in the event of a tariff-induced recession. That’s why we are maintaining our Stay Home (versus Go Global) bias, recommending that managers of global portfolios overweight US stocks.

Strategy: Another Strong Earnings Surprise on Tap for Q1. Joe has been tracking the quarterly earnings forecast for S&P 500 companies collectively each week since the data series started in Q1-1994. Each reporting season brings a typical playbook: Industry analysts cut their estimates gradually until the final month of the quarter, when some companies warn of weaker results. The combination of falling forecasts for companies that have underperformed earlier expectations, steady forecasts for those holding good news close to their vests, and insufficient estimate increases so close to reporting time to balance out the lowered expectations invariably creates an “earnings hook” pattern in the charted estimate/actual data as reported earnings exceed the latest estimates—i.e., a positive earnings surprise.

In other words, the final month of quarters usually sets the stage for better-than-expected earnings reports. When earnings forecasts fall sharply during the tail-end of a quarter, earnings surprises are typically smaller. Will Q1-2025 prove true to form? Joe believes so. Below, he digests the consensus’ final outlook for the index’s Q1 EPS and earnings growth rate ahead of the earnings season:

(1) Q1 estimate revision a touch deeper than usual. At the end of March, the S&P 500’s consensus Q1-2025 EPS estimate of $60.11 was down 4.3% from $62.82 at the start of the quarter in January (Fig. 4). Downward revisions activity has been relatively quiet in recent weeks. Indeed, nearly all of Q1’s decline occurred in the first half of February during the peak of the Q4 earnings season. Since then, the consensus Q1-2025 estimate has drifted just 0.8% lower.

While the 4.3% decline in the Q1 estimate over the course of the quarter is the biggest such drop in five quarters, it’s only marginally worse than the 3.2% drop for Q4-2024—which in turn was nearly spot on the post-pandemic average decline of 3.3% since Q1-2022. Viewed from a broader perspective, Q1’s 4.3% drop compares to an average 3.9% decline over the 124 quarters since consensus quarterly forecasts were first compiled 30 years ago.

This “not-too-cold” revisions activity implies yet another strong earnings surprise will be reported in Q1. In fact, S&P 500 companies have reported an aggregate earnings beat in 62 of the 64 quarters since the Great Financial Crisis, missing only in Q1-2020 and Q4-2022. With the typical earnings hook, we’re forecasting that Q1-2025’s final EPS and growth rate will be $63 and 11.4%, respectively.

If our forecast comes to pass, Q1 would mark a second straight quarter of double-digit percentage earnings growth for the S&P 500. It hasn’t posted a double-digit growth string in 10 quarters, since Q1-2022 ended a string of five quarters of double-digit growth following the pandemic.

(2) S&P 500 earnings growth streak to reach seven quarters. Analysts expect the S&P 500’s earnings growth rate to be positive on a frozen actual basis for a seventh straight quarter following three consecutive y/y declines through Q2-2023. They expect 6.3% y/y growth in Q1-2025, compared to 13.8% in Q4-2024, 8.2% in Q3-2024, 11.3% in Q2-2024, and 6.6% in Q1-2024 (Fig. 5 and Fig. 6). On a pro forma basis, they expect Q1 to represent a sixth straight quarter of positive y/y earnings growth, up 8.0% y/y (Fig. 7). These compare with 9.1% in Q3-2024, 13.2% in Q2-2024, and 8.2% in Q1-2024.

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Inflation In Trump’s World

April 1 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Economy: Expecting Unanchored Inflation Expectations? In yesterday’s Morning Briefing, we raised our expected 2025 PCED inflation rate from 2.0%-3.0% to 3.0%-4.0%. While services disinflation should continue, goods prices are very likely to raise consumer prices in short order. After the Trump tariffs’ “one-time price hikes” work through the economy, we think the PCED rate could return to 2.0%-3.0% next year. That’s the Federal Open Market Committee’s (FOMC) general expectation now as well, though it’s more optimistic about the ultimate PCED rate than we are, based on the FOMC’s latest Summary of Economic Projections (SEP) (Fig. 1).

Most mainstream monetary policy theory suggests that tariffs should be “looked through,” meaning they shouldn’t be a reason to raise interest rates in an attempt to counter tariff-induced higher prices; that would unduly tighten financial conditions. However, this Trump Tariff Turmoil 2.0 may poke holes in that theory should it alter Americans’ perceptions about inflation.

Tariff announcements have been capricious, and legal barriers prevent the tariffs from being rolled out all at once. So businesses and consumers will likely be seeing rolling price increases for several quarters. Moreover, if tariffs are used as negotiating sticks later in the year with no preannouncements, that could further upset the typical price behavior. Retaliation by other countries could easily raise prices as well. And of course, inflation remains elevated above the Fed’s 2.0% target, and the pandemic price shock is still fresh in Americans’ minds.

“Inflation expectations” is likely to be one of the Federal Reserve’s phrases of the year. The basic thought is that businesses and consumers make investment and consumption decisions in part based on their inflation expectations rather than on current inflation. When they expect higher inflation in the future, consumers may prepare by asking for a raise at work, businesses may jack up selling prices in anticipation of higher input costs, and investors may shift allocation decisions to protect their assets against inflationary effects. So just expecting inflation can lead to actual inflation, which is why policymakers are so scared about expectations becoming “unanchored” or rising above levels consistent with around 2.0% y/y inflation.

On the flipside, when inflation expectations are well anchored and people trust that the Fed will keep inflation near 2.0%, behavior normalizes when the Fed provides stimulus during a downturn. Anchored expectations also helps avoid deflationary spirals, where falling expectations reduce consumer spending and limit stimulus efforts.

Indeed, Fed Chair Jerome Powell mentioned inflation expectations early in his March FOMC press conference. He was optimistic and regarded them to be well anchored across various measures. However, signs are mounting that businesses and consumers are losing faith in inflation’s stability. The FOMC’s 100bps of interest rate cuts in the second half of last year, ongoing fiscal stimulus, and now volatile trade policy may be undermining faith that the Fed can achieve its 2.0% target as we speak.

Let’s discuss the latest inflation sentiment data as well as hard price data, and what it all may mean for the Fed:

(1) Powell on inflation expectations. The Fed’s dual mandate demands that the central bank balance price stability and full employment as equal goals, calibrating monetary policy to maximize both. However the two goals are interrelated, mostly via inflation expectations, as Powell has said many times.

For example, at the Jackson Hole Economic Symposium in August 2020, when Powell was announcing the Fed’s updated framework (updates occur every five years), he said the Fed would employ “average inflation targeting”—i.e., targeting 2.0% y/y inflation not continuously but as an average over multiple years. That concept is likely to be nixed in this year’s update, as it may have led the Fed to let inflation get out of control before hiking rates in 2022 (Fig. 2). But back in 2020, CPI inflation was just 1.3%; getting the rate up to 2.0% was the challenge and deflation was the worry. He said, “Well anchored inflation expectations are critical for giving the Fed the latitude to support employment when necessary without destabilizing inflation.” The risk was that, unanchored, inflation expectations would be too low.

Two years later, that same statement was true, but for the inverse situation—i.e., the risk was that inflation expectations would be too high for price stability. At the Jackson Hole Economic Symposium in August 2022, as consumer price inflation was above 8.0%, Powell cited the “public’s expectations about future inflation” as being important for the path of actual inflation over time, and a key learning lesson from the Volcker-era Fed. And in November 2022, Powell said that “

rice stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy … Without price stability, we will not achieve a sustained period of strong labor market conditions.”

(2) Inflation expectations and monetary policy. We can infer that Powell believes that when the labor market is hot, if inflation expectations become unanchored then the Fed will have to tighten policy so much that full employment cannot be sustained. Given that the unemployment rate is currently a low 4.1%, we think the Fed will be much more concerned about losing the public’s faith on inflation than about stemming a downturn in the economy (Fig. 3).

We’ve noted in our Credit Crisis Cycle theory that the Fed tends to cut interest rates in reaction to financial crises. Since 2008, this mostly has been done to prevent crises from morphing into credit crunches, which lead to economic downturns (Fig. 4). Successfully, the Fed averted long-lasting recessions in 2019, 2020, and 2023 (though perhaps at the cost of overstimulating the economy and accelerating inflation). However, today’s threat is macroeconomic policy uncertainty from Washington rather than any financial contagion, which the Fed would have the most firepower to fight. We therefore think that, absent a black swan event or unemployment surging toward 5.0%, it’s far more likely that the Fed will remain on hold with respect to rate changes this year—i.e., we continue to project “none and done.”

Because of the expected impact of tariffs on consumer prices, Goldman Sachs economists raised their year-end core PCE inflation forecast by 0.5ppt to 3.5% y/y. But they also upped their federal funds rate cut expectations this year from two to three, all in the second half of the year, based on expected weaker economic growth. During Q4-2024, they lowered their 2025 real GDP growth forecast by 0.5ppt to 1.0% y/y and raised their unemployment forecast from 4.2% to 4.5%. To us, these preconditions are not enough to spark an additional 75bps of rate cuts for a total of 175bps this cycle. In fact, we suspect the FOMC members may be regretting how much they cut rates last year amid a possible inflation redux.

(3) Measures of inflation expectations surging. Survey-based measures of inflation expectations are rising—rapidly. The University of Michigan consumer sentiment survey shows year-ahead expected inflation at 5.0%, nearly as high as the pandemic peak and 4.1% over the next five years, the highest on record (Fig. 5).

Inflation expectations in the New York Fed’s consumer survey are at or above 3.0% y/y for all future periods (Fig. 6). Even rent expectations are starting to increase, suggesting a broader shift in the public’s perception of inflation than just on tariff-related goods (Fig. 7).

(4) Actual inflation probably rising soon, too. If the 25% tariff on all autos is sustained, headline inflation may increase quickly.

Used car inflation surged during the pandemic as supply chains furled, which bled into new car prices (Fig. 8). While the rate of price increases has plateaued, the costs of auto maintenance, repairs, and insurance surged in 2023 and 2024 to keep up with the earlier price rises, which they tend to lag.

So just when auto industry inflation was poised to finally settle down this year, the coming tariffs will boost new car prices directly and likely will boost used car prices indirectly as demand shifts toward them, which threatens to keep insurance and maintenance costs on a continual climb. This “rolling inflation” could boost inflation expectations.

(5) PCED inflation. The Fed’s preferred inflation gauge has been accelerating since November. One- and three-month annualized core PCED inflation rates were 4.4% and 3.5%, respectively, in February (Fig. 9). Both are not just well above the 2.0% target but also higher than the 6- and 12-month annualized rates of 3.1% and 2.8%, respectively. Further monthly increases in the 0.2%-0.3% range would keep the core PCED above 3.0% by year-end, whereas anything north of 0.35% m/m would likely raise questions about whether the Fed needs to hike interest rates again.

(6) Commodities already rising. The price of copper has shot up recently, likely due to a combination of Chinese and European stimulus as well as tariff frontrunning. Given its role as a key input in industrial processes, copper is tightly correlated with “breakeven inflation” (the difference between nominal and inflation-adjusted Treasury yields) (Fig. 10). That suggests that inflation expectations—and bond yields—are likely to rise in the coming weeks.

While supercore (core services ex-housing) inflation is generally trending in the right direction, tariffs and increased demand for goods are likely to boost goods prices (Fig. 11 and Fig. 12). We expect durable goods inflation to turn positive during Q2, while nondurable goods inflation will likely climb above 1.5% y/y. The end of goods deflation combined with sticky and too-high services inflation risk sending inflation expectations—and therefore actual inflation—climbing out of control.

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Trump’s Reign Of Tariffs: Stagflation Odds Up, S&P 500 Target Down

March 31 (Monday)

YRI Bulletin Board. Our colleague Eric Wallerstein is taking a leave of absence. He has accepted a position on the President’s Council of Economic Advisers. We wish him all the best.
 
YRI Weekly Webcast. Join Dr Ed’s live webcast with Q&A on Mondays at 11 a.m., EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Reign Of Tariffs I: Losing Confidence. Does President Donald Trump want a recession? He is going to get one if he continues to pursue his chaotic tariff policies. Consider the following:

(1) CFOs & CEOs. According to a recent small survey of chief financial officers conducted by CNBC and discussed in a March 25 CNBC post: “In a word, the ‘pessimism’ has crept back in where the animal spirits had been after Trump’s election. That’s one way to sum up the results from the latest CNBC CFO Council quarterly survey for Q1 2025.”

Ninety percent of the surveyed CFOs say tariffs will cause “resurgent inflation.” The majority of the CFOs expect a recession in the second half of 2025. They should know: The CFO Council survey is a sampling of views from CFOs at large organizations across sectors of the US economy. The Q1 survey covered replies from 20 respondents and was conducted between March 10 and March 21.

The Business Roundtable CEO Economic Outlook Index dipped modestly during Q1 (Fig. 1). In a special question posed this quarter, chief executive officers were asked to identify policies and actions that are important for strengthening domestic manufacturing. Seventy percent of respondents selected keeping tariffs low on intermediate inputs and raw materials, particularly those that cannot be sourced in the US.

This quarter’s survey, conducted from February 19 through March 7, 2025, was completed by 150 CEOs. More than three-quarters of responses were submitted before the 25% US tariffs on Canada and Mexico were announced on March 3, 2025. Odds are that the Q2 survey will show a big drop in the CEO index, which could weigh on capital spending.

(2) Small business owners. The Uncertainty Index, compiled by the National Federation of Independent Business from a monthly survey of small business owners, was 104 in February, the second highest on record (Fig. 2). The highest was 110 during October 2024.

(3) Consumers. Also losing their confidence in Trump 2.0 are consumers. Debbie and I track the Consumer Optimism Index (COI), which is the average of the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI). It fell to 75.4 during March, which is the lowest since July 2022 (Fig. 3). In March 2017, during Trump 1.0, the COI was 111.3. Leading the way down has been the COI expectations component at 58.9 in March, the lowest since July 2022 (Fig. 4).

According to the CSI survey, consumers are depressed because their inflationary expectations soared in March to 5.0% over the next 12 months, up from 3.3% in January (Fig. 5). Their five-years-ahead inflationary expectations also jumped, to 4.1% in March from 3.2% in January. According to the CCI survey, more consumers are expecting fewer jobs will be available in six months (Fig. 6).

(5) Credit investors. The yield spread between the high-yield corporate bond composite and the 10-year Treasury bond yield has risen from a recent low of 239bps on January 24 to 320bps on Thursday (Fig. 7). That’s still a relatively narrow spread. Starting to show more signs of stress is the Invesco Senior Loan ETF (BKLN). It is down 1.7% so far this year (Fig. 8).

(6) US stock investors. On Saturday, March 22, President Trump said that he would be “flexible” on reciprocal tariffs. The S&P 500, which had fallen to a 2025 low of 5521.52 on March 13 (a 10.6% correction), peaked at 5776.65 on March 25 (Fig. 9). At Friday’s close, it was back down to 5580.94 as investors realized that Trump was actually turning less flexible on tariffs. Indeed, on Monday, March 24, Trump threatened that countries that purchased oil and gas from Venezuela would face a 25% tariff on trade with the US. The S&P 500 is now down 9.2% from its record high on February 19. The Nasdaq is back in correction territory, with a 14.1% decline (Fig. 10).

To be fair, the stock market’s woes aren’t all attributable to Trump 2.0. Investors have been questioning the sustainability and credibility of the AI story, with more concerns that it might be a bubble that is starting to burst. The Magnificent-7 have been at the forefront of this story. The Roundhill Magnificent-7 ETF (MAGS) is down 15.4% so far this year, while the Defiance Large Cap ex-Mag 7 ETF (XMAG) is down only 0.6% over this same period (Fig. 11). The S&P 500 Data Center REIT has dropped 21.8% since it peaked at a record high on November 29, 2024 (Fig. 12).

(7) Global stock investors. Even overseas stock markets are weakening as investors realize that Trump’s tariffs are bad news not only for the US economy but for plenty of other economies around the world. Indeed, many economies might be more vulnerable to the tariffs than the US if their exports to the US are greater than are their imports from the US. Trade is more important to many economies than it is to the US economy.

The outperformance of overseas stock markets relative to the US stock market, which started at the beginning of this year, might be over already, as the ratio of the US MSCI stock price index to the All Country World ex-US MSCI stock price index appears to be bouncing off its long-term uptrend line (Fig. 13). In addition, the China AI rally also seems to be over. The Invesco China Technology ETF (CQQQ) has declined 11.1% since it peaked this year on March 17 (Fig. 14). Over this same period, the Nasdaq 100 (QQQ) is down only 2.7%.

Reign of Tariffs II: Stagflationary Consequences.  Along with CEOs, CFOs, small business owners, consumers, and investors, we are losing our confidence in Trump 2.0. Trump’s Reign of Tariffs is tariff-y-ing:

(1) In a March 18 Fox Business Network interview, Treasury Secretary Scott Bessent said, “We are going to go to them [our trading partners] and say, ‘Look, here is where we think the tariff levels are, nontariff barriers, currency manipulation, unfair funding, labor suppression, and if you will stop this, we will not put up the tariff wall.’” If a country doesn’t change those policies, he continued, “then we will put up the tariff wall to protect our economy, protect our workers, and protect our industries.” That sounds like a reasonable way to force other countries to lower their trade barriers.

(2) Trump’s “flexible” comment a few days ago reflected his realization that estimating the impact of nontrade barriers was an impossible feat. So the reciprocal tariffs that he will be announced on April 2 will be based on estimates of average tariffs imposed by each trading partner with a trade deficit with the US.

In his Fox interview, Bessent said, “I’m optimistic that, April 2, some of the tariffs may not have to go on because a deal is pre-negotiated,” he added, “or that once countries receive their reciprocal tariff number, that, right after that, they will come to us and want to negotiate it down.”

(3) However, some tariffs will be permanent, according to Trump. On March 12, he imposed 25% tariffs on all steel and aluminum coming into the US; on March 26, he announced 25% tariffs on all motor vehicles and parts imported into the US. These will be even more prohibitive if they are stacked on top of the average reciprocal tariffs.

The permanent tariffs on autos and parts, along with the permanent tariffs on aluminum and steel and possibly copper, are already boosting the prices of the metals and may soon increase both new and used car prices (Fig. 15). Would-be auto buyers might respond to higher prices by continuing to drive their current vehicles. If so, then the auto industry will be hit with stagflation.

Initially, auto sales might boom in the next month or two as buyers scramble to buy autos before prices are raised to reflect the higher costs of producing a car in the US. Meanwhile, Trump warned automakers on Thursday not to raise their prices; yet not doing so would kill their profit margins. On Saturday, Trump told NBC News in an interview that he “couldn’t care less” if automakers raised prices.

For now, dealers have stockpiled a two- to three-month supply of new cars, so the impact of the tariffs might not start to be felt until June. At that point, vehicle prices could rise by more than 10% to offset the tariffs. That would push up auto insurance fees and the costs of maintenance and repair (Fig. 16).

(4) The collective impact of all these tariffs is increasingly likely to be stagflationary. The tariffs will be paid either by foreign exporters to the US, US importers, and/or US consumers. The result will be higher prices and narrower profit margins than otherwise.

Economists generally agree that tariffs are a tax on imported goods that are normally paid by the importing company, which in turn passes on some or most of the cost of the tariffs to consumers in the form of higher prices.

Reign of Tariffs III: Stagflationary Readings. It’s really a shame that Trump is so willing to take a wrecking ball to the economy. It has been very resilient over the past three years in the face of the tightening of monetary policy. We are losing our confidence that it can remain resilient in the face of Trump’s Reign of Tariffs. The latest batch of data suggests that stagflation is already eroding the stellar performance of the economy, which hasn’t been in a recession since the pandemic lockdown in early 2020:

(1) Personal income, consumption, and saving. Colder-than-normal weather during January and February undoubtedly depressed consumer spending those two months. Industrial production of utilities rose to record highs in both months (Fig. 17). The Atlanta Fed’s GDPNow tracking model is showing that real consumer spending rose only 0.3% (saar) during Q1. We expect to see strong rebounds in March and April consumer spending as the weather improves and consumers scramble to buy autos and other goods before their prices go higher. That could set up the economy to be quite weak during Q3 and Q4 if consumers retrench when they are hit by higher prices attributable to Trump’s tariffs. Capital spending is also likely to get hit during the second half of this year.

For now, the labor market remains strong, as reflected by low initial unemployment claims. February’s real personal income rose 0.4% m/m, and the nominal personal saving rate increased from 3.3% in December to 4.6% in February because the cold weather held down consumer spending.

(2) PCED inflation. We no longer expect that the PCED inflation rate will range between 2.0%-3.0%, as it has since early 2024 (Fig 18). Instead, we expect to see it range between 3.0%-4.0% over the rest of this year before it settles back down to 2.0%-3.0% next year, maybe. The PCED services inflation rate should continue to moderate (Fig. 19). However, the PCED goods inflation rate is likely to rise faster along with tariffs in coming months (Fig. 20).

(3) Regional business surveys. The ISM manufacturing PMI was showing signs of recovering during January and February (Fig. 21). The same can be said about the regional business surveys conducted by five of the 12 Federal Reserve district banks. However, the regional surveys suggest that the manufacturing recovery faltered in March in reaction to Trump Tariff Turmoil 2.0.

Just as disturbing is that the regional prices-paid and prices-received indexes jumped higher since the start of the year through March (Fig. 22 and Fig. 23). The surveys suggest that stagflation is seeping into the economy. The obvious source of the problem is Trump’s tariffs.
 
Reign of Tariffs IV: Recalibrating Our Forecasts Again. We’ve alerted you before that we might have to change our minds more often because Trump changes his mind so often. Here we go:

(1) Raising stagflation odds. We are reducing the subjective odds of our optimistic Roaring 2020s scenario from 65% to 55% and raising the odds of a pessimistic stagflation scenario from 35% to 45%. The former worked out great for us during the first half of the current decade. We still expect it to prevail over the remainder of the decade. But Trump’s Reign of Tariffs is likely to get in its way this year. The stagflation scenario includes the possibility of a shallow recession during the second half of this year. The higher inflation part of stagflation is almost a certainty.

(2) Real GDP. We had been expecting 2.5%-3.0% real GDP growth this year, similar to the pace of the past year (Fig. 24). We are lowering that to 1.5%. Here are our forecasts for the four quarters of 2025: Q1 (1.0%), Q2 (3.5%), Q3 (0.5%), and Q4 (1.0%). The last two quarters could have negative signs. The surge in Q2’s real GDP reflects a buy-in-advance rush by consumers during April and May before tariffs jack up prices in June.

(3) Inflation. As discussed above, we are raising our PCED inflation forecast range to between 3.0%-4.0% over the rest of this year and then lowering it back down to 2.0%-3.0% in 2026. That assumes that there won’t be a trade war with tit-for-tariff retaliation. If there is, there will be a recession that will bring inflation down.

(4) Interest rates. We’ve been predicting none-and-done for Fed rate-cutting this year because of better-than-expected GDP growth. Now we are predicting that the Fed won’t be able to ease even if the economy stagnates because higher inflation will force the Fed to stay put. The Fed Put will remain on hold. As a result, we aren’t changing our forecast for the 10-year Treasury bond yield to remain in the 4.25%-4.75% range this year.

(5) Stock market. We’ve previously written that we couldn’t rule out a bear market under the circumstances, which have continued to deteriorate under Trump’s Reign of Tariffs. Our increased stagflation odds—to 45%—is also the odds that the current stock market correction will turn into a full-blown bear market. In other words, if we have stagflation in the economy, we can expect to have a bear market in stocks.

So we are lowering our S&P 500 year-end target (again) from 6400 to 6100, which would be up 4% from the end of last year. In this scenario, the current correction could turn into a bear market in coming months before turning into a bull market again later this year on expectations of a resumption of the Roaring 2020s in 2026 and beyond. In addition, later this year, investors might begin to anticipate that the Fed will start lowering interest rates early in 2026 to clean up the mess from Trump’s Reign of Tariffs.

(6) Politics. The Stock Market Vigilantes are also losing their confidence in Trump 2.0. The risk is that they cause a bear market, resulting in a consumer-led recession as the negative wealth effect depresses consumer spending (especially by retiring Baby Boomers). This time, the Fed won’t come to the rescue so quickly if inflation is heading higher again. We are hoping that the Republicans will realize that the odds are increasing that they will lose their majorities in both houses of Congress if the White House continues to pursue stagflationary trade policies.

(7) Personal note. Admittedly, it’s getting harder to be optimistic, but we are doing the best we can under the circumstances.

Movie. “Eileen” (- - -) is a boring 2023 movie about a deranged young lady who works at a boys’ corrections facility. She becomes infatuated with a new female psychologist played by Anne Hathaway. The relationship leads to a crime. Watch the first 30 minutes and the last 15 minutes. Everything in between is a waste of time. (See our movie reviews archive.)

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On Utilities, Inventories & EVs

March 27 (Thursday)

Utilities: Going for Growth. Once a sleepy corner of the stock market, the S&P 500 Utilities sector is now a hotbed of debate. Fans believe that growth in data centers, cryptocurrencies, electric vehicles (EVs), the reshoring of manufacturing to the US, and ultimately robots will spark sharp growth of electricity demand. US power demand grew only 1%-2% annually over the past decade, muted by efficiency increases; but over the next 10 years, demand could grow 6%-8% annually according to a December 19 Fidelity report.

Naysayers warn that a bubble is brewing in data centers that could leave utility bulls charging at air. On Tuesday, one of those naysayers grabbed headlines: Alibaba Chairman Joe Tsai warned that construction of data centers may outstrip demand. Some projects are raising funds before locking in customers, and the building of data centers on spec suggests to him a bubble forming.

The S&P 500 Utility sector shed 1.6% on Tuesday in the wake of these comments, while the S&P 500 gained 0.2%. Still, the sector is in positive territory ytd through Tuesday’s close, while the S&P 500 is in negative territory.

Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Energy (8.9%), Health Care (5.6), Financials (4.3), Materials (2.9), Industrials (2.1), Real Estate (1.6), Utilities (1.6), Consumer Staples (0.9), Communication Services (-0.1), S&P 500 (-1.8), Information Technology (-7.7), and Consumer Discretionary (-9.5) (Fig. 1).

Folks who watch the real estate market appear to disagree with Tsai’s assessment. A recent report by Jones Lang LaSalle (JLL) noted that as 2024 concluded, existing data centers were full, space in data centers coming online imminently was largely spoken for, and the market for data centers—and therefore demand for electricity—should remain strong for years to come. Here are some of the report’s highlights:

(1) Tight market in 2024. The US data center vacancy rate fell to a record low of 2.6% by the end of last year. It’s even tighter in the more popular markets, like Northern Virginia, where vacancy is only 0.6%. “Tenants looking to lease any sizable amount of data center capacity must wait 24 months on average. Limited availability is constraining sector growth,” the report stated. Given the tight market, data center owners were able to boost rents on average by 12% y/y in 2024, and rents have risen by roughly 50% over the past five years.

The market’s tightness was apparent yesterday. Microsoft abandoned leases on new data center projects set to use two gigawatts (GW) of electricity in the US and Europe because it decided “not to support additional training workloads from ChatGPT, maker of OpenAI,” Reuters reported. But don’t expect those data centers to remain dark. Alphabet’s Google and Meta Platforms are expected to take over the leases.

In 2024, construction was completed on 2.5 GW of colocation capacity, and almost all of it was absorbed at delivery. At the end of last year, 6.6 GW of colocation capacity was under construction, and 72% of that space has already been leased. Demand comes from cloud providers (43%) and the technology (23%) and finance (9%) industries.

Here’s the market’s concern: Over the next few years, 22.9 GW of planned projects are in the pipeline but not yet under construction. Despite this large wave of potential supply, the bulls have two solid arguments: (1) Artificial intelligence is a growing source of demand. It represented about 15% of data center workloads, and it could grow to 40% by 2030, JLL noted. (2) The road from planning to completing a project is long and fraught with issues surrounding zoning land, accessing equipment, and buying electricity. So the planned projects will take years to complete and won’t hit the market all at once.

(2) Challenges to building. JLL considers obtaining power the “primary challenge facing the data center industry.” The US power grid is operating near full capacity, so building a new data center can require developing new electricity generation capacity. Those utilities that do have available capacity often don’t have enough of it to run a data center, anywhere from 100 megawatts to 1 GW.

Utilities had been inundated with requests from developers that were buying land on spec, hoping to get electricity run to that land with plans of flipping the improved land to make a profit—until, that is, last summer, when utilities began tightening their requirements, the report states.

Utilities want to see project leaders with development experience, signed tenants, and financing that’s in place. They’re charging application fees of $200,000 or more, checking credit, and requiring a load impact study to be done, which can take 8-12 months. Moreover, once approved, developers are being required to pay for the infrastructure hookup costs and being asked to sign take-or-pay contracts obligating them to pay a minimum amount of their planned power usage, even if that power isn’t used.

As a result, developers have found themselves sitting on land they’ve purchased that isn’t generating cash flow for years longer than expected. Proposed data center projects, particularly those in rural areas, often have to wait four years or more for a connection to the grid.

These tougher requirements may make projects more costly or mean they take longer to complete. But they may also mean that only “good” projects come to the fore and a bubble takes longer to develop, if it does at all.

(3) Supply chain knots. For would-be data center builders who have land and electricity, acquiring equipment can be the next hurdle. According to JLL, it can take 28 weeks on average for the delivery of data center equipment. While that’s improvement from pandemic lead times of 64 weeks, it’s still far longer than the 18 weeks it took in 2019. Generators, transformers, and switchgear have an even longer lead time of 11 months. More than 70% of data center equipment is manufactured in Asia. Some of that manufacturing is relocating to the US or North American, which could improve the situation.

(4) Utility data. The S&P 500 Utilities sector includes the S&P 500 Electric Utilities industry, populated with companies that generate, transmit, and distribute electricity, and the Multi-Utilities industry, with companies that provide a combination of utility services, including electricity, gas, and/or water. The former industry index is up 3.2% ytd, the latter up 3.3% ytd (Fig. 2 and Fig. 3). Both are expected to have decent revenue and earnings growth. The Electric Utilities industry’s companies collectively are forecast to grow revenues by 6.9% this year and 4.0% in 2026 and to grow earnings by 4.9% this year and 7.7% next year (Fig. 4 and Fig. 5).

The S&P 500 Multi-Utilities industry is expected to grow a touch faster. Analysts forecast revenues growth of 10.2% this year and 4.4% in 2026, while they predict earnings will improve by 7.3% this year and 7.7% in 2026 (Fig. 6 and Fig. 7). Both industries have sported forward P/Es north of 20 at various times in recent years, and now the Electric Utilities’ forward P/E stands at 17.1, and the Multi-Utilities’ forward P/E is 18.0 (Fig. 8 and Fig. 9).

Strategy: JBT Inventory Management? Inventories and supply chains are back in the headlines as those who import products appear to be stockpiling them in an attempt to jump ahead of tariffs. Just-in-time (JIT) inventory management is out. Just-before-tariffs (JBT) inventory management is in. But pre-tariff stockpiling ties up corporate cash flow and can leave companies exposed to an unexpected downturn in sales.

US trade imports have jumped sharply since October, while exports have remained flat. Imports increased 12% in January y/y to $3.3 trillion (Fig. 10). Meanwhile, total business inventories increased 2.3% y/y in January, led by a 5.0% y/y jump in retail inventories, followed by smaller increases in wholesale inventories (1.1%) and manufacturing inventories (1.0%) (Fig. 11).

Here are some anecdotes from businesses willing to take on the extra risk of stocking up ahead of tariffs:

(1) Retailers plan ahead. Some retailers have rushed to fill their shelves ahead of Trump’s tariffs. Costco’s inventories were up about 10% compared to the previous year in the three months ended February 16, a March 24 WSJ article reported. Inventories were also up at Williams-Sonoma, Zumiez, and Target.

(2) Stocking up on copper, too. Copper futures prices hit new records on Tuesday, at $5.18 a pound, up 30% ytd (Fig. 12). The rally was attributed to buyers’ stockpiling the metal ahead of Trump’s 25% tariff. We’ll be watching to see whether the price falls once the tariff is imposed.

Copper isn’t the only metal affected. To avoid tariffs on Canadian imports, Alcoa told Reuters in January that it would reroute its Canada-made aluminum to Europe and send its Australian aluminum to the US.

(3) Ford leasing trucks and warehouses. Ford builds the engines for its F-150 trucks and Mustangs in Canada, normally on demand. But with the threat of tariffs on Canadian imports looming, Ford has been leasing trucks and warehouses in Michigan and Ohio so that it can fetch and store its Canadian-built engines in the US asap, a March 21 article on Motor Biscuit reported. That said, the industry’s inventory-to-sales ratio remains unusually low at 1.4 in January (Fig. 13).

Disruptive Technology: Tesla vs BYD. Just over a month ago, Tesla’s Elon Musk said that 2025 might be the most important year in the carmaker’s history. He was referring to the company’s plans to introduce unmanned autonomous vehicles in the US and its intention to produce Optimus humanoid robots and semi-trailer trucks (more in the February 6 Morning Briefing).

Musk was right that 2025 would be a memorable year for Tesla but for reasons he might prefer to forget. His involvement with the Trump administration has made Tesla vehicles targets of vandalism at home and abroad by protestors of Trump 2.0’s policies. Tariffs by the administration Musk is helping stand to hurt Tesla’s US profits. And Chinese competitor BYD has introduced a supercharger that is faster than Tesla’s by a long shot. Tesla shares have fallen 28.7% ytd through Tuesday’s close, while the Nasdaq has lost only 5.4% over the same period.

Let’s home in on BYD’s plans to flood the world (excluding the US?) with cheap, fast-charging EVs:

(1) ‎Fastest charger wins. China’s BYD shocked the markets recently with a new charger that juices up an EV as fast as filling a tank of gas. Using BYD’s Megawatt Flash Charging for one minute can provide a car battery with the energy it needs to drive 49.7 miles. That compares with 11.2 miles using Tesla’s supercharger and also beats the charging times of LI Auto (26.1 miles/minute), Mercedes-Benz (20.5), Volvo (18.6), and Hyundai (14.3), according to a March 25 article in Finbold.

That said, US road warriors won’t find BYD chargers on their routes anytime soon. BYD plans to build more than 4,000 ultra-fast chargers across China. In the past, BYD EV owners have relied on other car manufacturers’ charging stations to power up.

(2) Excess capacity on the way? BYD is building out a ginormous EV manufacturing campus in Zhengzhou, the capital of China’s Henan province. After an eight-phase growth process, the campus will cover 50 square miles, a March 24 InsideEVs article reported. That’s 10 times the size of Tesla’s Nevada Gigafactory and roughly the size of San Francisco.

Almost 60,000 of BYD’s 90,000 employees currently work at the campus; they can also live on site. The facility will ultimately have the capacity to produce about one million cars per year. That’s in addition to BYD’s Latin American hub in Brazil, which when completed in 2028 will produce 300,000 cars a year.

BYD’s Q4 revenues topped Tesla’s for the second quarter in a row, coming in at $28.8 billion versus Tesla’s $22.6 billion. Given the capacity BYD is building, that trend is likely to continue. Recognizing the threat to US manufacturers, the Biden administration placed a 100% tariff on Chinese EVs, which Trump is expected to extend. BYD investors haven’t flinched. Shares of the Chinese automaker have risen 30.8% ytd through Tuesday’s close.

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On The Fed, The ECB & Growing Earnings

March 26 (Wednesday)

Global Central Banks I: Transitory, Redux. The Federal Reserve, like all of us, is unsure what shape and form Trump 2.0’s tariffs will ultimately take. One thing Fed officials do seem certain of is that tariffs will result in a one-shot increase in prices rather than a persistent inflationary shock. That’s evident in the Federal Open Market Committee’s (FOMC) Summary of Economic Projections (SEP), which was updated at least week’s meeting. The FOMC’s median projection for the core PCE rate this year was revised up from 2.5% to 2.8%, while those for 2026 and 2027 were left unchanged at 2.2% and 2.0%, respectively (Fig. 1).

The Fed’s use of “transitory” to describe the surge of inflation in 2021 was a historic policy mistake that led to the highest inflation in four decades. Given the word’s unfortunate baggage, we feel that Fed Chair Jerome Powell shouldn’t have fallen back on using “transitory” in last week’s press conference. Frankly, it may have been a mistake to underscore the market’s expectations for more rate cuts sometime this year as well. He would have been better off saying, “We are uncertain as to what tariffs that will be imposed and uncertain about whether their inflationary impact will be transitory or persistent. Therefore, we won’t be lowering the fed funds rate until we get a better sense of these issues.”

That begs the question: Should monetary policymakers be preparing to look past tariffs’ one-time effects on prices? A recent working paper by the Minneapolis Fed suggests so: Its authors opine that the optimal monetary policy response to tariffs is to set expansionary policy to mitigate tariff’s negative economic growth effects. But given the post-pandemic experience and lingering elevated inflation, that theory might not hold.

Let’s discuss the risks of trying to predict tariffs’ follow-through effects and how this could all go wrong for the Fed:

(1) Inflation expectations. From the Fed’s perspective, the biggest risk is that a transitory price increase morphs into a persistent inflation shock. Primarily, the FOMC is watching market-based and survey-based inflation expectations to see whether price increases are becoming entrenched in business and consumer psychology. This would lead to an unanchoring of inflation expectations, which arguably is the cardinal sin of central banking.

While the University of Michigan’s consumer inflation expectations have surged, our preferred gauge, from the New York Fed, remains okay relative to history (Fig. 2). Meanwhile, the difference between nominal and real Treasury yields (a.k.a. inflation breakevens) and long-term inflation swaps also aren’t signaling concern (Fig. 3).

(2) Retaliation. A big question mark with respect to trade policy uncertainty is what retaliation entails. While Trump 1.0 and the Biden administration mostly targeted China with tariffs, this time around the “Dirty 15” comprises most of America’s largest trading partners. Will those countries also raise trade barriers, or will negotiations bring down trade barriers reciprocally? Will non-tariff trade barriers, such as fines on US businesses in the EU or joint-venture sharing agreements with emerging markets, be removed or ratcheted up? Will there be an endpoint for the uncertainty, or will tariffs be raised and lowered persistently?

The scale, scope, and longevity of tariffs can only be speculated about at the present moment. However, sustained uncertainty may ultimately promote more “stag-” than “-flation,” whereas lower trade barriers with select trading partners would promote economic growth even as import inflation from other countries raises prices. The end result on the US economy is extremely path dependent.

(3) Supply chains. Another possible result of retaliatory tariffs is that they foster a weaker version of the supply-chain shock during the pandemic. As companies reorder their supply chains to avoid producing in high-tariff countries (and also reshore back to the US generally), prices will rise and productivity will fall in the near term. Regional Fed M-PMI price indexes all have been surging recently (Fig. 4). The ISM national M-PMI price index is already increasing, and the NM-PMI index would likely join it in this scenario, as wages and nonlabor costs rise in response to a higher cost of living (Fig. 5).

That said, supply chains are generally more resilient than they were pre-pandemic and have been in good shape for the past couple years (Fig. 6). Business owners and wholesalers are likely more adept and prepared for shifts this time around than they were during lockdowns—especially since lockdowns were accompanied by massive stimulus to aggregate demand.

(4) China. The property-led economic bust in China, and its export-led model to boost growth, helped lower prices across the world. We’ve argued that the recession in China may have been the recession many thought would be required here in the US in order to bring down US inflation. Given the deflationary backdrop in China, we aren’t betting that consumer stimulus being pursued by Beijing will be enough to substantially lift pre-tariff export prices from China (Fig. 7).

(5) Upshot. Generally, uncertainty tends to keep business investment and some consumer spending at bay. So unless 25% tariffs are slapped on all major trading partners and sustained there—which Trump 2.0 has suggested will not be the case—it’s hard to see a complete stagflationary scenario without a 1970s-style oil price shock.

It’s too early to tell exactly what tariff and trade policy will look like. However, we do think that the odds that the Fed Put is on standby for longer are higher than the market appears to think. The Fed’s dovish bias won’t be able to kick in as long as inflation is travelling higher, which is highly likely in the near term.
 
Global Central Banks II: The ECB’s Bad News Bear. With the benefit of hindsight, the modest interest-rate-cutting cycle by the European Central Bank (ECB) to “meaningfully less restrictive” may have been enough to support the region's flagging growth.

For years, ECB President Christine Lagarde has hammered home her refrain: “The central bank cannot be the jack of all trades”—i.e., it can’t single-handedly fire up the economy in the absence of fiscal help. Now that help is here. After US President Donald Trump’s warning that the US would no longer guarantee Europe’s security in the event of war, Germany’s lawmakers responded by greenlighting large-scale borrowing to fund defense spending and infrastructure projects. On Friday, new legislation passed its final hurdle, unlocking a 500-billion-euro fund and loosening austerity rules to fund defense expenditure. Meanwhile, the European Commission’s new growth strategy—dubbed the “Compass”—aims to revive Eurozone economic growth through additional fiscal aid.

With policymakers now bringing fiscal firepower to support the Eurozone, Lagarde can retire her refrain. The ECB is no longer on the hook for the full responsibility of stimulating the economy. Quite the opposite: Inflationary pressures may mount in the wake of the new fiscal support and the looming tariff conflict with the US, so maintaining rates in a neutral range, instead of lowering them into accommodative territory, is a better posture for the ECB.

Is there a risk that upward price pressures could compel the ECB to raise rates once again? Probably not. Most global central banks for developed economies (excluding Japan) are on pause with dovish leanings to ease if necessary.

Here’s a breakdown of the latest ECB-related developments:

(1) Rates neutralizing? Since commencing its interest-rate cuts in June 2024, the ECB has reduced rates by 150bps (Fig. 8). Its January and March rate cuts of 25bps each have lowered the deposit rate to 2.50%. However, the bank isn’t stimulating the economy yet, at least by its own standards. Its key rate remains at the top end of the ECB’s identified “neutral” range of 1.75%-2.50%, i.e., neither restrictive nor stimulative. In other words, the ECB is more or less in a holding pattern.

(2) Growth bearish? On March 6, the ECB revised its real GDP growth projections to 0.9% for 2025, 1.2% for 2026, and 1.3% for 2027—primarily due to the ongoing trade policy uncertainty.

These projections were made before Trump issued his ultimatum asserting that Europe needs to defend itself, and the ECB’s staff would not have had time to factor in the expected fiscal stimulus. During her March 6 press conference, Lagarde noted: “An increase in defense and infrastructure spending could also add to growth.” Last Thursday, however, she hedged in comments to the media that a possible escalation of the trade war with the US could further weigh on eurozone growth. For perspective, real GDP ended Q4-2024 at 0.9% y/y (Fig. 9).

(3) Disinflation tracking? Lagarde has reassured the financial markets that the “disinflation process is well on track.” She emphasized that wage growth has moderated as expected, with profits helping to buffer inflationary pressures.

And while she acknowledged the potential for some inflationary pressure from tariffs, she downplayed its significance, stating: “My suspicion is that markets are seeing it as a growth increase in the future financed over a long period of time … Is there a little inflation anticipation associated with that? Probably, but not that significant.”

Eurozone annual inflation stood at 2.3% in February, down from 2.5% in January (Fig. 10). However, the ECB is concerned about wage inflation, as it has moderated but is still elevated.

The ECB’s latest projections forecast inflation continuing to head toward the ECB’s 2.0% target by 2027, with projections of 2.3% in 2025 and 1.9% in 2026. These projections were made in light of tariff threats but before the announcement of the massive fiscal spending spree.

(4) Quantitative tightening? Besides interest rates, also under the ECB’s scrutiny is its balance sheet. Pandemic emergency assets were unwound as of December 14. As of Friday, the ECB’s balance sheet stood at 6.3 trillion euros—well above the 4.7 trillion euros it held pre-2020 (Fig. 11). In line with its normalization process, the ECB plans to let billions of euros in debt mature in the coming years.

