Q2 2025 Market Commentary

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The markets have had a steep sell-off over the first quarter of 2025. In our last commentary, we mentioned that valuations on the markets were high and we expected more volatility this year, and that has happened, and will likely continue. From its peak in early February, the Standard and Poor’s 500 Index (S&P 500) was down at its low on Monday, April 7th with a 21.4% decline, the technology heavy Nasdaq Index was down -27.4%, and the Russell 2000 Index, which comprises of small and medium sized companies is down -29.9%, according to William O’Neil & Company. The markets have subsequently recovered some of their losses over the following week. The markets have sold off due to high valuations, geo-political concerns, and concerns about tariffs. Financial markets hate uncertainty, and tariffs create uncertainty, and they reduce corporate profit margins as companies are forced to relocate factories from cheap areas to more expensive areas. Long term tariffs have the potential to bring back industry and jobs to America, but in the short term they will hurt corporate profits, and possibly increase inflation. In this commentary, we will discuss how low long market-sells usually last, how much damage is usually done, how large the inflationary impact of the tariffs could be, and highlight that the actual underlying economic data is still strong even though consumer confidence has taken a hit over the market sell-off.

Due to the market sell-off, consumer confidence has continued a yearlong decline and has hit its lowest point since 2022 (see chart below). However, the actual economy and consumer spending are still doing fine. CEO of Bank of America Brian Moynihan said on an interview with CNBC on March 27, 2025 that consumers at Bank of America were actually spending 5% more from their checking and credit card accounts at Bank of America this year than last year so far in 2025. He stated that the low consumer sentiment has not actually reflected what consumers are actually doing.

Other reports also confirm Brian Moynihan’s observations. For instance, another barometer for real-time spending can be found in weekly expenditures at restaurants. Though weak in February, restaurant spending was up 3.5% year over year as of March 30th, according to Bloomberg data drawn from credit- and debit-card transactions. Individual investors have also soured on the economy and the markets.

Individual investors who are bullish (think the market will go higher in the future) are also now back at levels of 2022, when the market was in its last major sell-off of over 20%. The good news here is that individual investors are almost always wrong on their market timing, and the fact that individual investors are bearish (think the market will go lower) is actually a positive indicator. The reason why individual investors being negative on the market is a positive signal is because if they are negative on the market, they likely have already sold their stocks and are waiting for a time to get back in, which creates future demand. Currently, almost 78% of individual investors are negative on the market, while 21.7% are positive (see chart below).

Even though consumers and investors are pessimistic, the underlying economic data of the economy remains solid. Indeed, rail traffic is currently up 4.5% year to date, which is a strong number. Part of these gains are from intermodal, which includes imports and exports, and may be higher as companies try to get ahead of tariffs. However, in general rail traffic is not showing signs of any economic slowdown and is in fact growing.

The trucking industry also serves as a barometer of the U.S. economy, representing 72.7% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods. In February, the American Trucking Association (ATA) advanced seasonally adjusted For-Hire Truck Tonnage Index equaled 115.2, up from 111.9 in January. The index, which is based on 2015 as 100, was up 0.6% from the same month last year, the second straight year over year increase, which hasn’t happened since early 2023. Moreover, the total truck tonnage increased 2.94% for the first two months of the year according to ATA Chief Economist Bob Costello, which also shows the economy is growing and solid.

The Labor Department Jobs Report on April 4, 2025 also showed that the underlying economy remains solid as nonfarm payrolls in March increased 228,000 for the month, which is another fine report and stronger than expected. More importantly, average hourly earnings increased an annual rate of 3.8%. This is important because the inflation rate last month dropped to 2.4% according to the last consumer price inflation report, which means real living standards increased at 1.4% at an annual rate last month.

Corporate earnings also suggest that the real economy is doing well. FactSet Corporation estimates that the total earnings as of March 31st will total $269.49 for the Standard and Poor’s 500 hundred largest U.S. companies (S&P 500) this year up from $243.02 last year. These earnings estimates have come down from $273 a share from December 27th, 2024, but still represents a robust 10.8% earnings growth rate led Artificial Intelligence spending. Moreover, earnings estimates are expected to continue for another double-digit earnings gain next year in 2026 (see chart below).

The S&P 500 stock indexed traded at 22.3 times earnings at the peak earlier this year, which is over the 18.6, 10-year average for S&P 500 price/earnings (PE ratio) ratios according to FactSet Research. It was also above the 19.8 and 13.3 two standard deviation band for price/earnings ratios we have seen over the last 35 years according to Charles Schwab Corporation.

If FactSet’s conglomeration of Wall Street’s earnings estimates for the S&P 500 are correct, and if the S&P 500 trades at its historical 10-year average of 18.6 times earnings, the S&P 500 should trade at a price level of 5,012, which is currently just 256 points or 4.8% below the current level of 5,268 as of April 10, 2025. Moreover, the good news is that the S&P 500 is now also trading at discount of 8.5% discount to the $5,718 (10yr historical PE ratio of 18.6 multiplied by $307.43 earnings estimate for next year) price target for calendar year 2026. So, the good news is that we are now no longer at high valuations, and are actually trading at a discount to next year’s earnings level, which should eventually bring support to the financial markets.

