Some Giveback
After the S&P 500 gained nearly 6% two weeks ago, there was some well-deserved giveback last week, as stocks fell 1.5%, mainly thanks to a huge drop on Wednesday after hawkish comments from Jerome Powell (more on that below).
As we noted last week, stocks are trying to carve out a potential low, but risks are clearly still high over the trade war and a Federal Reserve (Fed) in a tough spot. One potential positive is market breadth has held up quite well in the face of the near-bear market. The S&P 500’s advance/decline line is a cumulative tally of how many stocks advance and decline each day and it can give clues under the surface for how things are really doing. As the chart below shows, the S&P 500’s advance/decline line has held up well above the early 2025 lows, whereas price for the S&P 500 has broken beneath those levels, suggesting there is potential strength under the surface. Additionally, the S&P 500 found support just beneath the 5,000 level, which was also the lows last April 2024.
Sentiment Is Extreme
In many cases, sentiment is at extremely low levels, which could be positive from a contrarian point of view. Remember, once everyone is bearish the sellers may very well have exhausted themselves and a major low can form.
The recently released Bank of America Global Fund Manager Survey showed a record number of participants who intend to cut US exposure, as shown in the chart below. The survey also showed the largest two-month jump in cash since April 2020 and the 4th highest recession expectations ever. Given this survey looks at managers who manage actual portfolios, this is a very solid potential contrarian indicator.
Additionally, the National Association of Active Investment Managers (NAAIM) Exposure Index came in at its lowest level in 17 months, suggesting RIAs are finally tossing in the towel as well. Lastly, The Economist last October had a cover with $100 bills shooting into outer space with the title “The Envy of the World,” as everyone was bullish the US back then. Well, last week they had a cover discussing what could happen should there be a US dollar crisis. Just as sentiment was over the top on the US in late 2024, increasing the odds of potential trouble, now we are seeing the exact opposite backdrop.
The Best and Worst Days Happen Near Each Other
As we’ve noted recently, the best and the worst days tend to happen very close to each other. In fact, on Thursday, April 10 and Friday, April 11, the S&P 500 fell more than 10% for one of the worst two-day returns in history. Many investors couldn’t take it and after that historic selling decided to get out of stocks early that next week. Sure enough, a historic jump was right around the corner, with now one of the best two-day rallies ever. As the chart below shows, the best two-day rallies and declines tend to happen near each other, with the worst days usually happening first, often followed by a huge rebound. This is another reminder that volatility is the price we pay to invest, and if you want to experience the big rallies, you will have to withstand the sell-offs.
The Fed Is Caught Between a Rock and a Cold Hard and Lonely Place
Federal Reserve Chair Jerome Powell gave us the most detailed description of how the Fed is thinking about policy in the face of massive tariffs in a speech at the Economic Club of Chicago on Wednesday, April 16. Afterward Powell participated in a Q&A, with the former head of India’s Central Bank and University of Chicago professor, Raghuram Rajan. Rajan asked insightful questions, drawing out more of Powell’s thinking than anything we’ve seen or read in the recent past.
Powell’s prepared remarks started off by saying the economy was/is in good shape, including labor markets and the inflation picture. He emphasized that the labor market is in a solid place, highlighting some key points:
- Job growth has slowed, but lower layoffs and lower labor force growth has kept the unemployment rate low.
- Wage growth has moderated while outpacing inflation.
- The labor market is not a source of inflationary pressure.
We’re not sure we would paint as pretty a picture of the labor market as Powell, especially since hiring has been weak (payroll growth has been steady because layoffs are low). But ultimately, the last bullet is what is important because it tells you that all else equal, the Fed should be cutting now. There is no point keeping rates “meaningfully restrictive” (their own description) when higher rates tend to push inflation lower by lowering demand, which creates more unemployment and less income.
Moreover, the inflation data coming out has also been really positive, even though it’s still running a bit above 2%. Core Personal Consumption Expenditures (PCE), which is the Fed’s preferred inflation metric, is expected to rise just around 0.1% in March and clock in at 2.6% year over year. (March data will be released on April 30). That would be the slowest pace since March 2021. The core CPI (Consumer Price Index) metric was really soft in March, rising just 0.06%, and is up 2.8% year over year, also the slowest pace since March 2021.
In short, things were going well. Until tariffs.
“Life Moves Pretty Fast” -Ferris Bueller
Powell explicitly quoted Ferris Bueller to summarize how the new administration’s policy has completely upended their picture of the economy as we move forward, including policies around 1) trade, 2) immigration, 3) fiscal policy (taxes), and 4) regulation.