Lagarde has dismissed quantitative tightening (QT) as “not our key instrument,” claiming that it has “not been perceived as having a significant impact.” But we believe the ECB’s balance-sheet reduction does exert at least some tightening effect on the economy, particularly if and when Germany and others start issuing debt to fund this new fiscal spree.

(5) Equity markets rising. Despite some bumps along the way, the MSCI EMU (European Economic and Monetary Union) index has surged recently, breaking well above its 200-day moving average. From January 1 to March 25, the index spiked 10.5%, buoyed by fading US exceptionalism and the promise of increased domestic fiscal stimulus (Fig. 12). However, the index pulled back after the ECB’s second rate-cut announcement on March 6, the same day that Trump pulled the rug out under military aid to Europe.

(6) Bond markets souring or soaring? Germany's embrace of deficit spending—coupled with the likelihood that other more indebted nations may follow suit—has sent borrowing costs higher. Some have posited this is due to an erosion of confidence. We believe bund yields were too low due to lack of supply and weak growth—the projected increase in nominal growth from fiscal spending has helped them normalize.

German bund yields increased from 2.37% on January 2 to 2.81% as of Friday’s close (Fig. 13). At one point, they reached 2.90% on March 11, coinciding with the ECB’s March 6 rate cut along with Trump’s announcement.

Strategy: Growth Forecasts Positive Nearing Q1 Finish Line. The industry analysts’ consensus growth forecast for S&P 500 companies’ Q1-2025 earnings began the quarter at over 11%. It is exiting the quarter much lower, having edged down to 6.5% as of the March 20 week from 6.7% a week earlier (Fig. 14). Such declines are typical in quarters’ final weeks, when bad earnings news from a few major companies or industries tends to dominate estimate revisions activity. Also typical: The 6.5% y/y earnings growth rate is “back to trend” after stronger growth in prior quarters. At least Q1 earnings look set to post a y/y rise instead of the opposite, and for an eighth straight quarter.

The biggest downward revisions occurred earlier in the quarter for the steel industry in the Materials sector, followed by Consumer Discretionary (Telsa) and Industrials (Delta/Fedex) in recent weeks. While there are pockets of weak earnings growth or y/y declines within the S&P 500 sectors, revenues growth remains broad, as Joe shows below:

(1) Broad sector revenue growth expected in Q1. Nine of the 11 S&P 500 sectors’ revenues should grow y/y in Q1, a slight improvement from eight sectors in Q4 (Fig. 15). Information Technology has been leading all sectors in revenues growth since Q1-2024; its Q1-2025 revenues should rise at a double-digit rate for a fourth straight quarter. Continuing to lag is the Materials sector, with its quarterly revenues expected to decline y/y for a 10th straight quarter.

Among the two revenue laggards, a decent revenue surprise in Energy could turn that sector’s y/y growth rate positive, something we’re not expecting for Materials. If 10 of the 11 S&P 500 sectors do report rising y/y quarterly revenues for Q1, as we expect, that would be the most doing so since Q3-2022—hardly indicative of a revenues recession!

Here are the sectors’ proforma y/y revenues growth forecasts for Q1-2025: Information Technology (11.3%), Health Care (7.9), Utilities (6.0), Communication Services (5.3), S&P 500 (4.2), Real Estate (4.1), Consumer Discretionary (2.7), Consumer Staples (1.7), Industrials (1.5), Financials (1.2), Energy (-0.3), and Materials (-2.8).

(2) Earnings growth less broad for the 11 sectors. Seven of the 11 S&P 500 sectors are expected to show positive y/y earnings growth in Q1-2025, down from 10 in Q4 (which was the broadest growth among S&P 500 sectors since Q1-2021). Among the four lagging sectors, Consumer Staples’ earnings is expected to fall y/y in Q1 for the first time in ten quarters; Materials’ is expected to fall after rising in Q4 for the first time in 10 quarters; and Energy’s is expected to fall for a third straight quarter.

Among the five sectors expected to post single-digit earnings growth in Q1, for Utilities such a result would end its double-digit percentage growth streak at six quarters. We think Consumer Discretionary, at just 0.6% forecasted growth now, faces the possibility of falling y/y quarterly earnings for the first time since Q4-2022 because of the long list of challenges that Tesla has encountered so far.

Here’s how the S&P 500 sectors’ consensus earnings growth rates stack up for Q1-2025: Health Care (38.1%), Information Technology (15.9), Utilities (8.0), S&P 500 (7.7), Communication Services (6.1), Consumer Discretionary (0.6), Consumer Staples (-6.8), Industrials (4.2), Financials (2.0), Real Estate (-2.5), and Materials (-8.1), and Energy (-15.7).

Here are their y/y revenues and earnings growth forecasts: Communication Services (5.3% revenues growth, 6.1% earnings growth), Consumer Discretionary (2.7, 0.6), Consumer Staples (1.7, -6.8), Energy (-0.3, -15.7), Financials (1.2, 2.0), Health Care (7.9, 38.1), Industrials (1.5, 4.2), Information Technology (11.3, 15.9), Materials (-2.8, -8.1), Real Estate (4.1, -2.5), and Utilities (6.0, 8.0).

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Meet Scott Bessent

March 25 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Fiscal Policy I: Trump’s Treasury Man. Since President Trump took office two months ago, his economic team has been on the road making frequent media appearances. Between Treasury Secretary Scott Bessent, Commerce Secretary Howard Lutnick, and National Economic Council Director Kevin Hassett, there’s at least one media hit a day. The trio seems to be marketing Trump 2.0 to both Wall Street and Main Street. The bulk of their time is spent assuring that tariffs are a long-term net positive and that reversing the Biden administration’s “disastrous” policies may require some pain, but that both are part of a broader economic strategy to achieve more sustainable and America-first growth.

Hassett is the only one of the three with extensive policy experience, including serving as the chair of the Council of Economic Advisers (CEA) in Trump 1.0. So his views have been widely on display for some time. It remains to be seen how much sway Lutnick will hold in tariff negotiations that include US Trade Representative Jameison Greer, Bessent, Secretary of State Marco Rubio, and of course President Trump. So we have been focusing on trying to understand Bessent’s views.

Bessent is a self-professed economic history buff, having taught it at his alma mater Yale for several years despite holding just a bachelor’s degree. His motivation for leaving his hedge fund Key Square Group to join Trump 2.0 undoubtably is the opportunity to help spearhead what aims to be the largest realignment of global trade in decades.

What Bessent says and does as Treasury secretary will be key to the markets’ reactions to Trump 2.0 for several reasons: (1) The Treasury Department’s debt management strategy has gained outsized importance as the US deficit and debt ostensibly near tipping points. (2) Sanctions on Russian assets and their excommunication from the SWIFT international payments system may have hurt the dollar’s global status and elevated alternatives, as can be seen by gold’s surge since 2022 (Fig. 1). (3) Bessent may need to tap novel Treasury policies to achieve Trump 2.0’s mandate of a weaker dollar and lower bond yields.

A few long-form interviews of Bessent—including earlier this month on Face the Nation and on the All-In podcast (hosted by Trump’s AI and Crypto Czar David Sacks and a few other venture capitalists)—provide helpful insight into his views. They also help draw contrast to warnings by some in the financial media that the overarching economic plans are either doomed or lack cohesion.

Take a moment to consider some of the key takeaways regarding the next four year’s economic policies, and our spin on what they may mean for the financial markets:

(1) Unsustainable. Bessent recently asserted that the American Dream is built on upward mobility and rising per-capita wealth/incomes, rather than the availability of “cheap goods.” This drew fire from across the political spectrum, particularly with tariffs threatening to raise goods prices. But Bessent doubled down on his view, suggesting that unconstrained fiscal stimulus and overregulation led to record inflation for necessities and housing unaffordability (Fig. 2 and Fig. 3). Therefore, in his eyes, it’s no surprise that many Americans have been downbeat on the economy throughout the last few years, as real wages suffered despite strong reported economic growth. (In fact, the trend for real wages has been to the upside since 1995.)

(2) Regulation. Bessent believes that bank regulation has prevented the private sector from leveraging up (by preventing bank lending). Therefore, deregulation will help the private sector releverage and thus offset the negative growth impulse from government’s deleveraging as the fiscal deficit is reined in relative to GDP (Fig. 4). With bank lending standards easing and the private credit market flush with cash, there’s certainly a lot of pent-up supply of dollars to lend (Fig. 5).

A direct impact for bond yields is the Supplementary Leverage Ratio (SLR), which basically is a capital charge to banks for buying risky assets, but that includes Treasury bills and bank reserves. Despite the success of excluding Treasuries and reserves during 2020, the charge was reimposed in March 2021. By excluding bills and reserves permanently, which Fed officials have also supported, Bessent supposes that bill yields could fall by 30-70 bps. That would help save the government a lot of interest costs and also steepen the yield curve closer to historical norms (Fig. 6 and Fig. 7).

(3) Tax cuts. Bessent believes that deregulation, reordered global trade, and lower government spending can pay for tax cuts and (at least in theory) boost economic growth enough to increase total government revenue.

As a percent of GDP, government revenues did fall from 19% in Q4-2015 to 17% by the end of 2019 and the deficit grew from 2.4% of GDP in 2015 to 4.6% in 2019 (Fig. 8).

Bessent wants to lower the federal budget deficit slowly, noting that some deficit hawks do not realize that swift cuts would weigh unduly on economic growth. The goal of a 3%-of-GDP fiscal deficit still has an uncertain time frame, so even moderate progress toward it is likely to be received favorably (Fig. 9).

Fiscal Policy II: Century Bonds. Much ado has been made in the financial media and on Wall Street about the administration’s goal of deliberately weakening the dollar by issuing century bonds and pursuing a Mar-a-Lago Accord. This administration’s focus is on lowering the 10-year Treasury bond yield as opposed to buoying the stock market, with Bessent likely spearheading this direction.

As part of the century bond proposal, Bessent would convert foreign investors’ 5- and 10-year Treasuries into 100-year bonds, perhaps with a small withholding of interest payments (say, a percent or two of total coupon payments, not a full percentage point or two of yield). Nearly everything we’ve heard and read has been negative on this idea. Whether it will come to fruition remains to be seen. Most public responses have been quite critical. It’s also not clear why foreigners would cooperate with this scheme.

We do not think outright currency depreciation measures will be taken until 2026 at the earliest. Tariffs, fiscal deficit reductions, and the stick approach forcing other countries to spend on their own defense obviously are indirect means of achieving a lower dollar. They are already under way but will take a lot of time to fully flesh out. We think investors would be better served focusing elsewhere.

Whether the Fed can remain independent in a Trump 2.0 administration is a more pressing issue for the markets. But we aren’t too worried about this either: The idea of century bonds arguably underscores Trump 2.0’s commitment to Fed independence. In our view, perceived threats to the status quo of dollar dominance and Fed independence are overdone.

Foreign central banks and therefore economies depend on the New York Fed’s dollar swap lines to shore up the US dollar’s value during financial crises and dollar shortfalls. For instance, from March through April 2020, foreign central bank swap line borrowing surged from zero to $450 billion. Indeed, Reuters reported over the weekend that some European officials were worried that the Fed would still provide this liquidity during Trump 2.0. The recent firing of two democratic Federal Trade Commission officials and an executive order creating additional presidential oversight over all “independent regulatory bodies” have raised these concerns.

But the proposed century bonds would rely on these swap lines, to ensure the accessibility and liquidity of dollar funding markets. Taking a note from the Fed’s own playbook, Trump 2.0 imagines something similar to the Bank Term Funding Program (BTFP) for the rest of the world (ROW) (Fig. 10).

Domestic banks are forced to hold Treasuries by US government regulations. Therefore, they buy a lot of low-yielding debt as the debt stock grows rapidly during crises like those in 2008 and 2020, when the Fed had already slashed interest rates and the Treasury had to finance new stimulus programs. In 2023, the Fed backstopped its duration risk. So why not do the same for the ROW countries, which also hold US debt for economically mandatory reasons? The ROW remains the largest sectoral holder of US debt at about one-third (Fig. 11). Notably, that’s down from nearly 60% during the Great Financial Crisis—but largely because the Fed has picked up much of the tab via quantitative easing (QE), not because of lack of demand. Foreigners hold most of their debt in longer duration notes and bonds, as they largely serve the purpose of reserve accumulation and perhaps some liability matching (Fig. 12).

From Steve Miran, Trump’s current chair of the CEA: “Holding century bonds is less risky for reserve managers if they have access to swap lines granting them substantial short-term dollar liquidity. The desire to maintain access to such swap lines will be a powerful long-term incentive for remaining inside the U.S. security and economic umbrella.”

Fiscal Policy III: Fed Independence & the Treasury Market. One of the primary reasons that Treasuries are used as reserves is their market depth and liquidity. President Trump’s recent promotion of Fed Governor Michelle Bowman to vice chair of Supervision highlights that there will be no “shadow chair” and that the Fed will pursue thoughtful deregulation. On several occasions over the past two decades, regulators threatened Treasury market stability by tightening their grip over the banking system. As the debt stock grows, ensuring that the Treasury market is resilient is even more important.

There is no alternative to the Treasury market at the European Central Bank given its lack of jointly issued EU debt, and the Fed will remain the global financial system’s fire chief. When you want to de-risk, you buy US Treasuries. In times of acute stress, dollars are even more pristine collateral. We’ll likely all be talking about threats to the dollar’s status for years to come. But we believe that incremental shifts in the balance of global trade and seeking to prevent the debt-to-GDP ratio from spiraling out of control are not going to upset its global dominance (Fig. 13).

Bessent believes a sovereign wealth fund (SWF) could be crafted out of the government’s current assets. For instance, the Social Security trust fund (around $2.8 trillion in assets) should be able to invest in equities and other non-Treasury assets to boost returns. The Treasury’s claims on the government sponsored enterprises (GSEs), i.e., Fannie Mae and Freddie Mac, could be shifted to an SWF. Federally owned land could be used as an asset as well. Bessent doesn’t view a revaluation of the government’s gold holdings as a credible path to reducing the budget deficit, as some have suggested.

The jury is still out on what a SWF would look like; but if one is constructed, it would likely invest in domestic assets and encourage investment. On the margin, the idea can’t hurt.

Monetary Policy: Is Quantitative Tightening Still on? At last week’s March meeting, the Federal Open Market Committee decided to slow the Fed’s paring of its balance sheet. Previously, the Fed had capped the amount of maturing Treasury securities that could be reinvested to $25 billion. This was lowered to $5 billion, while the $35 billion cap on agency debt and mortgage-backed securities (MBS) was maintained.

Fed Governor Christoper Waller was the lone dissenter on this action, preferring to maintain the pace of runoff. In a statement, he said that bank reserves remain abundant at over $3 trillion and funding market conditions remain stable, suggesting no need to tamper with QT (Fig. 14). An outside but notable voice, Larry Summers said that the decision to taper QT was alarming and suggested that the private sector was struggling to absorb the onslaught of debt issuance.

We respectfully disagree with both Waller and Summers. The decision to limit QT was a technical one on the basis of market plumbing and functionality, not one of monetary policy to reflect the real economy. It’s unlikely to have any material impact over the intermediate term, either. Consider the following:

(1) MBS. The Fed would eventually like to hold no MBS, just Treasury securities. So there’s $2.2 trillion of unwanted debt on its balance sheet (Fig. 15). Given that most mortgage holders have much lower rates than prevailing rates today, many having refinanced during the pandemic, there’s little incentive to prepay. That’s lengthened the duration of the Fed’s MBS portfolio and kept the amount of MBS rolling off well below the cap, hence the decision to leave that cap unchanged.

(2) Rate pressures. While money market functioning broadly is in good shape and reserves are quite high, Waller is not necessarily right in saying there are no evident pressures. For instance, the spread between the Secured Overnight Financing Rate (SOFR) and the federal funds rate (FFR) has been more elevated recently than over the past few years (Fig. 16). This suggests financing in repo is getting tougher and tougher on stressful dates, such as quarter-end and year-end. So while everything is still fine, reserves have still been shrinking relative to GDP and thus their abundancy is diminishing as well. The Fed plans to end QT when reserves are “ample” (which means less than abundant but still much more than needed). The rise in SOFR relative to the FFR suggests ample is approaching.

(3) Treasury yields. In theory, QT raises Treasury yields by increasing the supply that the price-sensitive private sector has to hold. It’s the reverse of QE, which involves the price-insensitive Fed bidding up bonds and thereby lowering yields. So we’ve been asked many times what impact tapering QT will have on bond yields. It won’t be nothing but probably will be immaterial.

As the Treasury spends down its Treasury General Account (TGA) at the Fed to finance the deficit while the debt limit remains unresolved, reserves will get a boost. But eventually, the Treasury will rapidly rebuild the TGA, causing reserves to fall and potentially blowing through the “abundant” level the Fed hopes to eventually reach.

In short, the Fed, mindful of the volatility that could occur, decided to slow its pace of balance-sheet reduction for the time being and thus put less downward pressure on reserve balances. It’s prudent central banking, not a measure to ease monetary policy.

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The Fed’s Economic Forecast Versus The Consensus & Ours

March 24 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Forecasts I: The Consensus. Trump Turmoil 2.0 has caused a correction in the stock market. The S&P 500 fell 10.1% from its record high on February 19 through March 13 (Fig. 1). It was down 7.8% on Friday from its peak. The Nasdaq is down 11.8% from its peak on December 16 through Friday’s close (Fig. 2). The Magnificent-7 stocks led the recent rout. The Roundhill Magnificent Seven ETF (MAGS) is down 18.8% from its record high on December 17, while the Defiance Large Cap ex-Mag 7 ETF is down 6.0% since February 19 (Fig. 3). The latter is essentially the S&P 500 minus the Mag-7, i.e., the “S&P 493.”

As we’ve previously noted, S&P 500 corrections (10%-20% declines) typically occur when investors fear a recession is imminent. The decline is attributable to a drop in the forward P/E of the S&P 500. The forward earnings of the index continues to rise because industry analysts tend not to share the recession concerns of investors. That’s because such fears don’t plug well into the analysts’ earnings models; the analysts are more attuned to what managements are saying about the companies they cover. Bear markets (declines of 20% or more) occur when investors’ recession fears are realized, forcing industry analysts to scramble to cut their earnings estimates.

So the forward P/E is a leading indicator of the economy that isn’t very accurate, while forward earnings is highly correlated with the Index of Coincident Economic Indicators, which is the most accurate monthly indicator of the business cycle (Fig. 4).

Currently, investors fear a recession, while forward earnings continues to rise to record-high territory. On March 5, Debbie, Eric, and I raised our subjective probability of a recession from 20% to 35% because of the Trump administration’s increasing tariff turmoil and shotgun approach to reducing federal government payrolls.

Polymarket.com, an online betting platform, showed that the odds of a recession stood at 22% in mid-February (Fig. 5). It rose to about 40% during the first half of March and is now at 35%. Polymarket also allows traders to place a bet on “How high will inflation get in 2025?” However, the choices are limited to inflation rising above 3%, above 4%, and up to “above 10%.” The latest betting shows 48% odds on inflation rising above 3%.

Meanwhile, the March Consumer Sentiment Index (CSI) survey showed that respondents expect a median inflation rate of 4.9% over the next 12 months, while a similar February survey conducted by the Federal Reserve Bank of New York showed 3.1% over the same period (Fig. 6).

It’s hard to pin down a precise consensus outlook for inflation. The same can be said about an outlook for the economy. That’s partly because consensus forecasts change over time. Also, the consensus of the general public is bound to be different than that of economists, which is bound to differ from investors’ consensus. Different strokes for different folks, depending on their personal experiences and biases. Indeed, the CSI survey has become very partisan lately, with Democrats much more pessimistic than Republicans about the outlook for inflation and the economy.

The Wall Street Journal conducts a quarterly survey of economists. The latest survey was covered in a January 19 article. Here are the salient points:

(1) GDP & recession odds. The odds of a recession over the next 12 months in the January poll was down to 22%, the lowest since January 2022 and down from the most recent peak of 63% during October 2022. The economists collectively forecast that real GDP will increase 2.0% in 2025.

If we may be allowed to forecast the forecasters, we reckon that the survey in early April will show that their subjective odds of a recession has increased to 35%, the same as ours. We guess that their 2.0% real GDP forecast for this year will remain unchanged. Ours remains unchanged at 2.5%-3.0%.

(2) Inflation. Economists had already begun modeling the effects of President Trump’s plans to raise tariffs, cut taxes, and restrict immigration at the time of the article: “The upshot: Inflation and interest rates are likely to be higher for at least the next two years than forecasters anticipated before the election.”

The consensus of 73 economists showed the CPI inflation rate at 2.7% y/y through December 2025, up from 2.3% in the October survey. Their forecast for inflation this year is likely to be closer to 3.0% in the April survey on concerns that Trump’s tariffs are bound to boost prices at least on a one-shot basis. In late November, Trump said he would impose tariffs of 25% on Mexico and Canada and 10% on China on day one of his presidency. He started talking about more widespread “reciprocal tariffs” about a month ago. They are scheduled to be announced on April 2, which is likely to influence the next WSJ survey results.

(3) Interest rates. Here is what the WSJ article reported about the consensus outlook for interest rates: “Faced with stickier inflation, economists expect the Fed to keep interest rates higher through 2027 than previously forecast. The midpoint of the range of the federal funds rate [FFR], currently 4.375%, is now seen ending the year at 3.89%, up from the October average projection of 3.3%. Economists now expect the 10-year Treasury bond yield to end 2025 at 4.4%, up from an October projection of 3.7%.”

We reckon the consensus FFR forecast will remain about the same, calling for two 25bps cuts this year. The year-end bond yield forecast might drop a bit from the WSJ survey’s 4.4% to the current level of 4.2%.

We are still in the none-and-done camp on Fed rate cutting this year. If we are wrong, the current consensus of economists and the FFR futures market—two rate cuts—will likely be right (Fig. 7). We still expect the 10-year Treasury bond yield to range mostly between 4.25% and 4.75% this year.

Forecasts II: The Fed. The latest Summary of Economic Projections (SEP), released by the Federal Open Market Committee (FOMC) after its meeting last Wednesday, showed that the meeting participants collectively expect to lower the FFR from 4.25%-4.50% currently. In terms of their new economic forecasts, their “dot plot” continues to have two 25bps cuts this year, two next year, and one in 2027, with the “longer-run” FFR still seen at 3% (Fig. 8). The latter implies that the current level of the FFR is restrictive.

Presumably, most FOMC participants are anticipating that they will have to lower the FFR closer to its longer-run level to avert a recession. Indeed, they lowered their real GDP growth forecasts to 1.7% from 2.1% for 2025, to 1.8% from 2.0% for 2026, and to 1.8% from 1.9% for 2027 (Fig. 9). This likely reflects the growth drags from government spending cuts and the prospect of significant tariffs squeezing profit margins and household spending power.

That’s a relatively pessimistic forecast considering that the labor force is growing between 0.5% and 1.0% y/y currently and productivity is growing around 2.0% y/y (Fig. 10 and Fig. 11). Those numbers add up to real GDP growth rates of 2.5%-3.0% y/y, consistent with our more upbeat outlook (Fig. 12).

In the SEP, the median unemployment rate projection for the end of this year was raised from 4.3% to 4.4% (Fig. 13). It remained at 4.3% for the ends of both 2026 and 2027.

So why are Fed officials saying that they are in no hurry to lower interest rates if they are anticipating they will have to do so to avert a recession later this year? Indeed, just a few hours after the FOMC voted to leave the FFR unchanged, in a post Wednesday night on Truth Social, President Trump encouraged Chair Jerome Powell and his colleagues to ease policy as the administration enters the next phase of its aggressive trade policy.

“The Fed would be MUCH better off CUTTING RATES as U.S.Tariffs start to transition (ease!) their way into the economy,” Trump wrote. “Do the right thing. April 2nd is Liberation Day in America!!!”

The Fed is in no hurry to do so because the latest economic indicators suggest that the economy remains resilient. Furthermore, Fed officials have raised their inflation expectations since the December SEP, with core PCED now expected to end the year at 2.8% versus 2.5% in December, presumably reflecting upside pressure on prices from tariffs, but their 2026 forecast remains 2.2% (Fig. 14). In other words, the FOMC expects tariffs to have a transitory impact on inflation.

In his press conference on Wednesday, Fed Chair Jerome Powell confirmed all the above:

(1) Transitory uncertainty. Powell mentioned the words “uncertain” or “uncertainty” 16 times. He attributed the abnormal amount of uncertainty to Trump 2.0. For example, he said, “So in the current situation, there’s probably some elevated uncertainty because of … significant policy shifts in those four areas that I mentioned: tariffs, immigration, fiscal policy, and regulatory policy. So there’s probably some additional uncertainty, but that should be passing; we should go through that. And then we’ll be back to the regular amount of uncertainty.”

(2) Tariffs are the known unknown. The main source of uncertainty is clearly tariffs, according to Powell: “We don’t know what’s going to be tariffed. We don’t know for how long or how much [or] what countries. We don’t know about retaliation. We don’t know how it’s going to transmit through the economy to consumers. That really does remain to be seen. [T]here are lots of places where … that price increase from the tariff can show up between the manufacturer and a consumer. Just so many variables. So we’re just going to have to wait and see.”

(3) Inflation closer to target. Powell noted that inflation has moderated significantly over the past two years. He acknowledged that it “remains somewhat elevated relative to our 2 percent longer-run goal.” He also said, “Estimates based on the consumer price index and other data indicate that total PCE prices rose 2.6% over the 12 months ending in December and that, excluding the volatile food and energy categories, core PCE prices rose 2.8%.” He did not mention the recent spike in the CSI survey’s one-year-ahead expected inflation rate. Instead, he said that long-term inflation expectations “remain well anchored.”

It's not clear why Powell estimated December’s PCED inflation rates. January’s numbers came out at the end of last month showing headline and core inflation rates of 2.5% and 2.6% (Fig. 15). He might have misspoken and was actually referring to February’s PCED, which will be released on March 28.

February’s headline and core CPI inflation rates were 2.8% and 3.1% (Fig. 16). More encouraging were the 2.0% and 2.2% readings excluding shelter (Fig. 17). The CPI rent of shelter inflation rate remains elevated at 4.3% y/y, but it remains on a moderating trend (Fig. 18).

(4) Transitory tariff inflation. Powell mentioned the word “transitory” twice when he discussed the likely impact of tariffs on inflation. For example: “As I’ve mentioned, it can be the case that it’s appropriate sometimes to look through inflation if it’s going to go away quickly without action by us, if it’s transitory. And that can be the case [with] tariff inflation. I think that would depend on the tariff inflation moving through fairly quickly and critically as well [as] on longer-term inflation expectations being well anchored.”

Describing inflation as “transitory” didn’t work out so well for Powell last time, in 2021, just before inflation turned into a persistent problem during 2022 and 2023. Powell noted that Trump 1.0’s tariffs didn’t move the needle on inflation. But he didn’t mention that the Smoot-Hawley Tariff of June 1930 had an extremely deflationary impact, causing the global economy to fall into a depression.

(5) Good place. On balance, Powell came across as relatively optimistic: “And right now, we feel like we’re in a very good place. Policy’s well positioned. The economy’s in … quite a good place …[W] hat we do expect is to see further progress on inflation, and …as we see that—or if we were to see weakening in the labor market that could foster—we could then be in a position … of making further adjustments. But right now … we don’t see that, and we see things as in a really good place for policy and for the economy. … [S]o we feel like we don’t need to be in a hurry …to make any adjustments.”

Powell did not respond to Trump’s post Wednesday evening.
 
Forecasts III: Our Two Scenarios. We’ve decided to fold our 1990s meltup/meltdown scenario into our Roaring 2020s scenario. The current correction in the stock market suggests that the former has played out already, as the bull market’s highflyers have been hit hardest by the current correction. That leaves us with two scenarios: the Roaring 2020s, to which we assign a 65% subjective probability, and a mostly stagflation scenario, with a 35% probability. The former includes the possibility of a rebound in the former highflyers, while the latter includes the possibility of a recession.

So our base case continues to be more upbeat than both the consensus expectations of economists and the projections of Fed officials. In this Roaring 2020s scenario, productivity growth continues to be boosted by technological innovations. That boosts the growth rate of real GDP, keeps a lid on inflation, fuels the growth of real wages (i.e., consumers’ purchasing power), and lifts profit margins.

Movie. “I’m Still Here” (+ +) is a 2024 Brazilian docudrama about the Paiva family’s strength during the 1970s military dictatorship in Brazil. Fernanda Torres nails it as Eunice Paiva, a mom thrust into chaos after her husband, a former politician, gets snatched by the regime. Dictatorships are deadly. They kill their opponents and terrorize their citizens. Here in the US, partisanship has reached the point where Democrats and Republicans are accusing each other of being existential threats to our democracy. Fortunately, our constitutional system of checks and balances continues to work against extremists on both sides. (See our movie reviews archive.)

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China, War & AI

March 20 (Thursday)

China I: Finally Focused on the Consumer. Chinese consumer spending has been sluggish in recent years, dragged down by the sharp correction in home property values and stock market declines. The country initially tried to spur the economy by supporting its exporters, which only served to create gluts in the global markets. On Sunday, however, the country announced a plan squarely focused on supporting the consumer.

China’s General Office of the Communist Party of China Central Committee and the General office of the State Council issued a “special action plan for boosting consumption.” The wide-ranging plan has 30 points but is light on details, including how it will be funded. Here are some of the highlights based on a transcription by the folks at Sinocism:

(1) Promote income growth & boost benefits. The government will implement employment support programs to boost wage growth. They’ll be focused on key sectors, industries, grassroots urban and rural areas, and small and micro enterprise. Special training will be launched for targeted sectors and populations. The minimum wage will be raised, and the government will support farmers.

Unemployment insurance benefits will be disbursed to those eligible. The basic pension will be raised, and flexible employees will be allowed to enroll in pension and medical insurance programs. The government will strictly enforce rest and paid annual leave policies.

Assistance programs to low-income populations will be strengthened. Disabled elderly individuals will receive additional support. Elevators will be added to multi-story residential buildings, and meal services will be developed for seniors. Industries related to “anti-aging and silver economy tourism” will be promoted.

Trade unions will be encouraged to fund employee-related consumption, including holiday welfare benefits, fitness activities, and cultural and sports expenditures.

(2) Support families. The government will research the establishment of a childcare subsidy system and encourage the development of community-based childcare services, workplace childcare facilities, and integrated childcare and early education services. Local governments are directed to cover more employees with maternity insurance coverage and a year of pediatric services. More education resources will be given to towns with a net inflow of school-aged children, and the government will increase student financial aid subsidies.

(3) Stocks & lending. Measures will be taken to stabilize the stock market, strengthen strategic reserve forces, and improve market stabilization mechanisms. The removal of obstacles preventing firms (such as insurance companies and pension funds) from investing long-term capital in financial markets will be accelerated. The government will crack down on financial fraud, and more stable bond-related investments will be made available to individual investors.

Financial institutions will be encouraged to expand consumer lending within controlled risk parameters. Consumer loan limits, terms, and interest rates will be reasonably set to accommodate varying needs. And by 2025, financial subsidies will be provided for qualified personal consumer loans and loans extended to businesses in the consumer service sector.

(4) Repair the housing market. Local governments will accelerate efforts to repay outstanding debts owed to enterprises. Presumably, that refers to the payments owed to suppliers by developers that have struggled during the multi-year collapse of the property market.

To boost the property market, the redevelopment of urban villages and the renovation of dilapidated and hazardous housing will be accelerated. Local governments can use special-purpose bonds to acquire existing commercial housing and convert it into affordable housing. Interest rates on housing loans may be reduced, and buyers will receive more financial support.

(5) Encourage spending. The government will provide subsidies to encourage spending, including incentives to replace old cars with electric bicycles and to purchase smartphones, tablets, and smartwatches. Pilot programs will be launched to facilitate a market for used goods.

A newly launched AI+ initiative will boost the tech market by driving adoption of new AI technologies like autonomous driving, smart wearables, ultra-high-definition video, brain-computer interfaces, robotics, and additive manufacturing. The government will improve regulations for the “low-altitude economy” (activities that occur in the sky), to encourage low-altitude tourism, aerial sports and consumer-grade drones.

The government plans to boost cultural, sports, and tourism offerings; extend business hours; and increase visitor capacity. It hopes to attract more foreign visitors by offering visa-free entry, more duty-free stores, and more international exhibitions and conventions. Cruise routes will be expanded, and yacht registration and reporting procedures will be streamlined.

The government would also like to see a used car market develop. And it’s encouraging companies that sell their products overseas to sell more domestically and to develop their own brands.

(6) Recent positive data. Even before China’s consumer program has taken hold, economic data have begun turning up: China’s industrial production rose 5.9% in the first two months of 2025 compared to a year ago. That was down from a 6.2% y/y increase in December, but above expectations for a 5.3% increase (Fig. 1). Retail sales also improved, rising 4.0% y/y in January and February, up from 3.7% in December (Fig. 2).

The Chinese financial markets reflected these new signs of optimism. The country’s 10-year government bond yield has risen to 1.96% from a low of 1.61% in early January (Fig. 3). The China MSCI has soared 23.4% ytd, and the CSI 300 has gained 1.9% (Fig. 4). More than government policies, DeepSeek’s arrival and BYD’s new five-minute charging and battery system have bolstered Chinese confidence in the nation’s abilities.

Yet to be determined is how President Trump’s 20% tariffs on Chinese goods exported to the US will affect China. So far, the Chinese equity market is shrugging off the threat. The Organisation for Economic Co-operation and Development estimates that Chinese real GDP will grow by 4.8% this year and 4.4% in 2026, partially due to the increase in tariffs, a March 18 South China Morning Post article reported. That would be below China’s projected growth of around 5.0%.

China II: What If China Invades Taiwan? The question of whether rising tensions between China and Taiwan could spark an invasion of the island that sets off a World War III is undoubtedly a provocative one—yet it’s hardly a new concern. China’s ongoing ire toward the US over its support of Taiwan has long simmered beneath the surface. But a recent tweak to a routine US fact sheet on US/Taiwan relations has stoked fresh flames. For nearly half a century, Washington’s position has been clear: It doesn’t support Taiwan’s independence (archive). That language, however, was removed last week, drawing a sharp response from Beijing.

In retaliation, China conducted military drills in the air and water near Taiwan in a not-so-subtle show of strength. Meanwhile, President Trump, ever vocal on global security, has repeatedly warned that World War III is nearer than many realize. This sense of impending conflict gives context to his broader economic agenda—an agenda that includes aggressive protectionist policies and strong-arm tactics aimed at bolstering defense spending, especially in Europe, and bringing the manufacturing of key items back to US shores.

Is a global war, potentially triggered by Taiwan, a “when, not if” inevitability? The jury is still out, but the scenario is worth watching closely. One element that warrants particular attention is how the US has strategically aligned itself with Taiwan in semiconductor manufacturing.

It’s no coincidence that Washington has been ramping up efforts to secure its place in the chip race. Early March saw the Trump administration broker a deal with Taiwan Semiconductor, the island’s largest tech powerhouse, to establish chip manufacturing facilities in Arizona. For the US, the semiconductor race is a crucial front in its competition with China—one that will play a pivotal role in shaping future geopolitical dynamics. Taiwan is a key partner to the US in this race.

Economic interests are likely to trump moralistic or precedential boundaries in Trump 2.0. That is on display with the rare earths/critical minerals land-lease deal that the US asked for from Ukraine. Considering the business linkages between Taiwan and the US, we believe the status quo is likely to continue in the Taiwan Strait.
 
Disruptive Technologies: AI Hits & Misses. Companies are exploring how artificial intelligence (AI) can and cannot be used in their operations. Here are some examples of cases where AI solutions are big wins and others where humans’ jobs are probably safe.
 
(1) AI in the oil patch. Oil and gas companies are using AI to drill more efficiently. BP uses AI to steer drill bits and predict problems before they happen, a March 13 Reuters article reported. It’s allowing the company to drill more wells per year.

Chevron uses AI-powered drones that fly over its operations and report back on emissions leaks so workers can be alerted. AI has allowed Chevron to reduce the time that production was shut for repair and maintenance. And AI programs can take the reams of data on what’s beneath the ocean’s floor and create three-dimensional visualizations far faster than humans can.

(2) AI in finance. Moody’s has developed 35 AI agents that can work independently or in conjunction with each other. The agents are given specific instructions, personalities, and access to data and research. They can each come to different conclusions.

(3) AI in health care. Nurses’ workloads are lightening: Doctors’ offices are using AI agents to make appointment confirmation calls, and hospitals are using AI programs to monitor patients’ vital signs, alert staff to emergency situations, and generate care plans, a March 16 AP article reported. Hospitals like that AI frees up nurses for other work; the fact that Hippocratic AI charges $9 an hour versus nurses’ $40 probably doesn’t hurt either. Nurses complain that the AI systems create false alarms.

(4) What can’t AI do? Certain jobs appear safe from AI replacement, according to a September 24 TechTarget article. Ballerinas and singers can breathe easy, for example.

Jobs dependent on human interaction are likely safe; for example, social workers rely on empathy and emotional intelligence to connect with clients. Doctors and nurses may find some of their duties replaced by AI, but not all. Teachers are using AI to help develop lesson plans, but they’re still needed in the classroom to engage kids in learning.

Executives in the corner office are probably safe, as they’re making high-level decisions. Politicians, too (AI can’t kiss a baby!). And trade folks—e.g., plumbers, electricians, and craftsmen—can consider their positions safe as well.

Surprisingly, McDonald’s order takers may be safe for now. The company dropped its AI order taking system because it had challenges understanding accents and dialects, and that affected accuracy, a June 17 CNBC article. But then again, maybe the AI program just needed to be better. Yum Brands—owner of Taco Bell, KFC and Pizza Hut—announced this week that it’s partnering with Nvidia to roll out AI order taking, among other things, a March 18 CNBC article reported.

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Global Rotation

March 19 (Wednesday)

Strategy: Going Global. Both Chinese and Eurozone stocks have been significantly outperforming the US stock market so far this year. The MSCI China index, which includes LargeCap and MidCap listed equities, is up 21% ytd. The MSCI European Monetary Union (EMU) index is up 17.5% ytd. Meanwhile, the US MSCI is down 3.4% ytd.

Last year, the US stock market dramatically outperformed the others: The US MSCI was up 23.4%, while the China MSCI rose 16.3%, and the EMU MSCI gained 6.8%.

The rotation trade from the US to China and the Eurozone reflects a combination of macroeconomic, geopolitical, and technological factors. Perversely, President Donald Trump’s America First policies have been an important driver of the rotation.

In China’s case, the Chinese government has been stimulating domestic demand in response to concerns that Trump’s tariffs will depress exports to the US. In addition, stocks have benefitted from ongoing waves of stimulus targeted at halting deflation and releveraging the economy that’s suffering from bad debts. Also, the emergence of DeepSeek brought the AI trade to China and added concerns regarding US tech companies’ earnings (Fig. 1).

In the Eurozone, the central bank’s monetary easing (six rate cuts since mid-2024) has aided the financial markets, and now fiscal stimulus (including a landmark spending bill in Germany) has buoyed sentiment toward the real economy. Geopolitically, Trump 2.0 has also been a boon. The light at the end of the Russia-Ukraine war tunnel is becoming brighter, and proposed US tariffs have inspired more bloc unity and a commitment to increasing trade among EU members. Trump’s ambiguous support for NATO is also causing European governments to scramble to spend more on defense.

Recently, we cooled off on our long-held “Stay Home” (in US stocks) stance and warmed up to a “Go Global” one, suggesting that allocating more to select international markets is appropriate. Yet we’re hesitating on a significant shift, as US fundamentals continue to be strong and Trump’s reciprocal tariffs on April 2 could upset the global rotation trade. However, thus far market action suggests that investors generally believe a global trade war would weigh more heavily on the US economy than those targeted by US tariffs.

With that said, let’s evaluate the market fundamentals abroad, and whether the case for investing there makes sense for long-term investors:

(1) Valuation. One of the primary selling points global markets have going for them is relatively cheap valuations. We’ve noted that most of the correction in the S&P 500 stems from the Magnificent-7 stocks’ collective valuation multiple compressing. Cheaper stocks, both within the US and abroad, have been holding up much better.

The China MSCI stock price index currently trades at less than 12 times forward earnings (Fig. 2). China’s latest stock rally brings it back only to pre-pandemic levels. The EMU MSCI stock price index is trading at 14 times forward earnings, steadily climbing from its trough when Russia invaded Ukraine in 2022 but still somewhat low (Fig. 3). Eurozone stocks have been climbing to new record highs for several quarters.

(2) Forward revenues. Chinese companies’ forward revenues has been declining steadily since 2018 (Fig. 4). That’s particularly troubling given that China’s export-led model to stimulate economic growth has failed to keep manufacturers’ profits from turning negative recently (Fig. 5). This suggests that China’s economy cannot sustain itself without substantial government support and subsidies. Forward revenues in the Eurozone have surged since 2021 and is near record highs (Fig. 6).

(3) Forward profit margins. The aggregate forward profit margin of China MSCI companies is at a record high despite the weakness of manufacturers’ profits (Fig. 7). That’s likely because of the increasing dominance of technology stocks such as Alibaba, Tencent, and JD.com, which represent large chunks of China’s stock market. However, the forward margin, while high for China, is still relatively low at just 5.3%.

The EMU MSCI forward profit margin has climbed recently but seems to be stuck around 9.5% (Fig. 8). In comparison, the US MSCI forward profit margin stands at a record high of 13.4% (Fig. 9).

(4) Forward earnings. The China MSCI forward earnings per share (EPS) has been tracking sideways (if not declining) since 2017 (Fig. 10). Net earnings estimate revisions have been persistently negative since late 2021. The EMU MSCI forward EPS is around record-high territory, and its net earnings revisions is turning positive (Fig. 11).

(5) Sectors. The China MSCI’s rally has been entirely driven by its tech sector (Fig. 12). Looking at the Germany MSCI sector performance, the gains have been broader-based (Fig. 13). We feel comfortable with Europe from a long-term perspective but continue to think investors should underweight or avoid China given the unpredictability of government policies toward business.
 
Global Economy: Green Shoots. Global economic vibes beyond America’s borders are humming louder than they have in a long while. The International Monetary Fund’s (IMF) January playbook showed real global GDP growth ticking up in 2025 while US growth slows some. On a second-order basis, the improvement in global economic fundamentals bolsters the US economic outlook as well. We were beginning to wonder if/when a Eurozone recession and depressed demand in Asia would start to limit America’s growth prospects—that no longer seems a worry. Other than Trump’s trade war, everything is looking hunky-dory for the global economy.

The virtues of the US economy seem to be outperformed by those abroad for the first time in many years. Foreign fiscal firepower is being aimed at defense, productivity growth is starting to rise, and shoppers are opening up their wallets (rather than relying on American tourists to supply needed demand). Risks remain, however: Trade spats, lingering price pressures, and geopolitical gyrations still could put the brakes on the momentum overseas.

