While the economic data was a bit softer on the margin last week, markets were likely rattled more by concerns about the upcoming tariff announcements on President Trump’s “Liberation Day,” scheduled for Wednesday, April 2. Though the range of possible outcomes is extensive, the scope and size of the tariffs should be meaningful. Goldman Sachs estimates a five percentage point increase in tariffs trims 1-2% from S&P 500 earnings growth, so they have lowered their 2025 earnings per share growth estimate to 7%. Strategas Research Partners notes that the size of the contemplated tariffs could bring the total size to $300 billion, or 1% of U.S. GDP.
U.S. Trade
China, Canada, Mexico, and the European Union as a group account for almost 50% of imports in the U.S. Following COVID-19 and the last trade war, supply chains have made progress in diversifying away from China.
While supply chains have reduced their dependence on China, it still has the largest trade surplus with the U.S., making it likely to remain subject to significant and possibly increased tariffs. Mexico and Canada also have large trade surpluses, so they are targets.
Notably, the U.S. has significant leverage with many large trading partners as their exports to the U.S. make up a large enough portion of their GDP. If sizable tariffs crimp their net exports to the U.S., as would be expected, their economic growth will suffer.
The European Union has a significant trade surplus with the U.S., so they are expected to be targeted when the administration proceeds with reciprocal tariffs this week. Reciprocal tariffs are meant to place U.S. tariffs equal to those experienced by U.S. goods imported into that region. If value-added taxes (VAT) are included in the reciprocal calculation by the administration, then the tariffs on the European Union will be significantly higher than if only their tariff rates are considered.
Tariffs: Policy Uncertainty
President Trump’s use of tariffs and threats of additional tariffs has added to the policy uncertainty. Without knowing the size, duration, and cost to alternatively source the impacted imported product, it is impossible to estimate the impact of any future tariffs accurately. Furthermore, possible retaliation and the second-order effects must be considered.
Generally speaking, tariffs should be a headwind to economic growth as higher prices have a tax-like impact on consumer spending. They are likely to boost inflation readings on the margin, though all the increased costs might not be passed on to consumers, and strength in the U.S. dollar could provide further offsets. As we have experienced since mid-February, all other things equal, uncertainty lowers the valuation investors are willing to pay for risk assets such as stocks.
While the outcome is unclear, the Baker, Bloom, and Davis composite index of economic policy uncertainty measures policy uncertainty by examining the frequency of media references to it.
According to an analysis by Strategas Research Partners, stocks usually do quite well following periods of policy uncertainty. For example, policy uncertainty at current levels has, on average, been followed by over 20% returns from the S&P 500 in the 12 months after. The poor data typically weighs on stocks as readings worsen, but the pressure is released once past the point of maximum pessimism.
Market Reaction
After a 1.5% decline last week, the S&P 500 sits 9.2% below its mid-February high. The Magnificent 7, consisting of Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), has faired worse with a plunge of 20.5% since mid-December.
The more economically sensitive cyclical stocks have recently been underperforming the less economically sensitive defensive stocks. This suggests that an economic growth scare is one cause of the recent stock weakness and that stress intensified last week. While it should continue to be monitored, the relative weakness of cyclical stocks isn’t yet at levels seen before past recessions.
What To Watch This Week
Beyond Wednesday’s highly anticipated tariff announcements, Friday’s monthly jobs release will be an important marker. If job growth continues, there will be less concern about any drag from increased tariffs pushing the economy into recession. The March unemployment rate is expected to hold steady at 4.1%, but growth in nonfarm payrolls and hours worked should be closely watched for signs of further softness.
While the Federal Reserve projects two rate cuts, markets expect three for 2025, with the first in mid-June. These expectations could change quickly depending on this week’s releases.
Dealing With Uncertainty
If you own your stocks as an investment – just like you’d own an apartment, house, or a farm – look at them as a business. – Warren Buffett
Warren Buffett’s mentor, Benjamin Graham, taught him much about investing. Graham’s most essential lessons were to analyze stocks as a business and not react to short-term fluctuations in the quoted price of a stock. Buffett has said that chapters eight and twenty of Benjamin Graham’s “The Intelligent Investor” book are the bedrock of his investment process.
Graham thought investors should look at stock holdings as owning a part of various businesses, like being a “silent partner” in a private company. Hence, stocks should be valued as a portion of the company’s intrinsic value, not as something constantly changing in price on the stock market. An investor should take advantage of the stock market’s fickle view of a company or concerns about macroeconomic factors rather than allowing it to dictate what one should do. Valuing stocks as a business and purchasing stock with a “margin of safety” enable investors to ignore the market’s emotional ups and downs. For Graham, the “margin of safety” meant buying at a price below the “indicated or appraised value,” which should allow an investment to provide a reasonable return even if there are errors in the analysis.
The recent market turmoil makes it an optimal time to revisit investment first principles. Given the growing downside risk to the economy and the current inflationary environment, investors should find comfort in owning quality companies with pricing power when searching for opportunities during any selloff. Quality is defined as high returns on capital, consistent earnings, and low debt levels, which should help the company survive a possible economic slowdown or tariff-related challenges.
For example, consider Constellation Brands (STZ), which is best known for owning the rights to Corona and Modelo beers in the U.S. It also owns some wine and spirits brands, but beer accounts for about 80% of its sales. Potential tariffs on Mexico could negatively impact its beer earnings since almost all its beer is produced in Mexico. It seems unlikely that a tariff headwind will erode the long-term value of its beer brands, even if profitability could be dented in the short term. Corona and Modelo have two of the best growth profiles among beer brands, and alcohol consumption tends to remain relatively unscathed by economic downturns. Notably, there are fears that the GLP-1 diet drugs and a growing preference for cannabis could weigh on long-term alcohol consumption which could be a structural headwind. On the other hand, the stock is now selling for a multi-year low in valuation across several metrics. Constellation boasts a solid balance sheet and free cash flow generation to sustain it through a possible recession or tariff-related disruption.
Conclusion
Just as the zenith of economic and earnings optimism in early 2025 gave way to creeping concerns about the durability of growth under pressure from possible tariff increases, maximum pessimism will eventually give way to a better reality. History tells us that better stock returns follow maximum policy uncertainty. Whether next week’s tariff announcement provides that bottom is unclear, but markets have shifted from pricing in a benign environment to a more difficult path.
Current data points to an economic slowdown rather than a recession, which bodes well for reasonable returns from the correction bottom. Macroeconomic forecasting is fraught, so one should still admit that the odds of a recession have risen, and no one truly knows the eventual outcome. Though most are rightly concerned about the downside risk from tariffs, there is an upside if this pressure results in better trade terms for U.S. companies, and the tariffs can be reduced in the short term. In addition, the focus could shift to more market-friendly topics of tax cuts and deregulation.
In any case, investors must always deal with uncertainty and unpredictable market volatility. Warren Buffett and Benjamin Graham have provided a better blueprint for dealing with this by focusing on the health and valuation of the underlying businesses rather than the macroeconomic environment or the movement of stock prices. This focus doesn’t avoid the volatility but allows one to use it to their advantage if executed correctly. Just as Berkshire Hathaway (BRK/A, BRK/B) keeps more than enough cash to pay insurance claims without touching any stock investments, investors should have enough cash and bonds to cover short-term expenses to ignore any depressive states of the stock market and perhaps benefit from taking advantage when they invariably occur.
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