The fact that the underlying economy remains stable does not mean that the market will stop going down, but it does give indications on the potential severity of the sell-off. Additionally, since 1945 Guggenheim Research has done analysis that states once the S&P 500 goes down over 10%, the correction usually last 4 months (see chart below). We are now nine weeks into this sell-off. This means we have probably seen most of the damage from this current sell-off. Unfortunately, Guggenheim Research also states that once the market falls over 20% it usually takes a year to recover the losses. This alludes we will be in a volatile environment for a while. We would expect this sell-off to not be as severe as many major sell-offs in the past because it is rare to have a 20% sell-off in the market unless the economy turns down and there is a recession.

Since World War II, there have been only two market sell-offs in the S&P 500 of 20% or more not associated with a recession. The first 20% sell-off without a recession was in 1966, but earnings in the S&P 500 were down that year. Moreover in 1966, Vietnam and Johnson’s Great Society social programs began to push up government spending and inflation, so the Federal Reserve responded by tightening credit conditions early in 1966, which caused the markets to sell-off, and earnings to drop as companies borrowing cost increased. In the current market environment, earnings on the S&P 500 are expected to grow over 10%, and the market analyst and traders are actually pricing in Federal Reserve interest rate cuts for the year.

The second sell-off of 20% without a recession was the flash crash in 1987, which was driven by program trading. Market circuit breakers are now in place to prevent something similar from happening today.

There are other factors that could lead to a stabilization in the market, including the record amount of share buybacks expected to happen this year. Corporate America remains incredibly profitable and will use the down turn to buy back its own stock at reduced prices and increase future earnings. Citibank estimates that in 2025, there could be $1 trillion in cumulative stock buybacks, which would represent an 11% increase from the almost $900 billion in buybacks from 2024.

In addition, the Federal Reserve estimates that close to $7 trillion now resides in money market funds that have seen their interest paid out drop to close to 4%, from over 5% a year ago (see chart below). If the economy does slow down, the Federal Reserve will continue to cut interest rates, and thus money will then move back into the stock market looking for higher returns. Indeed, many utility stocks now pay more than 4% in dividends and may look attractive to investors in money market funds.

Another potential scenario is that the tariffs may bring investments back to the USA. On January 25th of this year Japan’s Softbank announced a $500 billion dollar investment to build AI infrastructure in the USA over the next 4 years, including $100 billion of investment to take place this year. Apple announced $500 billion dollars in USA investment and new factories over 10 years on February 24th. Taiwan Semiconductor has announced a $100 billion dollar investment to build another semiconductor factory in the USA on March 3rd. The United Arab Emirates announced a 10-year $1.4 trillion dollar investment in new AI infrastructure, $25 billion in energy investments, and the first brand new aluminum plant in the USA in 35 years on March 21st. Hyundai announced a new $20 billion auto factory in Georgia on March 23rd, and on March 24th, Siemens announced a new $10 billion investment in USA manufacturing to expand production. On April 14th, Nvidia announced a $500 billion investment in the USA over the next four years, including a new supercomputer factory in Texas. In total these announcements amount to $2.9 trillion dollars in investment since January.

Although the current administration has been vague on their trade strategy (which may be deliberate, to give them better negotiating leverage), current administration officials have given interviews and written papers which gives us clues to their intent, and how inflation might be affected. The current chair of the U.S. Council of Economic Advisors to the president, Stephan Miran, wrote a paper last November while he was chief strategist for Hudson Capital, a paper titled “A User’s Guide to Restructuring the Global Trading System”. In the paper, Miran wrote “In the macroeconomic data from the 2018-2019 experience, the tariffs operated pretty much as they will now. The effective tariff rate on Chinese imports increased by 17.9 percentage points from the start of the trade war in 2018, to the maximum tariff rate in 2019. As the financial markets digested the news, the Chinese Yuan (Chinese currency) depreciated against the dollar over this period by 13.7%, so that the after-tariff USD import price rose by 4.1%. In other words, the currency move offset more than three-fourths of the tariff, explaining the negligible upward pressure on inflation.”

Statista reports that the average annual tariff level in the United States was 2.5% in 2024, and under the new minimum tariff levels, this will increase to 10%. The USA currently imports $3.3 trillion a year according to Statista, which represents about 10.8% of the $30.34 trillion U.S. economy. Of this total import amount, China represented 13% of total imports or $438.9 billion. On Saturday, April 12th, smart phones, computers, and servers representing about 22% of China’s exports or $96 billion dollars were exempted from the reciprocal tariffs, and the remaining $342 billion of Chinese exports (or 10% of the total American imports would face the higher reciprocal rates). Thus, if we assume that the rest of China’s exports are eventually taxed at a still high 50% level, we can estimate an approximate inflationary impact. The formula would be a 7.5% tariff increase on 90% of total imports, a 47.5% increase on 10% of imports, multiplied by 10.8%, which is imports share of U.S. economy. This number comes to 1.15% increase in inflation, which when added to the current 2.4% rate of inflation would bring the annual inflation rate up to 3.55%, or similar to the annual rate last February, but still almost 50% more than the current rate.