Today, we’re dialing up the optimism and zooming in on the Eurozone and Asia. While recent economic data from Canada and Mexico have underwhelmed, and are especially disconcerting with tariff clouds looming, let’s focus for now on the upbeat regional stats and forecasts that have been boosting sentiment in the Eurozone and Asia:

(1) Eurozone’s green shoots appear. Recent macro data for the Eurozone and Germany show positive momentum, though they reflect trends before the US tariffs war escalated. With President Trump pushing Germany to boost defense spending, however, what once seemed unlikely in the Eurozone now seems more achievable. Consider the following:
Eurozone real GDP growth is expected to rise to an annual rate of 1.0% in 2025 from results of 0.8% in 2024, the IMF predicted in January (Fig. 14). At the time, we had our doubts, especially regarding Germany’s expected rebound to modest 0.3% y/y growth from a 0.2% contraction over the same time periods (Fig. 15).
Fiscal boosts, however, like the Eurozone’s 800-billion-euro defense spending plan announced in early March, could propel both Eurozone and German growth above the IMF’s forecast.
Germany’s real GDP growth would likely increase to an annual rate of 1.5% in 2026, up from its December forecast of 0.9%, German forecaster IfW said, on the basis of the public spending boost.
German economic sentiment jumped to 51.6 in March, the ZEW Indicator’s best since January 2023, driven by hopes of fiscal stimulus (Fig. 16).
Eurozone economic sentiment hit 96.3 in February, the highest in five months, reflecting improved industrial sentiment and reduced consumer pessimism, thanks in part to easing inflation and expectations of further rate-cutting by the European Central Bank (ECB) (Fig. 17).
German industrial production rose 2.0% m/m in January, a positive sign after a slump (Fig. 18). This increase wasn’t driven by tariff fears, as exports fell, but was led by a 6.4% rise in automotive production amid lower production and energy costs.
Eurozone industrial output is expected to improve with higher sentiment throughout Q1 of this year, according to early estimates.
German inflation (harmonized) was revised down to 2.6% y/y in February.
Eurozone overall inflation, early estimates show, fell to a rate of 2.4% y/y, signaling that price pressures are easing toward the ECB’s 2.0% inflation target.
(2) Asia’s indicators slowly rebound. From China to Japan and India, Asian nations are deploying aggressive fiscal policies through increased capital expenditure, tax cuts, and defense spending initiatives. Early signs of a rebound are already sprouting across the region:
China’s real GDP growth target is 5.0% for 2025, Chinese leaders confirmed at the National People’s Congress (NPC) meeting in early March (Fig. 19). To support this growth, more fiscal stimulus is coming. Officials indicated that they would raise the budget deficit to roughly 4.0% of GDP, the highest level in decades. For example, China’s leaders announced on March 6 a trillion-yuan state-backed fund will support AI initiatives.
China’s “Special Action Plan for Boosting Consumption,” including eight directives to do so, was issued by China’s central planners on Sunday. In an earlier NPC address, China’s premier Li said that the country would “move faster” to address inadequate domestic demand and make it the “main engine” of growth.
China retail sales data released on Monday showed upward momentum even ahead of the latest fiscal efforts, increasing by 4.0% y/y for the two months ending February, higher than the 3.7% increase in December and the fastest rate of increase since November.
China’s industrial output accelerated to a rate of 5.9% y/y for the combined January to February period.
Japan’s real GDP growth advanced 2.2% y/y during the last quarter of 2024, the Cabinet Office reported last week (Fig. 20). It was down from the initial estimate, but up from 1.4% in Q3-2024. The faster pace of growth was driven by a rebound in private capital spending and sustained government spending.
Japan’s government spending is set to rise further now that the pace of growth has quickened, as the government has set a 2.0% target for defense spending as a percentage of output.
India’s real GDP growth should exceed 6.5% for fiscal 2025-26, up from 6.3% in fiscal 2024-25, Moody’s Ratings said on Thursday. The growth is expected to be driven by increased government capital expenditure on domestic priorities, middle-class income-tax cuts, and monetary easing.
India’s flash industrial production indicates a gangbusters rise of 6.0% y/y during January, up from 3.2% y/y in December (Fig. 21).
India’s CPI dropped in February to 3.61%, which is below the Reserve Bank of India’s (RBI) target of 4.0%, suggesting that the RBI is likely to ease monetary policy further (Fig. 22).
Strategy: Analysts Widen Their Earnings Uncertainty Nets. LSEG released its snapshot of the monthly consensus earnings estimate revision activity for the past month. While the company provides raw data for all its polled measures, we focus primarily on the revenues and earnings forecasts, captured in our S&P 500 NRRI & NERI report. There, the analysts’ estimate revisions activity is indexed by the number of upward revisions in forward earnings less the number of downward ones, expressed as a percentage of total forward earnings estimates.

We look at this activity over the past three months because that timespan encompasses an entire quarterly reporting cycle. Since analysts’ tendency to revise their estimates differs at different points in the cycle, three-month data are less volatile—and misleading—than a weekly or monthly series would be. A zero reading indicates that an equal number of estimates were raised as were lowered over the past three months.

Joe highlights what’s most notable about the February crop of earnings revisions data below:

(1) S&P 500 NERI weakened considerably m/m. The S&P 500’s NERI index, which measures the revisions activity for earnings forecasts, tumbled nearly 3pts in February to a 25-month low of -4.8% from -2.0% in January (Fig. 23). That was the biggest m/m drop since December 2023 and makes February the 34th worst month in the 40 years of data recorded.

February’s rapid deterioration is a typical response from analysts when they broadly “nickel” their forecasts lower irrespective of a company’s fundamentals. No corresponding broad deterioration in forward earnings has occurred yet; most sectors’ forward earnings remain close to record highs (Fig. 24).

(2) Just three sectors had positive NERI. That’s unchanged m/m, but down from four sectors in December and nine in June 2024. Still, it beats January 2024’s result when only one sector, Tech, had positive NERI.

(3) Only two sectors’ NERIs improved m/m. Nine of the 11 S&P 500 sectors had NERI deteriorate m/m, the broadest decline since all 11 did in November 2023. Energy’s NERI was negative again in February (for the 22^nd time in 26 months) but improved for a third straight month. Utilities was the only other sector to improve m/m in February.

Financials’ latest NERI beat all other sectors’ (Fig. 25). It was positive for a 13th straight month, the longest streak among the S&P 500 sectors, followed by Communication Services (11 months) and Utilities (10). Among the poorer performing sectors, NERIs dropped to 56-month lows for Consumer Staples and Materials, followed by Industrials (26 month-low) and Information Technology (22). Tech’s NERI was negative for a second straight month.

Here’s how the NERIs ranked for the 11 sectors in February: Financials (4.9%), Utilities (0.9), Communication Services (0.3), Information Technology (-2.7), S&P 500 (-4.8), Consumer Discretionary (-5.3), Real Estate (-5.7), Energy (-5.7), Health Care (-6.1), Industrials (-9.9), Consumer Staples (-10.9), and Materials (-20.2).

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Trump 2.0 & Global Capital Markets

March 18 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Strategy I: Will Foreigners Dump US Assets? Some argue that foreign purchases of US assets have been a major driver of US stock market outperformance relative to the rest of the world for several decades. There is certainly supporting evidence for that thesis. As of Q4-2024, foreigners held roughly 37% of all American equities. That’s less than half of what US households and nonprofits (including the hedge fund community) own, but foreigners’ $34.2 trillion collective holding is a sizable chunk and could certainly move the needle (Fig. 1).

Some recent stories about foreign pension funds have sparked concerns. The Danish teachers’ pension fund AkademikerPension, with roughly $20 billion of assets under management, said it would sell its remaining Tesla shares and exclude itself and external managers from buying them due mainly to Elon Musk’s political interference. While it holds just 200 shares (approximately $48,000 worth), the fund said its stake was as large as $45 million at its peak. The UK government is also pressuring its pension funds to commit 10% of their assets to British equities (public and private), up from roughly 4% of total UK pension assets.

Will thorny trade negotiations and perceived beggar-thy-neighbor US policies prompt broader selling of US assets? Consider why foreigners buy US assets in the first place. It’s a chicken-and-egg situation. The evidence suggests to us that foreign investors tend to chase US market outperformance, not drive it. So while the recent rally in overseas stock markets and the decline in the dollar’s value suggest that foreigners have rebalanced their portfolios away from the US, we think much more than trade uncertainty would be necessary to cause a significant capital outflow attributable to foreign stock investors.

Consider the following:

(1) Valuation gap. US stocks trade at a substantial premium to equities abroad (Fig. 2). Arguably, that’s because foreigners plow more cash into US equities than into their own home markets. Indeed, as of the four quarters ended Q3-2024, foreign investment flows into US assets totaled $1.4 trillion, whereas Americans bought only $321 billion of international assets (Fig. 3).

But that gap can also be partially attributed to changes in valuation. As foreign markets have outperformed US markets this quarter, we should see international asset flows balance a bit once the data are updated (Fig. 4).

(2) It’s just trade. There’s not much the world can do about its US investment position. That’s because the US financial account deficit—driven by investments in US assets—is the reciprocal of the US current account deficit, driven by the greater importing of goods and services than exporting (Fig. 5). It’s no surprise that the dollar tends to rise and fall as foreign countries’ reserves and trade surpluses change (Fig. 6).

Arguably, the only way to prevent investment from flowing into US assets would be for the US to shrink its trade deficit. Coincidentally, that is a goal of Trump 2.0! But would that mean selling American stocks? It seems unlikely. Would any long-term investor with sizable assets feel comfortable not owning the world’s biggest multinational corporations such as Apple and Microsoft? Anyway, investors abroad with the most flexibility (private investors) buy US bonds, not stocks (Fig. 7). Primarily, those investments tend to be in US Treasuries as well (Fig. 8).

This is more mechanical than discretionary. Even if the trade deficit shrinks and foreign investors demand fewer Treasuries, that would likely be accompanied by a smaller fiscal deficit because the US economy would need to finance fewer imports. Thus, the supply of Treasuries would also fall. In some respects, the rest of the world has no choice but to buy US assets. Plus, the demand is unlikely to fall on its own when US assets yield much more than their foreign counterparts (Fig. 9).

(3) Home bias. It’s still the case that foreign investors own more US assets than assets in their own domiciles. That’s why the US stock market represents nearly three-fourths of the value of global equities, according to the MSCI indexes (Fig. 10). That raises the question, Could a coordinated dump of US assets occur over the short term, going against typical flows and depressing prices rapidly? It’s doubtful: A broad-based pivot away from US investment would require so much coordination that a host of issues would have to be contended with first. Almost all investment into the US now comes from private sources, rather than government investment bodies (Fig. 11). So we’d caution against overly worrying about inflows into US assets reversing.

Strategy II: Global Bond Selloff. Treasury Secretary Scott Bessent is spearheading Trump 2.0’s push to lower Treasury bond yields. Indeed, the Trump Put is likely on bonds rather than stocks. The campaigns to shrink the trade deficit, shrink the fiscal deficit, and lower energy prices all serve this overarching goal of lowering yields. One complication is that Trump 2.0’s protectionist bent has compelled foreign economies to stimulate demand at home, largely through deficit-financed fiscal easing. That has triggered a runup in global bond yields that may limit how far Treasury yields can fall.

Consider some of the latest policy actions:

(1) Europe. Germany’s “whatever it takes" government spending package is facing a last-minute hurdle in the courts but seems likely to go through. In essence, Trump 2.0 prodded German policymakers to wake up to the reality that the American security blanket will not be free of charge, instigating defense spending that isn’t subject to standing debt brakes and a commitment to infrastructure spending to revitalize German industry and counter Russia. Of course, German manufacturing has been collapsing since 2019, mostly due to competition from China (Fig. 12). But better late than never.

That has raised the 10-year German bund yield to above 2.8%, roughly the highest since 2011. Bunds are probably the most comparable asset to Treasuries from a reserve standpoint. However, supply is constrained by German austerity and thus has been inadequate to meet demand. Along with slowing economic growth, bund yields have been suppressed. Even as the spread between Treasury and bund yields is considerable, they historically have traded in tandem.

(2) China. Chinese 10-year government bonds yields cratered toward 1.5% late last year due to a combination of slowing growth, a busted property bubble, and inadequate supply. However, Chinese yields appear to have bottomed and now are climbing back toward 2.0% as China is unleashing fiscal stimulus to boost domestic demand. Over the weekend, Beijing outlined arguably its biggest consumer-focused stimulus plan yet. While Chinese bonds trade differently than Treasuries, Chinese stimulus has a large impact on the global economy and reduces deflationary pressure weighing on financial markets. Ultimately, that has a lifting effect on US Treasury yields.

(3) US debt still attractive. As most global central banks are easing monetary policy, US debt is still relatively attractive to global investors. Plenty of investors invest on an unhedged basis and thus aren’t constrained by high US funding rates. Meanwhile, those who invest while hedging their foreign exchange exposure are having some of their losses offset by the declining dollar. Japan is an exception, as the Bank of Japan has been raising interest rates, but thus far Japanese investors don’t appear ready to shift away from US debt on a wholesale basis. And they’re especially unlikely to do so if it would upset the Trump administration.

(4) Fed policy lending a hand. The Fed is likely to reinvest any principal proceeds from its agency debt and mortgage-backed securities (MBS) holdings (i.e., mortgage prepayments and maturing bonds) into Treasuries. All else equal, that should help contain Treasury yields by adding an extra source of buying pressure, even if the $2.2 trillion of agency debt and MBS take some time to roll off (Fig. 13). Furthermore, we expect quantitative tightening to be suspended and perhaps permanently ended during the first half of this year, which would remove some upward pressure from Treasury yields as well.

In fact, foreign private investors enjoy the extra yield they get from US MBS for essentially the same credit as the US government (Fig. 14). Those inflows are likely to continue, as MBS yields remain relatively elevated.

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The Bull Versus The Bear Case

March 17 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy I: The Valuation Problem. Last Thursday, I visited with some of our accounts in Connecticut. They seemed remarkably relaxed that day as the S&P 500 fell into correction territory. Many of them are seasoned institutional investors and have been through lots of corrections and bear markets. Everyone attributed the selloff to Trump Tariff Turmoil 2.0.

The bulls still believe (hope) that President Donald Trump is using tariffs as a bargaining tool to negotiate lower tariffs with America’s major trading partners. Some of them predict that if that’s not the case, then Trump will back off in response to political pressure to do so from lots of constituencies that stand to be harmed by a trade war. He might also back off if the stock market continues to tank. The bears warn that by the time Trump ever would relent, the economy would be in a consumer-led recession and the stock market surely would be in a bear market.

We remain bullish, but less so. On Wednesday, March 5, Eric, Debbie, and I raised the odds of a bearish scenario from 20% to 35%. That might entail an outright recession or a period of stagflation. On March 9, we wrote: We can’t rule out the possibility that a bear market started on February 20, the day after the S&P 500 rose to a record high. On March 13, we lowered our year-end 2025 S&P 500 target from 7000 to 6400.

We continue to bet on the resilience of the consumer, the economy, and corporate earnings, but we reckon that heightened recession fears will weigh on valuation multiples. We acknowledge that the risks of a recession and a bear market might continue to increase. It all depends on the often-unpredictable President, who frequently—and proudly—has referred to himself as “Tariff Man,” reflecting his strong support for protectionist trade policies.

We all know that the S&P 500 forward P/E and P/S are stretched by historical standards (Fig. 1). The latter, which is simply a weekly version of the Buffett Ratio, rose to a record high of 3.04 on December 4 (Fig. 2). It was back down to 2.75 last week, which is still very high. The forward P/E ratio remained below its previous two cyclical highs because the rising forward profit margin boosted earnings relative to revenues (Fig. 3). Nevertheless, the forward P/E was high at 20.2 last week, though down from a recent peak of 22.3 during the December 6 week.

We’ve argued that high valuation multiples might be sustainable if there is no recession in sight. Since the S&P 500 peaked at a record high on February 19, concerns about a recession caused by Trumps tariffs have been mounting, as we acknowledged by raising our subjective odds of a recession. Nevertheless, we didn’t change our optimistic outlook for forward earnings (Fig. 4). But we did lower our range for the forward P/E from 18-22 to 18-20 (Fig. 5).

The Nasdaq, which peaked at a record high on December 16, fell into correction territory (down 10%-20%) on March 6 (Fig. 6). It is down 12.0% through Friday. The S&P 500 fell into correction territory last Thursday and was down 8.2% from its record peak on Friday (Fig. 7).

Corrections occur when the stock market starts to discount a recession that doesn’t occur. It is almost always attributable to a drop in the forward P/E, while forward earnings continue to rise (or at least don’t fall). A bear market (down 20% or more) typically occurs when a recession happens, sending both the valuation multiple and earnings expectations tumbling. Only a few bear markets have occurred when no recession unfolded (i.e., in 1962, 1987, and 2022).

Now let’s turn to the case for a bear market followed by the case for a resumption of the bull market following the latest corrections in the Nasdaq and the S&P 500.

Strategy II: The Bear Case. The preliminary Consumer Sentiment Index (CSI) survey for March supports the bear case in which consumers reduce their spending, causing a recession. At the same time, higher inflation prevents the Fed from lowering interest rates. The CSI during the first two weeks of March fell to 57.9, the lowest since November 2022 (Fig. 8). That’s close to the average trough readings of the CSI during the previous six recessions!

In the latest CSI survey, inflationary expectations over the next year and the next five years spiked up to 4.9% and 3.9% (Fig. 9). In the past, such spikes were usually associated with rapidly rising gasoline prices (Fig. 10). This time, inflationary expectations have been inflamed by fears that tariffs will boost prices because they are akin to sales taxes.

Recently, several consumer-related companies have noted that consumer spending might be starting to flag. Walmart CEO Doug McMillon said “budget-pressured” customers are showing “stressed behaviors,” like buying smaller pack sizes at the end of the month because their “money runs out before the month is gone.” Kohl’s and Dick’s Sporting Goods issued weaker-than-anticipated annual forecasts. Delta, American, and Southwest Airlines cut their Q1 estimates, warning of the impact of a weaker economic backdrop on travel demand.

Here are more arguments for the bear case:

(1) Negative wealth effect. We’ve been observing that retiring Baby Boomers have accounted for much of the resilience of consumer spending, which was boosted by a very positive wealth effect for many as the value of their homes and stock portfolios appreciated. The risk now is that consumers will retrench because of the negative wealth effect attributable to falling stock prices. The Baby Boomers currently hold a record $25.0 trillion in corporate equites and mutual funds, or 54% of the total (Fig. 11). Falling stock prices could have a significant negative wealth effect on the spending of retired Baby Boomers.

(2) DOGE & employment. Elon Musk reduced Twitter’s workforce by approximately 80% after acquiring the company. The number of employees dropped from around 8,000 to about 1,500. He is now also in charge of the Department of Government Efficiency (DOGE) and has been taking a chainsaw to federal government payrolls, which totaled 3.0 civilian workers in January, before Trump 2.0 started to take effect. On Thursday, federal judges in California and Maryland ordered Trump’s administration to reinstate thousands of probationary federal workers who lost their jobs as part of mass firings carried out at 19 agencies.

Also at risk are jobs at contractors of the federal government. The General Accountability Office reported: “The federal government spends hundreds of billions of dollars each year on contracts, which consume a large portion of the federal budget. In FY 2023 alone, the federal government spent over $750 billion on contracts for a wide variety of goods and services—from cybersecurity software to consulting services to aircraft carriers—that are critical to the success of agency missions.”

(3) Uncertainty & capital spending. There may be method behind Trump’s tariffs and federal government job cuts, but they certainly have heightened uncertainty and anxiety about the economic outlook. There’s a strong correlation between the CEO Economic Outlook Index (compiled by the Round Table) and the yearly growth rate in capital spending in nominal GDP (Fig. 12). Policy uncertainty and fears of a trade war are bound to depress business confidence and capital spending. The uncertainty index, compiled by the National Federation of Independent Business in a monthly survey of small business owners, has been very volatile and elevated since Election Day (Fig. 13).

(4) AI bubble bursting. The Magnificent-7 companies are expected to spend a total of $325 billion on capital expenditures in 2025, $100 billion more than in 2024. This includes $75 billion of spending by Alphabet, $80 billion by Microsoft, $100 billion by Amazon, and $65 billion by Meta Platforms. It is widely assumed that this is mostly for AI infrastructure.

The fear now is that open-source large language models (LLMs) like DeepSeek and Manus, developed in China, require much less powerful semiconductors to operate. If so, then AI capital spending will tumble along with the profit margins on AI systems. Since DeepSeek was introduced on January 24, the Roundhill Magnificent-7 ETF (MAGS) is down 15.4% (Fig. 14).

(5) Trade war & global growth. Globalization has been the main driving force behind global economic prosperity. Global industrial production has been rising along with the volume of global exports for years (Fig. 15). Supply chains have become globalized, so products assembled in one country have parts manufactured all over the world.

If Trump’s reciprocal tariffs, which are scheduled to be imposed on April 2, lead to negotiations that result in deals to lower tariffs, that would be a very good outcome. If instead they exacerbate the global trade war, which has already started, that would be very bad.

In February, Trump directed his advisers to come up with new tariff levels that take into account the various trade barriers and other economic approaches employed by America’s trading partners. That includes not only the tariffs that other countries charge on US products but also the subsidies they provide to their domestic industries, their exchange rates, and other measures that the President deems unfair.

That’s fine, but this approach of shooting with reciprocal tariffs first and then talking later might quickly escalate into a trade war with a retaliatory tariffs spiral.

(6) The end of American Exceptionalism. Only a few months ago, American Exceptionalism was widely heralded, including in front-cover stories in the media. Indeed, the October 19, 2024 cover story in The Economist was titled “The Envy of the World.” It was a special report on the American economy. With the benefit of hindsight, that might have been an important contrary indicator, an example of the “front-cover curse” I’ve often mentioned.

Another contrary indicator was the substantial $289.0 billion in net purchases of US equities by private foreign investors through December 2024 (Fig. 16). As we have previously observed, foreign net inflows into US equities tend to be large near tops in the US stock market.

If American Exceptionalism has peaked, then it did so on December 24, 2024 when the ratio of the MSCI US stock price index to the MSCI All Country World (ACW) ex-US index (in dollars) peaked (Fig. 17). The ratio has dropped sharply since then, though it remains on the upward trend that started in 2010.

What has certainly been exceptional about the US stock market is its valuation multiple. Its gap with that of the rest of the world has been widening since 2012 (Fig. 18). Even now, while the MSCI US’s forward P/E has dropped two percentage points over the past few weeks to 20.7, that’s still well above the 13.8 of the MSCI AWC ex-US.

(7) The Stock Market Vigilantes. The economy is clearly being stress-tested by the turmoil unleashed by Trump’s tariff campaign and rapid-fire cuts in federal payrolls. The immediate impact has been rapid corrections in the Nasdaq and S&P 500. In effect, the Stock Market Vigilantes (SMV) are giving the administration a thumbs down. If this wild bunch forces stock prices into bear market territory, the negative wealth effect could cause a self-fulfilling recession.

The administration seems to be inciting the SMVs to do just that. Trump recently dismissed the significance of the stock market, saying “you can’t really watch the stock market” and “markets are going to go up and they’re going to go down.” Treasury Secretary Scott Bessent (who should know better) also downplayed the recent stock market selloff, calling it “a little bit of volatility over three weeks” that the administration is not concerned about. In effect, they are saying that there is no Trump Put for stock investors. At the same time, Fed officials have said that they are in no rush to provide a Fed Put, which in the past often made significant stock market bottoms.
 
Strategy III: The Bull Case. Now for an uplifting change, let’s review the bull case. To an important extent, it hinges on the resilience of the US economy. Over the past three years, the economy has demonstrated its resilience by growing despite widespread forecasts that fueled fears of a recession caused by the significant tightening of monetary policy. The lesson that should have been learned is that the US economy can perform remarkably well despite Washington’s constant meddling with it. Actually, that’s been true for a very long time.

Consider the following:

(1) Resilient consumers. We continue to monitor the weekly Redbook Research retail sales series, which is highly correlated with the monthly retail sales series compiled by the Census Bureau. The former was up solidly at 5.7% y/y during the March 7 week (Fig. 19). The growth rate of department store sales, which has been around zero in recent years, rose to 1.5% in the latest week, while discount store sales increased 6.9% (Fig. 20).

(2) Resilient labor market. So far, weekly initial unemployment claims suggest that the labor market remains tight: Claims have stayed around 220,000 since the last week of January, excluding a blip to 242,000 during the week of February 21 (Fig. 21). Separate data for federal government employees’ unemployment claims have spiked during the past two weeks, but to only around 1,600 per week (Fig. 22). Recent surveys of job openings conducted by the Conference Board, the National Federation of Independent Business, and the Bureau of Labor Statistics show that openings remain ample.

(3) No Tech Wreck likely. While cloud computing vendors might need to spend less to increase their capacity to run LLMs as a result of DeepSeek, they will still have to expand their datacenter capacity significantly to process and store more AI-related data.

We don’t think that there is a significant valuation problem in the S&P 500 Communication Services and Information Technology sectors—certainly nothing comparable to the technology bubble of the late 1990s. Together, these sectors account for about 40% of the market capitalization of the S&P 500, matching the peak in late 1999 and early 2000, just before the Tech Wreck. However, there’s more earnings justification this time: Their share of the S&P 500’s forward earnings is currently 35%, well exceeding the 22% peak just before the Tech Wreck (Fig. 23 and Fig. 24).

(4) The Fed Put is on standby. Fed officials have frequently stated that they are in no hurry to lower interest rates. That’s a dovish stance since it implies that they are focusing on lowering the federal funds rate, not raising it or holding it steady. If Trump’s policies show signs of pushing the economy into a recession, the Fed will act quickly to lower interest rates. That assumes, as we do, that inflation remains subdued at just a bit north of the Fed’s target of 2.0%. The Trump Put may be kaput, but the Fed Put remains on standby.

(5) Stock market sentiment is so bad. The Investors Intelligence Bull/Bear Ratio dropped to 0.80 last week. Readings below 1.00 have been strong buying signals in the past, though they can stay below 1.00 for some time before the market clearly bottoms. The AAII Bull/Bear Ratio is also very bearish, which is bullish from a contrarian perspective.

From a sentiment perspective, it is possible that Thursday’s selloff followed by Friday’s rally marked a bottom in the correction. We will be more inclined to call a bottom when we see the stock market move higher on a day or days when Trump blusters about tariffs again, which he did not do on Friday. Any day without a Trump tariff comment is a good day for the market. We know that on April 2 there will be lots of reciprocal tariffs imposed on many more nations by the administration, undoubtedly eliciting lots of comments from Tariff Man.

(6) Bottom line. We repeat ourselves: It all depends on the often-unpredictable President, who frequently—and proudly—has referred to himself as “Tariff Man,” reflecting his strong support for protectionist trade policies.

Strategy IV: RIP, Roaring 2020s? While there’s lots of uncertainty for now about the short-term outlook for the economy, we remain believers in our Roaring 2020s scenario, which we started to write about in 2019. That call worked out well during the first half of the decade. Along the way, we often were reminded that the Roaring 1920s ended badly because of the Smoot-Hawley Tariff, which was passed in June 1930. Unfortunately, such a scenario could happen again if Trump turns out to be a protectionist and triggers a global trade war.

In other words, we can’t dismiss the possibility that Trump will convert our Roaring 2020s scenario into the New Global Disorder of the 2030s—the analogy being the terrible 1930s.

Before that happens, we would expect lots of pushback from constituencies of Republican congressional representatives clamoring for an end to the tariff turmoil. The Republicans have very narrow majorities in both houses of Congress. They can expect to lose both those majorities if Trump uses tariffs to pursue protectionism, causing increasing retaliatory tariffs and a recession, rather than using them to negotiate freer trade by lowering tariffs in a reciprocal fashion to promote global prosperity.

Movie. “Paradise” (- -) is a 2025 Netflix series about a Secret Service agent who investigates the murder of the President of the United States, which occurs in a peaceful community of 25,000 people. It is a bit reminiscent of “The Truman Show” and “Pleasantville.” It is mildly entertaining, but none of the characters are particularly interesting. (See our movie reviews archive.)

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Lowering Our S&P 500 Targets

March 13 (Thursday)

Strategy I: Where Do We Go from Here? John Maynard Keynes is credited with saying, “When the facts change, I change my mind. What do you do, sir?” However, there is no definitive evidence that he actually said or wrote it.

Wall Street’s forecasting community (including us) is scrambling both to assess February’s weaker-than-expected batch of economic indicators for January and to reassess the likely near-term negative impact of Trump 2.0. The Citigroup Economic Surprise Index surprised most forecasters during the second half of last year with positive readings (Fig. 1). It has surprised them with slightly negative readings since February 20. We continue to bet on the resilience of the economy. However, we acknowledge that it is being severely stress-tested now by Trump 2.0’s tariff turmoil and shotgun approach to paring the federal workforce.

Perhaps the biggest surprise is that President Donald Trump wasn’t bluffing or even just exaggerating when he often said during his presidential campaign rallies that he loves tariffs. The widespread assumption was that his constant threat to raise tariffs was mostly a negotiating tool to force America’s major trading partners to lower their tariffs. However, he also often said that he viewed tariffs as a great way to raise revenues and to force US-based companies to move operations back to the United States.

President Trump talked about tariffs at the Inauguration Day parade held in the Capital One Arena in Washington, D.C. He said, “I always say tariffs are the most beautiful words to me in the dictionary.” He added that “God, religion, and love are actually the first three in that order, and then it’s tariffs.” That sounded like Trump’s typical bluster, positioning him to make deals to reduce other countries’ tariffs. But, apparently, he meant it: The man loves tariffs. He has even called himself “tariff man.”

On March 7, Commerce Secretary Howard Lutnick said, “We’re going to make the External Revenue Service replace the Internal Revenue Service.” In other words, revenues from tariffs will replace revenues from taxes on individuals and corporations. That’s simply dangerous and delusional nonsense. It certainly isn’t passing the sanity test in the US stock market. Consider the following:

(1) Over the past 12 months through January, federal tax receipts totaled $4.9 trillion (Fig. 2). That included a piddling $87 billion in customs duties (Fig. 3).

(2) A 20% tariff on all imports including goods and services would raise less than $1 trillion over a 12-month period (Fig. 4). It would take a 100% tariff to raise the $5 trillion necessary to shut down the IRS and replace it with the ERS. The tariff would have to be even higher if it is imposed on only on imports of goods, which totaled $3.3 trillion over the past 12 months through January—and that includes January’s huge jump inflated by importers’ front-running tariffs, especially of gold bars (Fig. 5).

(3) And that would still not balance the federal budget. To do that, customs duties would have to be much higher to match federal outlays, which were $7.1 trillion over the past 12 months.

(4) Of course, the above assumes that funding the External Revenue Service of America doesn’t instigate a global trade war, which might cause a depression and a collapse of global trade, including US imports! That is probably a bad—and very dangerous—assumption, since some countries are already retaliating against Trump’s tariffs. So far, that group consists of just Canada, China, and the European Union. But lots of others may join the fray on April 2, when the US is scheduled to impose reciprocal tariffs.

(5) Tariffs are taxes that are paid by consumers of those goods, importers of them, and/or exporters of the goods. Of the three, consumers are the ones most likely to pay the tax in the form of higher prices. The tax base of tariffs (i.e., imports) is much smaller than is the tax base that includes personal income and corporate profits. A consumption tax would make more sense as a revenue raiser, since consumption represents the largest tax base.

(6) Our message to the White House: Mr. Trump, don’t build your tariff wall! Tear down tariff walls around the world by negotiating free-trade deals!

Strategy II: Time To Blink? Given all the above, it isn’t surprising that many forecasters are turning more cautious on the economic outlook. Some are lowering their outlook for GDP and their year-end forecasts for the S&P 500.

We respect the economists and strategists at Goldman Sachs. That’s because they have often agreed with our outlook for the economy and financial markets. They are data dependent, as we are. However, it seems to us that they tend to tweak their forecasts faster and more often in response to new data than we do because we tend to stick to our base-case scenarios longer. So their forecasts occasionally reflect the latest data points sooner than we do. We, on the other hand, tend to question data that don’t support our outlook. More often than not, this approach has worked for us, as subsequent data and/or revisions in the previous data often proved to support our narrative after all. In other words, Goldman’s view tends to determine the consensus outlook. We tend to stray occasionally.

Both approaches have their advantages and disadvantages. The latest batch of economic indicators released on Monday, Tuesday, and Wednesday supported our resilient economy scenario with subdued inflation. Nevertheless, we can’t ignore the potential stagflationary impact of the policies that Trump 2.0 is currently implementing haphazardly. Consider the following:

(1) The labor market indicators in Tuesday’s NFIB survey of small business owners during February and January’s JOLTS report provided solid readings on the labor market. Job openings remained relatively ample (Fig. 6). There were even 662,000 job openings in retail trade during January, which should offset some of the concern about the spike of 39,000 announced layoffs in the industry during February (Fig. 7 and Fig. 8).

(2) Monday’s report on consumers’ inflationary expectations over the next 12 months released by the Federal Reserve Bank of New York showed a much more subdued response to tariffs during February than did the Consumer Sentiment Index survey (Fig. 9). The former reported the one-year ahead expected inflation rate at 3.1%, while the latter jumped to 4.3% (Fig. 10). February’s CPI inflation rate reported on Wednesday was a bit cooler than expected.

The above are certainly not stagflationary readings.

Yet Goldman’s economists cut their real GDP growth projection for 2025 from 2.4% to 1.7% in response to Trump’s tariffs. That was on Tuesday. On Wednesday, Goldman’s strategists lowered their year-end S&P 500 target from 6500 to 6200.

Today, we are blinking on the valuation multiple of the S&P 500. But for now, we are sticking with our strong estimates for S&P 500 companies’ aggregate earnings per share of $285 this year and $320 next year. We are still targeting forward earnings per share—i.e., the average of analysts’ consensus estimates for this year and next, time-weighted to represent the coming 12 months—of $320 at the end of this year and $360 at year-end 2026 (Fig. 11).

On the other hand, under the circumstances discussed above, we are lowering our forward P/E forecasts for the end of 2025 and 2026 to a range of 18-20, down from 18-22 (Fig. 12). That lowers our best-case S&P 500 targets for the end of this year from 7000 to 6400 and for the end of next year from 8000 to 7200 (Fig. 13). The worst-case scenarios using the same forward earnings and the same 18 forward P/E assumptions would be 5800 and 6500 for this year and next year.

That’s if President Trump relents, as we expect he will to avoid a recession that would cost the Republicans their majorities in both houses of Congress in the mid-term elections in late 2026.

Strategy III: Cover for Rate Cut? The latest inflation data may provide some cover for the doves at the Federal Reserve who want to cut the federal funds rate (FFR) later this year. We remain in the none-and-done camp. We have been concerned that services inflation was getting stuck at an elevated level, so probable increases in goods inflation would boost the overall inflation rate of the Consumer Price Index (CPI). The FFR futures market, meanwhile, expects slightly more than three 25bps rate cuts over the next 12 months, ostensibly due to disinflation and/or a cooling labor market (Fig. 14).

The Federal Open Market Committee (FOMC) is unlikely to cut rates when it meets next week. Last Friday, Powell said, “The economy is fine. It doesn’t need us to do anything, really. And so we can wait. ... We do not need to be in a hurry and are well positioned to wait for greater clarity.” Still, the FOMC likely has an overall dovish bias to ease conditions at any signs of cracks in the labor market. The prior day, Fed Governor Christopher Waller said that he sees two rate cuts later in the year as his base case.

February’s CPI gives Waller’s view more credence. On a monthly basis, headline CPI rose 0.22%, its slowest pace since August (Fig. 15). The core CPI increased by 0.23%, its second slowest pace since July. That brought the y/y rates to 2.8% and 3.1%, respectively, reversing a possible reacceleration in consumer prices (Fig. 16). That said, if tariffs stick, the one-time price increase and uncertainty regarding its impact on inflation expectations are likely to be enough to keep the FOMC on pause.

Consider the details of the latest CPI data, and what they tell us about how inflation may unfold in the coming months:

(1) Services. Services inflation remains far too high above the roughly 3.0% y/y increase that is historically consistent with overall 2.0% y/y inflation. However, it is steadily dropping and may reach 3.5% by the second half of the year. In February, CPI services was 4.1%, and 3.8% excluding shelter costs (Fig. 17).

Airline fares fell 4.0% m/m after increasing 1.2% the prior month. That caused transportation services to rise 6.0% y/y, actually its weakest pace since early 2022 (Fig. 18). Weakening demand for travel may keep transportation services inflation subdued, which is important as it’s been a major source of price pressure.

Removing shelter inflation, headline and core CPI rose just 2.0% and 2.2% y/y, in line with the Fed’s inflation target (Fig. 19). Shelter’s 0.3% m/m increase in February accounted for nearly half of the overall rise in headline CPI and is the primary sticking point in services inflation. Encouragingly, it rose just 3.6% on a three-month annualized basis, its slowest pace since 2021 (Fig. 20).

On the flip side, we expected auto insurance inflation to fall after jumping in January. Indeed, it rose just 0.3% m/m after increasing 2.0% the month before. However, it was still up 11.1% y/y (Fig. 21). We expect it to moderate in March.

(2) Goods. Tariffs are likely to make an immediate impact on goods prices, especially since they’ve been rising very slowly (or falling). CPI goods rose 0.6% y/y, down from 0.7% in January (Fig. 22). Durables continued to deflate by more than a percentage point in February, falling 1.2% y/y. Tariffs on Canada and Mexico may hit used cars the hardest—the CPI on used autos rose 0.9% m/m in February after rising 2.2% the prior month (Fig. 23).

The ISM manufacturing and services PMIs also suggest prices will be rising (Fig. 24). Potentially counterbalancing any stagflationary outcome is that we expect energy prices to remain contained. That should prevent an inflationary spiral as occurred in the 1970s (Fig. 25). Furthermore, Chinese producer prices fell 2.2% y/y in February, suggesting that US import price inflation will remain relatively contained once the price increases from tariffs are baked in (Fig. 26).

(3) Economic policy. A legitimate economic concern is that Trump 2.0 is enacting contractionary fiscal policy without accompanying easier monetary policy. Throw on tariffs—which in the end are a tax—and the compendium of US economic policy is a drag on growth. However, this latest CPI print may end the FOMC’s pause and cause it to cut the FFR if the economic fundamentals start to deteriorate. Further progress on inflation is likely needed to assure investors that the “Fed put” is back.

The Bank of Canada cut its benchmark interest rate by 25bps today to 2.75% to counter US tariffs. Last week, the ECB cut rates to 2.5%. With the FFR still between 4.25%-4.50%, the Fed has room to cut as the gap between US policy rates and global rates widens (Fig. 27). In the meantime, a stronger dollar (and weaker foreign currencies) would shift some of the impact of tariffs onto exporters and away from US importers. Uncertainty with respect to all of these market dynamics remains high, especially as we await clarity on the ultimate landing point for trade policy.

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On Japan, Crude Oil & Earnings

March 12 (Wednesday)

Global Strategy: Carry-Trade Calamity 2.0? Japanese government bond yields have surged on the back of stronger economic data. Hotter inflation data have also raised the odds of further Bank of Japan (BOJ) interest-rate hikes, boosting the yen. This has come while US Treasury yields have fallen, thus making the yen even stronger against the US dollar.

All of this is reminiscent of the carry-trade “blowup” last summer, when declining US interest rates and rising Japanese interest rates jeopardized the positions of traders who had borrowed cheaply in yen to fund trades abroad. Even if unwinding carry trades has put some pressure on global markets this time around, the latest Japanese data suggest it won’t last for long. Consider the outlook for Japan and the BOJ:

(1) Rates up. The 10-year Japanese government bond yield traded as low as 0.80% last September, and since has climbed above 1.50% (Fig. 1). While the yen hasn’t quite reached its peak of 140 to the dollar from last fall, it has strengthened from 158 in early January to around 147 today (Fig. 2).

(2) Nikkei down. The Japanese Nikkei has sold off alongside US tech stocks, now down 5.6% over the past month (Fig. 3). However, the rout hasn’t reached the extremes of last year, when Japanese stocks fell 25% in just two weeks.

(3) Not-so-hot economic data. Yesterday, Japan’s Q4 real GDP growth was revised down from 2.8% to 2.2% (saar) (Fig. 4). Private consumption was revised down from 0.1% to unchanged, while residential investment flipped from up 0.1% to down 0.2%. Japanese government bond yields and the yen pared some of their recent rise.

(4) BOJ is still a flock of doves. Inflation is still sticky in Japan, with the BOJ’s target rate rising to 2.5% in January—the highest since March 2024 (Fig. 5). We think the BOJ might stay on hold at its meeting next week after hiking to 0.5% in January—the highest since 2008 (Fig. 6).

(5) Carried out. There are plenty of signs that the carry trade is a fraction of its size last year. We think the most leveraged traders were already carried out by last year’s volatility shock. For instance, leveraged shorts against the yen have already been washed out by the latest strength (Fig. 7). However, the buildup of net short-term foreign assets in Japanese banks—which we believe are parked there to fund carry trades—remain fairly close to last year’s peak (Fig. 8).

In short, the latest Japanese data and our belief that the US economy remains resilient give us confidence that Carry Trade Calamity 2.0 isn’t a worry. But rising fears of a recession in the US combined with anticipation of BOJ rate hikes could prompt more carry-trade unwinds and therefore pressure on global markets.
 
Global Oil: Why Oil Prices Should Stay Range-Bound. Despite President Trump’s imposition of tariffs, including on Canadian oil, we expect global oil prices to remain within a historically low range for the foreseeable future. The tariffs may actually have a deflationary effect on oil, dampening global aggregate demand and suppressing prices, in our view.

On Monday, the price of a barrel of Brent crude oil hit below $70 for the first time in three years, at $68.33 (Fig. 9). It had traded mostly in a range of $75-$80 since September. The immediate trigger wasn’t Trump’s tariffs but OPEC+’s unexpected announcement of a supply expansion. Trump has been pressuring OPEC+ to lower oil prices, which tilted oil traders into a net bearish position.

A confluence of factors suggests to us that global oil prices will stay within a narrow, $65-$75 band through the end of this year. That's barring a severe global recession, which we are not expecting this year despite Trump’s Tariff Turmoil 2.0. In most scenarios, we can’t see oil prices dropping into the $50s, as at least one forecaster projects. That’s because geopolitical factors, such as tensions between the US and Iran and further meddling in the market by Trump and OPEC, likely will result in oil prices remaining around current levels.

Also supportive of oil demand would be the potential refilling of the US Strategic Petroleum Reserve, as the US energy secretary intends. On the other hand, the global addition of renewable energy sources to the energy mix should limit demand.

These countervailing influences support our case for a range-bound oil price. Let’s examine these and related factors:

(1) Demand-side factors. Three demand-related factors should help keep a lid on global oil prices:
Weak demand from China. The world’s second-largest economy is slowing, and we aren’t overly optimistic on the success of its recently announced stimulus plan (see yesterday’s Morning Briefing). The country also is shifting away from fossil fuels and growing its reliance on renewable energy sources, which will contribute to a steady decline in its oil consumption growth rate. China now generates 31% of its electricity from renewables, including wind, solar, hydro, and geothermal. Despite its dependence on coal, solar is expected to surpass coal as the leading energy source by 2026. In 2024, China led global energy transition investment, according to BloombergNEF data.
Weak demand from Europe. While our concerns about Europe’s economic slowdown have eased with the potential boost from defense spending under the European Union’s ReArm initiative (see yesterday’s Morning Briefing), Europe is quickly shifting to cleaner energy. Reliance on renewable sources is a pillar of Europe’s commitment to completely phase out Russian gas imports and to achieve energy independence. Last week, the European Commission (EC) replaced its Green New Deal with the Clean Industrial Deal, designed to support dual goals of decarbonization and economic growth.
Global shift toward renewables & mainstreaming EVs. As renewable energy sources continue to gain ground, catalyzed by government policies, the long-term outlook for fossil fuels, especially oil, appears increasingly uncertain. Renewable energy technologies—including solar, wind, and electric vehicles (EVs)—are fast becoming mainstream. As the EV market expands, a major inflection point is approaching: The sticker price will soon match that of a gas-powered car, perhaps as soon as this year. The rise of EVs is expected to dent demand for gasoline and diesel, pressuring oil prices downward.
(2) Supply-side factors. We see three major influences on oil supplies:
OPEC+ production increases should expand supply. Oil prices sank last week after OPEC+ agreed to increase crude production for the first time since October 2022. Over the next year and a half, the group will pursue a “gradual and flexible return” of 2.2 million barrels a day. This followed a long-delayed hike in production by eight countries: Saudi Arabia, Russia, Iraq, the United Arab Emirates, Kuwait, Kazakhstan, Algeria and Oman. Even before the OPEC+ alliance announced additional supplies, the International Energy Agency was already forecasting a surplus, with supply growth expected from non-OPEC+ sources. We expect OPEC+ to maintain global oil prices within a manageable range that protects producers.
Geopolitical risks threaten oil supplies. Geopolitical tensions in the Middle East consistently introduce uncertainty into oil pricing. Middle East tensions and Russia’s war in Ukraine are the two biggest known risk factors for energy in 2025, followed by trade-related disruptions. However, we note that supply disruptions from geopolitical causes are typically short-lived, causing oil price spikes but not rallies, as alternative oil sources usually step in to stabilize the market. Topping our list of geopolitical risks to oil prices are the tensions between the US and Iran over Iran’s evasive international shadow network that ships millions of barrels of Iranian oil to China amid US sanctions. Pressure on Iran could offset a global supply surplus, especially given the Trump administration’s aim to reduce the regime’s oil flows by 90%.
Shale backstops supply. The US shale industry has become a key counterbalance to global supply disruptions. President Trump’s executive order to "unleash America’s energy" lifts restrictions on oil and gas extraction and reverses several climate-related policies enacted by the Biden administration. Despite his tariffs, Trump has pledged to lower US energy costs. Even with falling oil prices, US shale producers are able to reduce costs and maintain output, helping to stabilize oil prices within a set range. Shale producers may be able to remain profitable at oil prices as low as $50 per barrel, the US energy secretary recently stated. While shale production provides a buffer against supply shocks, major shale producers are unlikely to significantly increase production, prioritizing returns to shareholders over aggressive drilling.
US Strategy: Earnings Growth Scare in Q1? The earnings warning season is upon us. On Monday evening, Delta Air Lines warned analysts that their revenues and earnings forecasts for Q1 were too high. The company said corporate and consumer spending stalled in Q1, growing at a slower-than-expected rate y/y. However, the company did not foresee a recession ahead and actually left its 2025 guidance unchanged on expectations of lower energy prices.

