Are The Markets Having a Tariff Tantrum

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Since last week’s note we got an onslaught of earnings and positive economic reports. The earnings have been good. Through Monday,?181 companies that have reported so far (36% of the S&P 500): overall, 79% are beating estimates, and those that “beat” are beating by a median of 6%. But, along with good earnings and good economic indicators we have also begun to see the tariffs from the Trump administration. The tariffs are something that the media has relentlessly sunk their teeth into along with DeepSeek. Last week the Columbians were warned about tariffs when they were?refusing to accept their illegal immigrants that were gathered here in the US. When alerted that we would be imposing tariffs on their coffee exports (their largest cash crop) they said they would gladly accept their citizens back.

This past weekend Trump gave some clarity on his tariff intentions with Mexico, Canada, and China. Even though his intentions were clear; stop allowing and facilitating illegal immigration and illegal drugs into the US or we will be forced to make you pay for our extra needed protection. The markets clearly didn't like this and opened down strongly on Monday. When it was reported that the new president in Mexico said she had a "good conversation" with Trump and that Trump said that he would put off the Mexico tariffs by a month, the markets quickly recovered. This was followed by Canada saying they are going to put in place a “drug czar” to attack the fentanyl movement, the markets liked this as well. ?I wonder what tariff surprises we will see next. I think that many are forgetting what the reasons for the tariffs being imposed truly are. In last Wednesday's Wall Street Journal there was an article titled, "How Much Do Tariffs Matter," by Donald Luskin, CEO of TrendMacro Research. What is important is that the economic effect is considered minimal, but the rejiggering of world trade could be longer lasting and more dangerous to global economies. The purpose given for the Mexico and Canada threats were based on illegal immigration and destructive drugs like fentanyl, for China and we are told the rest of Europe is yet to be given.

This last week we had a Fed meeting on Wednesday afternoon and the markets were uncharacteristically quiet after the results of the meeting were announced. Normally, there is a dramatic move in the markets and then a countertrade the following day. The Federal Reserve made it clear that it’s not about to cut short-term interest rates again anytime soon, which is good news if you’d like to see the Fed live up to its goal of bringing inflation down to 2.0% (a lofty goal indeed). I expect the Fed to use the tariffs as a reason to hold the line on short-term interest rates. Especially with the press focusing on the prices that do go up because of those tariffs.

Thursday showed?that?US gross domestic product (GDP) grew at an inflation-adjusted 2.3% annual rate in the fourth quarter, in line with its recent trend. The headline number belied by much greater strength in consumer spending, which accounts for approximately 70% of the US economy. The stock market has given a big boost to consumers. So, could a correction put a damper on consumption? It might, but I believe that the continued large balance of money market assets provides a purchasing backdrop that could be found very difficult to quench:

Monday, we got a whopper of a report that few mentioned. It was the ISM Manufacturing Index. The index beat consensus that was expected to remain below 50. Levels higher than 50 signal expansion; levels below 50 signal contraction. What is important is that we have been in the longest contraction period for US manufacturing since 1948!

The reason why this is important is that even during the Great Financial Crisis it wasn’t below 50 for even this long. This is also the first expansionary reading since October of 2022! The good news is that both demand and output were responsible for the headline increase. Many postulate that a “Trump Bump” could be showing up in the new orders data, as businesses get more certainty on policy framework from the new administration and can look forward to an easier regulatory environment in the next four years, as well as lower tax rates on profits.

I believe the most important point in this report is that it shows that it isn’t just technology companies and the economic benefits of technology that is driving the US economy, it is now the industrial underbelly as well. THIS IS HUGELY IMPORTANT! Going back to 1948 when PMIs are rising and moving above 50, the absolute forward return on industrials is highest and has a win ratio of 95%. I like this probability! Also note that this is the first important economic report of 2025, as it is a January report, not a 2024 report from the previous administration.

