A “Tarrif-fying” Ride | Steve Henderly, CFA
Printer Friendly PDF: May 2025 Commentary
Game theory is the study of strategic interactions between individuals or groups. It provides mathematical models to analyze competition, cooperation, negotiation, and conflicts. Game theory is also a useful framework for predicting behaviors of individuals where everyone is trying to outsmart each other. For example: In blackjack, players share a common opponent (the dealer) but make individual decisions. Inexperienced players often make suboptimal choices, such as flipping another card despite a mathematically strong hand. These “sub-optimal” decisions alter card flow for all the other players which can be frustrating. Dating back to President Trump’s first term, game theory is often cited when trying to explain or understand his unpredictable, sharp departures from established norms.
Is game theory at work in the current approach to tariffs? We must trust (hope?) there is an endgame, but whether the approach will be successful in either the short- or long-term is unknowable. We do know the volatility it created for financial markets over the last month was jarring. “Liberation Day” might more appropriately be labeled “Liquidation Day”. Markets voiced their disapproval of ‘reciprocal’ tariffs loudly via a swift selloff over just four trading days with the S&P500 briefly dipping into bear-market territory on April 8, defined as a drawdown of -20% or more (from the YTD high on 2/19). Yields on US bonds, widely viewed as the global risk-free asset, fluctuated wildly and speculation ensued that foreign investors were dumping their holdings of US debt. Nothing – other than perhaps gold – was spared in what was the most extreme market action since March 2020 when covid was bringing the global economy to an abrupt lockdown.
The market began to recover on April 9th when US stocks enjoyed their 3rd best day since 1950. This coincided with the Trump administration signaling it would suspend full tariff implementation on most countries except China and announced several product-specific exemptions. Investors were provided a reminder that the best days in market history are usually in close proximity to the worst. Commentary from the White House suggests the administration recognizes uncertainty and anxiety is too high and proposed level of tariffs is unsustainable – yes, even with China. US equities managed to largely climb their way back to conclude the month just -0.68% below where it began – virtually flat. A significant moral victory considering the depths of the pain just a few weeks earlier. What a crazy ride!
Are you “tariff-ied”? With less than 60 days remaining in the current tariff delay, where will we go from here? There are reports that China is now evaluating some of the proposals for negotiation (not yet negotiating), suggesting the world’s two largest economies are at least considering how to de-escalate tensions. Still, it would be surprising if a complete resolution to tariffs, especially with China, arrives without setbacks along the way. The US annual trade deficit with China is nearly $300B and consumers are likely to begin to see the impact of slower imports on store shelves over the coming weeks – both in the form of product unavailability and/or higher prices. The situation is fluid and we anticipate it to remain so over the summer, but the most important question facing investors is whether economic growth or inflation is the greater risk at this time.
The first official reading for 1Q GDP showed the US economy contracted -0.3% after adjusting for inflation – the first negative quarter since early 2022. Many economists anticipated the economy to contract slightly , but negative growth still creates headlines. What is concerning is that the 1Q data covers the period before most tariffs went into effect. There is evidence consumers and businesses pulled forward spending and activity during February and March creating noise in the data. So what will occur for 2Q if that behavior reverses in April and May (de-stocking of inventories)? Interesting fact: historically by the time economists officially declare a recession, the stock market already bottomed and is pricing for recovery.
How significant and lasting is the damage done to consumer and business confidence from the heightened uncertainty stemming from tariffs? Inflation presently looks contained, but tariffs will
result in higher prices for many goods; and other big changes since Trump took office like lower immigration can affect the labor supply and labor costs. It is important to keep in mind that tariffs will appear inflationary in the very short term, but they do not necessarily result in sustained inflation (they create a one-time price shock).
All of this complicates the uncertainty about the direction interest rates, and renewed friction between President Trump and Fed Chairman Powell did not help either. It’s no secret that the two men do not approve of each other. Powell does not seem eager to take action to heal a wound to the economy he views as self-inflicted by Trump. Yet the Fed’s objective is to facilitate full employment and price stability – in other words a healthy economy. The FOMC did not create the current economic weakness or tariff uncertainty, but these are the cards they were dealt. The recent behavior of the bond market suggests the Fed should be cutting rates now. Time is probably already ticking to limit economic damage from recent uncertainty – which can be accomplished via easing monetary policy and/or corporate and personal tax relief (proposals in Congress).
Was April 9th the market low? It is impossible to say, but V-shaped recoveries like enjoyed in recent weeks are historically rare. Aside from the last 10 years, sharp selloffs historically required time for repair. This suggests re-testing of former lows is possible and even probable. Technicians refer to this retesting/bottoming as a bang (high drama, like early April), followed by a whimper (a retest with less volume, but even more emotional exasperation). Prepare yourself for the possibility that retests are normal. While the markets recovered most of the early-April pain, the character of the rebound so far reflects a cautious tone. Defensives are outperforming more cyclical sectors and we do not see buying “urgency” typically found near new uptrends.
Are stocks “cheap” following the drawdown since February 19 peak? Compared to the beginning of the year, prices appear more attractive. But expected corporate profits are experiencing revision, making the question more tricky. Amid heightened uncertainty, it is difficult for analysts to make accurate projections about what profits will look like. Many companies are scrapping their estimates in recent days. If earnings contract materially then stocks are not nearly as cheap as one might think.
Could the US lose its reserve currency status? April was a month bond traders will talk about for years to come. Investors experienced dramatic swings in yield, fueling concern that foreign investors are dumping their holdings of US debt. Additionally, the US dollar weakened noticeably relative to other currencies during the month at the same time as the price of gold soared. It is important to note the decline follows a decade-plus streaks of dollar strength and was probably overdue. Losing our reserve currency status could happen… if we are not fiscally responsible in managing spending, debt, and continue world trade. But we will not lose reserve currency status overnight. It does highlight the importance of diversification and that many good investments reside outside the US.
As we look to May, investor sentiment is greatly improved from where it was a month ago. But in the short term, economic data – mostly reported with a 1-month lag – is of limited reliability. Much of what we’ll receive over coming weeks covers activity that took place prior to Liberation Day and does not yet reflect the dent in business and consumer confidence. As actual data catches-up with the economic releases, do not be surprised if the markets become weary again. We do not rule out the return of market stress. Be mindful that if it does, price will quickly sour sentiment and you may feel even more exasperated than you did a few weeks ago. Do not allow your emotions to cause you to fold your hand – the “cards” in your portfolio are high quality and will win over time. Your portfolio owns assets based on buckets of time, is diversified, and continues to behave better YTD than the indexes focused on by the headlines. In fact, through April 30, the S&P500 is off -4.92% while our most aggressive (mostly stock) client portfolios are down less than half that amount. The most conservative portfolios (mostly bonds) are still positive. Diversification helps you weather the storm.
Warren Buffet announces retirement from Berkshire Hathaway after six decades. Did you know that during his tenure, Buffett trailed the market a third of the time and lost money in 11 years?!? Patience and the ability to ignore fads and short-term pressure is what made him an epic compounding machine.
The lesson: stay disciplined and let time be your friend.
“It’s only when the tide goes out that you discover who’s been swimming naked.”