For the S&P 500 companies in aggregate, consensus estimates call for earnings to rise y/y for an eighth straight quarter, albeit at a slower “back-to-trend” rate. The consensus growth forecast for S&P 500 Q1-2024 earnings has dropped to 6.8% as of the March 6 week from over 11% at the beginning of the quarter (Fig. 10). The steep decline in recent weeks is typical of quarters’ final weeks, when bad earnings news tends to dominate estimate revisions activity.

However, there are still pockets of strong earnings growth within the S&P 500 sectors, as Joe shows below:

(1) What’s ahead for Q1 sector earnings growth? Eight of 11 sectors are expected to show positive y/y earnings growth, down from 10 sectors in Q4. Among the three lagging sectors, Consumer Staples’ earnings is expected to fall y/y in Q1 for the first time in ten quarters; Materials is expected to fall after rising in Q4 for the first time in 10 quarters; and Energy is expected to fall for a third straight quarter. Among the six sectors expected to post single-digit earnings growth in Q1, for Consumer Discretionary and Utilities such a result would end their double-digit percentage growth streaks at eight and six quarters, respectively.

(2) Health Care and Tech are Q1’s and 2025’s growth leaders. Just two sectors are expected to post double-digit percentage earnings growth in Q1, Health Care and Information Technology. That would mark the lowest count of sectors with double-digit percentage earnings growth since Q4-2022, when only Energy and Industrials posted such growth. The Health Care and Information Technology sectors are expected to grow revenues and earnings faster than the S&P 500, not just in Q1 but for all of 2025’s quarters (Fig. 11 and Fig. 12).

(3) Review: S&P 500 sectors’ Q4 revenues growth. Joe recently updated his analysis of Q4’s revenue and earnings results for the S&P 500’s sectors in our S&P 500 Quarterly Metrics publication. During Q4, eight of the 11 S&P 500 sectors recorded positive y/y growth in revenues, unchanged from Q3’s count. Here’s how the S&P 500 sectors’ y/y revenues growth rates stacked up in Q4: Information Technology (12.1%), Health Care (9.2), Real Estate (8.6), Communication Services (7.3), Financials (7.3), Consumer Discretionary (6.2), S&P 500 (5.2), Consumer Staples (1.4), Utilities (1.0), Materials (-1.8), Energy (-1.9), and Industrials (-3.0).

(4) Review: S&P 500 sectors’ Q4 earnings growth. On the earnings front, ten of the 11 S&P 500 sectors posted positive y/y earnings growth in Q4. That was the broadest sector growth since Q4-2021. Seven sectors posted double-digit percentage y/y earnings growth, the highest count since 12 quarters in Q1-2022. Here are the S&P 500 sectors’ y/y earnings growth rates for Q4: Financials (35.1%), Communication Services (31.5), Consumer Discretionary (27.2), Information Technology (19.8), S&P 500 (17.0), Real Estate (15.4), Health Care (14.3), Utilities (12.5), Industrials (8.0), Materials (2.0), Consumer Staples (1.5), and Energy (-29.1).

(5) Review: S&P 500 sectors Q4 profit margin. Profit margins improved q/q for just four of the 11 sectors in Q4: Financials, Industrials, Information Technology, and Real Estate. However, nine sectors, all but Energy and Materials, had higher Q4 margins y/y. Here’s how the sectors’ profit margins ranked in Q4: Real Estate (31.0%, six-quarter high), Information Technology (27.5, record high for the first time since Q4-2021), Communication Services (19.6), Financials (15.8, 10-quarter high), Utilities (13.1), S&P 500 (12.8, 10-quarter high), Industrials (11.0, six-quarter high), Materials (8.9, 18-quarter-low), Consumer Discretionary (8.9), Energy (7.8, 14-quarter low), Health Care (7.6), and Consumer Staples (6.5).

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Going Global Slowly

March 11 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Strategy I: Time To Go Global? A much more favorable macroeconomic and political backdrop in the US had kept us icy on international stocks for the past 15 years, even during the recent rally in the MSCI All Country World (ACW) ex USA Index. However, just this month, developments in both the Eurozone—particularly Germany—and China have thawed our stance a bit toward investing in advanced foreign economies.

We’ve preferred to “Stay Home,” favoring US large-cap stocks over international ones since at least 2010. The resilience of the US economy and favorable stock market fundamentals, including earnings growth, mean we’re maintaining our Stay Home posture. However, we’d caution against continuing to shun international stocks, successful as that strategy has been, simply out of inertia. Given that developments abroad have allayed some of our macroeconomic concerns, providing more support for a “Go Global” strategy, it makes sense to consider reallocating some funds to international stocks.

In portfolio parlance, we’re reducing our overweight on the MSCI US and paring our underweight of the MSCI ACW ex-US. Before we get into the macroeconomic factors underpinning this decision, consider some of the stock market fundamentals:

(1) Relative performance. The MSCI US index peaked relative to the MSCI ACW ex-US on Christmas Eve of last year (Fig. 1). In dollar terms, the US index has fallen 12% versus the ACW ex-US since. That’s been exacerbated by the dollar’s losing 4.3% ytd (Fig. 2). In local currency terms, the US index is down roughly 9.5%.

The international catch-up trade has a very high ceiling. The MSCI US is still trading at more than 21 times forward earnings, whereas the MSCI ACW ex-US index is trading at just 14 times forward earnings (Fig. 3). Arguably, European and Japanese stocks should represent much more than a combined 21% of the global market cap anyway (Fig. 4).

(2) Dollars versus local currency. This argument is perhaps even stronger for international investors, as they stand to lose doubly if US stocks and the dollar both underperform. The dollar’s underperformance could extend considering that its run since the pandemic means it may still be overvalued.

The reasons for the dollar’s fall are perhaps a better indicator of the outlook from here. We think it’s led by the outperformance of the euro and yen as their countries’ long-term bond yields jumped (Fig. 5). The economic growth scare in the US may have some impact but probably a limited one since 10- and 30-year Treasury yields haven’t fallen dramatically. The positive performance of the euro and yen are the results of the improving macro picture abroad, and a positive for the global economy. So unless the US government’s tariff turmoil and federal firings spark a recession that the rest of the world avoids, we aren’t overly worried about dollar downside.

(3) Productivity and profit margins. Another reason we’ve kept an underweight position on international stocks was the poor productivity growth abroad. While US productivity growth has been sustained since the Great Financial Crisis and accelerated after the pandemic, productivity growth has largely plateaued in the rest of the world for the past 17 years (Fig. 6).

However, forward profit margins suggest that may be changing. Analysts’ consensus estimates for the MSCI ACW ex-US index forward profit margin have risen from 7.7% before the pandemic to 9.6% today (Fig. 7). That included 50bps of forward margin expansion over the past year.

Strategy II: German Rearmament. Trump 2.0 may finally have prodded Europe into getting its act together. Germany is looking to exempt expenditures above 1% of GDP from the debt brake as part of a €500 billion infrastructure and defense fund. The European Union (EU) has followed suit by removing limits on European countries and adding new defense loans, potentially allowing for up to €800 billion of defense spending through the end of the decade.

These measures should help Germany meet NATO’s 2% of GDP defense spending target and instill fiscal stimulus into a very sluggish economy that needs it (Fig. 8 and Fig. 9). Notably, the EU almost never has met NATO’s 2% target. Markets have reacted swiftly, though nothing is set in stone and obstacles are emerging.

Consider the outlook for the European economy:

(1) Debt deluge. German bunds have sold off in anticipation of a flood of new debt issuance. The 10-year bund yield has risen from below 2.40% at the end of February to as high as 2.88% last Thursday (Fig. 10). French President Emmanuel Macron wants to raise defense spending to 3.0%-3.5% of GDP from its current 2.0% without raising taxes, another sign to the markets that the European economy finally will get the benefit of a looser fiscal stance.

(2) Strings attached. Germany’s Green party rejected the defense and infrastructure spending package on Monday. Germany’s center-right coalition of Christian Democrats and Social Democrats has until March 25 to pass the package; but it needs a two-thirds majority and is relying on the Greens. The Greens thus far have felt left out and emphasize the need for climate-related initiatives.

(3) Alleviating our concerns. Two broad factors have prevented us from upping our long-term opinion on Europe: fiscal conditions and political conditions (see our June 26 Morning Briefing titled “EU’s Foundation Cracking?”). Brussels has been threatening to rein in already austere fiscal policies, which hampered the EU’s recovery from the pandemic. Meanwhile, many European countries’ internal politics, along with the EU’s parliamentary politics, were fracturing. Increased tensions among parties led us to be concerned about the bloc’s future.

If Germany successfully gets this spending package through, it will address both of our concerns and effectively remove barriers from shifting to a neutral stance on European equities.

Strategy III: Chinese Consumption Soon? We’ve long believed that until China figured out how to spur domestic demand, it would be uninvestable over any long-term horizon. Consumer confidence has been crushed for years, especially after the property bubble burst and evaporated most households’ savings (Fig. 11). The most likely way of achieving greater domestic demand would be to increase fiscal stimulus to households. China’s cultural and political institutions thus far have prevented such a reallocation of capital.

The latest announcement on China’s annual economic targets and a seeming newfound commitment to the consumer may show that the Chinese Communist Party (CCP) has finally accepted what it takes to internally balance its economy. Consider the following:

(1) New targets, more lending. China’s roughly 5% real GDP growth target for 2025 will be accomplished via more government spending. The CCP recently raised its budget deficit plan from 3% of GDP to 4% (Fig. 12). The larger deficit will be funded via ultra-long-term government debt and local government debt. More money will be raised to recapitalize the state banks. Overall, China’s total social financing is likely starting a new uptrend after falling for two-plus years (Fig. 13). That’s a positive for global liquidity and stimulus.

(2) Consumer in need. Retail sales have been weaker than industrial production, as China targets manufactured exports to grow its economy rather than households (Fig. 14). Hopes that stimulus measures thus far were starting to take hold quickly faded when February’s CPI fell into deflation for the first time in roughly a year (Fig. 15).

We’re not yet convinced that China is ready to stimulate its household sector enough to increase domestic demand. It also does not appear to be willing to stop artificially boosting industrial capacity. China lowered its inflation target from 3% last year to 2% in 2025, a sign that the export-led strategy will continue. However, we believe the drip-drops of stimulus and increasing focus on the consumer are likely to build up enough counterweight to offset the effects of a trade war, which is a positive for the global economy and markets. So while we’re not bullish on investing in China, we are incrementally less bearish and therefore more positive on global markets broadly.

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High Noise-To-Signal Ratios Unnerving Stock Investors

March 10 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy I: The Economy’s High NTSR. The economy’s noise-to-signal ratio (NTSR) has been rising rapidly in recent weeks. As a result, it has gotten harder to get a read on the economy lately. Washington’s rapidly increasing NTSR is also troubling. Indeed, last Wednesday, our Morning Briefing was titled “Trump Turmoil Raises Odds Of A Recession.” We raised our subjective odds of a recession this year from 20% to 35%.

We are considering raising the odds again given that Trump officials recently acknowledged that they expect that their policies will cause some short-term pain. The near-term outlook for the economy and stock market has soured rapidly over the past few weeks.

The DOGE Boys have been firing government workers faster than we expected. That might slow now that various Cabinet secretaries reportingly are pushing back against Elon Musk’s terminators. The Trump administration’s tariff policies are instigating a retaliatory trade war rather than the negotiations to reduce tariffs that we had expected. More “reciprocal” tariffs will be imposed on April 2 by the Trump administration, which also aims to raise revenues with tariffs, implying that some of the tariffs will be permanent.

Stock investors are confused and seem to have concluded that the economy may be falling quickly into a recession. We’ve been betting on the economy’s resilience, but we can understand why risk-off is the stock market’s current default option.

The Nasdaq is in correction territory, and the S&P 500 seems to be headed in the same direction (Fig. 1). The Nasdaq fell below its 200-day moving average at the end of last week and has found support at the bottom end of its short-term upward trending channel. There is another uptrend line that started in 2010, which would provide support for the Nasdaq but in bear market territory (Fig. 2). The Nasdaq index is currently 9.8% below its record high of 20173.89 on December 16.

The S&P 500 is down 6.1% from its record high on February 19 (Fig. 3). It is slightly below its 200-day moving average. It has been a very rapid decline. It reminds us of the plunge in the S&P 500 during the Kennedy Slide of 1962 (also known as the “Flash Crash of 1962”). The stock market did not experience a stable recovery until after the end of the Cuban Missile Crisis in October 1962 (Fig. 4). The crash was partly attributable to a big price increase by US Steel that was loudly and successfully opposed by the Kennedy administration. This time, the selloff is largely attributable to Trump Tariff Turmoil 2.0.

Corrections are caused by fears that the economy is falling into a recession. During these events, stock prices fall 10%-20%. But they recover relatively quickly once those fears abate. During the bull market from 2009 through 2020, we counted 66 “panic attacks,” which included a few corrections. Bear markets occur when the correction turns into a decline of more than 20%, usually because a recession happens. There have been only three bear markets that occurred without an accompanying recession: the one in 1962, the one late in 1987, and the one in 2022.

There is certainly a recession scare currently. Our bet on the resilience of the economy is keeping us in the correction camp. However, Trump Tariff Turmoil 2.0 has the potential to cause a fourth bear market without a recession.

Yes, but what about the latest batch of economic indicators that are heightening recession fears? Consider the following:

(1) Atlanta Fed versus New York Fed Nowcasts. The Atlanta Fed’s GDPNow tracking model is currently showing Q1’s real GDP decreasing by 2.4% (q/q saar). However, the New York Fed’s Nowcast tracking model shows it increasing 2.7%! Go figure.

We usually favor the Atlanta Fed model over the New York Fed one. However, this time, we are betting on the New York Fed’s forecast. We don’t know why the two models differ so much.

What we do know is that the Atlanta Fed estimate dropped from +2.3% to -1.5% following the release on February 28 of a big jump in January’s imports, led by an odd jump in gold imports. In addition, on that same day, January’s real personal consumption expenditures showed a big decline of -0.5% m/m. The GDPNow estimate was lowered again to -2.8% on March 3 after the release of the ISM manufacturing index for February. It is currently -2.4%.

(2) Surging (gold) imports. In a March 7 post on LinkedIn, Pat Higgins, the creator of GDPNow, explained that much of the widening of the trade deficit in January was due to an increase in nonmonetary gold imports from $13.2 billion in December to $32.6 billion in January. This accounted for nearly 60% of the widening of the goods trade deficit. Higgins concluded: “Removing gold from imports and exports leads to an increase in both GDPNow’s topline growth forecast and the contribution of net exports to that forecast, of about 2 percentage points.” That’s obviously a significant swing.

(3) Weak (and strong) retail sales. Furthermore, the drop in real consumer spending during January undoubtedly was caused by inclement weather that month, which was the coldest since 1988. Industrial output of utilities soared to a record high in January (Fig. 5). Auto sales fell sharply in January and rebounded slightly in February (Fig. 6).

Retail sales excluding food services dropped 1.2% m/m during January. Again, we blame the weather. Nevertheless, it still rose 4.0% y/y (Fig. 7). The Redbook retail sales index rose to 6.1% y/y during the February 28 week. Then again, the Consumer Confidence Index survey showed a sharp decline in vacation plans during February (Fig. 8).

Furthermore, Target said on Tuesday that it expects little to no sales growth this year, with CEO Brian Cornell telling CNBC that higher prices are on the way. Walmart and electronics retailer Best Buy also recently warned about expectations for 2025.

(4) Mixed signals from the PMIs. February’s purchasing managers added to the dissonance provided by the latest batch of economic indicators. The M-PMI dipped to 50.3 in February from 50.9 in January (Fig. 9). However, those were the first back-to-back readings above 50.0 since September and October 2022. Then again, February’s M-PMI subindexes for new orders (48.6) and employment (47.6) fell below 50.0. The regional business surveys conducted by five of the 12 Fed district banks showed better growth during February.

February’s NM-PMI remained solidly above 50.0 at 53.5 (Fig. 10). All its major subindexes did the same. Just as we expected, the S&P Global flash NM-PMI provided a misleadingly weak estimate of the ISM version of this index (Fig. 11).
 
Strategy II: Labor Market’s High NTSR. Friday’s employment report for February also provided plenty of mixed signals. The payroll employment series (which measures the number of full-time and part-time jobs) rose 151,000, while the household employment series (which measures the number of workers with one or more jobs) fell 588,000. The latter is very volatile. It was up 2.2 million during January following an annual benchmark revision. The former was weaker than we expected, as we had anticipated a rebound from January’s cold blast. Well, it turns out that the weather was also bad in February. Consider the following:

(1) Bad weather again? The household employment survey shows that 404,000 nonagricultural workers were not at work during February, the most since February 2014. The survey also found that 1.31 million nonagricultural workers who work full time had to work part time last month because of the weather. That’s the most since February 2021 (Fig. 12).

We had expected average weekly hours to rebound in February. Instead, it remained flat at January’s level. If bad weather depressed both months’ readings, then there should be a solid rebound in average weekly hours during March.

(2) Payroll employment. While February’s payroll employment gain was weaker than we’d expected, the three-month average gain was 200,000 (Fig. 13). That’s a robust reading. Excluding government, the three-month average was 169,000. That’s also a solid reading.

The questions ahead are how much will federal government employment fall in coming months as a result of the activities of the DOGE Boys, and will private payroll gains more than offset the losses of federal jobs? We think so, though this is certainly one of the great uncertainties resulting from Trump Turmoil 2.0. The losses started in February with federal government employment down 10,000 (Fig. 14). This number could potentially double, triple, or even quadruple in coming months.

(3) Earned income proxy. During February, private-sector payrolls rose 0.1%, the average workweek for private-sector workers was unchanged, and average hourly earnings in the private sector rose 0.3%. So our Earned Income Proxy edged up 0.4% m/m (Fig. 15). We expect bigger rebounds in February’s retail sales and total consumer spending from January’s deep freeze, unless bad weather kept shoppers at home during February too.

(4) Unemployment and layoffs. The bad news is that February’s Challenger Report showed that government-announced layoffs totaled 62,240 (Fig. 16). The private sector isn’t likely to significantly offset such job cuts if they all hit in March and April, especially since the Trump administration is planning even more layoffs.

In the private sector, announced layoffs in retailing during February totaled 38,960, the second highest tally on record. Retail payrolls fell 6,300 during the month. Information employment rose 5,000 last month. Announced layoffs in technology totaled 14,550. This means that we should expect sizeable increases in weekly initial and continuing unemployment claims in coming weeks.

While the official headline unemployment rate remained low at 4.1% during February, the U-6 rate rose to 8.0%, the highest since 2021 (Fig. 17). The latter was boosted by more workers employed part-time for economic reasons (Fig. 18). Both jobless rates are bound to increase during the next few months.
 
Movie. “A Complete Unknown” (+ +) is a 2024 musical drama about Bob Dylan, starring Timothée Chalamet. Lots of Dylan’s great songs are featured, with Chalamet doing a good job of singing them. Dylan comes across as self-absorbed and obsessed with his privacy. He has a couple of girlfriends in the film, including Joan Baez. Both women are frustrated that he doesn’t share more about himself with them. He comes across as socially awkward and a complete unknown. However, he does relate well to Woody Guthrie, Pete Seeger, and Johnny Cash. (See our movie reviews archive.)

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China, Tariffs & Quantum Computing

March 06 (Thursday)

China: Putting on a Brave Face. In a trade war with President Trump, China won’t win if it fights fire with fire. The US runs a trade deficit of $1.5 trillion, and the vast majority of US imports comes from either the EU, China, Mexico, or Canada (Fig. 1 and Fig. 2). China, on the other hand, has far more exports than it has imports, resulting in a trade surplus of $1.0 trillion, using a 12-month sum (Fig. 3).

More specifically, the US imports $273.5 billion more from China than it exports to China. Due to that imbalance, China will never be able to match the US’s 20% tariffs dollar for dollar. Nor would it want to risk angering the current resident in the Oval Office because China needs US exports to bolster its weak economy.

After meeting on Tuesday, Chinese leaders announced a GDP target of 5.0% for 2025, the same target it had last year and a touch slower than its Q4 GDP of 5.4% (Fig. 4). The 2025 target is a tall order given the economic headwinds the economy faced last year, which will be amplified by the US tariffs this year. Last year, exports represented nearly a third of China’s 5% GDP growth, a March 5 WSJ article noted.

China also announced targeted import restrictions on US goods and tariffs on certain US imports. But the moves aren’t considered excessive, indicating the country’s desire to avoid escalating the already delicate trade situation. If the country did decide to get more aggressive, sharply raising prices on its exports sold in the US, it would inflict more pain on US companies and consumers. Imagine the howls if the country doubled or tripled the prices of China-made goods that US consumers are accustomed to having, like gaming consols, smartphones, or pharmaceutical ingredients.

China announced on Tuesday several measures it will be taking to help achieve its economic growth target and gave some details on how it would counter Trump's tariffs. Let’s have a look:

(1) Spend more money. The Chinese government set a budget deficit target of around 4.0% of GDP, up from 3.0% last year and the highest level in years. It’s an indication that the government plans to open its purse strings and spend to boost economic growth, the March 4 WSJ reported.

(2) Impose tariffs. In response to the latest round of Trump tariffs, China announced targeted tariffs on US imports that will begin on March 10. It’ll place a 15% tariff on US chicken, wheat, corn, and cotton products and a 10% tariff on sorghum, soybeans, pork, beef, seafood, fruits, vegetables, and dairy products. In addition, the Commerce Ministry added more than 24 American companies to export control and corporate blacklists. The country also said it was suspending imports of US wood and US soybeans from three companies.

US farmers no doubt aren’t happy; China was the third largest importer of US agricultural products last year.

(3) Keep expectations low. Chinese leaders set a target of 2.0% for consumer inflation, down from last year’s goal of 3.0%. The Chinese economy’s sluggishness has weighed on inflation, which came in at 0.5% y/y in January, or 0.2% excluding food and energy (Fig. 5). The country’s producer price index registered deflation, coming in at -2.3% y/y in January (Fig. 6). China’s economic woes and dance with deflation are reflected in its 10-year government bond yield of 1.76% and tepid demand for bank loans (Fig. 7).

Conversely, investors have received two good pieces of economic news recently. China’s official manufacturing purchasing managers index (PMI) indicated that the industrial sector entered expansion territory above 50.0 in February, rising to 50.2 from January’s 49.1 (which may have been weakened by the Lunar New Year holiday). New orders in February also rose, to 51.1, but new export orders registered at only 48.6. The non-manufacturing PMI edged higher as well, to 50.4 from 50.2 in January (Fig. 8). However, some of this activity may have been artificially inflated by US companies racing to import goods before the Trump tariffs hit.

The excess capacity and excessive debt in China’s residential real estate market have been drags on the general economy in recent years. Data remain mixed, with new home sales from China’s 100 biggest property developers climbing 1.2% y/y in February after a 3.2% decline in January.

The Shenzhen Real Estate stock price index has popped up 27.8% from its 17-year low on August 28, but remains depressed and is down 1.1% ytd (Fig. 9). Likewise, the CSI 300 has dropped 1.3% ytd through Tuesday’s close, but the China MSCI has jumped 12.7% (Fig. 10).

Strategy: CEOs Do the Tariff Tap Dance. Companies have been preparing for US tariffs and the expected responses from targeted countries for months. From moving production to cutting costs, here’s a quick look at what some executives in the retailing, refining, and farming industries are saying about their companies’ tariff-readiness:

(1) Tariffs create uncertainty. Given the uncertainty created by tariffs, Target aims to maintain a “larger-than-normal cushion” on its balance sheet, said CFO Jim Lee on Tuesday on the company’s earnings conference call. The company has been pulling production out of China and moving it to other countries in Asia and Latin America. The increased diversity of production locations gives them more flexibility.

The uncertainty surrounding the tariffs and its impacts on consumer demand contributed to Target’s decision to eliminate its quarterly earnings guidance and give extremely wide 2025 earnings guidance. The company now forecasts net sales growth of around 1% this year and adjusted EPS of $8.80-$9.80 compared to last year’s adjusted EPS of $8.86. Granted, Target had operating issues last year before tariffs were even an issue. So it’s certainly possible that the retailer is using tariffs as an excuse that buys it more time to turn around operations.

(2) Tariffs hit refiners. Trump’s tariffs will impact US imports of Mexican and Canadian crude oil, much of which is of the “heavy” variety that US refiners use. Valero executives discussing tariffs noted that the company’s operations on the US Gulf Coast could limit the impact by importing crude from other countries in the world. But if the tariffs are extended, they could reduce the refiner’s throughput by 10%, said an executive on the company’s January 30 conference call.

(3) China retaliation hurts crops. The folks at ADM were well aware that tariffs wouldn’t be a problem for ADM. Rather, it was the retaliation in response to the tariffs that would potentially cause the problem. “[W]e saw in 2018 how the corn imports from China were reduced by almost like 9 million tons from the U.S. Whether that's going to be something that's going to happen again or not, we'll have to see,” said ADM CEO Juan Luciano during the company’s February 4 earnings conference call.

And as we noted above, China did announce on Tuesday that it will impose additional tariffs of up to 15% on certain US farm products, including soy, wheat, and corn. The company plans to cut up to 700 jobs globally this year after reporting a 16% decline in adjusted EPS in Q4 due to falling crop prices and reduced trade flows.

Disruptive Technologies: Big Guys Elbow into Quantum Computing. Recently, tech giants Amazon, Google, and Microsoft all have announced breakthroughs they’ve made in quantum computing. Conversely, small startup quantum computing companies have watched their stocks tumble ytd, as they are racking up losses. In this David vs Goliath tale, it looks like Goliath may win.

Here’s some of the recent news out of the quantum computing industry:

(1) Lots of new chips. Amazon, Google, and Microsoft each has developed new chips that can be used in quantum computers. Some aim to reduce computing errors; others hope to increase the number of qubits a chip can hold.

Amazon’s quantum computing chip, dubbed “Ocelot,” will lower the cost of reducing quantum computing errors by up to 90%. “It’s designed to test our ability to perform quantum error correction, and once we have that building block, then we can scale it up to a much larger size,” said Oskar Painter, head of quantum hardware for Amazon Web Services, as quoted in a February 27 WSJ article.

Microsoft has developed a new state of matter—one that’s not a solid, liquid, or gas—and uses it in its new quantum chip called “Majorana 1.” If successful, the quantum processing unit, or QPU, will ultimately hold a million quantum bits.

Google’s new chip, Willow, helps to reduce errors “exponentially.” It performed a computation in under five minutes that would have taken one of today’s fastest super computers 10 septillion years to calculate, the company’s December 9 blog stated. The more qubits Google added to its computer, the fewer errors it experienced. The system, which uses 105 qubits, was also able to fix errors in real time.

(2) China & others in the mix, too. Chinese scientists at the University of Science and Technology introduced a quantum computer prototype called “Zuchongzhi 3.0,” with 105 qubits, reported a March 4 article in Global Times, a publication controlled by the Chinese Communist Party. The scientists claim that the quantum computer can process quantum random circuit sampling tasks one million times faster than Google’s Sycamore processor. This follows news of a Chinese prototype quantum computer named “Wukong,” which has 72 qubits and can be accessed in the cloud.

Finnish company IQM Quantum Computers launched Europe’s first 50-qubit quantum computer located at the facility of its partner, VTT Technical Research Centre of Finland. Companies and researchers will have access to the computer through the VTT QX quantum computing service. The 50-qubit computers follow earlier models that had five and 20 quibits, a March 4 article in HPC Wire reported.

Meanwhile, Dutch startup QuantWare has developed a 3D quantum chip architecture it calls “vertical integration and optimization,” or “VIO.” This 3D architecture should allow for more qubits on one chip. A single chip may ultimately be able to hold one million qubits, making it much faster than current chips linked together with fewer qubits. QuantWare is currently accepting orders for its first QPU, Contralto-A, for quantum-error correction. It aims to be the quantum equivalent of what TSMC is to Apple or to Microsoft in traditional computing, a March 4 article in The Next Web reported.

(3) US startups slump. Quantum startups rallied sharply in late 2024 on a batch of good news. Google announced the strong performance of Willow, its quantum chip. IonQ shipped its first quantum computer to a European customer. And Quantum Computing and D-Wave took advantage of the market’s rally to sell stock and raise cash. The industry was also hopeful that the Trump administration would provide support because during Trump’s first term he signed the 2018 National Quantum Initiative Act, which bolstered government research in the area.

In 2024, shares of quantum startups soared: Quantum Computing (up 1,606.2%), Rigetti Computing (1396.1%), D-Wave Quantum (800.8%), and IonQ (215.7%). Then in January, Nvidia CEO Jensen Huang said in response to a question that practical quantum computers are still roughly 20 years away. A few days later, Meta Platforms CEO Mark Zuckerberg shared a similar opinion, stating that quantum computers are “still quite a ways off from being a very useful paradigm” and that many people think it’s a “decade plus out.”

January’s CEO comments cooled investors’ enthusiasm, and they began to focus on the large losses that the quantum startups were racking up, as well as their need to raise additional cash to continue operations. IonQ, for example, doesn’t expect to be profitable until 2030. And D-Wave recently sold $150 million of stock to boost its cash balance to around $320 million. The deal gives D-Wave the necessary capital and ability to get to sustained profitability and positive cash flow, said its CEO.

In short, the quantum stars of last year have fallen to Earth this year. Here are their ytd performances through Tuesday’s close: Quantum Computing (-68.2%), Rigetti Computing (-48.5), IonQ (-46.5), and D-Wave (-36.7).

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Trump Turmoil Raises Odds Of A Recession

March 05 (Wednesday)

Strategy I: Trump Turmoil 2.0. We haven’t had to change our subjective probabilities for our three alternative economic scenarios for quite some time. We are doing so today and may have to do so more frequently in coming months or even coming weeks in reaction to the volatile nature of policymaking under President Donald Trump. The initial animal spirits of Trump 2.0 have been trumped by the uncertainty unleashed by Trump Turmoil 2.0. The administration has been in office for less than two months. The whirlwind of tariffs imposed on America’s major trading partners, federal job cuts implemented by the DOGE Boys, and the upending of the world order have been head spinning.

We held off changing our probabilities because we expected that the master of the art of the deal was going to get a deal with Canada and Mexico that would allow him to declare victory and bury his threat to impose 25% tariffs on America’s only two neighbors and biggest trading partners. In fact, on February 28, US Treasury Secretary Scott Bessent said Mexico proposed matching Washington’s tariffs on China and urged Canada to do the same—signaling a potential path for Mexico and Canada to avert levies on their own exports in the coming days.

“I do think one very interesting proposal that the Mexican government has made is perhaps matching the US on our China tariffs,” Bessent told Bloomberg Television. “I think it would be a nice gesture if the Canadians did it also, so in a way we could have ‘Fortress North America’ from the flood of Chinese imports,” he said.

Here is a quick timeline of related events since then:

(1) On Monday, March 3, Trump said that that there was “no room for delay,” and he implemented the tariffs on Canada and Mexico on Tuesday. Trump has said the tariffs are means to several ends: force the two US neighbors to step up their fight against fentanyl trafficking, stop illegal immigration, eliminate the Americas’ trade imbalances, and push more factories to relocate in the US.

(2) Trump had already put a 10% tariff on imports from China in February. The rate was doubled to 20% on Tuesday. Instead of rapid-fire trade deals, the US has triggered a trade war. Canada imposed retaliatory tariffs on the US on Tuesday. Mexico will announce similar measures on Sunday.

(3) On Tuesday, a foreign ministry spokesperson in Beijing warned, “China will fight to the bitter end of any trade war.” China is one of the biggest customers for US agricultural produce such as chicken, beef, pork, and soybeans, and now all those products will face a 10%-15% tax, which will take effect on March 10. Beijing’s relatively limited response suggests that the Chinese would like to negotiate with the US on trade issues.

Beijing is not ramping up the rhetoric or the tariffs in the same way as it did in 2018, during the last Trump administration. Back then, it imposed a tariff of 25% on US soybeans.

(4) Last weekend, Warren Buffett made a rare comment on Trump’s tariffs, warning of their negative effects on consumer spending. “[W]e’ve had a lot of experience with [tariffs]. They’re an act of war, to some degree,” said Buffett. “Over time, they are a tax on goods. I mean, the tooth fairy doesn’t pay ’em! … And then what?”

Strategy II: Recalibrating the Odds. Now that Trump has started a trade war, it could escalate. Or it could de-escalate. Either way, uncertainty has increased significantly, as evidenced by the sharp decline in stock prices on Monday and Tuesday (Fig. 1 and Fig. 2). Interest rates have continued their recent decline, as the odds of more Fed rate cuts have increased—notwithstanding evidence that inflation remains stuck above the Fed’s 2.0% target and the likelihood that tariffs will boost inflation, at least initially (Fig. 3 and Fig. 4).

In recent commentaries, we’ve downplayed the likelihood of a recession in 2025. Indeed, in recent days, we’ve observed that the downward revision in the Atlanta Fed’s GDPNow tracking model from 2.3% (q/q saar) on Thursday to an estimated -2.8% for Q1 reflects two temporary factors: a surge in January’s imports, due to importers’ frontrunning tariffs, and the coldest January since 1988, which depressed consumer spending (Fig. 5, Fig. 6, and Fig. 7). We expect that these big drags on GDP will be reversed in February and March. So we are projecting that real GDP will be up by at least 1.5% during Q1.

However, the negative consequences of Trump 2.0 policies are occurring before the positive ones. Tariffs, deportations, and federal government job cuts are weighing on the economy. An extension of the 2017 tax cuts has yet to occur. Business deregulation is unfolding slowly. Onshoring is underway, and more companies are committing to increase their capital spending in the US.

Considering the above, we are recalibrating our subjective probabilities for our three scenarios:

(1) Roaring 2020s (55%, unchanged). Our subjective probability of our base case remains the same at 55%. We are assuming that the trade war doesn’t escalate. We are continuing to bet on the resilience of the economy and on a technology-driven boost in the growth rate of both productivity and real GDP.

In this scenario, the economy continues to grow, a tariff-related spike in inflation proves transitory, and the stock market remains choppy during the first half of the year, with the S&P 500 remaining below its February 19 record high. The index resumes its climb in record-high territory during the second half of the year, reaching 7000 by year-end (Fig. 8).

(2) Meltup/meltdown (10%, down from 25%). Arguably, there has already been a meltup in some areas of the stock market. They’ve been melting down since mid-February. Combining the odds of these two bullish scenarios reduces the odds that the bull market remains intact, without a correction or bear market in 2025, from 80% to 65%.

(3) Bearish bucket (35%, up from 20%). Over the past three years, we’ve assigned a 20% subjective probability to the various prospects that could go wrong for the economy, resulting in a recession and a bear market for stocks. We are raising it to 35%. During 2022 and 2023, our main concern was that geopolitical crises (including the war between Russia and Ukraine and the proxy war between Israel and Iran) would cause oil prices to soar, forcing the Fed to maintain a restrictive monetary stance and causing consumers to retrench. That seems less likely, as the oil price has remained weak.

Over the past couple of years, the risk of a federal government debt crisis also rose a few times along with bond yields. But now the 10-year US Treasury yield is down from a recent high of 4.79% on January 13 to 4.24% today. That’s despite signs that Trump Tariffs 2.0 are already boosting expected and actual inflation. Bond investors are giving more weight to the “stag” than the “flation” components of a stagflation scenario. We are doing the same by raising the odds of a tariff-induced recession from 20% to 35%.

Trump’s tariffs and DOGE-mandated job cuts are depressing consumer confidence. Trump delivered on his promise to stop illegal immigration. Oil prices are falling as he promised, though that may have more to do with weak demand than more supply. Mortgage rates are falling. However, he promised to lower consumer prices. Instead, his tariffs will drive these prices higher.

We are still betting on the resilience of consumers and the economy. However, Trump Turmoil 2.0 is significantly testing the resilience of both. That’s why we’ve recalibrated our subjective probabilities.

Global Commodities: Dr Copper Goes Rogue. You may recall that we often call copper “the metal with the PhD in Economics.” That’s more than a quip: This malleable metal’s price activity usually correlates with the currents of the global economy. But not lately. Is Dr Copper hanging up her economic forecasting hat?

Copper can be thought of as the lifeblood of progress. It’s critical to industries that are critical to modern life including defense, infrastructure construction, and emerging technologies (e.g., electric vehicles, clean energy solutions). As the second most consumed material, copper is strategically important geopolitically. This deep integration into the word’s essential systems suggests price action that’s predictably tied to global economic fundamentals. Yet that hasn’t been the case of late.

Copper has rallied 8.6% from the start of this year to $9,394 per metric ton (MT) as of March 3. The ascent has not mirrored the state of the global economy, which has been stagnating this year, according to our Yardeni Research Global Growth Barometer.

Why has the copper price disconnected from the forces that typically move it and commodity prices generally (Fig. 9)? Two factors stand out:

(1) Metals tariffs revisited. Investors are probably positioning themselves for the likely fallout of Trump’s impending tariff regime. It’s not a new story: Under both Trump 1.0 and Trump 2.0, tariffs on various metals were framed as measures to protect American industries, ostensibly on national security grounds. Next week, on March 12, 25% tariffs on steel and aluminum take effect; whether copper will be next must be on commodities traders’ minds.

President Trump, on February 25, suggested as much in a social media post, referring to the “decimation” of the American copper industry and calling for an investigation by executive order into whether copper tariffs should be levied under the same Section 232 provisions that justified the steel and aluminum tariffs. We expect copper tariffs in the range of 10%-25% to become effective shortly after the investigation window closes in November.

For the administration, the inflationary consequences of such tariffs are seen as a necessary price to pay for the fortification of domestic production.

(2) Refining China’s copper production. Meanwhile, the world’s largest copper producer—China—made supply-altering moves in February. A regulatory shift aims to curb the overcapacity in China’s refining sector. Construction of new copper smelters could be halted unless there is sufficient concentrate to support them in an attempt to rebalance an industry long plagued by excess production.

This is important because China is the world’s largest producer of refined copper, controlling over half of global copper refining production; Chile and Peru dominate unrefined copper output (Fig. 10 and Fig. 11). Notably, neither Chile nor Peru have ramped up production much in recent years (except for a restart in Chile after a temporary interruption in January owing to widespread power outages).

Besides producing the most refined copper, China is also the world’s most voracious consumer of unrefined copper. In 2023, China mined a mere 1.7 million tons of unrefined copper while producing over seven times that amount in refined form.

To address this imbalance, China is not just slowing new construction of smelting facilities. Over the coming years, the country aims to boost its domestic copper mining efforts by as much as 10% to reduce its dependency on foreign copper concentrate. If it succeeds, China’s copper refinery expansion may get a reboot, boosting global supply once again. However, it could be a long wait.

On the demand side, China's government is expected to unveil a large stimulus package at the National People's Congress on Wednesday. China has struggled to match the government's 5.0% growth target, under pressure from its property market slump. The stimulus could revive domestic aggregate demand along with the demand for copper. However, the effects of China's stimulus efforts so far have been limited.

Looking ahead, we think the current copper price may already reflect these developments. Our gut sense is that copper won't rally much further in the near term toward the previous high of $10,800 per mt set on May 20. That assumes that the US will impose a probable 10% tariff on copper and that China's refined copper supply constraints are offset by continued weakness in global aggregate demand.

The global economy may continue to muddle along or weaken further, especially considering the recent trade developments. In other words, the divergence between the copper price and global economic indicators likely won't get much wider; but the neat correlation of the past might not return unless and until the global economy powers up again.

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Trump’s Crypto Reserve Put & US GDP Math

March 04 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Cryptocurrencies: Trump’s Crypto Reserve Put. Under Trump 2.0, every week is likely to be an action-packed week for financial markets and the economy. That’s because President Donald Trump likes to issue Executive Orders and to post on Truth Social, his social media outlet. He does both on almost a daily basis.

On Sunday, he announced the creation of a “strategic crypto reserve” that will include bitcoin (BTC), ether, XRP, Solana’s SOL token, and Cardano’s ADA, in a post on Truth Social. CNBC noted: “This is the first time Trump has specified his support for a crypto ‘reserve’ versus a ‘stockpile.’ While the former assumes actively buying crypto in regular installments, a stockpile would simply not sell any of the crypto currently held by the US government.” On Friday, Trump is hosting the first White House Crypto Summit.

It’s hard to say how this will all play out. The immediate impact was to boost the price of bitcoin by 10% to $94,343.82, up from a three-month low of $78,660.00 on Friday morning (Fig. 1). This level is likely to provide strong downside support to bitcoin now that we have the Trump Put in the crypto market.

Here are some of the possible implications of this development:

(1) Bitcoin was created with the notion that it would be completely independent of any influence by central banks and other government institutions and officials. The supply of bitcoin is limited to 21 million bitcoins by the program that created it. Now, the US Treasury will have the power to support its price and drive it higher simply by purchasing more bitcoin for the US crypto reserve. In addition, the supply of cryptocurrencies (which has no self-imposed limits) includes other cryptocurrencies that also now have the support of Trump’s “crypto reserve put.”

(2) In effect, the US government is adopting the business model of Strategy, the bitcoin company operated by Michael Saylor. Instead of issuing convertible bonds to purchase bitcoin, the US government can issue US Treasury securities to purchase bitcoin and other cryptocurrencies.

(3) Tesla already owns quite a bit of bitcoin, almost 10,000 BTC, and now must report its market value quarterly. On January 31, Yahoo!Finance reported: “The Financial Accounting Standards Board (FASB) rule change related to digital assets resulted in Tesla recording $600 million extra in net income during Q4 2024. Under the new mandate, companies need to update the values of digital assets through market evaluations each quarter, which allows Tesla to show its Bitcoin holdings at the current fair market price.”

(4) Increasingly, publicly traded companies are buying bitcoin as part of their financial strategies, joining those like Tesla with significant bitcoin holdings already (e.g., Saylor’s Strategy and Marathon Digital Holding). They claim that bitcoin is a potential hedge against inflation and a way to diversify their assets. The bitcoin holdings of public companies are tracked on CoinGecko’s website. (We at YRI are considering joining the list too!)

(5) We’ve previously observed that BTC’s price has been highly correlated with that of Proshares UltraPro QQQ (TQQQ) (Fig. 2). TQQQ is one of the largest leveraged ETFs that tracks the Nasdaq-100 index. TQQQ is typically used by day traders because it was built for short holding periods. If more of the companies in the Nasdaq-100 become leveraged plays on bitcoin, the correlation between the two of them will be even tighter. In effect, the Trump crypto put will support the Nasdaq-100 and the broader stock market.