However, as Walmart, Costco, and Target have already publicly told suppliers, they want NO price increases. In effect, they want the overseas suppliers to take the earnings cut. Moreover, if other countries do devalue their currencies the price increases could be less.

Interestingly, Treasury Secretary Scott Bessent has announced that 70 countries have approached the U.S. to renegotiate trade deals with America, which suggest that these higher level of tariffs may not be permanent. What is also interesting is that in an interview with Real Clear Politics on April 4, 2025, Bessent said that he would like to divide the world into three trading groups. The first group would be the GREEN GROUP, which would receive little to no tariffs with the U.S. and vice versa. This group would mainly include allies that have defense treaties with the U.S., where both nations are pledged to come to each other’s defense and would include countries like Canada, Japan, Australia, New Zealand, and NATO countries. The second classification would be the YELLOW GROUP, which would be a higher tariff and include friendly countries like Brazil, but whom the U.S. does not have a defense treaty with. Lastly, the RED GROUP would be countries that are hostile to the U.S. like Iran and China and would receive the highest tariff rates. In addition, if any country wanted to stay in the green group, they would also have to have high tariffs on China and Iran as well so that those countries could not circumvent U.S. tariffs or sanctions by exporting their products to a third country and then reexport products to America.

Perhaps the biggest obstacle to securing a new trade treaty will be China, due to its enormous size and power. However, there are many cracks appearing in the Chinese economy which suggest that maybe the U.S. and China could come to some agreement. Due to China’s one child policy, the population of China has been declining for working age Chinese for over 8 years, which has led to higher wages for Chinese workers, taking away some of China’s cost advantages.

The biggest problem in China is their overpriced and declining real estate market. Their market imbalance dwarfs the financial crisis that America experienced in 2008-2010. The cost to buy a new apartment in urban China is 29 times the average salary, compared to the average salary for the median home in the U.S., which is 5.5 times salary. Newsweek reports that 70% of China’s wealth is tied to real estate because the country has very strict capital controls which disallow money to leave the nation. Newsweek also reports that since many Chinese do not trust their own stock market, they invest surplus capital into Chinese real estate with many middle and upper class Chinese citizens owning multiple apartments. This has now led to a situation where Newsweek estimates that between 65 to 80 million apartments in China now sit empty, or more than enough to house the entire population of Brazil. Worse, since 40% of China’s bank loans are tied to real estate, they could face a major capital crunch.

The Chinese banking sector had $58.54 trillion of assets as of August 25, 2024, with an economy the size of $19.53 trillion. By comparison, the U.S. banking system has assets of $23.7 trillion for a $30.34 trillion dollar economy, which shows how much more leveraged the Chinese banking system has become. In the book Red Capitalism by Carl Walter and Fraser Howie, these former investment bankers detail how China is able to keep its banking system going even with high levels of non-performing loans. Namely, China uses its banks to finance growth in unproductive investments like empty apartment buildings, or redundant airports which fuels massive GDP growth, and then funnels export earnings to make cash injections to its second tier banks, which can then use that cash to buy bad debt of its top tier banks. Since the People’s Bank of China (China’s central bank) has set a very low 6.6% reserve requirement for loans in China (the U.S. has a 10% requirement), the Chinese government can funnel $6.6 million dollars into a second tier bank, and then buy $100 million of bad loans from the first tier bank. The first tier bank can then turn around and make new loans. Since many of the bad loans are to Chinese state-owned companies, the loans get an “A” investment rating even if they make no or minimal payments. However, this system breaks down if there are no export earnings.

The Chinese government may also be willing to compromise on a trade treaty because China is likely already in a recession. The official growth estimates this year in China calls for 5% economic growth, but as Gao Shanwen, chief economist at SDIC Securities and a former official at China's central bank, has famously said, “Chinese officials do not believe their own growth estimates.” Indeed, any first-year economic student can tell you that with China’s current inflation rate of -0.70% (yes deflation), and a 10-year bond rate of 1.66%8, the country is likely in recession right now.

In conclusion, we believe that the next several months will continue to be volatile for the financial markets. Corporate profits are still growing nicely, and economic activity is solid, so we do not see a recession at the current time. Unfortunately, geo-political fears, and tariffs fears will continue to cause uncertainty, and likely lead to slower growth. The tariffs also could potentially lead to a higher than expected drop in corporate profits and higher inflation. Notwithstanding this, we believe that the bigger underlying problem in the markets was the high valuations that we started the year with, and the good news is that we are now back to historically fair valuations after this sell-off. This in time will set up a recovery in stock prices in the future, but we are still too early in the sell-off for that to happen right away. As a result, we continue to like large capitalization, brand name companies who provide goods and services that consumers and businesses use on a daily basis and are returning cash back to investors from either dividends or stock buybacks as the best way to deliver positive risk adjusted returns. Thank you for your continued support.

Sincerely,

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