Well, a lot has happened since the second quarter started on April 1^st . . .  Since the president’s April 2 “Liberation Day” tariff presentation, stocks have made a huge roundtrip.  First, they plunged about 13% in the first week as investors fretted about what the new tariff regime would mean for the U.S. economy, trade and corporate profits.  Then, in the ensuing weeks, the administration announced a 90-day delay in the implementation of its proposed “reciprocal tariffs” and retreated on its very high level of tariffs for China, reducing them from 145% to 30% while negotiations are ongoing.  (China, in response, reduced U.S. tariffs to 10%.) Stock investors celebrated, driving the S&P 500 back up to levels above where the index traded on April 2^nd.  U.S. Treasurys had the opposite reaction, however.  Since April 2^nd, bonds have sold off, pushing the yield on the 10-year Treasury from 4.2% up to 4.59% today.

Inflation Still Benign as Tariff Impact Still Unknown

Many economists argue that tariffs are inflationary and are set to simultaneously push up prices for consumers while stifling growth—the dreaded stagflation scenario.  So far, inflation remains in check.  In April, the Consumer Price Index (CPI) registered a 0.2% increase (seasonally adjusted) and a 2.3% increase over the last year.  We are expecting to see inflation’s progress toward the Federal Reserve’s 2% inflation target slow down a bit as the next couple of months of inflation data are posted, and we expect the Fed to delay interest rate cuts for at least several more months as it waits for indications about how tariffs (and other things, such as the proposed federal tax legislation) are affecting the economy, employment and inflation.

Corporate Earnings Off to a Solid Start 

With the first quarter earnings season winding down, it is clear that most companies had a strong start to the year.  However, on the conference calls to discuss results, managements were almost uniformly uncertain about how their businesses would be performing for the rest of the year.  With so many companies either importing finished goods or parts, their managements were just at a loss to give any kind of firm financial guidance with the tariff terms still in flux.  Given that the rules of the game have been suspended, we expect companies to pare back both their capital expenditures and hiring until there are clear terms on trade.  All in all, the corporate sector is in stand-by mode until there are some definitive trade agreements.

Moody’s Downgrades U.S. Credit Rating

On May 16^th, Moody’s became the last of the three major rating agencies to strip the U.S. of its top credit rating, dropping its rating by one notch to Aa1 from its top rating of Aaa.  (Standard & Poor’s downgraded in 2011 and Fitch Ratings in 2023).  Bond prices weakened immediately, sending the 30-year Treasury above 5% and the ten-year Treasury to 4.5%.  Moody’s cited the increasing U.S. federal budget deficit as a prime consideration, as well as the rising cost of rolling over existing debt tranches in today’s higher-rate environment.  (Note that the tax bill currently in Congress will likely raise the federal debt by trillions of dollars over the next ten years.)  Any way you look at it, we continue to put our economy at risk from the growing chasm between federal tax revenues and federal spending. The projected federal deficit for this fiscal year (which began Oct. 1) of $1.05 trillion is currently running 13% higher than in the previous fiscal year.  While there may be no specific, discernible impact from the Moody’s downgrade, the fact remains that we are on an unsustainable fiscal path.  If bond yields do trend upward, higher financing costs will flow through to consumers with credit card debt or those seeking mortgages and other types of financing, pressuring both our overall economic growth and our ability to continue financing our own debt at reasonable rates.  At some point markets may react, potentially pushing stocks lower, bond yields higher and the dollar lower as investors demand a higher margin of safety for holding U.S. assets.

As always, we welcome your comments and feedback.  Please contact us know if there is anything you would like to discuss about your investments or the markets.

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