(6) President Trump might believe that if the government’s US crypto reserve appreciates significantly in value, then it can be used to pay off the US federal debt. That would be a “beautiful thing.” The problem is that when and if the Treasury announces such a move, the price of bitcoin and other cryptocurrencies would probably crash. A less market disrupting plan might be for the Treasury to add its bitcoin reserve to its cash management account and use some of the bitcoin reserves to fund government outlays.

(7) We are wondering if there are any historical analogies for the US crypto reserve. What if the federal government had established a US Beanie Babies Reserve? Beanie Babies are a line of stuffed toys created by American businessman Ty Warner, who founded Ty Inc. in 1986. He created a shortage of them by producing limited editions during the 1990s. They were collected not only as toys but also as a financial investment due to their high resale value. However, the Beanie Baby Bubble eventually burst.
 
US Economy: Imports & M-PMI Turn Q1-GDP Growth Negative. The latest economic indicators aren’t supporting our resilient-economy thesis. Nevertheless, we are sticking with it for now. Consider the following:

(1) Atlanta Fed’s GDP Now & CESI. The Atlanta Fed’s GDPNow tracking model lowered the estimated growth rate of Q1’s real GDP from 2.5% (q/q, saar) to -1.5% on Friday and then further to -2.8% on Monday (Fig. 3). Friday’s downward revision was attributable to a huge increase in imports during January and to a significant drop in consumer spending during the month. Monday’s downward revision was attributable to weak construction data in January and to a drop in the new orders index of February’s M-PMI.

The Citigroup Economic Surprise Index (CESI) has turned negative over the past few days and was -16.5 on Friday (Fig. 4).

(2) Purchasing managers surveys. Monday’s M-PMI report for February was weaker than expected at 50.3, down from 50.9 in January (Fig. 5). Those were the first back-to-back readings above 50.0 since late 2022. However, the new orders index (48.6) and employment index (47.6) were both below 50.0 last month.

We’ve previously observed that the correlation between the M-PMI and the quarterly growth rate in real GDP of goods isn’t very high, especially of late (Fig. 6). While the former has been mostly below 50.0 since late 2022, the latter has been mostly positive.
 
The same can be said about the correlation between the NM-PMI and the quarterly growth rate of real GDP of services (Fig. 7). Neither the M-PMI nor the NM-PMI is particularly useful for assessing the current growth rates of goods and services in real GDP when the economy is expanding. They are more useful for that purpose when they fall significantly below 50.0, signaling a recession.

February’s NM-PMI will be released on Wednesday. Stock investors were spooked on February 21 when the S&P Global “flash” estimate showed a sharp drop to 49.7 from 52.9 in January (Fig. 8). We don’t expect a similar drop in Wednesday’s report from the Institute of Supply Management.

In any event, the Atlanta Fed and the financial markets may be giving both the M-PMI and NM-PMI more weight than they deserve. Nevertheless, we will continue to track the regional business surveys conducted by five of the 12 Federal Reserve district banks for insights into the national M-PMI (Fig. 9). The former misleadingly indicated a stronger national M-PMI in February.

We will also be monitoring the prices-paid and prices-received indexes in the regional and national business surveys. February’s M-PMI prices-paid index jumped to 62.4, the highest reading since June 2022 (Fig. 10). The bond yield fell as investors focused more on the “stag” than the “flation” in the stagflation scenario that’s been gaining credibility.

(3) Construction. Following the release of Monday’s construction report for January, the GDPNow model slashed the residential construction component of Q1 real GDP from 1.4% to -4.9% y/y and lowered the nonresidential structures component from -2.0 to -2.5% y/y (Fig. 11). January’s actual m/m changes in these two categories were -0.4% and 0.1%.
 
(4) Imports. Following the release of the advance report for January’s merchandise trade data, imports growth in Q1’s real GDP was boosted from 5.4% to 29.7% y/y (Fig. 12). That remarkable jump was attributable to importers front-running Trump 2.0 tariffs.

Real GDP is basically a measure of domestic production that is calculated by adding up the sources of domestic demand and adding exports (which are not included in domestic demand, but boost domestic production), while subtracting imports (which need to be subtracted from domestic demand to calculate domestic output). So soaring imports depressed GDPNow’s real GDP growth estimate for this quarter significantly. Some of that surge was attributable to imports of gold.

Imports are likely to have fallen in February and to fall again in March, which would boost Q1’s real GDP in the GDPNow tracking model.

(5) Personal income, consumption & saving. Personal income jumped 0.9% m/m during January (Fig. 13). Total wages and salaries rose only 0.4% m/m. Total personal income was boosted by a 1.8% increase in government social benefits and a 1.2% increase in nonlabor income (from dividends, interest, rents, and proprietorships).

Despite the jump in income, personal consumption fell 0.2% m/m, resulting in a 32% increase in personal saving. The personal saving rate jumped from 3.5% during December to 4.6% during January (Fig. 14). We attribute the weakness in January’s consumption to inclement weather. It was the coldest January since 1988. In addition, December’s m/m rate in consumer spending was revised up from 0.7% to 0.8%.

In the GDPNow tracking model, Q1 real consumption growth was lowered from 2.2% to 1.3% y/y after the release of the personal income report on Friday. It was lowered again to 0.0% on Monday. We aren’t sure why, so we submitted an inquiry.

In any event, we are reasonably sure that consumer spending will rebound in February and March.

(6) Q1’s GDP. Our bottom line is that we expect to see real GDP increase during Q1 between 1.5% and 2.5%. We are betting on the economy’s resilience. We are keeping the stagflation scenario in our what-could-go-wrong bucket with a 20% subjective probability.

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Testing The Resilience Of The US Economy

March 03 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy I: Addressing the Growth Scare. On Friday, the Atlanta Fed’s Q1 GDPNow model fell from 2.3% to -1.5% (q/q, saar) (Fig. 1). Naturally, that amplified the ongoing concerns that the US economy is quickly slowing, perhaps due to uncertainty attributable to Trump 2.0. While much of the drop in the model’s estimate did have to do with Trump 2.0, January’s trade data that triggered it don’t portend a significant economic slowdown. Neither do January’s consumption data, in our opinion. Both were released on Friday.

Here’s more:

(1) Frontrunning tariffs. In the GDP calculation, when US imports rise faster than exports, that weighs on real GDP growth. In January, goods imports soared to a record high, causing the trade deficit to widen 70% y/y to $153.3 billion, or a $1.8 trillion annualized deficit (Fig. 2). The bulk of this surge represented importers getting ahead of potential tariff increases. Imports of industrial supplies increased by 63.2%, and imports of consumer goods rose by 25.9%.

The trade data went from weighing on the GDPNow model’s expected Q1 growth by -0.41% to -3.70%, leading to the huge swing (Fig. 3).

(2) Wait for the February data. The problem with the GDPNow model is that it can be erratic, and its latest swing catches only the surge in imports. The reason net exports are subtracted from overall GDP is that usually imports are already accounted for in consumption and inventory investment data—that’s why they typically correlate with US economic growth. Consumption was weak in January because of the coldest January weather since 2011. We expect that consumption will rebound while imports weaken in February and March. If so, then real GDP should grow at least 1.5% in Q1 and 2.5% in Q2.

(3) Markets’ reaction. The 10-year Treasury yield now stands just below the bottom of our 2025 expected range of 4.25%-4.75%, hovering around 4.20% (Fig. 4). It had been around 4.25% on Friday—and stocks had been up on the day—until Ukrainian President Volodymyr Zelenskyy’s public meeting with President Donald Trump and Vice President JD Vance turned into a chaotic shouting match. Stocks managed to finish the day higher thanks to some month-end markups (or window dressing).

In any event, the markets may be reading too much into the trade data that are temporarily weighing on GDP expectations. We’re still expecting a rebound in the February and March economic data; however, growth will likely slow during Q1 and perhaps Q2 before accelerating in the back half of the year as uncertainty fades.

Strategy II: Animal Spirits Trump Uncertainty. If you’re searching for a bearish narrative, take your pick. Bearish prognosticators have been licking their wounds since the no-show recession of 2022 and 2023 and since the 2024 summer slowdown proved to be a head fake. Trump 2.0 seems to be bringing them out of hibernation.

Among the many economic challenges ahead cited by the growing cohort of bears are:
Fiscal stimulus will diminish, weighing directly on GDP. In other words, a fiscal cliff is coming soon.
Consumers will retrench because they are too leveraged or have run out of excess savings.
The positives of Trump 2.0’s pro-business stance are outweighed by the negatives of policy uncertainty, drummed up by daily executive orders and tariff announcements. This uncertainty will restrain capital spending and is already spurring a slowdown in the services economy.
The Department of Government Efficiency (DOGE) is slashing the federal workforce and contracted workers. That will jack up unemployment and knock down consumer spending.
Should DOGE fail in its aims of narrowing the budget and slowing the growth in federal spending, then higher interest rates and a fiscal crisis are inevitable. Corporate defaults, slimmer profit margins, and lower stock prices surely would follow. The reduced net wealth effect would weigh doubly on consumer spending. Construction employment would suffer from the housing market malaise under higher rates.
So whether DOGE succeeds or fails, the thinking goes, the economy is doomed. Woe is us! The wall of worry grows a brick row higher each day.

We believe the current uncertainty will be offset by the US economy’s dynamism. The economy has demonstrated its resilience since the pandemic started. That’s especially true over the past three years, when monetary policy turned restrictive to beat down inflation yet the economy continued to grow. There hasn’t been a recession since the pandemic lockdowns during the first two quarters of 2020.

We expect that pro-business policies, as they emerge, will boost longer-term confidence, allaying short-term uncertainties related to Trump 2.0. We think the naysayers are hanging too much significance on what drove economic growth in the years that followed the pandemic and not enough on what will drive it going forward.

Ironically, their excuse for being wrong in expecting a recession over the past three years is that fiscal policy was stimulative, which staved off the downturn. Now that it is likely to turn less stimulative, the odds of a recession are increasing again, in their opinion. That is such yesterday thinking! We are thinking ahead to tomorrow, focused on future developments that are already stimulating the economy such as the tech-led productivity boom at the crux of our Roaring 2020s outlook. In short, our long-held bullish stance remains intact.

Consider some rebuttals to the bears’ concerns:

(1) Government vs private sector spending. There’s a certain fatalism in believing that the US economy is heading for a debt crisis but at the same time believing that anything done to avert it would plunge the economy into a recession caused by a fiscal cliff anyway.

Some chalk up America’s real GDP growth in the post-pandemic period mostly to massive fiscal stimulus. We agree that the pandemic-time fiscal stimulus was excessive, as the sticky inflationary pressures still evident four years later attest. But more importantly, we believe that the private sector can offset the slowdown in government spending and is likely to do so by allocating capital to more productive projects and sectors.

For instance, the Biden administration focused too much on electric vehicles and green energy and not enough on semiconductors, defense, and the electric grid. The CHIPS and Science Act (around $53 billion in appropriated funds) paled in comparison to the Inflation Reduction Act (a $400 billion hit to the federal deficit), and the Infrastructure Investment and Jobs Act (around $550 billion in new spending). But the AI boom is already boosting massive private-sector spending on R&D, information processing equipment, and software, which now account for half of all nonresidential fixed investment (Fig. 5 and Fig. 6). Between Apple’s latest announcement and Stargate (Microsoft/OpenAI, Oracle, and SoftBank), there’s $1 trillion of planned capital spending over the next four years.

(2) Offering outlay relief. We were encouraged by the latest budget bill passed by the House of Representatives, which includes $2 trillion of directed spending cuts over the next decade. All else equal, lower federal spending means slower economic growth. If federal spending does fall by $2 trillion by 2035, GDP growth will be lower unless consumption and investment rise and/or the trade deficit narrows. We are optimistic that all three of these will occur.

Can personal consumption expenditures and fixed investment increase by an extra $2 trillion over the next 10 years? Certainly. Consumption is 68% of GDP, or $19 trillion, and will likely breach $25 trillion within the next decade (Fig. 7). Investment is 18% of GDP, or $5 trillion, and will likely breach $7 trillion. Given our expectations that productivity growth reaches 3.0%-3.5% by 2030, an extra $2 trillion is achievable (Fig. 8). We expect both tax cuts and deregulation to accelerate consumption and capital spending, helping to quicken those productivity gains.

(3) Taming trade. The trade deficit can also do some lifting. Reducing net exports from the current -3.1% of GDP to -1.5% would improve GDP by $663 billion by 2035 (assuming annualized nominal GDP growth of 4%). So consumption and investment combined would have to pick up by only $1.3 trillion. These are not mutually exclusive events. Increased domestic investment is the likely result of Trump 2.0’s nascent trade policies, which are also aimed at improving the trade deficit. This scenario includes consumers’ spending more on domestically produced goods and services.

(4) Reducing revenues? Or raising them? The $2 trillion of spending cuts in the House bill were paired with $4.5 trillion in tax cuts. The reduction in receipts from the baseline would roughly reduce federal revenues by about 1.0%-1.5% of GDP through the next decade (Fig. 9). In our opinion, the stimulative impact of lower taxes and encouraged investment in the US will offset a portion of the cuts with higher growth.

(5) Putting a dent in the deficit. If outlays grow at a 5% average annualized rate—which is roughly average for the 2014-19 period—then the $2 trillion in spending cuts will push federal outlays down to about 20% of GDP. That would be historically normal and consistent with a budget deficit that’s 3% of GDP (Fig. 10 and Fig. 11).

We’re doing very back-of-the-envelope math here, but the point is that lower federal spending is not a doom scenario for the US economy and Trump 2.0’s economic goals are more realistic than they get credit for. In other words, the markets aren’t pricing in these optimistic possibilities.

(6) Consumers keeping it cool, not cooling. The US consumer is fine. Since the root cause of rising unemployment last year was mostly immigration and increased labor force participation, we do not believe DOGE-related firings will spiral into mass layoffs (Fig. 12). Government employees make up just 12.5% of total payrolls, and state and local governments should be less affected by DOGE than the federal government (Fig. 13). As long as the unemployment rate remains in the 4.0%-4.5% range that we expect—which is likely now that immigration has slowed substantially—consumers will continue to spend apace.

Last Monday on CNBC, JP Morgan CEO Jamie Dimon, long bearish on consumer spending, said he now sees consumers as nearly “back to normal”: “[T]hey don’t have all the extra money, but they have jobs. Wages are going up. …So you are starting to see what I put at normal. Credit costs have normalized. So it’s just almost back to what I call a normal environment.”

Dimon was among the most worried about the consumer throughout 2022 and 2023. As he suggests, real wages are rising (Fig. 14). We expect rising productivity growth to keep that train on track (Fig. 15).

(7) Uncertainty abounds. Certainty is good for business. The outlook has gotten more uncertain over the past few months (Fig. 16). But we do not expect this uncertainty to persist. While the S&P Global NM-PMI contracted slightly this month, it tends to be more volatile than the ISM NM-PMI (Fig. 17). Redbook retail sales are still up 5.9% y/y (Fig. 18). And based on regional Fed manufacturing surveys, we expect the ISM M-PMI to post a second straight month above 50.0, indicative of expansion (Fig. 19). Last month marked the index’s first foray into expansion territory since the Fed started tightening in early 2022 and suggests the manufacturing sector has finally entered a rolling recovery.

(8) Housing horror show. The housing market has been a mess for several years, if not since the turn of the century. With overall construction employment around record highs, several observers have insinuated that the economy is entering a cyclical slowdown as housing permits and starts fall (Fig. 20 and Fig. 21).

But as Austin, Texas shows us (see this recent Bloomberg story), deregulation is the answer to high home prices. We believe Trump 2.0 will tackle this on a national level, stimulating more housing starts and permits and thereby keeping employment elevated.

Meanwhile, the supply of construction employment has fallen with decreased immigration, so employers are likely to hold onto their workers. And though many in construction are working on nonresidential buildings, it’s notable that roughly half of residential construction employment is remodelers (Fig. 22). That suggests that construction employment is relatively shielded from any potential housing slowdown, and that construction skills are transferable across different types of projects.

(9) Winning with the wealth effect. The excess-savings-depleting story that led to a lot of worry about the economic outlook over the past couple years was a nonstarter, in our opinion, mostly because retiring Baby Boomers were sitting on huge nest eggs that continued to appreciate. Between near-record stock prices and high home prices, the Baby Boomers now hold roughly $83 trillion of the $160 trillion in US household wealth (Fig. 23). So we haven’t been worried about the relatively low personal savings rate; in fact, we think it may fall into negative territory by the end of the decade.

Could the wealth effect reverse? A bear market in stocks and much lower home prices likely would lead consumers and businesses to pull back some of their spending. But that would be likely only in a recession, which we see as improbable at the moment. If a recession were to become more likely, automatic stabilizers and the ease-first-ask-questions-later Fed would quickly restimulate markets and the economy. Both a recession and a fiscal crisis are in our 20%-probability what-could-go-wrong bucket of economic scenarios. We still apply an 80% subjective probability to outcomes that are bullish for US stocks.

Movie. “Zero Day” (-) stars Robert De Niro as former US President George Mullen, who is tasked with heading a commission to investigate a cyber-attack that kills thousands of Americans. It is a who-done-it Netflix series. De Niro seems to be bored by the plot. That’s because it is boring and predictable, mostly because it is inane. The problem with conspiracy movies is that they are competing with all too many conspiracy theories swirling around on social media. So it is hard for screenwriters to come up with an original conspiracy. (See our movie reviews archive.)

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Homes, Earnings & Clunkers

February 27 (Thursday)

Consumer Discretionary: Gimme Shelter. After a couple of tough months, the housing industry enjoyed positive news this week. The interest rate on home mortgages fell to the lowest level this year, 6.85%. While that’s still more than twice the interest rate that lucky homebuyers enjoyed in 2021, it’s an improvement from 2024’s peak of 7.22% (Fig. 1).

Positive news also came from Home Depot and Lowe’s, members of the S&P 500 Home Improvement Retail industry. Both reported Q4 earnings that beat expectations and said their slow but steady improvement should continue this year. Indeed, the industry’s stock price index looks like it’s about to break out from a multi-year consolidation.

Members of the S&P 500 Homebuilding industry, on the other hand, may need more time before their correction since October concludes. Home prices remain high, and housing inventory is building, no pun intended.

Here's a look at these giant home-related industries:

(1) To-do lists grow. Both Home Depot and Lowe’s reported positive same-store sales for the first quarter in two years during Q4, and both managements are optimistic that the improvement will continue in 2025.

Both Home Depot and Lowe’s have been working to increase revenue ever since it peaked on an annual basis in 2023. Over the past year, that’s become more difficult due to rising interest rates, which make funding large home remodeling projects more expensive.

Home Depot executives aren’t counting on a large drop in interest rates this year to hit their targets. Instead, they believe consumers are slowly acclimating to higher interest rates and have the flexibility to tap home equity—which has surged in recent years—to fund projects. The pandemic was five years ago, and even the new things purchased back then are starting to wear.

The S&P 500 Home Improvement Retail stock price index peaked during the pandemic buying surge in 2021 and subsequently fell sharply. In the ensuing years, it has gradually risen and appears close to setting a new high (Fig. 2). The industry’s forward operating earnings per share remains 10.2% below its October 2022 peak, but operating earnings is expected to grow 4.8% this year (Fig. 3 and Fig. 4). The Home Improvement Retailers’ forward P/E at 23.2 is extended for the industry but should improve as earnings growth resumes (Fig. 5).

(2) Homebuilders face a changing market. S&P 500 Homebuilders have defied pessimists’ expectations for the longest time. Their profitability improved for much of past five years, notwithstanding doomsayers’ predictions of slowdowns during the pandemic or the Fed’s rate-hiking cycle, which began in 2022 (Fig. 6). Analysts expect y/y earnings comparisons to bungee from an 11.4% drop this year to 13.7% growth in 2026 (Fig. 7).

Such a quick rebound seems optimistic. If interest rates and inventories remain elevated, homebuilders might be forced to cut selling prices or offer higher financing incentives to move inventory. If interest rates fall, the new home market could face increasing competition from existing homeowners, who have been stuck in their homes and need to sell.

Nationally, home prices have been rising and inventories climbing. Home prices in the Case-Shiller 20-city index rose in December by 0.5% m/m and 4.5% y/y. January saw new home sales (counted at contract signings) tumble (10.5% m/m and 1.1% y/y), dragged down by cold weather in the Northeast (Fig. 8). Inventory levels remain unusually high, with the ratio of new homes for sale to new homes sold at 9.0 months (Fig. 9 and Fig. 10).

The S&P 500 Homebuilding stock price index has rallied almost nonstop since 2020. From its four-year low on March 23, 2020, the index has gained 347%, and that includes its recent 29% correction from its October peak (Fig. 11). The spring selling season has never been so important.
 
Strategy: Searching for Earnings Growth. With market volatility on the rise and stock indexes under pressure recently, investors may be looking beyond the richly valued S&P 500 Information Technology sector for earnings growth opportunities. The S&P 500 Health Care sector stands out as a strong earnings grower this year based on analysts’ 2025 consensus estimates; so do certain insurance industries in the Financials sector. And several industries with expected earnings declines this year look bound for double-digit earnings growth in 2026. Bargain hunters, take note.

Here are the 2025 earnings growth estimates for the S&P 500 and its 11 sectors: Information Technology (20.0%), Health Care (18.6), Industrials (16.7), Communication Services (12.2), S&P 500 (12.0), Consumer Discretionary (7.5), Utilities (6.7), Financials (6.4), Materials (5.2), Real Estate (3.4), Consumer Staples (2.7), and Energy (1.5) (Table 1).

Let’s dive deeper into some of the details:

(1) Health Care: Strong earnings, bad politics. As investors have turned away from high-valuation areas of the stock market, they’ve embraced the S&P 500 Health Care sector. Its stock price index has risen 7.9% ytd through Tuesday’s close, and it sports a below-market forward P/E of 17.8 (Fig. 12 and Fig. 13).

Investors may have decided that the uncertain politics sounding the Health Care sector are outweighed by the strong 2025 earnings growth forecast for most industries in the sector including: Biotechnology (34.0%), Pharmaceuticals (29.3), Health Care Facilities (13.3), Health Care Distributors (10.5), Health Care Equipment (10.1), Health Care Services (9.1), Managed Health Care (5.8), and Health Care Supplies (-1.9).

Here's how the stock price indexes of the Health Care industries have performed ytd through Tuesday’s close: Health Care Services (21.9%), Biotechnology (14.8), Health Care Equipment (10.8), Pharmaceuticals (8.9), Health Care sector (7.9), and Managed Health Care (-3.7) (Fig. 14).

CVS Health has been the standout stock in the Health Care Services industry, having risen 41.8% ytd after a dismal 2024. CVS replaced its CEO last fall and recently reported Q4 earnings that soundly beat analysts’ consensus estimate. For now, worries about the Trump administration potentially changing reimbursement policies for pharmacy benefit management companies, like CVS’s CVS Caremark, appear to be on the back burner.

Within the Biotechnology industry, Gilead Sciences is the standout recent performer, with its share price up 20.7% ytd and 51.6% y/y. Gilead shares started 2024 depressed after the company’s cancer drug proved ineffective against lung cancer. But the disappointment was quickly swept away by accelerating sales of its HIV drugs. The company recently projected earnings per share of $7.70 to $8.10 for 2025, above the $7.61 analysts had been expecting.

Other Biotechnology outperformers include Amgen (up 21.1% ytd), Vertex Pharmaceuticals (19.3), and AbbVie (14.9).

The Health Care sector’s ytd stock returns would be an even more impressive 9.5% excluding the dismal performance of one of its largest members, United Healthcare. UNH stock has dropped 7.0% ytd, pulling down the ytd gain of the Managed Health Care industry index to -3.7% (Fig. 15). The stock’s weakness reflects federal investigations into United Healthcare’s billing practices as well as earnings hits from higher medical costs.

The Managed Health Care industry has the weakest 2025 earnings growth forecast in its sector, at 5.8%, though its outlook improves in 2026, when analysts are forecasting 11.5% earnings growth.

(2) Insurance is steady eddy. Analysts anticipate strong earnings growth this year for several insurance industries. In most cases, rate increases and investment portfolio gains should more than offset insurance claims.

The Reinsurance industry is expected to be the third fastest earnings grower in the S&P 500 this year as it recovers from a drop in earnings last year. Here are the consensus expectations for the insurance-related industries’ earnings growth (and in one case contraction) this year: Reinsurance (63.6%), Multi-line Insurance (25.2), Insurance Brokers (9.7), Life & Health Insurance (9.1), and Property & Casualty Insurance (-4.7).

While the Reinsurance industry’s stock price index has fallen 5.3% ytd, the rest of the industries’ stocks have had positive ytd performances: Insurance Brokers (11.7%), Multi-line Insurance (8.5), S&P 500 Insurance Industry (6.6), Property & Casualty Insurance (5.4), and Life & Health Insurance (1.1) (Fig. 16).

(3) A peek into 2026. Among the industries with declines in earnings growth forecast for 2025, a handful looks poised for earnings rebounds in 2026, with double-digit growth forecast. For example, the S&P 500 Agricultural & Farm Machinery industry is expected to see earnings fall 25.3% this year, only to enjoy a 14.1% increase in earnings in 2026.

Other industries that fall under this umbrella are: Construction Materials (-23.2% in 2025, 16.2% in 2026), Steel (-16.2, 44.9), Agricultural Products & Services (-12.2, 10.9), Homebuilding (-11.5, 13.7), Personal Care Products (-9.5, 16.3), Property & Casualty Insurance (-4.7, 17.9), Construction & Transportation Equipment (-3.6, 15.4), Oil & Gas Refining & Marketing (-3.1, 54.4), Integrated Oil & Gas (-2.7, 20.2), Commodity Chemicals (-0.9, 38.8), Home Furnishings (-0.9, 20.9), Cable & Satellite (-0.2, 11.4), and Automobile Manufacturers (-0.1, 17.0).

Disruptive Technologies: Startups Pay the Piper. Several startups we’ve discussed here in recent years have announced bankruptcy filings.

Some of their problems arose from technology that didn’t quite make the grade despite compelling concepts (what’s not to like about beating traffic in a flying taxi or generating electricity from solar panels on your home?). Other problems derived from the changing capital markets and political environment. Low interest rates and the roaring IPO market of 2021 has been replaced by high interest rates and a picky IPO market. And while the Biden administration threw money at anything green, the Trump administration is yanking it back.

Here's a look at some of the ashes:

(1) Electric trucker crashes. Nikola, an electric truck maker that once had a market value north of Ford Motor’s, filed for bankruptcy protection earlier this month. The company will forever be remembered for its video of a prototype truck apparently operating but actually gliding downhill. The company, whose founder was convicted of securities fraud, went public via a special purpose acquisition company in 2020 and made 235 hydrogen electric trucks before closing shop.

The use case for electric semis hasn’t exactly played out. Using electric trucks to drive between ports and nearby warehouses seems smart, but building an electric charger system cross country has been tough. Electric trucks can cost two to three times what diesel trucks cost, and the added weight from the batteries means drivers can’t transport as much cargo, according to an August 28, 2023 article in Marketplace.

Now the political environment is growing tougher as well. Regulations to incent/force manufacturers to produce more electric vehicles may be eliminated by the Trump administration. These include 11 states’ rules requiring the manufacturers of trucks, including large semis, to sell an increasing portion of emission-free models as part of their total sales; a California state law requiring fleet owners to buy more zero-emission trucks; and tightened federal tailpipe emissions requirements. Moreover, a group of 19 states is challenging the legality of California’s requirements for truck manufacturers, a February 25 Bloomberg article reported.

That said, there are electric trucks in operation. Schneider National’s 92 Freightliner eCascadia all-electric semi trucks have racked up more than 6 million miles around the ports of Southern California. The company’s 92 trucks were purchased using funds from environmental or governmental groups.

Amazon recently ordered more than 200 Mercedes-Benz eActros 600 electric semi trucks to add to its UK and German fleets this year, a January 14 Electrek article reported. The company already has 30 electric semis in Europe and 50 in California, in addition to thousands of electric delivery vans.

Tesla appears to be moving ahead with its development of electric semis. Two were spotted in January pulling two tandem trailers, according to a post on X, and more should hit the road later this year. Tesla is actually late to the party and faces competition from EV truck manufacturers like Peterbilt and Volvo.

(2) Solar company goes dark. Last summer, one of the largest solar panel companies, SunPower, filed for bankruptcy protection. It was just one of the many solar companies to fall on hard times as Chinese solar panels, with better technology and lower costs, hit the US market. Higher interest rates and funding costs made solar projects too pricey for some homeowners. And in 2022, the California Public Utilities Commission slashed by 80% the rate that utilities are required to pay solar customers for electricity exported to the grid.

(3) Air taxis crash. German air taxi manufacturer Volocopter filed for bankruptcy but continues to look for a new investor to keep the company afloat, a December 30 article in Deutsche Welle reported. Another German air taxi, Lilium, declared bankruptcy and shut operations on Tuesday.

US air taxi companies are encountering turbulence as well. Shares of Joby Aviation and Archer Aviation both are trading in the single digits. Both companies’ shares are down roughly 20% ytd.

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On Bitcoin, India, And S&P 500 Earnings

February 26 (Wednesday)

Crypto: Leveraged Bitcoin with Convertible Bonds. We have viewed bitcoin as a digital tulip. That’s not to rag on bitcoin or its investors; rather, we’re suggesting that speculation in high-beta novel assets like bitcoin has evolved in the modern financial system.

Unlike tulip bulbs, bitcoin can be traded online, 24/7, globally, and has multiple uses. It can be used as a currency for transacting or stored for its appreciation potential. While bitcoin tends to trade like a triple-levered Nasdaq 100, it did not collapse during the recent Fed tightening cycle, a fact that has encouraged institutional players to join the fun (Fig. 1).

Michael Saylor’s Strategy (a.k.a. MicroStrategy, ticker: MSTR) has garnered attention for its strategy of accumulating bitcoin during its meteoric rise. Even after falling roughly 40% since November (including 10% on Tuesday), MSTR is still up about 220% over the past year and about 2,180% since it began purchasing bitcoin in August 2020 (Fig. 2). Levering up to purchase bitcoin via a combination of equity and debt issuance has led to MSTR’s trading at a premium to its nearly 500,000 of bitcoin holdings, which are worth roughly $47 billion. Bitcoin is up 706% since MSTR began buying it.

A key part of Strategy’s strategy is to issue 0% coupon convertible bonds to fund its bitcoin purchases. Let’s explain why this works, and perhaps how it unravels:

(1) Bitcoin goes up. A core component of Strategy’s playbook is to issue 0% convertible bonds at little cost, buy bitcoin with the proceeds—driving up bitcoin’s price, which in turn causes MSTR’s share price to rise—then issue more debt or equity at a higher valuation, buy more bitcoin, and so on. Rinse, wash, repeat.

Since 2020, Strategy’s bitcoin holdings have risen from $250 million to nearly $50 billion. The company’s “21/21 Plan” aims to raise $42 billion over three years to buy more bitcoin.

(2) Convertibles can’t go belly up ... right? On February 20, Strategy issued $2 billion in convertible senior notes due in 2030 with a 35% premium, meaning that investors could convert their bonds into MSTR shares if the price rose more than 35% and pocket the difference. That followed a $3 billion issuance of convertibles due in 2029 last November, which were priced at a 55% premium.

So if the convertibles pay no coupon and investors can only experience upside after sizable price appreciation, why don’t they just buy MSTR? Or bitcoin?

Institutional investors are big fans of buying convertibles because they can participate in bitcoin’s/MSTR’s rise while limiting their downside risk. Bondholders still get their principal back if they choose not to convert into shares (i.e., if MSTR falls substantially, as it has been doing in recent days). In the event of bankruptcy, the notes are senior to shareholders. MSTR also has a legacy software business that brings in roughly $500 million in annual revenue, so there are some assets to fall back on, even in the event of a bankruptcy.

All that said, convertibles aren’t “risk free.” For instance, MSTR’s zero-coupon convertibles issued in November are now trading at a 23% discount to par (or 77 cents on the dollar). The stock would now have to more than double in price for it to make sense for an investor to exercise the conversion option. Hedge funds using arbitrage strategies, such as shorting MSTR and buying the convertibles, might still profit from the price difference as well as the embedded long-volatility component of the convertibles. So there’s protection in buying convertibles, but no free lunch.

(3) When does the gravy train end? Rather than repay principal on maturing convertibles, MSTR tends to roll them over, or issue more debt to pay off the old ones. If demand for bitcoin dries up or the price falls substantially, MSTR may not be able to tap the capital markets to repay investors their principal. Selling bitcoin to finance those repayments would lead to a downward spiral, as is often the case in the post-mortem of many leveraged bets.

We think bitcoin is probably here to stay. MSTR may or may not be. Trump 2.0 seems invested in crypto’s success, but a recession or economic slowdown undoubtedly would hurt bitcoin’s price. If you choose to invest, caveat emptor.

Following today’s 3% drop, bitcoin is now down more than 16% from its December 17 peak. And after discounting its future cash flows and assessing the quality of its management team, we see additional downside as a reasonable possibility. Still, we do expect US macroeconomic data to improve next month, so we could see bitcoin back above $90,000 in short order.
 
India I: Is the Party Over? India’s equity and credit markets have become hotbeds of speculation. Deputy Governor Rajeshwar Rao recently voiced concerns about over-leveraging in unsecured credit markets and a “frenzy” in capital markets. Overheating of Indian equities, a theme we’ve discussed since last summer, is now more evident.

Investor demand for India’s government debt soared following its inclusion in global bond indices, helping to lower the spread between the 10-year Indian government bond yield and the comparable US yield to only 231bps (half as much as five years ago) (Fig. 3). But now, the upside in India’s financial markets may be fading—especially with signs of a potential economic slowdown.

Let’s have a closer look:

(1) Equity valuation has downshifted. India’s MSCI stock market index surged from a low in October 2023 to a record high in September 2024, peaking at a valuation of 25 times forward earnings per share (EPS). This multiple since has retreated to a 14-month low of 20.8 as of Tuesday’s close, marking a souring of investor sentiment.

(2) Equities have retreated. The India MSCI index is down 7.0% ytd (Fig. 4). Real Estate stocks, collectively down 22.1% ytd, have been a major drag on the index so far this year, while Communications Services stocks have bucked the trend with a modest ytd increase of 2.4% (Fig. 5).

(3) Earnings momentum has stalled. Forward EPS for Indian companies in the India MSCI rose 21.4% from August 2022 through the start of 2024 (Fig. 6). From mid-2024 until now, however, the index’s forward EPS has stalled out.

(4) Bond yields have cooled. India’s 10-year government bond yield fell below 7.00% in mid-2024 and has continued to inch lower; it now stands at 6.70% (Fig. 7).

India II: India’s Make-or-Break Moment. India’s real GDP growth has cooled from its heady 8.4% y/y rate during India’s last fiscal year, ended March 2024, and the Reserve Bank of India (RBI) projects continued slowing to around 6.5% y/y by fiscal 2026.

But Prime Minister Narendra Modi’s government isn’t sitting idle. To put growth back on the 8% track, fiscal and monetary policymakers have introduced stimulus measures that include substantial tax cuts and easing of credit rules. Driving these moves is Modi’s ambition to transform India into the world’s third-largest economy by 2030, his Make India Great Again (MIGA) plan. But whether the country can return to its previous pace is an open question.

To help support the economy, the RBI’s new chief (as of December), Sanjay Malhotra, has moved the monetary policy needle to neutral from his predecessor’s hawkish position. Accommodative measures taken include delaying new banking regulations that might have hampered credit flows and lowering the RBI’s key short-term rate in February.

In addition to monetary policy support, the government recently has slashed taxes to reinvigorate consumption. But the fiscal supports are a mixed bag. Modi’s budget for next fiscal year cuts spending on social programs. Modi has been criticized for allowing the economy to fall into a middle-income-trap.

It is not yet clear whether these fiscal and monetary supports will be enough to restore and sustain a growth trajectory near the previous 8% y/y pace. Here’s more:

(1) Growth slowdown is apparent. India’s Q3-2024 GDP fell 7.9% q/q but increased 5.6% y/y; that compares with year-earlier growth of 8.6% y/y (Fig. 8).

(2) Sentiment is weakening. Worsening this slowdown are weakening consumer and business sentiment (Fig. 9).

(3) Fiscal support waivers. Fiscal spending reached nearly 90% debt-to-nominal GDP shortly after the pandemic but eased to 83.5% by Q2-2024 (Fig. 10).

(4) Monetary easing & inflation. The RBI lowered the short-term rate to 6.25% in February 2025, after having held it steady at 6.50% since February 2023.

India’s inflation remains above the bank’s 4.0% target despite having fallen from above 6.0% in October 2024 to 4.3% in January 2025 (Fig. 11).

India III: Modi’s MIGA Vision. India’s path to becoming the third-largest economy by 2030 is fraught with challenges, from internal inefficiencies to geopolitical issues. But with monetary easing, fiscal support, and bold initiatives, India aims to reattain close to an 8% y/y growth trajectory. Whether these efforts can overcome the structural hurdles facing the economy remains to be seen; but for now, India continues to push ahead on the global stage.

Vineet Jain of The Times Group introduced Prime Minister Narendra Modi at the 2025 Global Business Summit, highlighting Modi’s broad growth strategy and listing its key initiatives:

(1) MIGA: Modi’s strategy for global leadership. Modi’s MIGA plan seeks to position India as a global leader in key industries by 2030, promoting both self-sufficiency and stronger international partnerships.
 
(2) US-India COMPACT. The expanding US-India alliance is focused on technology, defense, and trade. This strategic partnership is designed to counterbalance China, creating new opportunities for collaboration in AI and space exploration.
 
(3) “Make in India.” The Make in India initiative has revitalized domestic manufacturing, attracting significant foreign investment and positioning India as a competitive hub for manufacturing.

(4) AI & “Digital India.” India is emerging as a global leader in AI, with a young population and increasing government support. The Digital India initiative is transforming the country, enhancing everything from e-commerce to government services.

(5) “Startup India.” The Startup India initiative has fostered a flourishing entrepreneurial ecosystem, with growing investment in sectors like fintech and edtech.

(6) India as a global manufacturing alternative. India’s push to become a global manufacturing hub is positioning the country as an alternative to China in the global supply chain.

(7) Global technological leadership. India’s success in space exploration and its growing role in semiconductor production underscore its rise as a technological power.

Strategy: Are Earnings Forecasts Stalling or Falling? Ready or not, the Q4 earnings season is set to add Nvidia to the S&P 500’s results as the index passes the 90% complete mark by week’s end. It has been a “less strong” earnings season so far for the Magnificent-7 companies, with their future guidance less encouraging than in recent quarters. That has doused investors’ enthusiasm for most of the group. Last week’s earnings warning from richly valued Walmart unnerved investors even further, and some of them removed the stock from their shopping carts.

At a time when valuations are priced for perfection, investors urgently want to know: What’s happening with earnings forecasts now? Below, Joe lends some perspective on recent consensus earnings estimate trends:

(1) No sign of an earnings pothole ahead. Estimates are pausing just below their recent record highs amid uncertainty about tariffs and lingering inflation. A return to estimate cutting as usual following the unusually strong post-pandemic years is occurring now. However, the recent declines have been relatively minor in the grand scheme of estimate revisions history even if they don’t seem so in the context of recent years: From 2021 to 2024, consensus annual earnings forecasts on the whole fell less than usual and sometimes even improved from initial forecasts.

Since 1978, I/B/E/S has been calculating consensus bottom-up S&P 500 earnings forecasts, derived from each individual analyst’s estimate for an S&P 500 company that they follow (Fig. 12 and Fig. 13). Over time, professional investors—and hopefully the investing public generally—have learned that analysts’ initial forecasts are typically too high and decline steadily until the company reports results.

It has been a good bet to make, as the annual forecast fell during 76% of time—or in 34 of the 45 years—from 1980 to 2024 (Fig. 14). Our measure tracks how much each calendar year’s forecast changed in the 24 months from the initial estimate to actual reported earnings (e.g., for calendar year 2024’s EPS forecast, we track how much that estimate changed from its initial forecast in February 2023 to its final value in February 2025).

(2) Estimates are declining, but much less than in the past. To give some perspective, the S&P 500’s consensus annual earnings forecast fell an average of 11.1% during the past 45 years. During the 11 years that ended with results that were surprisingly better than initially expected, forecasts posted an average gain of 7.2%. During the 34 years with declining annual EPS forecasts, they tumbled an average 17.0%.

(3) 2024 estimate rallied higher. The S&P 500’s reading for the 2024 estimate ranked an impressively high 12th, with a 24-month decline of just 1.4%. The cumulative estimate change for 2024 actually improved as the finish line approached, something that typically occurred during one-third of the 45 years. So 2024 was a very good year, and we think that bodes well for the 2025 forecast.

(4) How is the S&P 500’s 2025’s estimate looking at the halfway point? The S&P 500’s consensus annual earnings estimate for 2025 is down just 1.7% so far, after 12 months—the halfway mark between initial estimates for the year and the final results we’ll see about a year from now.

When similar low-single-digit percentage 12-month declines occurred—which they did during 10 of the past 45 years—the actual earnings finally reported were down from initial estimates by percentages in the single digits for most years (all but 1981 and 1984).

We think that the momentum clocked at the halfway mark bodes well for the direction of the consensus 2025 estimate over the final 12 months.

(5) Forward earnings remains strong for nine S&P 500 sectors. Relatively few of the S&P 500 sectors have forward earnings still well below their post-pandemic record highs in 2022. In fact, most sectors still have forward earnings near their record highs. During the February 20 week, the S&P 500’s forward earnings was just 0.3% below its record high in late January (Fig. 15). A whopping nine of the 11 sectors are less than 2.0% shy of their all-time record-high forward earnings! Just two sectors, Energy and Materials, remain far below their record highs and show few signs of improving.

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DOGE & The Deficit

February 25 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: The DOGE Days. We’re optimistic that Trump 2.0 can cut federal spending. However, we doubt that will be accomplished via the Department of Government Efficiency (DOGE).

Our measuring stick for success is cutting outlays as a percentage of GDP, currently 23.9%, to 22.0% by 2028, where it stood in the months leading up to the pandemic. An even better scenario would be lowering it to 20%, its pre-Great Financial Crisis level (Fig. 1). Using Q4 US nominal GDP of $29.7 trillion and assuming it grows by around 5% each year, that would require roughly $650 billion of cuts annually. That's about half of total discretionary spending (Fig. 2). There appears to be little to no chance that this can be achieved via DOGE.

In the next section, we detail the strategies President Trump is using to rein in spending, and their likelihood of success.

We do applaud the virtues of what DOGE—and many of Trump's cabinet picks—are trying to accomplish. Politicians from both sides of the aisle and nearly all investors agree that the federal government spends profligately and often inefficiently. Trimming the fat and cutting out waste will help bring down the federal debt and boost productivity, as well as usher in an ethos of cost savings and spending scrutiny that may bring longer lasting benefits. Moreover, deregulation will free up the private sector from administrative and compliance expenses that cost much but produce negative returns.

Unfortunately, DOGE’s early start suggests it may cause more collateral damage than any achieved savings justify. Consider why the DOGE Boys may have bitten off more than they can chew:

(1) Savings don’t add up. Doge.gov states that the department’s estimated savings amount to $55 billion, to be achieved through “a combination of fraud detection/deletion, contract/lease cancellations, contract/lease renegotiations, asset sales, grant cancellations, workforce reductions, programmatic changes, and regulatory savings.”

DOGE says it’s working to upload all of the data transparently and has started with contract and lease cancellations, which “account for approx. 20% of overall DOGE savings.” The list, however, has been shrinking. A WSJ analysis found the canceled contracts totaled $16.5 billion on February 17, but are down to just $7 billion as of the 20th, or 13% of stated savings. The WSJ’s analysis found that the true savings were more like $2.6 billion. That is roughly what the US will spend to service its debt each day this year (Fig. 3). The WSJ also suggested that some of these cancelled contracts were already spent or represented budget allotments that may or may not have been used in full eventually.