Americans’ spending picked up in the final three months of 2024, to a 4.2% annual rate of increase, the strongest pace in almost two years and an acceleration from the preceding quarter's?already robust 3.7%. This spending has actually been rising faster than incomes owing to consumers' surging wealth illustrated above. In other words, the economy is reflecting the stock market and not the other way around, as conventional wisdom holds. Many attribute the growth in consumption to a combination of large cash balances and the stock markets. From the third quarter of 2023 to the third quarter of 2024 household assets rose by $17.9 trillion, with $10 trillion coming directly from equities and another $2.6 trillion came from real estate. Below is a graph of the progression of assets in various assets classes combined, going back to 2010, just post Great Financial Crisis:

All of this is good, and indicative of a very healthy economy, but it doesn't necessarily portend a continued strong stock market. For this reason, I don't necessarily welcome a change but look forward to it to see if the dynamics of the markets are changing. Last week I started the note with a chart showing the number of corrections that tend to occur during a year based on severity.?This is a chart that you should cut out and paste on the wall. What it shows quite blatantly is that it doesn’t really matter the “reason” for a market sell-off, what matters is that we simply have them of varying degrees with varying levels of severity. Note that we normally have 3-4 draw downs of around 5% each year. The 10% variety normally happens once a year, and big ones of 15-20+% a every year to two.

It is said that when a market is in an uptrend, and then an abrupt change occurs, this is when it is appropriate to measure the change, evaluate the extent of the change, and then monitor what moves first and the most after the change. This can lead to an understanding of groups/sectors/companies that will now begin to lead on both the declining and the advancing side moving forward. This is why managing the markets is an ever-changing, always breathing affair. Does it mean that the interpretations are always going to be right? Of course not! But what is important is to begin to recognize longer-term trends that are beginning so as to take advantage of opportunities or to avoid negative situations. Because there are so many different variables to consider, and at times some variables are more important and others that were more important have become less important, computers (AI) can’t make these adjustments yet.?This is why the DeepSeek moment was so important last week. It was clearly a change in the wind, the gravity of which is still yet to be seen.?Tech has grown to a huge and oversized portion of the overall market. Does this mean that the party for tech is over? Or does this simply mean that it needs to take a rest and let some of the rest of the market play catch up due to their benefits from using technology? This is still yet to be determined, but the PMI report discussed above could be giving an indication of the market broadening and showing other industries benefiting.

We will strive to make these adjustments when we feel it is appropriate to do so. This last week’s 1 day flurry that was attributed to DeepSeek is one such event. Looking deeper into it, it can be seen that the broad market dropped by over 1%, yet at the same time the Advance/Decline line rose. This is a very uncommon event. Going back to 1980, it has only happened 11 times. It seems like a lot, but in actually a very uncommon number over a 45 year period. So, the logical question then becomes, what has happened next? The chart below shows a large probability of the markets being higher over the next 1-day to 1-year period.?

I often provide factoids on what markets generally do when they are acting in a certain way and this week I wanted to provide the facts from the January Barometer. According to Thomas Lee of FundStrat, "Overall, there are six reasons (given Jan 31 close above 5881.63 on the S&P 500) that show 2025 tracking better than our base case":

– Barometer “first 5 days” positive = 82% win-ratio for the year probability. – Sentiment capitulation in Dec to Jan chop = good, provides one of the digestion periods necessary for the next upleg. – Inflation tracking “softer” than consensus view, in the face of a strong economy means the Fed can stay permissive with interest rates.? – Fears of “day 1 tariffs” overblown = continued trade based on agreed upon and fair practices. –?January Barometer “positive” = 89% win-ratio. If January is positive, then an 89% probability of a positive?outcome for the year and a median return of 19%.?

Bottom line, 2025 is tracking better than Thomas Lee's base case even with a current environment that looks far less than attractive given trade skirmishes and Chinese DeepSeek. Ultimately the market has not acted in the last few weeks the way that it acted in the past year. This could be a changing of the guard before continued progression, or it could be a period of contraction to provide a pause that refreshes. My indicators still show continued strength under the hood from a breadth perspective, yet it is not fun to watch tech leadership diminish even though there have been no negative earnings forecasts. I will be vigilant at keeping you informed and will of course be here to answer any questions you may have.?

Ken South, Tower 68 Financial Advisors, Newport Beach

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Kenneth H South CA Insurance Lic # 0A75043. State of domicile is CA and principal place of business is 610 Newport Center Drive, Suite 1520, Newport Beach, CA.