The level of tariffs has been much higher than expected, and as a result the expected economic impact is likely to be higher too. In short, Powell said they expected higher inflation and slower growth ahead. The only good news there is that long-term inflation expectations, including within markets, appeared to be well anchored around their 2% target. This is actually another way of saying investors believe the Fed will do what it takes to tame inflation. More than anything else, central bankers worry about losing credibility as inflation expectations surge, which is what happened in the 1970s. That loss of credibility itself could push inflation higher.
Currently, inflation expectations, as measured by breakeven inflation (the difference between nominal yields and real yields taken from TIPS securities), are consistent with the Fed’s 2% target. 5-year breakevens are at 2.3% and 10-year breakevens are below 2.2%. Note that these track CPI, which tends to run 0.3 – 0.4%-points below the Fed’s preferred PCE metric. These metrics suggest markets believe the Fed can and will bring inflation under control. (This could also mean higher rates in the future.)
Powell believes tariffs are highly likely to generate a temporary rise in inflation through a one-time upward shift in the price level. But he thinks inflationary effects could also be persistent, and that’s going to depend on:
- How large the tariffs are.
- How long the tariffs take to pass through to consumer prices.
- How long the Fed keeps long-term inflation expectations well anchored.
Powell said their main obligation is to keep inflation expectations well anchored, and to make sure a one-time increase in the price level does not become an ongoing inflation problem. They’re going to balance their two mandates of maximum employment and price stability. But he then added:
“Keeping in mind, without price stability we cannot achieve long periods of strong labor market conditions.”
Translation: They’d like to achieve both sides of their mandate, but if forced to choose between taming inflation and avoiding higher unemployment, they’re going to do what it takes to tame inflation first.
The language is very similar to what Powell used to say back in 2022 and 2023, when they were raising rates. At the time, they even said that a recession may not be avoidable, as they expected the unemployment rate to rise from 3.5% to above 4.6% (thankfully, it didn’t go higher than 4.2%). Powell and the Fed were willing to do what it takes in 2022 – 2023 to tame inflation, even at the expense of the labor market. And Powell just sent a loud and clear message that they’re willing to do so again.
This is incredibly hawkish. The only way to be more hawkish is to explicitly say they’ll consider rate hikes once again.
Powell is also worried that extremely high tariffs, such as those proposed, could result in a supply shock that further lifts inflation, similar to what happened in 2022, when supply chains got clogged, leading to more persistent inflation. Powell pointed out that CEOs he’s spoken with have said that high tariffs on imported goods that are used as inputs into their processes are a big issue. Supply disruption can take years to solve and result in higher inflation for longer. An example: car supply chains may be disrupted and could take a few years to get fully resolved. And that assumes we have certainty about the level of tariffs, whether over the next year or even after the current administration.
This is where it would actually be beneficial for Congress to mandate the tariffs into law, as it would give a bit more certainty. The problem is Congress is not even close to being involved at this point.
Markets Expect Cuts That May Not Be Forthcoming
For the time being the Fed is going to wait for more clarity from the data. Keep in mind that the status quo is not a good place. Powell has repeatedly said that rates are meaningfully restrictive right now, and if income growth continues to ease, that means policy is actually getting tighter if they don’t do anything. That’s not good for cyclical areas of the economy, including housing and manufacturing, which are also going to be hit by the weight of tariffs.
We wrote in our 2025 Outlook that elevated interest rates are a risk. Since the tariff mess started, we’ve been writing that the biggest risk is actually the Fed pausing and sitting on their hands for longer. We still have no idea where tariffs will end up, let alone the economic impact. But what we suspected was that it would force the Fed to wait to cut rates again, and Powell just confirmed that.
We’ll close with something Powell pointed out at the event. What we’re seeing now are in fact fundamental changes to long-held US policy. There’s no modern experience with this. Even the Smoot-Hawley tariffs were 100 years ago, and these are larger. That means there’s structural uncertainty as well, beyond immediate uncertainty related to tariffs (how much, on whom, for how long, etc). What’s going to happen is that businesses and households will step back from making decisions. Powell hopes things will become more certain, but that will depend on their understanding of what is normal, or rather, the new normal.
Ultimately, if uncertainty remains higher, it will weigh on investment and expected rates of return will have to be higher (to compensate for higher risk). If US risks are structurally higher, it will make investing in the US less attractive. Powell noted that we don’t know that this will happen, but that will be the effect. It’s incredible that the country’s chief central banker is saying this.
We’re clearly in uncharted waters now.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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