Cutting spending won’t help balance the federal budget deficit if it also reduces assets or prevents an investment from yielding a return, for instance. That seems to be lost on DOGE's “shoot first, ask questions later” approach to cuts. One canceled $230 million contract was to modernize the Social Security Administration’s (SSA) technology. This arguably would have helped to address the SSA’s organizational malaise and alleged fraud, problems that Musk has targeted.

(2) Lower wage costs? One benefit of the wave(s) of federal resignations and layoffs is that it lowers the government’s wage expenditures. The federal government employs about 2.4 million civilian workers, or 1.4% percent of the US workforce (Fig. 4). The federal government spent around $293 billion to compensate its employees last year, including benefits. That’s less than 4.5% of federal outlays. And roughly 60% of total compensation goes to workers in the Department of Defense, the Department of Veterans Affairs, and the Department of Homeland Security. Feasibly, the government can’t save much here.

(3) But less income for workers! Personal incomes may fall more than government savings on compensation.

One reason: According to the Congressional Budget Office (CBO), around 13% of federal government employees have less than a high-school education. That’s less than the private sector, where non-diploma workers comprise one-third of employees. However, strong federal benefits mean these workers earn 40% higher compensation working for the government than their private sector counterparts.

Rising unemployment was mostly concentrated in this part of the labor market last year (Fig. 5). While it has subsided in recent months, and less immigration may cap the unemployment rate for less educated workers, those vulnerable to federal layoffs are likely to see fewer job opportunities and less compensation as they exit.

(4) Shadow government jobs. The private sector is likely to lose more jobs than the public sector, too. Federal funding and grants, including via environmental and educational agencies, pay a lot of employees’ wages. For instance, the Mercatus Center found that in some states (e.g., Maryland, New Mexico, and Virginia) between 7.7%-10.7% of nonfarm payroll jobs are funded by the federal government through contracts to private-sector firms.

Government data also show that federally funded research centers account for around 18% of total US R&D expenditures as of 2022. So it’s no surprise that some US research universities are pausing doctoral admissions in anticipation of funding cuts and that China is advertising itself as a safe haven for aspiring PhDs as a result. The prospective brain drain, if sustained, would be an unquantifiable loss in the precise fields in which the US is seeking to compete with China and lead the world. We hope that this pro-tech administration will find a way to correct course shortly.

(5) Budget deadline & tax cuts. The federal government is currently operating under a continuing resolution until March 14, so there's only three weeks for Congress to pass a new budget deal for fiscal 2025. Republicans in the House and Senate are working on tax cuts as part of a giant, all-encompassing, bill (or two). Extending the 2017 Tax Cut and Jobs Act, a core component of whatever deal the GOP constructs, is estimated by the CBO to reduce revenues by $4.6 trillion over the next decade. No tax on tips, Social Security benefits, or overtime pay are also Trump priorities. But reducing federal receipts to below the current 17.5% of GDP would complicate plans to rein in the budget deficit (Fig. 6).

That said, individual income taxes continued to rise during Trump 1.0 as the economy grew (Fig. 7). Cuts to social programs are also likely, which would reduce “mandatory” outlays.

Strategy II: Putting the Budget on a Sustainable Path. The US federal budget deficit is driven by Americans consuming and investing more than we produce and save. The causes of this imbalance and who bears the ultimate responsibility for it are up for debate. Trump 2.0 believes that it can reduce the pressure on the fiscal deficit by producing more at home and therefore helping to balance the trade deficit.

As we wrote in our February 19 Morning Briefing, defense makes up $1.1 trillion of the federal government’s annual spending, or 3.7% of GDP. The Eurozone spends less than €330 billion annually, less than 2% of its GDP (Fig. 8). Meanwhile, NATO wants to spend more than 3% of GDP on defense, which would roughly double Europe’s defense expenditures and could allow for a lot of relief from our deficit funding.

But going line item by line item isn’t a viable solution to getting the fiscal train back on the tracks. A rewiring of global trade may be necessary. Consider how that may be achievable:

(1) Current account deficit. The US current account balance, which comprises net trade but also earnings and payments on foreign investments, is around historical lows. At 4.2% of GDP as of Q3, the current account deficit has only been lower in the runup to the Great Financial Crisis (GFC) (Fig. 9). One reason is that the US primary income balance—what America earns on assets overseas versus what it pays to foreign creditors—has turned negative for the first time on record (outside of one brief blip in 2001).

It’s no secret that the rest of the world (ROW) owns more US assets than the US owns foreign assets. And despite a net international investment position of nearly -$24 trillion, very low US interest rates have allowed America to pay little to creditors while earning much more on assets abroad. For instance, a few selected foreign countries own $3.34 trillion of Treasuries (Fig. 10). Most of these were acquired during the zero-interest era following the GFC and therefore have very low coupons relative to current rates (Fig. 11).

Notably, members of Trump’s economic team have proposed debt-issuance strategies that would lessen the debt-servicing burden. However, action is already being taken on the secondary income balance, which is at a record low of -0.84% of GDP. This balance includes foreign aid, remittances, and contributions to multinational institutions. By pulling out of several of these organizations, limiting foreign aid, and reducing immigration right out of the gate, we believe half a percentage point of GDP can be saved here alone.

(2) Latest executive orders. President Trump issued two executive orders (EOs) regarding trade and investment on Friday. Both target unfair practices by China and protect the US private sector abroad.

The “America First Investment Policy” encourages foreign investment into the US while limiting US investment in China. An expedited process for allies to invest in the US will help restructure the grossly negative international investment position, help US companies like US Steel, and encourage domestic employment.

While the EO expands restrictions on investing in Chinese military-linked companies and instructs the Treasury Department to crack down on Chinese investments, it will also encourage allies to pivot away from China to receive favorable terms for investing in the US.

And domestically, the EO will expedite environmental and regulatory reviews for large investments of over $1 billion. Given the outsized burden that these reviews place on projects in the US, this could encourage a manufacturing boom that revitalizes the US industrial base.

The “Defending American Companies and Innovators from Overseas Extortion and Unfair Fines and Penalties” EO is meant to investigate foreign digital services taxes, regulations, and IP transfer requirements in the name of creating reciprocal tariffs to balance trade. We believe this is part of the “race-to-the-bottom” tariff measures that will lead to reduced trade barriers, not greater ones.

(3) Upshot. One of the most contrarian positions right now is to be bullish on global trade and domestic manufacturing. We believe Trump 2.0 will aid US companies and domestic investment without creating a Smoot-Hawley redux. The imbalances that have sidelined US goods producing and led to a huge wave of offshoring since China entered the World Trade Organization in 2001 are finally being remedied. The Roaring 2020s may very well lead to the Roaring 2030s in this outlook. While markets in Europe and other countries are likely to benefit from finally investing in their own economies, we remain bullish on the US and continue to favor our long-standing “Stay Home” investment stance—overweighting US equities in global portfolios—over a “Going Global” one.

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A Tale Of Woes

February 24 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Strategy I: Accentuating the Negatives. I was on the road again last week, speaking at the MoneyShow conference in Las Vegas and meeting with a couple of our accounts in Texas. At a client appreciation dinner for one account in Houston, I learned a lot about the oil and gas business from the folks at my table. I told them that everything I know about their business I picked up by watching the TV series Landsman, starring Billy Bob Thornton.

In my presentations, I accentuated the positives for the US economy and stock market while acknowledging the negatives. The S&P 500 rose to a record high of 6144.15 last Wednesday. But then it fell 2.1% during the last two days of the week to close at 6013.13, nearly back down to its 50-day moving average (Fig. 1). That minor decline from the record high seemed to unleash lots of negative chatter in the financial press about what could be going wrong for the economy and the stock market. It didn’t take long to hear stock market pundits accentuating the negatives.

On Friday, for example, billionaire Steve Cohen, founder of Point72 Asset Management, described a bearish outlook at the Future Investment Initiative Institute’s summit in Miami Beach. He pointed to sticky inflation, slowing growth, and the possibility of retaliatory tariffs as drags on the US economy. “I’m actually pretty negative for the first time in a while,” Cohen said. “It may only last a year or so, but it’s definitely a period where I think the best gains have been had and wouldn’t surprise me to see a significant correction.” Cohen also accentuated the possible negative effects of the Musk-led Department of Government Efficiency (DOGE).

Such concerns have been building for the past few weeks, particularly in response to the Trump administration’s policies, which are widely viewed as chaotic and uncertainty stirring, with unclear effects on the economy and stock market. Uncertainty is often a negative for business spending, consumer sentiment, the outlook for corporate earnings, and the stock market. Is it this time too?

Consider the following:

(1) Animal spirits vs policy uncertainty. The unleashing of animal spirits by the election of President Donald Trump for a second term has already been offset by “policy uncertainty” under Trump 2.0. For instance, the survey of small business owners conducted by the National Federation of Independent Business (NFIB) shows a dramatic increase in the outlook for general business conditions. This series, which measures the percentage of better minus worse assessments soared from -5% during October 2024 to 47% during January (Fig. 2). On the other hand, the NFIB’s uncertainty index was 100 during January, one of the highest readings of this series since it started during 1986 (Fig. 3).

(2) Walmart. The selloffs in the S&P 500 and the Dow Jones Industrial Average on Thursday and Friday were led by an 8.9% drop in Walmart’s stock price. The company’s earnings rose to a record high during Q4-2024, but management provided cautious guidance for 2025. Given that the stock’s forward P/E had nearly doubled since September 2022, from 20 to last Wednesday’s peak of 38, it took only that whiff of a headwind to send it sliding (Fig. 4).

Specifically, what Walmart’s CFO John David Rainey said was that consumers’ “wallets are stretched.” But he also said that their spending remains steady. He noted that Walmart’s shoppers in Mexico seemed to be pulling back, maybe on tariff talk. Walmart will also have to pay an additional 10% tariff on goods imported from China. If the company can’t find alternative cheaper vendors for these goods elsewhere, it will have to either accept a smaller profit margin or pass the prices increases on to consumers, who might respond by buying less.

(3) Consumer sentiment. Also weighing on the stock market on Friday was the release of January’s Consumer Sentiment Index (CSI) survey. It seems to be more sensitive to inflation than the Consumer Confidence Index survey, which is more sensitive to employment. In any case, the former showed a sharp decline in the overall CSI from 71.1 in January to 67.8 in February, the lowest since July 2024 (Fig. 5). There was a significant 12% decline in buying conditions for durable goods, partly due to concerns about the impact of tariff policies.

It seems many people are worried about the potential return of high inflation soon. Year-ahead inflation expectations surged from a recent low of 2.6% during November to 4.3% in February, the highest since November 2023 (Fig. 6). Interestingly, Republicans expect zero inflation, while Independents and Democrats expect 3.7% and 5.1%! This survey clearly is biased by extreme partisanship. Inflation expectations for the next five to ten years is now up to 3.5%, the highest since April 1995. The increase over the past two months has been the largest since February 2009.

In the past, the CSI survey’s year-ahead inflation expectations series was driven mostly by the price of gasoline (Fig. 7). The latter has been relatively subdued recently. So the current jump in inflation expectations is probably attributable to tariff talk or maybe soaring egg prices or both.

(4) Retail sales. Retail sales fell 0.9% m/m during January (Fig. 8). That was a significant drop suggesting that consumers might be retrenching. We attribute the weakness to bad weather and to faulty seasonal adjustment. This is confirmed by the weekly Redbook retail sales series, which was up 5.8% y/y through the February 14 week (Fig. 9). We expect to see a strong rebound in retail sales during February and March.

(5) Consumer credit & delinquencies. Consumer credit jumped $40.8 trillion during December, one the biggest monthly gains in the history of the series (Fig. 10). We view that as an aberration rather than an indication that consumers’ budgets are stretched. The ratio of consumer credit to disposable personal income remains relatively low (Fig. 11).

Alarmists are also ringing their alarm bells about delinquencies on consumer credit cards that are overdue by 90 days or more. They rose to 11.4% of credit card balances during Q4-2024 (Fig. 12). Furthermore, 7.2% of credit cards transitioned to such delinquency status at the end of last year (Fig. 13). Those are concerning developments, but they’re hardly alarming when compared to past experience.

(6) Purchasing managers’ survey. Another reason that the stock market sold off on Friday was the release of February’s S&P Global services PMI, which showed a steep decline from 52.9 in January to 49.7 this month (Fig. 14). We doubt that the services economy stopped growing in February. We expect that February’s ISM nonmanufacturing PMI will show a stronger reading when it is released in early March.

(7) Inflation & the Fed. Also unnerving investors last week was the jump in February’s prices-paid and prices-received indexes in the regional business surveys conducted by the Federal Reserve Banks of New York and Philadelphia (Fig. 15). Both were released last week. They suggest that tariff talk is already putting upward pressure on prices. If so, then the Fed’s rate-cutting will remain on pause for a while. We are already fielding questions from accounts wondering if the Fed’s next move might have to be a rate increase if inflation heats up. It's possible, but not likely.

We attribute the spike in these regional PMIs to tariff talk, including worrisome scenarios that we think won’t pan out. We are expecting lots of bilateral negotiations between the US and its major trading partners to lead to bringing down tariffs in a reciprocal fashion rather than to retaliatory tariff wars.

(8) Valuation & Buffett. Among the most unsettling development since early last year has been seeing Warren Buffett raising cash at Berkshire Hathaway Inc. The amount of cash and equivalents held by the firm rose to a record $334 billion at the end of last year.

In his annual letter to investors, released on Saturday, the Oracle of Omaha didn’t explain why he had raised so much cash. Instead, he wrote, “Despite what some commentators currently view as an extraordinary cash position at Berkshire, the great majority of your money remains in equities. That preference won’t change. While our ownership in marketable equities moved downward last year from $354 billion to $272 billion, the value of our non-quoted controlled equities increased somewhat and remains far greater than the value of the marketable portfolio.”

Buffett also avoided any mention of Trump 2.0 or recent macroeconomic developments. He also didn’t comment on the stock market. We suspect that Buffett believes that the stock market is overvalued since he hasn’t found much to buy in it lately. So he decided to cash some of his gains and park the funds in Treasuries, which he did discuss at some length in his letter. He noted that Treasury bills provided a good return, which boosted Berkshire’s earnings. He proudly wrote that his company “paid far more in corporate income tax than the U.S. government had ever received from any company—even the American tech titans that commanded market values in the trillions.”

Walmart’s selloff last week suggests that heady valuation multiples are vulnerable to fall if investors have second thoughts about their heady assumptions for corporate earnings. The Buffett Ratio, a measure of valuation, is in record-high territory (Fig. 16). That’s probably all we need to explain why Buffett has been raising cash!

(9) Time to sell? So why aren’t we recommending selling stocks? We are expecting that the bull market will be driven by earnings growth rather than higher valuations this year and likely through the end of the decade. We are sticking with our technology-driven, productivity-led Roaring 2020s scenario. It remains our base case, with a subjective probability of 55%.

We assign another 25% to a 1990s-style meltup. But unlike the meltdown that followed the meltup back then, we expect that any post-meltup meltdown will be short-lived and a great buying opportunity, because our base-case Roaring 2020s economic scenario will keep corporate earnings aloft.

We assign the remaining 20% subjective probability to a bucket of everything that can go wrong. These possible scenarios include a 1970s-style twin peaks in inflation. Another possible bearish outcome would be a debt crisis. And now that Trump is moving to impose tariffs, a trade war becomes a possibility.

Strategy II: Accentuating the Positives. The list of woes above seems to have hit the stock market hard during Thursday and Friday of last week. The list is mostly about developments suggesting that consumers might be retrenching because they have too much debt, inflation may be starting to erode their purchasing power again, and they are uncertain whether Trump 2.0 will or will not benefit them personally. Consider the following:
 
(1) Jobless claims. Economists are now watching initial unemployment claims in the area around Washington, DC as the DOGE Boys are firing federal workers in roles that they deem unnecessary. We are watching DC area unemployment too; but we will also continue to focus on the national claims data, which remained subdued through the week of February 14 (Fig. 17).

(2) Corporate earnings. We will also be monitoring the weekly data on the forward earnings of the S&P 500, S&P 400, and S&P 600 for signs that Trump 2.0 is weighing on the earnings estimates of industry analysts. All three dipped over the past couple of weeks (Fig. 18). However, the forward earnings of the S&P 500 remains in record-high territory, while that of the S&P 400 remains near its previous record high in early 2022.
 
(3) Capital spending. Policy uncertainty might depress capital spending. Maybe. We aren’t convinced. Technology accounts for about half of capital spending. We expect that business spending on technology won’t be slowed by uncertainties about Trump 2.0. Companies need to proceed with such spending to boost their productivity and to remain competitive.

(4) Reciprocal tariffs. As noted above, we expect that Trump’s threat to impose reciprocal tariffs is likely to lead to bilateral negotiations with America’s major trading partners which should lead to lower tariffs rather than a retaliatory trade war.

(5) Energy supremacy. One of the central pillars of Trump 2.0 is to exploit America’s abundant energy resources. Last week, the Trump administration issued its first approval for exports from a new liquified natural gas (LNG) plant, which Commonwealth LNG has proposed to build in Cameron Parish, Louisiana. The Houston-based company plans to build a natural gas export terminal on 150 acres where the mouth of Calcasieu Ship Channel meets the Gulf of America. The plant would export up to 9.5 million metric tons of LNG per year—the equivalent of just over 3,700 Superdomes filled with natural gas.

The facility that Commonwealth LNG plans to build will be one of 16 export terminals proposed on the Gulf Coast. It’s less than a third of the size of another LNG terminal proposed to be built just across the Calcasieu Ship Channel called “CP2,” which would be the world’s largest LNG plant if constructed. (See also U.S. LNG Export Terminals–Existing, Approved not Yet Built, and Proposed.)
 
Movie. “SAS: Rogue Heroes” (+ +) is a 2022 British historical series about the exploits of the British Army Special Air Service (SAS) during the Western Desert Campaign of World War II and the subsequent Allied invasion of Italy. Some of the characters are based on the actual commandos who fought in those campaigns. They were certainly a rogue group of heroes, with lots of success at weakening German and Italian forces so that the regular Allied armies could follow up and defeat them. It’s a fast-paced story with lots of good acting. (See our movie reviews archive.)

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On Crude Oil, Valuation & AI

February 20 (Thursday)

Energy: OXY & Oil. Perhaps now we know why Warren Buffett’s Berkshire Hathaway has built a 28.2% equity stake in Occidental Petroleum that’s worth more than $13.5 billion. Occidental managed to increase production, increase its dividend, and pay down debt last quarter even though the price of crude oil slid, bringing its y/y decline to 9.2% (Fig. 1).

The company benefitted from the production it acquired through a $38 billion purchase of Anadarko in 2019 and a $12 billion purchase of CrownRock last summer. Last year’s deal helped increase Occidental’s worldwide production to 1,463 million barrels of oil equivalent per day (MBOE/D), up from 1,230 MBOE/D in Q4-2023.

Let’s drill down for a deeper look:

(1) Adjusted earnings rise. Despite the oil price weakness, Occidental reported higher Q4 adjusted net income than a year ago: $792 million (80 cents a share) versus $710 million (74 cents). The adjusted figures exclude a long-term environmental liability the company had to recognize after a federal court ruling that’s being appealed.

On the earnings conference call, CEO Vicki Hollub noted that the company has been replacing higher-cost production with a higher volume of lower-cost new reserves, and its annual capital spend for oil and gas development is less than its annual depreciation, depletion, and amortization cost. “This is driving increased earnings per barrel and increased earnings per share,” she explained.

Earnings also benefit as the company reduces its debt and related interest expense. It plans $1.2 billion of divestitures in Q1, and the proceeds will be used to reduce debt. As debt is paid down, the cash that was used to meet interest payments can instead be returned to investors.

One major Occidental project launching this year removes carbon dioxide from the atmosphere. The project received funding under the Biden administration, as it would reduce greenhouse gasses. Hollub has been talking to President Trump about the need to continue the funding because the nation will need carbon dioxide pumped into depleted oil wells to increase the oil ultimately recovered. Enhanced oil recovery will add 50 billion to 70 billion barrels of oil to US reserves, which would increase US energy independence by more than 10 years—a business case she believes will resonate with Trump.

Occidental shares rose 4.4% on Wednesday to $50.99, an improvement from the slide off their recent peak of $69.26 on April 11.

(2) Producers keep producing. Having flexibility is important in an era when global oil production continues to outpace consumption, even as OPEC+ keeps 2.2 mbd of production off the market. According to a US Energy Information Administration report, global consumption of petroleum and other liquid fuels was less than production last year, which should continue: 2024 (102.77 mbd consumption, 102.84 mbd production), 2025 (104.14, 104.56), and 2026 (105.18, 106.16).

What could buoy consumption? If the aggressive fiscal actions taken by Trump 2.0 and the Chinese government improve global economic growth, that might increase business and consumer confidence and spending. We’ve been watching for signs of this in copper prices, which have popped 14.9% ytd (Fig. 2).
 
Strategy: Rising P/Es Outside of Tech. There’s much handwringing about the S&P 500’s forward P/E of 22.4, which is up two points from a year ago and well above its long-term average of 15.8 (Fig. 3). Is it precariously high, too high to be sustained? (FYI: The forward P/E is the multiple based on forward earnings, i.e., the time-weighted average of analysts’ consensus estimates for the current year and following one.)

The S&P 500 Information Technology sector is often blamed for pulling the broad index’s valuation skyward. It sports a forward P/E of 28.8, up modestly from 27.7 a year ago (Fig. 4). And the sector has industries with very lofty forward P/Es, including Application Software (34.7) Systems Software (30.4), Semiconductors (28.7), and Technology Hardware, Storage & Peripherals (28.2) (Table 1).

But the Information Technology sector isn’t solely responsible for the S&P 500’s recent multiple expansion. A forward multiple in the high 20s has been the sector’s norm during most of the post-pandemic era. And the sector has experienced only about one point of multiple expansion over the past year, whereas the S&P 500’s forward P/E is up two points.

Multiple expansion has been broad based, affecting 10 of the S&P 500's 11 sectors: Real Estate (forward P/E of 37.2 currently, 36.5 year ago), Information Technology (28.8, 27.7), Consumer Discretionary (28.5, 24.5), Industrials (22.9, 20.2), S&P 500 (22.4, 20.4), Consumer Staples (22.0, 19.4), Materials (20.7, 19.4), Communication Services (20.5, 18.2), Utilities (17.9, 15.1), Financials (17.4, 15.1), Health Care (17.3, 18.9), and Energy (14.5, 11.8).

The Consumer Discretionary sector's forward P/E jumped the most dramatically, boosted by the P/E multiple increases in stocks of companies that make autos, movies, and sneakers. Let's take a look at the changes in these and other notable industries:

(1) Rocketing retail. The S&P 500 Consumer Discretionary sector’s forward P/E has jumped to 28.4 from 24.5 a year ago (Fig. 5). Except for the period just after the pandemic, when its forward P/E soared to 40.5, the sector’s earnings multiple is as high as it has been at previous peaks in 2021 and 2009. But at those prior P/E peaks, the sector’s earnings were depressed, unlike today when they are at record levels (Fig. 6).

Some of the multiple expansion is due to the Automobile Manufacturers industry, which has a forward P/E of 41.2, almost double the 22.9 of a year ago. Tesla’s shares have jumped 77.1% over the past year to $354.11 as of Tuesday’s close, while its earnings per share is expected to decline from $4.30 in 2023 to $2.93 in 2025. The rise in share price and decline in expected earnings have pushed its forward P/E up to 126.7 (Fig. 7).

Other Consumer Discretionary industries rocking high forward P/Es: Broadline Retail (33.8 currently, 37.5 last year), Movies & Entertainment (32.0, 28.4), Footwear (30.5, 25.4), and Restaurants (27.9, 24.3).

The Consumer Staples Merchandise Retail industry, in the Consumer Staples sector, stands out with a forward multiple that has climbed to a record high of 36.8, up from 27.9 (Fig. 8). Blame the share price surges of Costco Wholesale, up 45.9% y/y, and Walmart, up a whopping 82.8% y/y—boosting their forward P/Es to 55.7 and 37.6.

(2) Defense & Meta. Another standout is the Aerospace & Defense industry, with a forward P/E of 27.7, near its record high and up from 21.1 a year ago (Fig. 9). This Industrials sector’s industry has some standout stocks, like GE Aerospace, and some clunkers like Boeing.

Given the 20-day record rally in Meta shares, it’s surprising that its industry, the S&P 500 Interactive Media Services industry, has such a reasonable forward P/E. The industry, which also includes Alphabet, has a such strong collective earnings growth outlook—45.8% in 2024 and 9.3% projected this year—that its forward P/E remains a reasonable 22.8 (Fig. 10 and Fig. 11).

(3) P/E compression hurts Health Care. The only sector in the S&P 500 to see its forward P/E drop y/y is Health Care, from 18.9 a year ago to 17.3 today (Fig. 12). The industry has been buffeted by rising costs, drug development misses, and uncertainty around how the Trump administration will address health care costs and insurance.

Here are some of the industries whose forward P/Es have fallen y/y: Life Sciences Tools & Services (24.0 currently, 27.8 one year ago), Health Care Supplies (18.1, 25.9), Biotechnology (16.5, 16.8), Health Care Distributors (15.6, 15.8), Pharmaceuticals (15.4, 18.4), Managed Health Care (14.5, 15.7), and Health Care Facilities (12.0, 14.6).

Disruptive Technology: AI Programs Improving. The number of artificial intelligence (AI) programs continues to multiply, and the programs themselves continue to grow ever more sophisticated. Large language models (LLMs), like ChatGPT and others, are being rapidly updated in a bid to avoid commoditization. Developers have also created AI agents that are like apps. They use LLMs and control the user’s computer or other device to execute a command—e.g., make a restaurant reservation or buy a product.

Here’s a look at some of the latest advancements:

(1) Something to honk about. Block—formerly known as “Square”—has introduced a free, open-source framework, dubbed “Goose,” that developers can use to develop AI agents that embed the LLMs of their choice. The program was originally developed to help programmers write and fix code. But it has the potential to execute numerous tasks, like organizing calendars and sending emails. It runs locally, allowing users to retain control over their information.

OpenAI also has developed an AI agent dubbed “Operator.” It was used by a NYT reporter to order a new ice cream scoop on Amazon and book a Valentine’s Day reservation, according to the February 1 article. Operator occasionally asked questions to clarify the task at hand. The reporter compared it to having an AI driver for one’s computer.

Operator has its limitations, however. It requires a human to actually execute a purchase; it isn’t allowed to gamble, so can’t play online poker; and it is prevented from entering websites that require users to prove they’re not robots. Operator is available to ChatGPT Pro subscribers for $200 a month.
 
(2) Grok aces the test. xAI’s Grok-3 is the best AI LLM based on testing in math science and coding. It outscored OpenAI’s GPT-4o, Claude 3.5, DeepSeek-V3, and Google’s Gemini-2 Pro, according to data reported by Elon Musk and the folks at xAI in an X video. The team expects Grok’s results to continue to improve as it undergoes additional training. The LLM also outperformed the competition on a crowdsourced platform, Chatbot Arena.

Additionally, Grok is developing a reasoning model that takes a bit longer to respond as it “thinks,” working its way through a question to offer higher-quality results. Grok can be creative and combine two games upon request. “We’re seeing the beginnings of creativity,” says Musk. To achieve this, xAI built a ginormous data center with 200,000 GPUs.

(3) ChatGPT’s still evolving. Sam Altman laid out the roadmap for ChatGPT in a recent post on X. OpenAI plans to roll out GPT-4.5, its last non-chain-of-thought model. It then will introduce GPT-5, which will be able to determine whether an inquiry can be answered simply or requires its chain-of-thought reasoning capabilities. In the latter case, ChatGPT will break down the problem into steps that are displayed and can be checked. GPT-5 at “standard intelligence” will be free to users, and smarter versions will require a subscription.

(4) Lots of new guys. At the heels of the large established LLM companies are a slew of startups hoping to replicate, if not exceed, their success. Earlier this week, OpenAI’s former chief technology officer Mira Murati launched Thinking Machines Lab, which aims to build AI systems that “encode human values and aim at a broader number applications than rivals,” a February 18 Reuters article reported.

Another OpenAI alum, co-founder Ilya Sutskever, has started Safe SuperIntelligence with Daniel Levy and Daniel Gross, a February 18 Fast Company article reported. The company, which aims to create a safe superintelligent AI system, has no product on the market but is in the midst of raising $1 billion of capital at a valuation north of $30 billion.

(5) China's LLMs improving too. China's tech gurus also aren't sitting on their laurels. In the January 23 Morning Briefing, we highlighted a number of Chinese tech developers creating LLMs, including Moonshot AI. It has developed a LLM and popular chatbot, both called “Kimi.” Moonshot recently updated Kimi, the LLM, with version 1.5, which can recognize text, images, and code as well as conduct advanced chain-of-thought reasoning. Founded in 2023, Moonshot is backed by Alibaba and valued at $3.3 billion, a February 2 article in The Guardian reported. Kimi 1.5 is free to use and has reportedly performed well in benchmark testing.

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European Renaissance?

February 19 (Wednesday)

Weekly Webcast. If you missed Tuesday’s live webcast, you can view a replay here.

Eurozone I: The EC’s Grand Plan To Revive Growth. Forget the US—Europe’s real enemy is self-imposed stagnation. That’s the conclusion of Mario Draghi, former prime minister of Italy and former president of the European Central Bank (ECB), in a February 14 opinion piece for the Financial Times. Draghi argues that internal barriers within Europe, from regulatory red tape to national protectionism, do more harm to economic growth than any tariff the US could levy. According to the International Monetary Fund, Europe’s internal hurdles act as an effective tariff: a staggering 45% for manufacturing and an even more crippling 110% for services.

But fear not, dear reader—help is on the way from Brussels. Ursula von der Leyen, president of the European Commission (EC), is spearheading a fresh initiative aimed at reviving the European Union’s (EU) flagging economic fortunes. If the EU were graded on its ability to churn out reports and blueprints, it would make the High Honors roll. But execution? That’s another story.

To kickstart the revival, von der Leyen tasked Draghi with drafting a comprehensive report on European competitiveness. This report, 80-some pages long, forms the backbone of the EC’s bold new five-year plan, the so-called Competitiveness Compass. The ambition of this sprawling vision for Europe’s future is evident. But the EU’s economic revival will take more than a fancy new compass. It will require the kind of political unity that the EU has never fully achieved.

The Compass, unveiled during von der Leyen’s January 21 keynote address at the World Economic Forum, presents several pillars that could redefine Europe’s economic landscape if only they were more than repackaged failed initiatives. Here’s why we say so:

(1) A centralized fiscal union: Been there, done that. To start, von der Leyen aims to tackle Europe’s chronic underinvestment in innovation by establishing a centralized fiscal union. “We do not lack capital. We lack an efficient capital market,” von der Leyen noted, lamenting the inefficient deployment of savings into early-stage, high-risk technologies with the potential to reshape industries.

Indeed, the EU sits on an enormous capital pool—€1.4 trillion in household savings, nearly double that of the US. The EU plans to unify EU capital markets by creating a Savings and Investments Union that facilitates cross-border investment and provides fiscal support for national governments.

But the road is already paved with disappointment. A similar vehicle launched in 2020, the Capital Markets Union (CMU), has failed to deliver thus far. A recent European Parliament report noted the CMU’s dismal performance, urging greater supervisory integration or abandonment of the initiative altogether. Are Draghi and von der Leyen making the same mistake again but hoping for a different result?

(2) A centralized, but optional, regulatory regime: Deregulatory in theory only? Next up is a move to simplify the EU’s regulatory maze. While European businesses have long battled 27 different national regulatory frameworks, the Commission’s proposed solution is to give them a 28^th set of rules to follow, if they wish. This new framework, optional for member states, would centralize EU corporate law, insolvency, labor law, and taxation under a single banner, with the goal of eliminating the costly and time-consuming differences between member states.

Von der Leyen framed the proposal as a deregulatory push, but it’s not as liberating as that sounds: To do any good, the new regime must be adopted by national governments. The Commission seems confident of widespread adoption because the new laws are “better.” But deeper integration of the member states is an idea floated in various forms since 2010, and it faces formidable opposition from member states with their own entrenched interests.

(3) A centralized energy directive: High hurdles. Then there’s the EU’s energy strategy. Energy independence is a top priority for the EU given that recent years’ geopolitical turmoil—most notably Russia’s invasion of Ukraine—has jeopardized energy imports. Von der Leyen has called for the removal of remaining energy trade barriers among member countries to create a truly integrated energy union across the bloc.

The Commission’s plan to centralize energy policy will focus on expanding renewable energy resources and improving storage and distribution. While the EU has made strides in wind and solar power generation, it has struggled with the all-important tasks of storing and efficiently utilizing this energy across borders.

Expect more details in February, but don’t be surprised if the EC reintroduces many of the same ideas that underpin the Green Deal that itself is on the brink of failure.
 
Eurozone II: Europe’s Enemy #1 Is Not Trump. Europe’s red tape is nothing new, but it has garnered renewed attention considering recent developments, particularly the return of US President Donald Trump to office. Conventional wisdom might suggest Europe should be worried.

But James Bianco, president of Bianco Research, LLC, shared a contrarian view worth some consideration in a recent LinkedIn post: “The best thing to happen to Europe is Donald Trump. Trump’s presence will force much-needed change in Europe/Germany.” With Trump back in the political spotlight, Bianco argues, his tariff threats and deregulatory policies might be the catalysts Europe needs to dismantle its trade barriers and revise its suffocating regulatory framework. Such reforms are what Europe long has needed to spark economic growth.
 
Indeed, investor optimism seems to be building. Bianco points to the upward momentum of the Stoxx Europe 600 (9.0%) and Germany’s DAX (18.4%) indexes since the November 4, 2024 US election. But do these outperformances reflect genuine expectations of a turnaround in Europe’s growth prospects or are investors simply drawn to European equities that have been battered into undervaluation (Fig. 1)?

Our read: It’s likely the latter. While the long-term investment horizon could offer opportunities in Europe’s beleaguered equities, the region’s growth prospects aren’t exactly lighting up the horizon. A near-term economic rebound still seems unlikely. The state of the Eurozone economy remains grim.

A few key metrics illustrate just how much work lies ahead:

(1) Eurozone earnings growth is weak. Eurozone earnings growth remains sluggish, underpinned by deep-seated structural challenges in key sectors (Fig. 2).

(2) Eurozone real GDP growth is dismal. The Eurozone’s economic growth continues to lag that of the global economy (Fig. 3).

(3) Eurozone manufacturing and services are struggling. Both the manufacturing and services sectors are finding it difficult to regain pre-energy-crisis levels of activity (Fig. 4).

(4) Eurozone productivity and investment are tepid. Productivity growth remains underwhelming, compounded by persistently low investment across the region (Fig. 5).

Eurozone III: European Renaissance 2.0, Defense Edition. Vice President JD Vance proposed an inverse Marshall Plan at the Munich Security Conference. He said what many American economists have been suggesting for years: The EU must have the gall to spend what’s needed to generate their own economic and defense security.

We do not believe the US security umbrella is vanishing under Trump 2.0; instead, we think the administration is attempting to alleviate the strains of US hegemony on America’s trade balance and fiscal deficit. If Europe can pony up to help Ukraine, defend itself, and spur economic growth, then the US government can spend less to those ends, while the American private sector—including S&P 500 companies—can benefit from greater global demand.

In response to Vance’s comments, NATO Secretary General Mark Rutte said the alliance’s defense spending target would rise from its current 2%-of-GDP guideline for nations to “considerably more than 3%.” European leaders, including British prime minister Keir Starmer, are now gathering in Paris for an emergency summit on the Russia–Ukraine war. An increase in EU defense spending is likely to be bazooka-style, large and fast. Consider some of the possible ramifications for the global economy and markets:

(1) Peace dividend. We believe that a significant coordinated fiscal impulse from the Eurozone could offset a slowing one in the US. “Coordinated” is the operative word, as national schemes like Italy’s superbonus largely used up the Eurozone's fiscal space without a commensurate increase in sustainable growth or productivity. Meanwhile, spending on infrastructure, energy, and defense is likely to make its way to US companies and exports. In fact, the US may be able to lower its own defense spending while increasing defense-related imports, a win on two Trump 2.0 fronts.

Defense constitutes $1.1 trillion of US government spending annually, as of Q4, or 3.7% of GDP. Meanwhile, the Eurozone spends less than 330 billion euro annually (projected as of Q4), below NATO’s 2%-of-GDP guideline (Fig. 6). Rebalanced trade and more productive fiscal spending worldwide are now probable outcomes.

(2) Debt. The spending would likely be financed by large-scale debt issuance. The EU's debt-to-GDP ratio was 81.7% at the end of 2023; we think it could reach 90% by the end of the decade even as strong growth offsets some of the issuance (Fig. 7). That’s likely to result in higher yields on German bunds, French OATs, etc. (Fig. 8). We do not think the Brussels-born constraints on national-level fiscal spending will be enforced.

(3) Tech. Shares of Rheinmetall, a German automotive, defense, electronics and engineering firm, rose 12.1% today and are up 124% over the past year. It has an American subsidiary, American Rheinmetall, which builds high-tech tanks. Perhaps the US auto sector can be repurposed to produce more high-tech goods, aiding employment and production in the Rust Belt. American defense and aerospace production has risen to new record highs for months (Fig. 9).

(4) Dollar. A “European Renaissance 2.0” could weaken the dollar in a way that doesn't threaten its reserve status, as favored by Trump 2.0. Treasury Secretary Scott Bessent has sought to “fix” the practice of foreign governments’ artificially weakening their currencies against the dollar, so as to help US exporters maintain international competitiveness.

The euro is down 3.0% against the dollar over the past year but up 1.7% over the past month (Fig. 10). While parity looked possible for a moment earlier this year, there are now a number of possible tailwinds for the euro over the long term.

Strategy: An Earnings Season for the Masses. Through midday Tuesday, 78% of the S&P 500’s companies have reported December-quarter earnings. Among the 390 reporters so far, the aggregate revenue surprise relative to analysts’ consensus estimate is lighter than usual at 0.6%, but the earnings beat is a hearty 6.6% (Fig. 11 and Fig. 12). Moreover, the vast majority of the index continues to report positive y/y growth.

Below, Joe shares additional data on how the S&P 500 companies collectively fared last quarter and how the Boeing strike impacted the aggregate Q4 results:

(1) Wider swath of companies growing now. While the S&P 500’s aggregate revenue surprise for Q4 has underwhelmed so far, close to three-fourths of the index’s members have shown positive y/y growth in revenues despite declining inflation. In fact, the percentage of S&P 500 reporters to date that achieved y/y revenues growth last quarter, 73.5%, is the greatest in more than two years. If it doesn’t change measurably when the rest of the Q4 results are in, the S&P 500 will reach its highest quarterly reading by this measure since Q3-2022 (Fig. 13). Likewise, the percentage of S&P 500 companies with positive y/y earnings growth rose to 71.8% from 66.3% in Q3 (Fig. 14). That’s the first reading above 70% since Q4-2021, and we expect this measure to remain strong in the coming quarters.

(2) Boeing overshadows results again. Looking at the earnings surprise results so far for the S&P 500’s 11 sectors shows broad-based beats (Fig. 15). Industrials was the only sector to miss on the bottom line, and that was primarily due to Boeing’s miss. Without Boeing, the sector’s earnings surprise improves from a miss of 2.0% to an earnings beat of 3.5%. In addition, Industrials’ Q4 earnings growth improves when Boeing is excluded, from a decline of 5.9% y/y to a 4.3% gain.

Boeing’s earnings miss in Q4 was large enough to tamp down the overall S&P 500’s figures as well. Without Boeing, the S&P 500’s earnings surprise improves to 7.1% from 6.5%, and y/y earnings growth improves 1.0ppt to 14.0% from 13.0%.

(3) S&P 500 on target for record-high quarterly EPS. The S&P 500’s blended Q4 EPS (i.e., estimates blended with actual results reported so far) slipped 52 cents w/w to $64.19 from $64.71 a week earlier (Fig. 16). Despite that minor hiccup, the S&P 500 is still on track to post its third straight quarter of record-high EPS. As the remaining 110 companies release their results over the next month, the blended actual should start moving higher again.

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The Gunfight At DOGE City

February 18 (Tuesday)

YRI Weekly Webcast. Join our live webcast with Q&A on Tuesday at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Federal Budget I: The DOGE Boys. “The Gunfight at Dodge City” is a 1959 Western film. After his brother the sheriff is murdered, Bat Masterson is elected to the job of sheriff and is determined to find the killer and make Dodge City safe. Today, there are gunfights going on in DOGE City to restore law and order to fiscal policy. Will the new sheriff in town get the job done, or will the Bond Vigilantes do it?

The Department of Government Efficiency (DOGE), led by Elon Musk (who reminds us of a superhero on a mission to save humanity), is scrambling to uncover waste and fraud in the federal government. That should be easy. The question is whether he and his team—a.k.a. the DOGE Boys—can find enough waste and fraud to make a big difference to the federal budget outlook if eliminated.

The reason the boys are scrambling is that the Democrats are regrouping and coming to DOGE City for a gunfight. The Democrats have rounded up a posse of Democratic district attorneys from all around the country to stop Musk’s muckrakers by filing motions in courts to block them from raking the muck they find.

Treasury Secretary Scott Bessent probably also alerted the DOGE Boys that the Bond Vigilantes might be coming to DOGE City for a shootout if the Trump administration doesn’t convince them there’s no need for a gunfight because the President will deliver fiscal discipline and resist telling the Fed to lower interest rates.

After all, the Fed did lower the federal funds rate (FFR) by 100bps from September 18 through December 18 last year, but the Bond Vigilantes immediately expressed their dismay that monetary policy was stimulating an economy that didn’t need to be stimulated and enabling fiscal excesses. They did so by pushing the bond yield higher by 100bps (Fig. 1). In the past, the Fed lowered the FFR from cyclical peaks because the peaks were followed by recessions (Fig. 2). There has been no recession this time.

Now, consider a few of the recent developments that led up to the trouble brewing in DOGE City:

(1) Summer 2024. Elon Musk floated the concept of DOGE in discussions with Donald Trump during the summer of 2024 as the then-former President campaigned for a second term. In an August campaign event, Trump said that, if elected, he would consider giving Musk an advisory role on how to streamline the government. Musk immediately tweeted, “I am willing to serve.”

(2) October 27, 2024. Elon Musk first declared that DOGE would cut $2 trillion from the federal budget on October 27, 2024, during a Trump rally at Madison Square Garden. Over the 12 months through January, the federal government’s budget deficit totaled $2.14 trillion (Fig. 3).

(3) January 8, 2024. However, on January 8, 2025, Musk stated in an interview with Mark Penn that achieving the $2 trillion cut was unlikely and that the best-case outcome would be around $1 trillion. Over the past 12 months through January, federal government outlays totaled $7.1 trillion, with $6.0 trillion in mandatory outlays (including Social Security, Medicare, health, income security, national defense, and net interest) (Fig. 4). Net interest outlays alone totaled $920.6 billion, exceeding the $910.2 billion spent on defense over the last 12 months (Fig. 5).

(4) January 20, 2025. On Inauguration Day, President Trump signed an Executive Order titled “Establishing and Implementing the President’s ‘Department of Government Efficiency.’” The order renamed the existing United States Digital Service “the United States DOGE Service” (USDS). Within the USDS, a new organization was established, the US DOGE Service Temporary Organization, which is headed by the USDS administrator (Musk) and is scheduled to be terminated on July 4, 2026.

Each government agency must establish a “DOGE Team of at least four employees, which may include Special Government Employees, hired or assigned within thirty days of the date of this Order. Agency Heads shall select the DOGE Team members in consultation with the USDS Administrator. Each DOGE Team will typically include one DOGE Team Lead, one engineer, one human resources specialist, and one attorney.”

The goal of this Executive Order is to modernize “federal technology and software to maximize efficiency and productivity.” To achieve that, the DOGE Teams will have “full and prompt access to all unclassified agency records, software systems, and IT systems.”

Needless to say, DOGE has stirred up lots of controversy in Washington. There are almost daily headlines on DOGE’s success at finding lots of inefficiencies, waste, and possible fraud within the government accounts. Many of these headlines are generated by Musk’s tweets on X.

There is lots of pushback by Democrats, who are challenging the legality of the DOGE Boys’ flipping through government files. Douglas Holtz-Eakin, who had served as the director of the Congressional Budget Office, compared DOGE to the former Grace Commission, which had zero of its 150 proposals enacted.
 
Federal Budget II: In Bessent We Trust. It’s too soon to tell how much DOGE will reduce government spending. However, Treasury Secretary Bessent is certainly aware of the need to reduce the federal budget deficit relative to nominal GDP. He has committed to halving this ratio from 6% to 3% (Fig. 6).

This ratio was last at 3% during Q4-2015 (2.93%, to be exact). Since then, Trump 1.0 tax cuts drove it up to 4.65% during Q4-2019 (just before the pandemic), and Biden’s outlays raised it over 6% during Q4-2024.

Trump 2.0 is borrowing a page from the Clinton administration’s playbook, specifically the one in which Robert Rubin and James Carville warned Clinton that he had to respect the power of the Bond Vigilantes and maintain fiscal discipline. On February 6, US Treasury Secretary Scott Bessent said that he and President Trump are less concerned about the federal funds rate (FFR) and instead are hoping to contain the 10-year Treasury yield. Bessent’s message to the Bond Vigilantes was that he has explained to President Trump that they have the power to stymie his fiscal agenda.

However, on February 12, Trump posted the following on his Truth Social platform: “Interest Rates should be lowered, something which would go hand in hand with upcoming Tariffs!!!” That assertion flew in the face of economists’ expectations that tariffs would fuel inflation and postpone rate cuts as well as what Federal Reserve Chair Jerome Powell told US lawmakers the day before: that the Fed was in no rush to cut its short-term interest rate again given an economy that is strong overall.

The Bond Vigilantes are biding their time, waiting to see how much the Trump administration can slow the increase in federal spending because of the efforts of the DOGE Boys. If they don’t deliver enough spending cuts, there could be a gunfight at DOGE City, with the Bond Vigilantes shooting holes in the Trump administration’s fiscal agenda, including the extension of his tax cuts.

It is good that Bessent understands the power of the Bond Vigilantes. In effect, he represents their interests within the Trump administration. Eric and I believe that by appointing Bessent as Treasury Secretary and establishing DOGE, Trump bought his administration some time to deal with the federal budget mess.

Federal Budget III: Tracking The Bond Vigilantes. “Bond Vigilantes” is the phrase I coined in July 1983 to refer to bond investors, acting in their own financial interests, when their activity drives up bond yields out of belief that the government will fail in its duty to keep the budget deficit from ballooning and inflation contained via fiscal and monetary policy. They’ll demand greater yield for their long-term bond investments if they think the value of their investment will be eroded by inflation over the term. Higher bond market yields effectively push up other interest rates—so it’s as if bond investors are taking fiscal and monetary discipline into their own hands, vigilante style, when the government drops the ball. (See The Bond Vigilantes excerpt from my 2018 book Predicting the Markets.)

One way to monitor the activities of the Bond Vigilantes is to compare the 10-year Treasury bond yield to the growth in nominal GDP on a y/y basis (Fig. 7 and Fig. 8). When the spread is positive while the economy is growing, they are doing what they can to slow it down. They were asleep at the reins during the 1960s and 1970s, when inflation got out of hand. They were much more vigilant during the 1980s and early 1990s.

The Bond Vigilantes were stymied by the Fed’s QE (quantitative easing, i.e., buying bonds) and ZIRP (i.e., zero-interest-rate policy) from 2008 through 2022, i.e., between the Great Financial Crisis and the Great Virus Crisis, when the Fed’s monetary stance was ultra easy. The bond market was rigged by the Fed during this period. The Fed tightened monetary policy by raising the FFR and ending QE from March 2022 through August 2024, allowing the bond yield to normalize.

The 10-year Treasury bond yield is currently about 4.50%, having risen back up to around where it was before the Great Financial Crisis (Fig. 9). The spread between the bond yield and the growth rate in nominal GDP was -70bps during Q4-2024. It remains around zero currently. Nominal GDP growth was 5.0% y/y during Q4.

We conclude that the Bond Vigilantes aren’t saddling up just yet to ride into DOGE City for a gunfight with the Trump administration. But ask us again if the yield jumps above 5.0% with attendant widespread fear that it is heading toward 6.0%.

The Bond Vigilantes have never been potentially more powerful than right now given that total federal public debt outstanding is a record $36.2 trillion with a record $28.5 trillion in marketable US Treasury securities (Fig. 10).

Economy I: Seasonal Sales Issues. Retail sales fell 0.9% m/m in January, one of the worst monthly readings in years. And because of the 0.7% m/m increase in CPI goods inflation, real retail sales fell by 1.6% m/m last month (Fig. 11 and Fig. 12). Those are ugly numbers, and they brought a few bears out of hibernation to proclaim that the long-awaited economic slowdown is here!

We’re not too worried about January’s one-off dip in spending; January is always a bad month for retail sales after December’s spending bonanza and before seasonal adjustment. We continue to be optimistic on the US consumer. Here’s more:

(1) Smoothing out seasonals. The Census Bureau’s seasonal adjustment is an attempt to smooth out the December surge and January plummet in spending each year. For instance, retail sales fell 16.5% m/m in January on a non-seasonally adjusted basis, a tad less than it fell in January 2024 (-16.8%) and 2022 (-17.0%) and a bit more than it fell in 2023 (-14.8%) (Fig. 13).

In several economic indicators, including retail sales, the seasonal adjustments haven’t fully caught up to the post-pandemic shifts in consumer behavior. January's retail sales rose 4.2% y/y on a seasonally adjusted basis and 4.8% not seasonally adjusted.

The Redbook retail sales series shows a solid increase of 5.3% y/y through the week of February 7, 2024 in nominal terms (Fig. 14). It has a good correlation with the comparable growth rate for monthly retail sales excluding food services. We also note that the winter deep freeze, and perhaps the fires in California, likely weighed on consumer activity last month (Fig. 15).

(2) Auto regression. After a very strong Q4, auto sales fell off in January (Fig. 16). The seasonally adjusted annualized rate for total new-vehicle sales fell from 16.9 million units in December to 15.6 million in January. We believe auto dealers used discounts to clear out their inventories heading into the end of last year, which contributed to the big drop in Q4-2024 GDP inventory investment but also spurred a lot of sales. So in Q1, we're likely to see inventories rebuilt but sales slow a little.

Auto sales (-2.8% m/m) was the biggest overall drag on January retail sales. Sporting goods, hobby & bookstores (-4.6%) experienced the largest monthly drop off. We expect that the category also suffered from some seasonal adjustment misreads and will likely rebound next month.

Economy II: Manufacturing Mojo. Hours worked by manufacturing employees fell by 0.7% m/m in January, which typically would suggest that industrial production fell by about the same amount. However, industrial production rose 0.5% m/m after adding 1.0% in December (Fig. 17). We had expected the bad weather to weigh unduly on hours worked, but we thought it would be less likely to influence manufacturing. So the increase was encouraging and suggests US manufacturing may be in the first inning of its rolling recovery. The 2.0% y/y increase in production is the largest increase since the Fed began its last round of rate hikes in 2022 (Fig. 18).

Looking deeper at the latest industrial production data, the restarting of Boeing’s production after worker strikes accounted for 0.2ppts of the total 0.5% increase, according to the Fed. Aerospace rose 6.0% m/m, while the index for utilities jumped 7.2% due to demand for heating (Fig. 19). Utilities production continues to make new monthly highs, and the demand for data processing and new energy sources from the AI boom suggest it won’t be stopping (Fig. 20).

Autos fell 5.2% m/m, dragging on the index for manufacturing output. Given Trump 2.0 initiatives to reshore auto manufacturing, we think OEMs have enough stick and carrot to pick up production by the end of the quarter.

Movie. “September 5” (+ +) is a 2024 docudrama thriller about the 1972 Munich Olympics massacre of Israeli athletes from the perspective of the ABC Sports reporters as they admirably rose to the occasion and covered the terrible events. It is a harrowing reminder of the fact that jihadist terrorists have been terrorizing all too many countries for all too long. By staging this attack in Germany, the Black September terrorists meant to send a signal that they remained committed to killing Jews, as did the Nazis in World War II. The brutality of the October 7, 2023 attack by Hamas on Israeli civilians including men, women, and children was also aimed to be a reminder of the Holocaust. The world remains a dangerous place for all too many innocent civilians. (See our movie reviews archive.)

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On Tariffs, IPOs & AI Tools

February 13 (Thursday)

China: Tussling with Trump's Tariffs. The trade war between the US and China continues to heat up as Trump 2.0 approaches its second month and the US merchandise trade deficit hits record levels (Fig. 1). Placing tariffs on goods from China and other countries is part of Trump’s efforts to boost US manufacturing, level the global trading field, and raise revenues to pay for the tax cuts he plans to extend. The tariffs are also aimed at increasing national security by securing the border with Canada and Mexico against illegal immigration and drugs.

Until 2019, the US imported more goods from China than any other country. Now US imports from China ($444.9 billion, 12-month sum) account for about 13.5% of total US imports, trailing imports from the EU ($605.8 billion) and Mexico ($505.9 billion) (Fig. 2). Some Chinese manufacturers have relocated to Mexico and other nations to dodge tariffs, but plenty still ship directly to the US. While off its highs, the US merchandise trade deficit with China remains extremely large at $273.5 billion, using a 12-month sum (Fig. 3).

Let’s take a look at Trump 2.0’s recently announced trade policies and China’s responses:

(1) Trump wastes little time. Less than a month into the job, President Trump has imposed an additional 10% across-the-board tariff on goods imported from China, reportedly to encourage China to do more to stop the flow of fentanyl into America. His actions elevate the US tariff rate on Chinese goods above the tariff rate that China imposes on foreign goods: 7.5% using a simple average and 3.0% using a time-weighted average (Fig. 4).

President Trump initially canceled the de minimis trade exemption allowing duty-free importing of goods valued at less than $800, which benefits Chinese online retailers like Temu and Shein. But he subsequently reversed that decision, delaying the rule’s suspension.

Just this week, Trump announced a 25% tariff on steel and aluminum; but that shouldn’t affect Chinese producers much, as only 2% of US steel imports came from China in 2024 (most came from Canada, Brazil, Mexico, and South Korea).

Finally, Trump announced plans to impose “reciprocal” tariffs on a country-by-country basis. In other words, if a country imposes a 10% tariff on American cars sold there, the US will impose at least a 10% tariff on all cars it imports from that country. In setting the tariffs, the US reportedly will also take into account any barriers the country erects to disadvantage US manufacturers, such as value-added taxes on goods made by US companies, government subsidies that tilt the competitive playing field in domestic companies’ favor, or regulation preventing US companies from doing business in the country. “[T]he administration could attempt to calculate how much US trade is diverted by foreign trade barriers, and then devise a US tariff rate to reflect that trade volume,” a February 11 WSJ article reported.

(2) China responds. China responded to Trump’s 10% tariffs on Chinese goods by launching a trade dispute at the World Trade Organization (WTO). The country claims the Trump administration made “unfounded and false allegations” about China’s role in the fentanyl trade to justify tariffs on Chinese products. The dispute is expected to have little impact because the WTO’s dispute settlement system has been neutered by the Trump and Biden administrations, which blocked the appointment of new judges.

China’s response also included a 15% duty on coal and natural gas imports from the US and a 10% duty on US petroleum, agricultural equipment, high-emission vehicles, and pickup trucks. The US tariffs apply to about $450 billion of Chinese goods, while the Chinese tariffs apply to only $15 billion to $20 billion of American goods. In addition, China added tungsten, tellurium, bismuth, molybdenum and indium to its export control list.

China has placed restrictions on US technology companies that could be used as trading cards when negotiating with Trump regarding tariffs. China started an antitrust investigations into Google, which follows an investigation of Nvidia launched last year.

Financials: IPOs Heat Up. The S&P 500 Financials sector is starting 2025 near the top of the ytd performance leader board. Investors hope that some of the sector’s largest players will benefit from the Trump administration’s business-friendly policies reducing regulation and keeping the capital markets humming along.

Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Communication Services (7.1%), Financials (6.5), Health Care (6.0), Materials (6.0), Energy (6.0), Consumer Staples (5.2), Industrials (5.1), Utilities (4.7), Real Estate (3.8), S&P 500 (3.2), Consumer Discretionary (-0.1), and Information Technology (-0.5) (Fig. 5).

Within the Financials sector, the Investment Banking & Brokerage and the Diversified Banks industries have turned in the strongest performances. Both are helped by the strong stock market and the anticipation of healthy capital markets activity including mergers and acquisitions.

This week will provide clues as to whether the largely moribund IPO market can return to life. Seven deals are scheduled to price this week, including a $1.1 billion offering from SailPoint, an enterprise security firm that secures digital identities.

The following is the ytd performance derby for the S&P 500 Financials sector’s industry indexes through Tuesday’s close: Investment Banking & Brokerage (11.3%), Diversified Banks (11.3), Insurance Brokers (8.0), Consumer Finance (6.8), Regional Banks (6.7), Financials Sector (6.5), Financial Exchanges & Data (6.1), Asset Management & Custody Banks (-1.3), and Reinsurance (-7.4) (Fig. 6).

Here’s a look at some of the week’s upcoming IPO deals and a few launched earlier this year:

(1) Improving IPO market. After an extremely strong market in 2021, when 397 IPOs priced, IPO issuance activity fell off a cliff, with only 71 deals pricing the next year, according to data from Renaissance Capital. Activity has slowly been improving in the subsequent years—108 deals in 2023 and 150 in 2024—and the initial 2025 pace looks promising (Fig. 7).

So far, 24 deals have priced this year through Tuesday, up 26.3% over same period last year; but the proceeds were only $4.4 billion, down 23.6% y/y. That said, 31 IPO deals have been filed with the Securities and Exchange Commission ytd, marking a 19.2% y/y improvement. And the deals that have come to market are performing well. The Renaissance IPO ETF has climbed 6.0% ytd through Tuesday’s close, besting the S&P 500’s 3.2% performance over the same period.

(2) A big test. The pricing and performance of SailPoint’s $1.1 billion IPO will be the latest indicator of whether the market can continue its recovery. In a positive sign, the price range of the shares being offered was increased to $21-$23 from $19-$21 originally.

(3) Health care IPOs faring well. Some of the best performing IPOs so far this year are in the health care industry.

Medical device manufacturer Beta Bionics has developed the iLet Bionic Pancreas, an insulin delivery device cleared by the Food and Drug Administration that autonomously determines insulin doses without requiring a user to count carbohydrate intake. The $204 million offering, which priced on January 29, has traded up 32.7%.

Biotechnology company Metsera is developing injectable and oral nutrient stimulated hormone analog peptides to treat obesity and related conditions. The company is in the midst of a phase 1/2 trial for its injectable, with results expected midyear. The $275 million IPO was priced at $18 a share, above its initial $15-$17 range, and it has since traded up by 70.9%.

Another biotech company, Sionna, is developing a treatment for cystic fibrosis that is in phase 1 trials. Shares of the $191 million IPO have traded up 13.4% since coming to market.

(4) Industry numbers. Both the S&P 500 Investment Banking & Brokerage and the Diversified Banks stock price indexes are at record highs (Fig. 8 and Fig. 9).

The Investment Banking & Brokerage industry’s forward operating earnings per share has broken out to a recent new high and is approaching levels last seen before the 2008 financial crisis (Fig. 10). The industry is expected to grow operating earnings by 14.8% this year and 13.2% in 2026 (Fig. 11). Diversified Banks’ forward operating earnings per share is at a new record high (Fig. 12). Its earnings growth is expected to rebound from 3.9% this year to 13.6% in 2026 (Fig. 13).

However, both industries’ forward P/Es are extended relative to historical levels: 15.4 for Investment Banking & Brokerage and 13.1 for Diversified Banks (Fig. 14 and Fig. 15).

Disruptive Technologies: AI Loved by the Masses. We’ve been writing about large language models (LLMs) since early 2023, shortly after ChatGPT made its historic splash. It’s been interesting to watch AI gain acceptance. First, just techies were excited about what AI could offer. Then kids started using it to cheat on their homework. Now, recognition of AI’s capabilities is on everyone’s radar and experimentation with AI has gone mainstream.

Last weekend, Jackie and a group of fifty-something friends discussed how they were using AI at work. One was experimenting with an AI program that turns textbooks or long passages into podcasts. Another uses it to respond to her emails more quickly and to help format Excel spreadsheets. A teacher uses AI to produce lesson plans. None of these folks are techies, but each was excited about using AI to save time at work.

Here’s our latest look at some of the popular and novel ways that AI programs are being used at the office:

(1) The AI podcast. Google’s NotebookLM will summarize and make connections between materials that a user uploads. The materials may be a long book, academic pdfs, websites, videos, or all of the above. But what makes NotebookLM eye-popping is its Audio Overview feature, which presents the uploaded material in a conversational podcast format, hosted by two “people.” Teachers are using it as a way to reinforce lessons. Students, however, may consider it to be a more entertaining version of Cliff Notes.

(2) AI monitors customer feedback. Frame AI analyzes customers’ calls, chats, surveys, and emails to alert companies to risks or opportunities they might otherwise miss. According to the company’s website, Frame AI can use unstructured data to glean insights about what customers want and ways they might use a product. Customer testimonials on Frame AI’s website said the AI program allowed them to respond more quickly to customers, anticipate their needs, and improve both customer experience and efficiency.

(3) AI sees if you’re sleeping. Read AI can do all the things you’d expect AI can do with a meeting, like providing a transcript and a summary. What caught our attention is its ability to measure the engagement of those attending online meetings by using AI, natural language processing, and computer vision technology. Read AI measures meeting attendees’ verbal and non-verbal cues and translates that into real-time and post-meeting sentiment and engagement metrics. It can also apply AI to past meetings to give presenters coaching metrics and recommendations to help them become better speakers.

(4) AI at school. Magic School and Google’s Gemini are the AI apps used to save time by our schoolteacher friend. Magic School can generate lesson plans, worksheets, rubrics, quizzes, academic content, report-card comments as well as questions, summaries, or presentations based on YouTube videos or a text. Gemini offers many of the same functions. They both make tedious tasks simpler and faster to accomplish.

(5) Lots of overlap. Lots of AI apps aim to do roughly the same things, and not all are likely to survive. For example, many AI apps do voice-to-text translation, and many read text out loud. Multiple apps create pictures, edit photos, turn data into charts, help with grammar and schoolwork, and of course answer questions. We wish AI could help us determine which of them will survive and which will go the way of Pets.com.

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On Liquidity, Tariffs & Earnings

February 12 (Wednesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy: Lacking Liquidity? Fed watching is important insofar as we can generate alpha in identifying economic developments that Fed officials may be misinterpreting.

For instance, the Federal Open Market Committee’s (FOMC) mistaken concern about last summer’s labor market weakness led to 100bps of rate cuts. Whether due to confirmation bias, institutional groupthink, or simply a desire to avoid a recession at any cost, we believed the Fed wasn’t acting appropriately based on the economic fundamentals. Economic growth was strong, and inflation remained sticky, leading us to grow increasingly bearish on long-term bonds as the rate cutting cycle proceeded last year (Fig. 1).

But one ball that the Fed is not likely to take its eyes off is liquidity. For all the hoo-ha about the ill effects of quantitative tightening (QT) and balance-sheet rundown, there’s next to no chance that the Fed will endanger market liquidity and let short-term interest rates spike. Some commentators have pointed to the nearly drained Overnight Reverse Repurchase Facility (RRP)—with $76 billion in it as of Tuesday—as evidence that a malfunctioning of short-term funding markets is imminent, which will make the financial markets go haywire (Fig. 2). Such episodes have cascaded into broader financial markets and sparked volatility across asset classes before. We are confident that this won’t be the case this time around.

Here’s why:

(1) QT refresher. The Fed’s balance sheet has shrunk from a peak of around $8.9 trillion in 2022 to $6.5 trillion of Treasuries and mortgage-backed securities today (Fig. 3). However, bank reserves have barely budged, remaining around $3.2 trillion or roughly double pre-pandemic levels (Fig. 4). One reason reserves have remained elevated is that the RRP drained as opposed to bank reserves.

(2) Will reserves start to drain? Yes, but probably not much. The Fed is likely to end QT later this year, or as soon as repo markets exhibit any signs of potential stress.

Frankly, there are more tailwinds to liquidity than headwinds. Fed Governor Michelle Bowman, who may be tapped as the Fed’s next vice chair of Supervision, recently highlighted several bank regulations that need to be relaxed. Included were measures that will make it easier for large banks to absorb Treasury supply. That’s a good thing considering that we don’t see Treasury supply slowing anytime soon (Fig. 5). We also believe the Fed will start to reinvest maturing mortgage-backed securities into Treasuries, another positive for Treasury market functioning.

(3) Money supply. The Fed’s lowering the federal funds rate by 100bps and banks’ easing of lending conditions in response have led to a pop in M2 money supply, which was up 3.9% y/y as of December (Fig. 6). In fact, M2 is rising in nearly every region and country globally, with the notable exception of China, which is firing several stimulus salvos as we write.

The theme of this story is to not sweat QT, as that’s one area the Fed is on top of.

Global Trade I: National Security—Steel Matters. On Sunday, Trump announced global tariffs of 25% on steel and aluminum, with no countries exempted. These followed earlier threats of 25% tariffs on most Canadian and Mexican goods and 10% on all Chinese imports. The tariffs on Canada and Mexico were postponed for 30 days as Trump worked out a deal with both countries to tighten border security, limiting the flow of immigrants and drugs into the US.

The broad tariffs on Canada and Mexico imports were likely a negotiating tactic, aimed at increased border security versus tit-for-tat tariffs. However, we think the new steel and aluminum tariffs reflect a different approach that prioritizes domestic industry and rebalancing trade. Boosting US steel production and prohibiting Chinese dumping practices are priorities of their own, and thus we believe these tariffs may stand longer than the initial Canadian and Mexican proposals. This comes with the usual caveat that everything in Trump World remains negotiable.

It's important to understand why steel gets extra attention from this administration:

(1) Peter Navarro’s intentions. Peter Navarro, Trump’s senior trade advisor, emphasized that the tariffs are not just about trade. “It’s about ensuring America never has to rely on foreign nations for critical industries like steel and aluminum,” he recently told reporters. The tariffs aim to end foreign dumping, boost domestic production, and secure the steel industry as vital to both economic and national security, he added. Under Trump 1.0, Navarro dismissed concerns about modest inflationary effects from eliminating unfair trade practices.

(2) A familiar story. In January 2018, Trump 1.0 imposed tariffs on steel and aluminum following a US Department of Commerce Section 232 report. It concluded that steel is critical to national security, expanding that to include industries beyond defense.

The 2018 report noted that steel imports were harming the US steel industry. To sustain it, mills need to operate at 80% or more of their capacity, which requires reducing imports via quotas or tariffs. US steel production capacity utilization was 74.6% in September 2024, according to the International Trade Administration.

(3) No exceptions this time. Back under Trump 1.0, Canada, Mexico, and Australia were exempt from the tariffs. South Korea, Brazil, and Argentina agreed to quotas. In April 2022, President Joe Biden then replaced European and Japanese tariffs with quotas as well. These exemptions ultimately weakened the impact of the broader tariffs on the US steel industry, the current administration believes.

(4) Economic consequences in 2018. In Trump’s view, sustaining these domestic industries is worth the economic costs. When these tariffs were last imposed, they raised prices for consumers and reduced domestic growth, according to a May 2024 Tax Foundation report. The US International Trade Commission found that steel and aluminum prices increased by 2.4% and 1.6%, respectively, following the 2018 tariffs. Removing these tariffs would have led to a modest increase in real GDP growth of 0.02% y/y.

Given steel's importance in construction (e.g., rebar) and auto manufacturing, it's a critical commodity in the reshoring efforts.

(5) Targeting Chinese dumping. These tariffs also aim to undermine China’s steel industry, which is plagued by overproduction. China’s share of global steel production exceeds 50%, while the US accounts for just 5%.

While China’s steel isn’t a top US import, it impacts global prices. Price differentials between US steel and the world remain elevated at $762 per metric ton as of September 2024 versus the world at $480 and Chinese prices at $376, according to the US International Trade Commission’s data.

China is the world’s largest steel producer, and its steel exports have been on the rise, further pressuring domestic US producers. Exports from China are expected to top 100 million tons in 2024, the highest since 2016. Only 1.0% of Chinese steel mills are profitable, according to a Chinese consultancy quoted in the Financial Times.

(6) Canada’s major role. Canada, though not a major global producer of steel, supplies the largest portion of US imports in the world. It accounted for 22.5% of US imports through September 2024. Canada also imposed tariffs on Chinese steel in October 2024 to protect its domestic industry from China’s oversupply, though China’s prices remain competitive even with the added tax.

We’ve suggested before that Trump’s desire to incorporate Canada into the US is driven by energy security. We believe US steel industry security is also a part of Trump’s short list of reasons to bring Canada into the US.

Global Trade II: Required Reading on Reciprocal Tariffs. Along with the 25% steel and aluminum tariffs, Trump hinted at imposing reciprocal tariffs on more countries and imports soon. To understand this, we return to our March 8, 2018 Morning Briefing, in which we analyzed Peter Navarro’s views on reciprocal tariffs. Navarro repeatedly has championed the idea of “free, fair, reciprocal trade,” aiming to level the playing field in global trade.

Here’s more:

(1) Navarro’s identity crisis. Navarro believes trade deficits are harmful because they must be offset by foreign investment. This investment could benefit US investors, increasing demand for financial assets and pushing US interest rates down. But protectionists like Navarro see this as problematic, fearing increased foreign control over US assets.

(2) Conquest by purchase. Navarro’s primary concern is “conquest by purchase,” whereby large trade deficits allow foreign rivals to buy US companies, technologies, and farmland. This, he argues, could ultimately affect national security if these entities control critical industries.

(3) Focus on trade in goods. Navarro emphasizes that the US must rebuild its manufacturing base to secure national defense. Only one company in the US can repair Navy submarine propellers, and no US company can produce certain critical military technology, he argued in 2018.

(4) Fast forward to 2025. For those interested in a deeper dive into US trade deficits with specific countries and the dynamics of reciprocal tariffs, Navarro’s chapter in the Heritage Foundation’s Project 2025 Mandate For Leadership (starting on page 765) offers valuable insights. This section, which outlines a comprehensive vision for US trade policy, aligns closely with what is unfolding in the Trump 2.0 trade agenda.

Strategy: Q4’s Earnings Hook Has Arrived. Through midday Tuesday, 65% of the S&P 500’s companies have reported December-quarter earnings. Among the 325 reporters so far, the aggregate revenue and earnings beats relative to analysts’ consensus estimates are 0.7% and 6.7%, respectively (Fig. 7 and Fig. 8). Below, Joe shares data on how these S&P 500 and the six Magnificent-7 reporters to date fared last quarter:

(1) S&P 500 looks bound for record-high quarterly EPS yet again. The S&P 500’s blended Q4 EPS (i.e., estimates blended with actual results reported so far) jumped $2.32 to $64.71 from $62.39 a week earlier (Fig. 9). That boost is typical of past quarters, when earnings “hooks” in the charted blended data appeared after companies reported results that beat expectations. The current blended EPS of $64.71 is on track for the index to post its third straight quarter of record-high EPS (Fig. 10).

The Q4 quarterly EPS growth rate soared 4.1ppts w/w to 13.3% from 9.2% (Fig. 11). That’s ahead of the forecasted 11.8% at the beginning of the quarter and 8.2% at end of the quarter. It’s also the highest y/y quarterly earnings growth rate since Q4-2021, when growth was winding down from the fast-paced recovery that followed pandemic lockdowns (Fig. 12).

(2) Don’t fear falling growth expectations for Q1-2025. This is always a busy time of year for analysts as company managements share their expectations for the year ahead. This year, it’s been even busier as Trump 2.0 plans have come to light.

Adjustments to analysts’ models for news on tariffs and dollar impacts have lowered the S&P 500’s Q1-2025 earnings estimate by 2.5% since the start of the quarter (Fig. 13). We’re not worried since that’s less than the average 4.2% decline seen for Q1s since 1995. The consensus now expects S&P 500 earnings to rise 8.3% y/y in Q1-2025 (Fig. 14). That’s down from 9.8% a week earlier and 11.1% at the start of the quarter six weeks ago. The most affected S&P 500 sectors have been Financials (due to California fires) and Consumer Discretionary (Tesla).

For the rest of the 2025, analysts are expecting y/y earnings growth of 9.8% for Q2, 11.9% in Q3, and 12.6% in Q4. The 4.1ppts decline w/w in Q4-2025’s growth forecast to 12.6% from 16.7% turns out to be a nothing-burger. All of the change in the growth rate this week was due to higher base period earnings from Q4-2024.

(3) Mag-7 results. Among the Magnificent-7 companies, only Nvidia has yet to cross the Q4 reporting finish line. Tesla undershot estimates on both the top and bottom lines, and Alphabet missed on the top line. The six companies mostly recorded double-digit percentage revenues and earnings growth. Tesla managed to eke out single-digit y/y percent gains in both those measures. Also underperforming the group on both measures was Apple, which posted earnings growth of just 10.1% on a revenue gain of 4.0%.

Tesla’s weakness dragged down the Mag-7’s aggregate surprise and y/y growth numbers, causing the group to be a negative contributor to the overall S&P 500’s revenue surprise metrics among reporters so far. However, the Mag-7 remains a net positive contributor to the S&P 500’s y/y growth rates in revenues and earnings and the aggregate earnings surprise.

Excluding the Mag-7’s December-quarter results from the S&P 500’s improves the revenue surprise to 0.7% (from 0.6%), lowers the earnings surprise to 6.5% (from 6.7%), and drops revenues growth and earnings growth to 3.5% y/y (from 4.5%) and to 10.8% y/y (from 14.9%). The Mag-7’s six reporters to date posted a collective 0.2% revenue surprise, 7.2% earnings surprise, 9.8% y/y revenues growth, and 26.6% y/y earnings growth.

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Roaring 2020s & Reciprocal Tariffs

February 11 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

US Economy I: On the Road Again. Taylor Swift’s “The Eras Tour” was her sixth tour. It started on March 17, 2023 in Glendale, Arizona and concluded on December 8, 2024 in Vancouver, British Columbia. My “Roaring 2020s Tour” started in California at the end of January 2024. My latest stops were in Georgia and Tennessee last week. Next week, I’ll be in Las Vegas and Houston.

My tour has been well received, though not as well as Taylor’s. My main Roaring 2020s themes are the following:

(1) Resilient economy. We should be impressed by how well the US economy has grown over the past three years despite the significant tightening of monetary policy. The most widely anticipated recession of all times has been a no-show, attesting to the resilience of the economy. That increases the chances that the current economic expansion, which began in Q3-2020, will continue for longer than it has lasted so far; maybe there will be no recession through the end of the decade. Perhaps the Roaring 2020s will even be followed by the Roaring 2030s.

Real GDP has increased 23.5% since Q2-2020 (the bottom of the two-quarter recession) through Q4-2024 (Fig. 1). The full recovery from the recession in early 2020 took only 20 months, one of the shortest recovery periods on record (Fig. 2). The post-recovery expansion has lasted 38 months so far through the end of 2024. We think it could last at least as long as the 1990s expansion (i.e.,105 months) in our Roaring 2020s scenario. It could be even longer if the 2030s also roar.

(2) Washington matters less. We should also be impressed by how well the US economy has performed for many years despite the meddling of Washington. We attribute this to the work ethic of American workers and the business acumen of American company managements. Together, they’ve driven real GDP to new record highs for decades despite quixotic government regulations and fiscal policies.

Americans also do entrepreneurial capitalism extremely well, creating new technologies and businesses. Since the pandemic, the 12-month sum of new business applications has consistently exceeded 5.0 million, according to the US Census Bureau (Fig. 3). That’s certainly an important driver of both employment and capital spending in the US economy.

The number of sole proprietorships was approximately 29 million in 2021 (Fig. 4). Within the category “personal income,” proprietors’ income in December totaled a record $2.0 trillion (saar), while rental income totaled a record $1.1 trillion, for a record $3.1 trillion combined (Fig. 5). Nonlabor income, which includes these two sources plus interest and dividend incomes, accounts for 28.1% of personal income, up from 24.6% at the start of the 1970s (Fig. 6). Americans’ high nonlabor income helps to explain why consumer spending has become increasingly resilient.

(3) Capital markets. America’s capital markets survived the Great Financial Crisis and have become increasingly sophisticated and diversified ever since. Venture capital is readily available for startups. The capital markets also have more shock absorbers since the Great Financial Crisis. Private debt markets allow for restructuring bad debts without causing financial crises. Distressed asset funds do the same.

Since the Great Financial Crisis and the Great Virus Crisis, the Fed has become more adept at rapidly establishing emergency liquidity facilities to stop financial crises from spreading and becoming economy-wide credit crunches, which then cause recessions. That’s exactly what happened during March 2023, when a banking crisis in California was quickly contained (Fig. 7 and Fig. 8).

(4) Technology and productivity. The US economy has been experiencing a Digital Revolution since the 1950s, when IBM mainframe computers proliferated in business, government, and academia. The Digital Revolution is all about data processing, i.e., processing more and more data faster and faster at lower and lower cost. From this perspective, AI is an evolutionary development in the Digital Revolution. AI allows more data to be processed faster than ever before and at a lower cost, as DeepSeek has demonstrated. So much data can be processed that we need large language models (a.k.a. LLMs) to make some sense of it all and use it to increase productivity.

When the use of personal computers proliferated during the 1990s, the only “apps” widely run on them were Excel and Word. Now tens of thousands of apps are available with more being produced every day, some written by AI coding software! Most are for entertainment, but many are also boosting productivity.

High-tech now accounts for 50% of nominal business capital spending, up from close to 20% in the mid-1960s (Fig. 9). This obviously doesn’t include lots of consumer spending on technology hardware and software (Fig. 10).

(5) Resilient consumers. As noted above, consumers collectively have diverse sources of income that help to explain why the tightening of monetary policy didn’t depress their spending. On balance, higher interest rates benefit more consumers than they hurt. During December 2024, personal interest income totaled a record $2.0 trillion, while personal nonmortgage interest payments totaled $0.6 trillion (Fig. 11).

Furthermore, as we have noted often in the past, the household sector has a record $159.9 trillion in net worth, with about half of that held by Baby Boomers, a group that’s continually retiring (Fig. 12). These seniors will probably turn the overall personal saving rate negative as they spend down their retirement assets in coming years. While they are doing so, the values of their homes and stock holdings continue to rise!

(6) Accentuating the positives. The theme song of the Roaring 2020s might be a 1944 tune titled “Ac-Cent-Tchu-Ate the Positive.” It was nominated for the Academy Award for Best Original Song at the 18th Academy Awards in 1945 after being used in the film “Here Come the Waves” with Bing Crosby and Betty Hutton.

During my “Roaring 2020s Tour,” I encourage our accounts to accentuate the positives and to consider the possibility that the US economy will continue to grow and the stock market will continue to rise to record highs. It’s happened more often than not in the past.
 
US Economy II: The 1920s Ended Badly. Invariably, the pushback that Eric and I get on our Roaring 2020s scenario is that the Roaring 1920s ended badly. It was followed by the Great Crash in the stock market and the Great Depression in the economy. These calamities had multiple causes. We believe that the most important cause was the Smoot-Hawley Tariff, which was enacted during June 1930.

Roughly half of the stock market drop in late 1929 was reversed during the first few months of 1930, with the S&P 500’s predecessor index (the Standard Statistics Company’s index of 233 US companies) back to where it had been the year before. That was not the Great Crash. Rather, the Great Crash started in May 1930, a few weeks before the Smoot-Hawley Tariff was enacted (Fig. 13). Industrial production also crashed after the tariff was enacted (Fig. 14).

The tariff act prompted retaliatory tariffs by many other countries. The resulting trade war caused commodity prices to collapse along with global trade. Farmers were especially hard hit and were forced into bankruptcy, which exacerbated the banking crisis.

On June 12, 1934, Congress enacted the Reciprocal Tariff Act. It authorized the president to negotiate trade agreements with separate nations to reduce tariffs in return for reciprocal reductions in tariffs. Between 1934 and 1945, the United States signed 32 reciprocal trade agreements with 27 countries.
 
US Economy III: Retaliatory vs Reciprocal Tariffs. On Friday, President Donald Trump indicated that reciprocal tariffs might replace the proposed 10%-20% universal import duty that was a key part of his economic agenda during the campaign. He is leaning toward implementing “mostly” reciprocal tariffs rather than broad import duties applied across the board. Trump announced on Sunday that he is slapping a universal 25% tariff on all imports of steel and aluminum. It will apply to Mexico and Canada as well, even though on February 3 he gave both countries a 30-day extension of an across-the-board 25% tariff on imports from them (except for a 10% tariff on Canadian oil).

Is this the start of Smoot-Hawley 2.0? We doubt it. Much will depend on whether Trump views his tariffs as retaliatory or reciprocal. The latter implies that the US is matching tariffs imposed on US goods and that there is a willingness to negotiate to lower or no tariffs. We think that’s Trump’s goal.

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Anatomy Of Full Employment

February 10 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Labor Market I: Finding Full Employment. Friday’s January employment report confirms every part of our optimistic outlook on the labor market. The unemployment rate fell to 4.0%, its lowest since last May, even though more Americans decided to participate in the labor force (Fig. 1). Before we discuss the January data, let’s review our labor market outlook.

As we’ve argued since last summer, the post-pandemic period was historically anomalous and led many to misread an apparent slowdown in the jobs market as harbingering a looming recession. In fact, the largest wave of immigration on record helped raise the unemployment rate without any material layoffs. Also, labor market indicators such as hiring and quits fell. Such cooling has preceded recessions in the past, but this time it was simply the natural result of the pandemic’s massive labor market churn settling down. Normalization was to be expected, but it was widely misinterpreted as a sign that the “long and variable lags” of a Federal Reserve tightening cycle finally had clamped down on the economy.

The labor market is likely to chart a slightly different path going forward than it did over 2023 and 2024. Greatly reduced immigration and mostly topped-out labor force participation and employment metrics from native-born workers mean that the labor force will grow at a slower pace. However, we believe demand for workers is stronger than most do. Thus, we think it is likely that the unemployment rate will remain at full employment around 3.7% to 4.3%.

Barring unexpected events, we’re expecting monthly payroll growth to average around 150,000-175,000 workers over the coming quarters and years, below the roughly 175,000-180,000 average pace just before the pandemic. Despite the slowdown of employment growth, strong productivity gains and a full-employment labor market should spur robust real wage growth.

This should maintain the solid pace of consumer spending growth and real GDP growth. Furthermore, consumer spending should continue to get a boost from rising nonlabor income, including interest and dividends. In addition, retiring Baby Boomers will continue to spend their retirement funds, which may very well cause the personal saving rate to turn negative.

Now let’s assess the implications of the January data for the remainder of this year—and consider the outlook for the rest of President Trump’s second term:

(1) Payroll growth. Despite January’s lower-than-expected payroll gain of 143,000, the three-month average monthly increase in payrolls reached 237,000, as November’s and December’s initial figures were revised up by a collective 100,000 (Fig. 2). At the end of last year, we had an above-consensus forecast that the three-month average would be at least 200,000 after the January report. In fact, were it not for the Los Angeles fires, it might even have topped 250,000.

Roughly 591,000 workers weren’t at work in January due to bad weather, the highest monthly total since February 2021 (when winter storms blanketed the country and led to the Texas freeze and power crisis) (Fig. 3). Based on the increase in California’s jobless claims over the past few weeks, this was likely due to the multiple weeks of LA fires—despite the Bureau of Labor Statistics’ (BLS) specious declaration that the fires had no impact on employment. That seems to be the BLS’ go-to response to seemingly all extreme weather events whether it’s the case or not. But we suspect the fires had at least some impact on payroll growth because of the significant drop in average weekly hours worked to the lowest since the pandemic (Fig. 4). This series should rebound sharply in February.

(2) Labor market reacceleration. The labor market may be picking up, as it has been doing since last November’s Election Day. Exhibit A is that the birth/death adjustment provided a boost to January’s payrolls gains, and we expect it will continue to so, as business applications are rising due to Trump 2.0 business optimism, a.k.a. Animal Spirits (Fig. 5). Exhibit B is that the percentage of private industries reporting high payrolls over the past three months (a.k.a. the payroll diffusion index) surged to 64.8%, the highest since January 2023 (Fig. 6).

(3) Goods gaining ground? Dragging on payroll employment have been the goods-producing sectors, i.e., mining, lodging, construction, and manufacturing. Even as construction employment has climbed to new highs, overall goods employment has stagnated and even fallen over the past few years (Fig. 7). However, we’re expecting a turnaround as manufacturing enters a rolling recovery.

The ISM M-PMI rose above 50.0 in January after 26 months in contraction, propelled by strong new orders, expanding employment, and higher production (Fig. 8). The payroll diffusion index for manufacturing industries also surged to a multiyear high, of 57.6% (Fig. 9).

Demand for labor in goods industries ostensibly is increasing. But the growth in labor supply is undoubtedly starting to wane. New unskilled immigrants find much of their work in goods-producing sectors. Southern border crossings have plummeted since last summer and are very likely to remain low under the current administration (Fig. 10). So over-the-table hiring (that is recorded by government statistics) is likely to accelerate. Over a longer-term horizon, if Trump 2.0 succeeds in its goals of rebalancing global trade, domestic manufacturing employment should increase as well. A lower US corporate tax rate plus tariffed foreign goods should make producing in the US more cost-competitive despite the higher cost of employing American workers.

(4) Leaving, not losing. The number of workers who were unemployed due to layoffs fell in January, while the number of job leavers rose (Fig. 11). Workers reentering the labor market, currently the largest source of unemployment, also increased. On balance, these conditions helped to boost the employment-population ratio for prime-age (25-54 years) workers to a historically high 80.7% (Fig. 12).

If you want a job, you can find one: While it started taking longer for unemployed workers to find jobs, January’s duration of unemployment fell for those seeking jobs for the longest time periods (Fig. 13).

And if you have a job, you’re in good shape: The number of employed workers losing their job remained at one of the lowest rates on record in January (Fig. 14).

(5) Not so bad for natives. The fact that foreign-born workers have made up most of the employment gains since the pandemic has roused some concerns about the state of the labor market (Fig. 15). We believe that to be misleading without proper context. While native-born employment has remained relatively steady post-pandemic, plenty of native-born workers have entered the labor market and/or found news jobs. However, these additions have largely been offset on a net basis by the wave of retirements, masking the actual increase, which is evident from the boom in payroll growth. Moreover, foreign-born workers account for only about a fifth of US employment, so a small absolute increase in their ranks (from around 27,000 to 31,000) represents a large percentage change, which can sound alarming.

(6) Revisions are a non-event. The final revision of the BLS’s Quarterly Census of Employment and Wages (QQCEW) reduced the initial downward revision for the period from April 2023 to March 2024 from -818,000 payrolls to -598,000. Also included in the January data were the Census Bureau’s update, which found that several million more immigrants came into the US over the past two years than initially estimated. Even after the big update to the size of the labor force, demand for labor continues to outstrip supply (Fig. 16).

The large upward revision in the labor force and household employment, to 170.7 million and 163.9 million Americans respectively, will likely correlate with upward revisions to real GDP growth, business output, and therefore productivity growth.

(7) Average hourly earnings. Wage growth beat expectations in January. Average hourly earnings increased 0.5% m/m and 4.1% y/y, and it increased 4.2% y/y for production and nonsupervisory workers. While we believe nominal wages growth will continue to outpace inflation, we think annual raises boosted the data. We’re expecting a gradual slowing in the y/y figure as it converges toward the Employment Cost Index, which is currently up 3.6% y/y (Fig. 17).

The jump in wage growth was offset by the drop in the average workweek in our Earned Income Proxy (EIP). Combined with the added 143,000 payrolls, our EIP rose 0.27% m/m in January. Typically, this would lead to an increase in retail sales by around the same amount, or less than 0.1% m/m in real terms. However, we wouldn't be surprised if consumer spending was a bit higher than that last month, as the fires in California may have boosted demand for services in the short run. In any case, we expect a rebound in consumer spending this month.

Labor Market II: Counting on Productivity. We believe productivity growth is on its way up from the cyclical lows of just 0.5% in 2015 to 3.5%-4.0% annually by the end of the decade. And that’s on an annualized 20-quarter moving average basis, meaning that productivity growth is accelerating now since this figure rose to 1.8% during Q4-2024 (Fig. 18).

As population and labor force growth wanes, productivity will be the source of real economic growth. Indeed, productivity is highly correlated with real wage growth because in a competitive labor market, workers are paid their fair wage in real terms. So with the economy potentially settling in at full employment, more productive and better paid workers will drive rising consumer spending going forward. Here’s more:

(1) Not more labor, but more productive labor. Productivity increases when workers produce more output for every hour they work. That productivity rate times the total number of hours worked equals real GDP growth. However, the rate of growth for aggregate weekly hours has slowed, and we wouldn’t be surprised if it slows even further through the end of the decade (Fig. 19). Fewer new employees and shorter workweeks will become the norm.

(2) Productivity and labor costs. Productivity growth declined from 2.1% to 1.6% y/y in Q4, while unit labor costs (ULC) increased from 2.2% to 2.7% y/y. Both represent changes in direction due to a big decline in durable manufacturing output amid higher hourly compensation.

We expect the trends in both (i.e., higher productivity growth, lower ULC inflation) to resume this quarter. Falling auto inventories and stalled auto production dragged down real GDP growth last quarter. As the latest labor force revisions are factored into growth data, we expect an upward revision to output to raise productivity growth and lower ULC inflation. Nonetheless, manufacturing productivity appears to be growing for the first time since the Great Financial Crisis (Fig. 20).

(3) Investing in capital. An economy at full employment means it is difficult and costly to hire new workers, so businesses are encouraged to invest in technologies to augment their workforce. Entrepreneurship also encourages productivity, and we’ve seen a boon in new business creation since the pandemic (Fig. 21). In our opinion, the normalized-interest-rate environment makes it difficult for so-called zombie companies to stick around and artificially boost capacity, instead inspiring actual innovation. Federal Reserve Governor Adriana Kugler highlighted both of these as factors driving the productivity boom in a speech on Friday.

The latest technological innovation is artificial intelligence. AI is much more likely to creatively disrupt services-providing and white-collar employment than production and supervisory workers, in our opinion. But because there is a shortage of highly skilled labor, this innovation will do more to alleviate labor cost pressures for employers and to benefit employees by making them more productive than it will to eliminate jobs and create an oversupply of workers. Indeed, we’re optimistic that AI will create more jobs than it displaces, or at least not raise the unemployment rate. In our base-case productivity-led Roaring 2020s scenario, American workers and consumers will prosper to a degree they haven’t in decades.

Movie. “Mothers’ Instinct” (2024, ++) stars Anne Hathaway and Jessica Chastain as neighborly mothers with sons who are the same age and best friends. When one of the boys dies in a terrible accident, the friendship of the two mothers is strained. More deaths are ahead as the plot thickens and suspicions mount. One of the mothers is a psycho, but which one? The film (and its musical score) is an homage to the directing style of Alfred Hitchcock. The two leading ladies deliver superlative performances. (See our movie reviews archive.)

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Palantir, Semis & Tesla’s Big Year

February 6 (Thursday)

Information Technology I: AI Software Reigns. Palantir is known for providing software to the US government, so when its AI business with corporate America accelerated sharply, surprised investors sent its shares surging higher. Companies are using Palantir’s AI software to cut costs and become dramatically more efficient. “AI is a pivotal component in driving innovation and efficiency, something companies need to embrace or fall behind,” said Palantir’s Chief Revenue Officer Ryan Taylor on its February 3 earnings conference call.

Palantir’s Q4 total revenue increased 36% y/y to $828 million, and revenue from its US government business grew 45% y/y to $343 million. But it was the 64% y/y jump in revenue from Palantir’s US commercial business, to $214 million, that captured investors’ attention. The company expects 2025 total revenue growth of 31% y/y, the midpoint of its estimate range. Palantir’s shares surged 24.0% on Tuesday to $103.83, far outpacing the S&P 500’s 0.72% gain.

Palantir executives shared some interesting perspectives on its conference call about large language models (LLMs), corporate adoption of AI, the unofficial US war with China, DeepSeek, and the Trump administration’s new Department of Government Efficiency (DOGE). Here’s a look:

(1) Palantir on LLM commoditization. Palantir has benefitted from the plethora of LLMs that have entered the market. LLMs are being commoditized as they grow more similar and the price of inference drops “like a rock,” said Chief Technology Officer Shyam Sankar on the conference call. That benefits the companies that use LLMs, like Palantir; but it hurts companies that make LLMs, like Alphabet’s Google.

Alphabet announced on Tuesday that its capital expenditures would increase to $75 billion this year, up nearly 50% from $52.5 billion in 2024. It’s not the only company spending like a drunken sailor. Microsoft plans to spend $80 billion on capital expenditures in its fiscal year ending June, up from $55.7 billion the prior year. It said most of the funds would be used to build AI infrastructure. Conversely, Palantir spent only $12.6 million on capex last year and didn’t state its plans for 2025. Ballooning capex spending on AI and related infrastructure has raised concerns about whether the big spenders will ever earn a reasonable return on their investments.

(2) Palantir on the power of its AI programs. Palantir executives illustrated how companies are deploying Palantir’s Artificial Intelligence Platform (AIP) to save time, increase efficiency, and cut costs with examples including:
A global insurance company’s two-week underwriting process was reduced to three hours.
A multinational bank’s back-office processes were shortened from five days to three minutes.
An engineering and construction firm now identifies risks culled from large technical documents in minutes instead of months.
Rio Tinto uses AIP to coordinate 53 driverless trains, improving throughput and safety.
Palantir is also using AI in its Warp Speed operating system to improve manufacturing. The software optimizes production schedules, reduces bottlenecks, streamlines engineering changes, automates visual product inspections, enhances material resource planning, and provides a unified interface connecting multiple systems.

(3) Palantir on DeepSeek & China. The folks at Palantir believe that the war between the US and China has already begun, pointing to the LLM DeepSeek as the latest evidence. Sankar described the engineering of DeepSeek’s R1 as “exquisite.” He concludes: “[We] have to wake up with the respect for our adversary and realize that we are competing. But they absolutely did steal a lot of that through distillation of the models.”

The AI race between the US and China is just the latest battle in the war that began when China entered into the World Trade Organization, said Sankar. Other battles include the opium war (fentanyl is the leading cause of death among 18- to 45-year-olds in the US), the diplomatic war (Belt and Road initiatives span the globe), and aggressions by the Chinese Communist Party that fall short of open warfare (e.g., Chinese ships are suspected of cutting underseas communications cables).

(4) Palantir on DOGE. Sankar sounded optimistic about Elon Musk’s leadership of DOGE, with good reason: Palantir stands to benefit if the government uses more of Palantir’s products to become more efficient. “[T]the work that we’ve done in government, it’s deeply operational, it’s deeply valuable, and we’re pretty excited about exceptional [DOGE] engineers getting in there under the hood and being able to see that for a change,” said Sankar.

(5) Investors’ new AI darling? Palantir joined the S&P 500 last fall as a member of the Application Software stock price index, which has climbed 9.7% over the past year, hitting a new high late last year (Fig. 1). The industry’s revenue growth has been extremely steady: 11.1% in 2024, 10.8% in 2025, and 11.1% in 2026 (Fig. 2). Earnings growth has decelerated from 29.2% in 2023 to an expected 12.6% this year and 14.5% in 2026 (Fig. 3).

The industry’s forward P/E has fallen a bit over the past few years, but not Palantir’s. The Application Software industry’s forward P/E is 34.4, down from a recent peak of 53.8 in November 2021 (Fig. 4). That looks like peanuts compared to Palantir’s forward P/E of 189.2—more than triple its P/E in mid-2024 (Fig. 5). Watch out, Nvidia, the stock market may have adopted a new darling.

Information Technology II: Semi Stocks Are Cheaper Now. A handful of semiconductor companies have reported mixed quarterly earnings results over the past few days.

Advanced Micro Devices shares fell 6.2% on Wednesday—bringing their one-year decline to 35.7%—even after reporting a 69% jump in chip sales to data centers. The segment’s $3.9 billion of revenue missed analysts’ $4.1 billion forecast. The reaction may be overdone given that the company posted 24% Q4 revenue growth and 43% adjusted operating income growth.

In the December quarter, Qualcomm's revenue rose 17% y/y, and its adjusted earnings per share jumped 24% to $3.41, beating analysts' estimates. Shares of the cell phone chip manufacturer fell roughly 4.5% in aftermarket trading on Wednesday, giving back some of the 14.5% ytd gains the shares had enjoyed.

Infineon Technologies, a German semiconductors manufacturer for auto and industrial use, reported an 8% y/y decline in December-quarter sales. Despite the decline, investors may be signaling that the worst is over because the shares have climbed roughly 13% over the past two days and are up 24.9% from November’s low.

Nvidia shares have tumbled 17.2% since their January peak, spooked by news that China’s DeepSeek managed to develop a competitive AI offering without spending billions on Nvidia’s most advanced chips. However, some have speculated that DeepSeek did have access to at least some of Nvidia’s highest-end chips and essentially used distillation to steal ChatGPT’s knowledge. Also reassuring for Nvidia investors has been the planned capex announced by Google and Microsoft, a sign that chip spending will continue. Nvidia’s shares have climbed 4.0% so far this week (through Wednesday’s close).

Nvidia’s recent downdraft has taken some of the excess out of the S&P 500 Semiconductors index’s valuation. While analysts expect the industry to produce robust earnings growth of 45.5% this year, its forward P/E has fallen to a more reasonable 25.6 from a recent high of 49.7 on June 19, 2024 (Fig. 6 and Fig. 7).

Disruptive Technology: Tesla’s Big Year. Ever effusive, Elon Musk recently said 2025 may be the most important year in Tesla’s history. The company plans over the next 12 months to introduce unmanned autonomous vehicles in the US, to produce Optimus humanoid robots, and to produce a semi-trailer truck.

Musk needs investors to focus on the future because sales of Tesla’s electronic vehicles (EVs) have slowed. Last year was the first time that the number of Teslas sold worldwide declined. In Q4, Tesla’s automotive revenue fell 8% y/y to $19.8 billion, its total operating income dropped 23% y/y to $1.6 billion, and the operating margin contracted to 6.2% from 8.2% a year earlier as the company cut prices to move inventory. Sales may fall further if President Trump successfully eliminates the rebates that EV buyers receive.

Nonetheless, Musk sounded optimistic during the company’s recent earnings conference call: “I’m highly confident that all transport will be autonomous electric, including aircraft, and that [the transition] simply can’t be stopped any more than one could have stopped the advent of … the internal combustion engine.” So far, investors are going along for the ride. The company’s stock price remains near its record high, and its forward P/E is a lofty 129.8 (Fig. 8 and Fig. 9).

Here’s a look what Musk had to say about Tesla’s 2025 product launches as well as the competition Tesla faces.

(1) Full self-driving arriving. Autonomous vehicles and humanoid robots have the same problem: Both require huge amounts of AI training that consumes vast amounts of computer processing. Yet both products are massive opportunities for Tesla. Optimus has the potential to generate more than $10 trillion in annual revenue, Musk said.

Tesla expects to launch in June unsupervised full self-driving (FSD) cars as a paid service in Austin, using Tesla’s fleet of cars. That will be followed by unsupervised FSD in California and in other regions this year and in all of North America in 2026. Next year, private Tesla owners will be able rent out their vehicles by adding them to the fleet of company-owned Teslas available for hire.

Also happening this year: Tesla owners will be able to use their FSD mode without watching the road (currently, they can use FSD but must keep their eyes on the road). During Q4, Teslas using Autopilot experienced one crash for every 5.9 million miles driven compared to the US average of one crash every 700,000 miles.

Internationally, the rollout of FSD is being delayed by “regulations and bureaucracy” in Europe and by the Chinese government, which won’t let Tesla train its software in China. Instead, Tesla is training its FSD software on videos of China’s streets that are publicly available. Musk estimates that unsupervised FSD will be available in most countries by the end of next year.

Tesla currently has thousands of unsupervised FSD cars operating at its California factory. Musk said other automakers are interested in licensing Tesla’s FSD technology, realizing that they’ll need to offer this feature to remain competitive.

(2) Optimus arriving. Optimus humanoid robots require even more training than autonomous vehicles due to their varied uses and complexity. Fortunately, the cost of training is dropping “dramatically,” said Musk. By year-end, Tesla should have several thousand Optimus robots working in its factories on the most boring, tedious, annoying, and dangerous tasks. We’ll be interested to see if profit margins improve when the company no longer has to pay humans for this work.

Tesla may start delivering Optimus robots to customers in 2H-2026. Once production rises to one million robots a year, the cost of production will fall to $20,000 per robot or less, and the robot’s price will be determined by market demand.

(3) Commercial trucks coming too. Telsla’s electric semi-trailer truck factory in Reno is under construction, and the first few semis are expected to roll off the production line late this year. With more truck drivers leaving the profession than joining it, there’s a need for autonomous trucks, which could grow into a $10 billion to $12 billion a year business for Tesla, Musk said.

(4) Tesla faces competition. As we discussed in the August 8 Morning Briefing, Tesla faces international competition. In China, Shanghai Qingbao makes robots used in tourism and conventions, and UBTech’s robots are on NIO’s EV factory floors, a February 4 South China Morning Post article reports. Unitree Robotics’ robots recently went viral dancing during China’s Spring Festival Gala.

At home, Figure AI has robots set for BMW’s factory floors later this year, and Boston Dynamics’ Atlas continues to improve. It can now analyze and adapt to its surroundings, functioning on its own without any preprogrammed sequences or remote control, as it reportedly did in this video.

The most recent addition to the party: OpenAI. The company filed a trademark application on January 31 for hardware that includes headphones, goggles, glasses, remotes, laptop and phone cases, smartwatches, smart jewelry, and virtual and augmented reality headsets, a February 3 PYMNTS article reported. The application also mentioned robots, and OpenAI has begun putting together a robotics team—of human hires (for now?).

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Investing Outside The Mag-7

February 5 (Wednesday)

Strategy I: Digging for Value in US Stocks. Our equity market preferences have been heavily biased toward US large-capitalization stocks for the past few years and remain so. We’ve preferred the Stay Home investment style—i.e., overweighting US stocks in global portfolios—over Go Global, which we’ve recommended underweighting since at least 2010. While ex-US developed market indexes look cheap on a relative valuation basis and may even have spurts of outperformance relative to US stocks, that’s been the case since roughly 2009. At the moment, we see don’t see enough fundamental economic reasons to inspire us to go neutral on the US and upgrade foreign markets.

Within the US, we still like the LargeCaps, but have grown increasingly interested in the S&P 493. We think there’s room for the ex-Mag-7’s collective profit margin to expand as productivity increases and the high-tech solutions (i.e., artificial intelligence, automation, etc.) utilized and churned out by the Mag-7 firms are implemented (Fig. 1). To be clear, we do not believe the Mag-7 are grossly overvalued—in fact, we think their current collective forward P/E of 29.4 is supported by strong profit margins and earnings growth expectations. However, we see room for the S&P 493 to outperform as its collective multiple expands above 20 times forward earnings (Fig. 2).

That's not to say that we have S&P 500 blinders on. In fact, we believe that the US MidCaps (represented by the S&P 400) present an interesting opportunity, especially for investors who share our optimistic outlook for the US economy and markets. We'll also touch on the possible opportunity in Value stocks.

Here’s more on how we’re thinking about US equities:

(1) A smidge of SMids. For much of the Federal Reserve’s latest tightening cycle, it’s been an S&P 500 story with seven main characters. Indeed, it’s been tough sledding for SMidCaps as far back as Trump 1.0. The S&P 400 and 600 have both been trounced by the S&P 500 (Fig. 3). Part of that story is that SMidCaps tend to have more leverage and less resilient cash flows, so two Fed hiking cycles and a pandemic took their toll.

It’s also a Growth versus Value story, as SMidCaps tend to trade at cheaper valuations given their sector composition (lighter on the new economy tech-y industries, heavier on the old economy sectors like Industrials), greater earnings uncertainty, and survivorship bias. Both the SmallCaps and MidCaps are trading around 16 times forward earnings versus the S&P 500’s 21.8 (Fig. 4). The best performing smaller stocks have often been Growth names that either grew into the S&P 500 or were picked off in a buyout by an S&P 500 company. So perhaps SMidCaps are just a big Value trap that should be avoided at all costs? We think that applies broadly to SmallCaps, but not so much for MidCaps.

(2) Not-so-mid Mids. The S&P 400’s forward earnings per share (EPS) is just a touch away from notching a new record high for the first time in 33 months (Fig. 5). The S&P 600’s forward EPS has plateaued at 11% below its 2022 record high and shows few signs of acceleration.

Analysts expect MidCaps’ earnings growth to be strong this year (13.7%) and next (16.5%) after a 1.5% dip last year (Fig. 6). We believe last year’s poor earnings have rendered MidCaps unappreciated by the broader investor community.

(3) Buy the dip? We’re still in buy-the-dip mode for the US LargeCaps on the basis of volatile macro news but solid fundamentals. (The same goes for Super Bowl hors d’oeuvres, especially since the tariffs on Mexican goods won’t be taking effect.) But beware of apparent dips that are actually traps. US Value stocks might be a case in point.

Part of the S&P 493 is indeed Value stocks. Within this cohort, we broadly favor cyclical sectors such as Financials, Industrials, Consumer Discretionary, Information Technology, and Communication Services (in no particular order). We would also avoid overly cheap plays (Fig. 7).

It can be tempting to dip into names trading cheaply relative to fundamentals when Growth has done so well for so long and the spread in valuations is so wide (Fig. 8 and Fig. 9). Active portfolio managers can certainly find good buys in this pile, and we would suggest identifying companies that have the highest opportunity to replace labor costs with automation and/or higher productivity and thus to expand profit margins. But from a factor perspective, we’d hesitate to rotate into broad-based Value.

To those managing global portfolios, we understand that the MSCI World ex-US is trading below 14 times forward earnings (Fig. 10). And plenty of Value stocks in the Eurozone trade below 10 times forward earnings. Combing through underappreciated stocks may produce strong returns; cigarette butts are often still smokable. But we do not see the caliber of fundamentals to suggest longer-term outperformance.

Strategy II: Financials Shine Among Q4 Reporters to Date. Through midday Tuesday, just over 41% of the S&P 500’s companies have reported fiscal Q4 earnings. Among the 211 companies that have reported so far, the aggregate revenue and earnings beats relative to analysts’ consensus estimates are 1.3% and 6.6%, respectively (Fig. 11 and Fig. 12).

We have more Q4 data in hand for some of the S&P 500 sectors than others at this point. Two-thirds of the companies in the S&P 500 Financials sector have already closed their books on Q4, for example, but less than 10% of firms in the Utilities sector have done the same. However, enough data has been reported to begin seeing takeaways about the quarter for the S&P 500, a few sectors, and the Magnificent-7.

The results to date combined with the Trump 2.0 policy agenda particulars suggest a higher growth path ahead for the Financials sector. Below, Joe compares the sector’s Q4 results with those of the S&P 500 companies and the four Magnificent-7 companies that have reported so far.

(1) A breakout quarter for Financials? The firms in the S&P Financials sector collectively overshot analysts’ consensus earnings estimate by 12.1%--the sector’s biggest earnings beat since Q3-2021—outperforming the S&P 500’s Q4 earnings beat reported to date (Fig. 13 and Fig. 14). Financials, primarily viewed as a Value sector, bested its consensus revenue estimate by 2.0%, also ahead of the S&P 500.

In another solid performance for the sector, a record-high 89.8% of the firms recorded higher Q4 revenues than in the year-earlier quarter (Fig. 15). Looking at the bottom line, Q4 earnings rose y/y for 85.7% of the sector (Fig. 16). That’s the highest percentage of companies with earnings growth since Q2-2021 and ranks among the best readings in the 60-plus quarters since the Great Financial Crisis.

(2) Financials’ strength casts shadow over early Mag-7 results. Four of the Magnificent-7 companies have reported Q4 already. Tesla undershot estimates on both the top and bottom lines, but it did manage to eke out single-digit y/y percent gains in those measures (notwithstanding all the Tesla Cybertrucks on the road). Tesla’s weakness dragged down the Mag-7’s aggregate surprise and y/y growth numbers, causing the group to be a negative contributor to the overall S&P 500’s revenue and earnings surprise metrics among reporters so far. However, the Mag-7 remains a net positive contributor to the S&P 500’s y/y growth rates in revenues and earnings.

The S&P 500’s revenue surprise of 1.3% improves to 1.4% when the Magnificent-7’s revenue surprise of just 0.3% is excluded. Likewise, the S&P 500’s earnings surprise improves to 6.9% from 6.6% when the Mag-7’s 5.7% surprise is excluded. Looking at their y/y growth rates, S&P 500 revenues growth drops to 3.0% from 3.6% when the Magnificent-7 (8.6%) is excluded. Earnings growth drops to 11.1% from 1.5% with the Magnificent-7 (16.9%).

(3) New era ahead for Financials and US? We think the Financials sector’s strong performance in Q4 is a sign of better times ahead. Trump 2.0 promises to be a growth catalyst for the sector as regulatory restraints are released. President Trump’s announcement on Monday of the creation of a Sovereign Wealth Fund could be a positive for the industry too. How it will be funded remains to be seen, though initial indications suggest a plan to monetize the asset side of the US balance sheet. As government agencies and offices are closed for good, there will be physical assets left over to deal with.

This reminds us of the Resolution Trust Corporation (RTC). The RTC liquidated assets from failed financial institutions; it was a temporary government-owned agency created in 1989 by the Financial Institutions Reform, Recovery, and Enforcement Act (a.k.a. FIRREA) and operated until 1995.

Strategy III: S&P 500 January Revisions Activity Stable, But Few Leaders. Early this week, LSEG released its January snapshot of the monthly consensus earnings estimate revision activity over the past month. While the company provides raw data for all its polled measures, we focus primarily on the revenues and earnings forecasts, captured in our S&P 500 NRRI & NERI report. There, the analysts’ estimate revisions activity is indexed by the number of upward revisions in forward earnings less the number of downward ones, expressed as a percentage of total forward earnings estimates. We look at this activity over the past three months because that timespan encompasses an entire quarterly reporting cycle. Since analysts’ tendency to revise their estimates differs at different points in the cycle, three-month data are less volatile—and misleading—than a weekly or monthly series would be.

Joe highlights what’s most notable about the January crop of earnings revisions data below:

(1) S&P 500 NERI negative for a fifth month. The S&P 500’s NERI index, which measures the revisions activity for earnings forecasts, was negative for a fifth straight month, but ticked up to -1.8% from an 11-month low of -1.9% in December (Fig. 17). A zero reading indicates that an equal number of estimates were raised as were lowered over the past three months. January’s -1.8% is an improvement from its year-earlier reading of -3.8% and is nearly spot on with the average reading of -1.9% seen since March 1985 when the data were first calculated.

(2) More sectors have positive NERI than a year earlier. Three S&P 500 sectors had positive NERI in January, down from four sectors in December. But that’s up from just one sector with positive NERI a year earlier in January 2024, when Energy made a brief appearance above ground level.

Financials’ latest readings were best in class among the S&P 500’s 11 sectors (Fig. 18). This sector’s NERI was positive for a 12th straight month and at a 35-month high of 7.9%. Among the poorer performing sectors, Industrials’ NERI dropped to a 24-month low, followed by the NERIs of Materials (at a 22-month low) and Health Care and Information Technology (both 12-month lows). Tech’s NERI turned slightly negative for the first time in 13 months.

Here’s how the NERIs ranked for the 11 sectors in January: Financials (8.0%, 35-month high), Communication Services (6.3), Utilities (0.6), Information Technology (-0.2), Real Estate (-1.5), S&P 500 (-1.8), Consumer Discretionary (-2.6), Industrials (-4.2, 12-month low), Health Care (-4.6), Consumer Staples (-8.8), Energy (-9.5), and Materials (-11.1).

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Trump’s Tariffs: The Art Of The Deal

February 4 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Geopolitics I: What Trump Wants from Canada & Mexico. It’s become abundantly clear to Melissa, Eric, and me what President Donald Trump wants from Mexico. To Trump, Mexico is a looming security threat. In his view, the country must reclaim control over the drug trade and the migrant flows spilling over the southern US border. His demand is simple: curb the cartels and stem the flow of illegal substances. But there’s more to it—Trump is furious that Chinese companies are increasingly using Mexico as a gateway to sidestep US tariffs. For Trump, Mexico’s economic proximity to China is an unacceptable strategic liability.

But what does Trump really want from Canada? That’s less obvious. The dealmaker-in-chief has an end in mind beyond the revenues from the 25% tariffs slapped on Canadian and Mexican goods (10% for Canadian oil).

A closer examination of this administration’s foreign policy blueprint hints at an overarching objective of economic and national security. For Trump to secure the US’s energy future, he needs the Western Hemisphere to function as a coherent energy bloc. This means both a reliable, unimpeded flow of oil and natural resources from Canada and a safer Mexico. And that means both countries under the US’s thumb.

Let’s break it down:

(1) The first global trade war punch. Trump’s recent flurry of tariffs is a textbook example of his “America First” foreign policy.

In late January, Trump fired a 25% tariff salvo at Colombia, punishing the nation for failing to control its citizens illegally present in the US. Colombian President Gustavo Petro initially brushed off Trump’s threats. But he quickly backed down, acknowledging publicly his responsibility for his country’s undocumented citizens. Why the sudden 180?

Trump had sent an unmistakable message on social media: “FAFO” (standing for “F*** Around, Find Out”) accompanied by an AI-generated image of a steely-eyed Trump in a gangster-style fedora. Leaving to the imagination what happens when one disrespects US interests packed a more powerful punch than any diplomatically worded retaliatory threat ever could.

Mexican President Claudia Sheinbaum earned a one-month pause on any tariffs after speaking with President Trump. She agreed to send 10,000 soldiers to the US–Mexico border to prevent the trafficking of fentanyl and other drugs, and assured Trump that Mexico is committed to stymying China. Speaking ostensibly to her domestic shareholders but using a Trumpian tone, Sheinbaum spoke about onshoring and “Made in Mexico” products. We think Mexico’s president is onboard with Trump 2.0 and the realignment of global trade/security.

(2) Canada’s strategic value. Unlike Mexico, Canada doesn’t pose a direct security threat to the US. It’s a peaceful, stable country with a population of just 38 million—roughly 10% of the US population—but one that controls vast tracts of resource-rich land.

Canada’s oil exports to the US make it an indispensable partner. It ships about 3.9 million barrels per day across the border, easily outpacing Mexico’s second-place 397,000 barrels. In fact, Canada is the largest foreign oil supplier to the US. Canadian and Mexican imports account for roughly 25% of the crude oil processed in US refineries. Trump’s tariffs on Canadian goods may appear as a protectionist move on the surface; but in reality, they’re a negotiation tactic aimed at asserting greater control over Canada’s most vital commodity, energy.

(3) The 51st state? Trump’s frequent suggestion that Canada should be the 51st US state has raised eyebrows in both Ottawa and Washington. Is it just bravado, or does Trump have a genuine vision for further integration with Canada? Given the current geopolitical landscape and Trump’s well documented tendency to push the envelope, we doubt this is idle talk. The tariffs are more than a mere trade measure; they are part of a larger bargaining strategy to bring Canada closer into the US orbit, especially when it comes to energy resources. Posturing aside, a North American security zone appears to be taking shape as of Monday afternoon.

It appears that Canadian Prime Minister Justin Trudeau, like Sheinbaum and Petro, has come to terms with the reality that not accepting the US’s demands would mean facing a dire economic future. Trudeau announced that tariffs would be paused for at least a month on the basis of a $1.3 billion border plan and a U.S.-Canada Joint Strike Force.

(4) The blueprint for US–Canada relations. Trump’s second term will likely be shaped by the Heritage Foundation’s Project 2025 mandate. This framework calls for a hemisphere-wide energy strategy that aims to reduce US reliance on foreign, often unstable, sources of fossil fuels.

In this context, Mexico and Canada become critical. The Project 2025 document states: “The [US] must work with Mexico, Canada, and other countries to develop a hemisphere-focused energy policy that will reduce reliance on distant and manipulable sources of fossil fuels. ...” If Trump is serious about achieving energy independence and security, Canada’s vast reserves and Mexico’s proximity to the US become indispensable components of this vision.

(5) Day One priorities. Trump’s goal isn’t just about curbing illegal immigration or stifling drug imports; it’s about reclaiming US sovereignty over energy and countering the destabilizing influence of external powers like China. Among Project 2025’s Day One priorities is tackling the proliferation of socialist and progressive regimes across the Western Hemisphere. The document also states that halting the fentanyl crisis—largely facilitated by Mexican cartels—is an urgent priority.

Reshaping US relations with its North American neighbors isn’t about dollars and cents; it’s about ensuring that the US holds the reins on global energy production and security—effecting a geopolitical recalibration.

Geopolitics II: Will Tariffs Boost Inflation? They didn’t in 2018, at least for US consumers. PPI finished consumer goods inflation averaged around 4.5% y/y from 2017-18, until the Federal Reserve’s monetary tightening started to weigh on price pressure in 2019 (Fig. 1). Yet CPI and PCED goods inflation remained subdued. Services inflation across measures failed to breach 3.0% y/y during Trump 1.0 as well (Fig. 2). Ultimately, substitution and shifting consumer preferences can offset increases in the prices of certain goods.

All that said, goods deflation has been a major tailwind for the Fed’s latest rate-cutting campaign. Because services disinflation has been slow and may be stuck at levels higher than would be consistent with 2.0% overall inflation, a supply shock that raises good prices would likely raise interest rates. The biggest risk in this for the Fed is that inflation expectations become unanchored and rise above 3.0%.

But we’re less worried about tariffs sparking an inflationary spiral than we are about them weighing on economic growth. A global trade war that severely hurts economic growth would be among the worst-case scenarios. However, it remains in our lowest-subjective-probability (20%) “what could go wrong” bucket. That’s because, in our view, it is better to think about such a shock as a tail risk with large consequences rather than a high probability event. So let’s dig deeper into the possible inflationary impact of tariffs:

(1) Inflation expectations. President Trump has inherited a very different economy than he did in his first term. Then, the economy was still relatively stagnant in the wake of the Great Financial Crisis. Policymakers were worried about deflation, not inflation. Today, the economy is at full employment, inflation is elevated, immigration is slowing, fiscal conditions are very loose, and monetary conditions are relatively neutral. Consumers are fed up with inflation—so the margin for error is thinner. The New York Fed’s consumer survey shows expected inflation running at y/y rates between 2.7% and 3.0% over the next several years (Fig. 3). Treasury breakeven inflation remains historically normal, though a recent decoupling of its relationship with oil prices suggests that bond investors may be getting more worried about inflation (Fig. 4).

But tariffs may not feed through to inflation expectations unless there is substantial stimulus to demand.

(2) Demand. Tariffs during Trump 1.0 neither boosted overall consumer inflation nor dented demand. Personal consumption expenditures (PCE) across goods and services were normal throughout Trump 1.0 (Fig. 5). Durable goods spending fell negative in Q1-2019; however, the Fed was also reducing its balance sheet and raising rates during this time (so much so that the Fed overdid it and reversed course later that year).

Lower tax rates are a form of stimulus, but the delta from a 21% corporate tax rate to 15% rate and the extension of the TCJA is dwarfed by Trump 1.0’s fiscal stimulus. If anything, the overall fiscal impulse is likely to decline. Given the ISM M-PMI’s latest rise into expansion above 50.0 and normalizing consumer demand for goods, we do not think demand will dramatically fall due to tariffs nor will it accelerate because of stimulus (Fig. 6). This would be somewhat of a Goldilocks outcome amid a reordering of global trade.

(3) Labor. We understand concerns about the cost of labor rising, as producers may have to shift from reliance on foreign workers to more expensive US labor, and many of the cheapest workers in America are either being deported or prevented/discouraged from entering the country. That said, labor costs weren’t a major issue during Trump 1.0 (Fig. 7). Despite record immigration over the southern border, labor costs soared during the Biden administration due to massive amounts of fiscal stimulus and monetary easing. We believe productivity growth will contain unit labor costs while boosting real wages as it rises toward 3.0% y/y (Fig. 8).

Also, more money to American workers means more spending power for American consumers.

(4) China. China’s exports are surging. China’s imports have plateaued for years (Fig. 9). Export-oriented economies like China rely on the US to consume their goods. That’s especially true for China these days given the Chinese Communist Party’s (CCP) attempt to export its way out of the economic malaise stemming from a property-market bust. Outside of certain critical minerals, the US is far less dependent on China than China is dependent on the US and its other trading partners.

While China could devalue its currency to offset the impact of tariffs—which we expect will be substantial once they are implemented (either late Q1 or in Q2)—the yuan is already nearing levels that risk capital flight (Fig. 10). Maneuvering around tariffs via Vietnam or Mexico is unlikely to prove as successful as it was during Trump 1.0 this time around. Unless China’s autocratic state completely reorders its economy, the burden to reach a “deal” by making concessions is much more likely to fall on the CCP than the US.

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Anatomy Of Gross National Product

February 3 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy I: The Year of the Consumer. The American economy put up impressive numbers in 2024. Much of the financial media chatter has focused on the advent of artificial intelligence (AI) and Trump 2.0. But lost in hullabaloo is the fact that the US consumer is powering the economy to new heights. We expect that the consumer will continue to do so in 2025.

We are big believers that improvements in automation, robotics, and data processing (i.e., AI and quantum computing) will continue to boost worker productivity, alleviate high-skilled labor shortages, and stimulate capital spending. We are also Trump 2.0 bulls, expecting deregulation and lower taxes to fuel more domestic investment, hiring, and consumption.

However, the strength of the consumer is the engine of economic growth. Indeed, personal consumption expenditures on goods (21.4%) and services (46.8%) make up 68.2% of US nominal GDP (Fig. 1).

Many hard-landers who had been calling for a recession over the past three years have thrown in the towel. But even more people now seem to be expecting an economic slowdown this year. The pervasive pessimism hinges on the consumer, specifically the prospect that consumer spending will slow as the result of weakening hiring, rising consumer credit delinquencies, depleted saving, and perhaps deportations.

Even if the consumer doesn’t buckle, Trump 2.0 trade wars might cause a recession after all. US export industries might suffer as America’s trading partners retaliate. American consumers and businesses will have to pay more for imported goods, parts, and materials. Tariffs are taxes, which could depress economic growth. But considering that the economy withstood the most rapid Federal Reserve tightening cycle in four decades without a slowdown, we are optimistic about its resilience to shocks.

Our base-case outlook remains our technology-driven, productivity-led Roaring 2020s scenario, with a 55% subjective probability. As a result, it’s more than likely that the current bull market in stocks is not nearing its final inning, nor even the seventh inning stretch. Our S&P 500 price targets of 7000 by year-end 2025, 8000 by the end of 2026, and 10,000 by the end of the decade remain intact.

Here's more on the sources of last year’s GDP growth and what we expect this year:

(1) New records. Last year, real GDP rose 2.8% to yet another record high of $23.5 trillion (saar), increasing 2.3% q/q (saar) in Q4 (Fig. 2). The quarterly slowdown in headline GDP growth from Q3’s 3.1% was largely due to volatile inventory investment. Importantly, real personal consumption expenditures (PCE) rose to a new record high, reaching $16.3 trillion after growing 4.2% (saar) in Q4 and 2.8% for the whole of 2024. That was the highest quarterly growth since Q1-2023 and up from 1.9% in Q1-2024. Real consumer spending on both goods and services rose to record highs last quarter (Fig. 3).

(2) Goods boom. Real consumer spending on goods jumped 6.6% q/q (saar) during Q4, led by a 12.1% leap in durable goods purchases. Perhaps some of the increase stemmed from consumers’ front-running potential tariffs. More likely, it was driven by year-end incentives that boosted auto sales. However, we note that durable goods consumption had been accelerating throughout the year. After falling 1.8% in Q1, real durable goods PCE increased 5.5%, 7.6%, and 6.6% in Q2, Q3, and Q4, respectively, to a new record high (Fig. 4).

Demand for goods, especially durables like autos and appliances, surged during the pandemic. So consumer demand that goods producers normally would have seen in 2022 and 2023 was pulled forward into 2020 and 2021. But consumers were back buying briskly during 2024 despite higher interest rates. This is one sign that higher-for-longer (or, in our view, normal-for-longer) interest rates won’t slow consumers’ purchasing of big-ticket items.

One tailwind for goods consumption has been deflation. PCED durable goods prices fell 1.1% y/y in December and have been falling since June 2023 (Fig. 5). However, nondurables prices are starting to increase, and durable goods prices are likely to follow. That's even before the Trump administration’s tariffs take effect. Goods inflation will weigh on inflation-adjusted real consumption. The question is how much rising prices impact demand. As of now, we aren’t expecting overall demand to decrease meaningfully. Still, a negative hit to growth from trade wars is in our “what could go wrong” bucket, to which we currently assign a 20% subjective probability.

(3) Incomes rising on all cylinders. Driving consumer spending has been real income growth. In December, disposable personal income (DPI) rose 5.0% y/y to a new record high of $22.1 trillion (saar) (Fig. 6). In real terms, DPI rose 2.4% y/y in December and has been increasing at roughly its pre-pandemic pace, if not a bit faster.

The historically tight labor market and rising productivity have fueled real wage gains, particularly for lower-wage workers, who represent roughly four-fifths of US employment. Their nominal wage gains have been outpacing inflation for nearly two years after stagnating for much of the early-to-mid 2010s (Fig. 7).

While the overall labor market has been red hot, the white-collar job market was much cooler over the past few years. Inflation eroded the wages and salaries of higher-wage workers for much of the post-pandemic period. Now, their real income growth is accelerating rapidly.

While higher-wage workers’ real wages fell during the pandemic, rising nonlabor income and a huge wealth effect from rapidly rising stock and home prices more than offset that. Interest, dividend, rental, and proprietors’ incomes all have risen to record highs, totaling $7.1 trillion (saar) in December (Fig. 8).

Nonlabor income has been a boon, particularly to the retiring Baby Boomers and high-income households, as have rising asset prices. A reduced need to save leaves even more after-tax income to be spent. That’s one reason that the savings rate is down to 3.8% as of December (Fig. 9). We expect it to turn negative over the remainder of this decade as retirees continue to spend without the benefit of any labor income.

Slowing immigration is likely to weigh on the growth rates of the labor force and technology-led productivity enhancers may and aggregate weekly hours. So it’s likely that real average hourly earnings growth and the wealth effect will be the main drivers of consumer spending over the next few years (Fig. 10, Fig. 11, and Fig. 12).

US Economy II: Investment Slowdown? While last year was a bright one for business capital spending, it finished with a whimper rather than a bang. For much of 2023 and 2024, government incentives and real business needs sparked a boom in nonresidential fixed investment, particularly in high-tech sectors and construction of manufacturing facilities. The weakness in Q4 was an anomaly in this respect, but we don’t expect it to be the start of a trend.

Technological innovation, of course, is a linchpin of our Roaring 2020s scenario, and we expect areas like software and research and development (R&D) to continue growing into a bigger part of the overall economy. The pro-tech, pro-business stance of Trump 2.0 and real demand for AI will continue to drive the high-tech investment boom that now accounts for more than half of US capital spending (Fig. 13).

While the Mangificent-7 tech companies will continue to shell out cash for new AI- and energy-related projects, the rate of growth for that spending may slow this year and next. However, we believe that slowing capex growth by the Mag-7 will be offset by hastening of the S&P 493’s collective investments in technology to augment the productivity of their workforces. Eventually, even small- and medium-sized businesses will be investing in AI-enabled products to increase productivity and efficiency. No doubt, venture capital and private equity firms will implement these technologies across their portfolio companies to boost profit margins.

Here’s more on the capital investment front:

(1) Temporary weakness in Q4. Overall economic growth was strong during Q4. Real final sales, which excludes business inventory investment, rose 3.2% q/q (saar) in Q4. Real private domestic demand—the Fed’s preferred measure of core real GDP, which excludes federal spending, business inventory investment, and trade—also rose 3.2%. However, these were mostly consumer driven. Real business investment rose just 1.5% q/q (saar) in Q4 and 1.7% for the whole year. Though it did reach a record high of $3.5 trillion (saar), annual growth was down from 3.2% in 2023 and 7.8% in 2022 (Fig. 14).

Intellectual property (IP)—which includes software, research and development (R&D), and entertainment, literary, and artistic originals—rose 2.6% q/q (saar) to a new high of $1.5 trillion (Fig. 15). However, annual growth was down from 5.8% in 2023 to 4.1% in 2024.

Capital equipment investment fell 7.8% q/q (saar), its worst quarter since the pandemic. On a y/y basis, it slowed marginally from 3.5% to 3.4%. However, we expect equipment investment to rebound this quarter as information processing equipment reaches a new record high alongside R&D and software investment (Fig. 16).

(2) Volatile inventories. Slower private inventories investment reduced real GDP growth by 0.93ppt in Q4 after dragging it down in Q1, largely due to inventory drawdowns by wholesalers and auto dealers (Fig. 17). We expect inventory investment to rebound during the first half of this year.

US Economy III: Trade Wars & DOGE. On Saturday, President Trump imposed tariffs of 25% on imports from Canada and Mexico. Chinese imports were slapped with an additional 10% tariff. These developments are bound to weigh on US economic growth unless trade negotiations between the US and these three trading partners move quickly to reverse the tariffs. Also weighing on the economy might be the Trump administrations moves to cut government spending through executive orders and the efforts of the Department of Government Efficiency (DOGE).
 
(1) Trade wars could weaken global economic growth. The US trade deficit impacted Q4’s GDP growth only minimally, but naturally it will be highly topical this year. Trade is not a large portion of US nominal GDP but invariably is interconnected with intermediate prices, labor costs, and the revenues of domestic producers. Given our optimistic outlook for the US consumer—especially relative to Chinese and European consumers—we do not expect tariffs to significantly reduce the trade deficit, which stood at $1.3 trillion (saar) in Q4 (Fig. 18).

YRI’s real global growth proxy accelerated to 3.8% y/y in Q4 (Fig. 19). It is simply the sum of real US exports and imports. It is currently growing about as fast as just before Trump 1.0 tariffs turned its growth rate negative in 2019. Trump 2.0 tariffs could turn it negative again.

(2) Government spending slowdown. Even if the Department of Government Efficiency (DOGE) manages to cut federal spending and therefore weigh on real GDP growth, we expect businesses and consumers will fill the gap. Deregulation and lower tax rates are likely to spur more hiring and investment in an economy already at full employment. That should drive increased productivity growth and real wage gains.

Movie. “Woman of the Hour” (2023, +) is another serial killer movie based on a true story. Too bad there is no shortage of films of this genre. This one is about Rodney Alcala, who appeared in 1978 on the television show “The Dating Game.”  He was captured in 1979 and identified as a serial killer for murdering numerous women and girls. Anna Kendrick is the director and stars in the movie. Beware of strangers taking your picture and striking up a conversation. Evil may lurk behind that charming veneer. (See our movie reviews archive.)

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