S&P 500 Hits Correction Territory as Tariff Uncertainty Surges

Tariff clarity and resolution will eventually arrive, and combined with the Federal Reserve pursuing a more accommodative monetary policy, oil and gasoline prices falling, and Treasury yields off their recent peaks, the dynamics for a rebound in common stock prices have been developing for the past couple weeks.

Equity Markets

The S&P 500 Hits Correction Territory as Tariff Uncertainty Surges

March opened with investors in risk-off mode with mounting concerns about the outlook for the economy, punctuated by threatening tariff headlines. The pullback in stock prices since the February 19 high on the S&P 500 largely resulted from the whiplash of back and forth changes in tariff policy from President Trump and mounting concerns about the economy falling into a recession. These concerns ratcheted a touch higher when President Trump sidestepped ruling out a recession in an interview on March 9, while Commerce Secretary Lutnick said two days later that a recession would be worth the structural changes that President Trump’s tariff policies would put in place.

It was presumed by the markets after last fall’s election that President Trump’s second term would be similar to his first, giving priority to tax cuts, deregulation, and boosting economic growth. However, in less than two months the Trump administration’s tariff policies created a headwind for common stocks as business, consumer, and investor confidence eroded. Investors are worried that a large percentage of the tariffs will be passed on to consumers, boosting prices, and that households and businesses will pull back, leading to a contraction in the economy. What was previously viewed as a thriving economy with accelerating growth prospects due to the potential of deregulation and tax cuts, has been replaced with massive uncertainty and a growing chance of a mild recession.

Investors, households, and businesses are also waiting on a comprehensive, well thought out and coordinated tariff gameplan. So far, the tariff announcements are largely viewed as following an ad hoc approach that cites illegal drug traffic as the reason for tariffs one day, only later to have unfair trade conditions, revenue generation, and retaliation held out as the rationale. All constituents appear to be weary from the tariff drama.

A key policy issue the markets are dealing with today is that the current sequencing of policies is reversed from President Trump’s first term. In 2017-2019, President Trump led with a massive tax cut and deregulation efforts, which were then followed by modest tariffs, primarily against China. So far in his second term, President Trump has led with heavy, disruptive tariffs on a much broader basis, with an extension of the tax cuts a back half of the year agenda item.

President Trump’s rapid fire tariff announcements are stress testing the markets and the economic outlook, raising fears of a recession and forcing the markets to reprice common stocks with the S&P 500 closing -10.1% below its February 19 record high to the recent low on March 13. Stock prices rebounded modestly over the back half of March as the major stock market measures reached oversold territory, and valuations on many of the highest quality and innovative companies that have driven technological change and the growth in corporate earnings were trading at much more reasonable prices that began to attract new capital.

President Trump gave stocks a temporary boost on March 21 by saying that there could potentially be “flexibility” in his reciprocal tariff plans. President Trump is proposing reciprocal tariffs in an effort to level what he considers an unfair tariff playing field. This comment was followed by reports from multiple media outlets that the Administration’s April 2 announcement on reciprocal tariffs could be narrower than initially planned, excluding some nations and sector specific tariffs. Just last week, President Trump added that the reciprocal tariffs will likely be more “lenient than reciprocal.”

We were not surprised by President Trump’s attempt to tone down the expected aggressiveness of the Administration’s April 2 reciprocal tariff announcements to lessen the extent to which policy uncertainty is weighing on the outlook for the economy, and ultimately stock prices. The Administration is keenly aware of the impact that policy uncertainty is having and is walking a fine line between the benefits that tough talk has on the negotiating aspects of tariffs and the potentially disruptive impact of harsh tariff policies that could fundamentally restructure supply chains and economic and trade relationships across the world.

Make no mistake, however, that the tariff situation remains fluid and uncertainty remains high regarding President Trump’s tariff agenda and potential retaliation from major U.S. trading partners. Increasingly it appears that President Trump is leaning toward a protectionist posture, using tariffs to revive the U.S. industrial base and workforce.

Only last week President Trump added to the previous tariff news by announcing 25% tariffs on global automotive imports to the U.S, which weighed on stock prices to the end of the month, while pushing Treasury yields lower. President Trump doubled down on the automobile tariffs by stating that if the European Union and Canada worked together to harm the U.S. economically, they would face levies that were “far larger than currently planned.”

So far, no clarity, lots of ambiguity, but maybe a glimmer of hope that the U.S. will not plunge the global economy into an all out trade war. Investors are questioning if the markets are dealing with the calm before the storm or is it possible that President Trump’s reciprocal tariff gameplan could eventually lead to widespread trade negotiations and a lower tariff framework on a global basis.

For the full month of March, the major stock market measures declined by -4.2% to -8.2%. For the first quarter of 2025, the major market indices have fallen -1.3% to -10.4% with the NASDAQ suffering the largest decline. Since the presidential election, the DJIA has declined -4.0% while the S&P 500 is lower by -5.3%. The NASDAQ Composite has fallen -8.9% while the Russell 2000 has experienced the largest decline since the election at -15.9%

Federal Reserve Holds Rates Steady, Says Uncertainty Has Increased

The Federal Reserve kept the target range of the federal funds rate at 4.25% to 4.50% at the March 18-19 FOMC meeting, where it has been since December. Holding rates steady was largely an acknowledgement by the FOMC Committee that progress on lowering the inflation rate has stalled over the past six months. Chair Powell addressed the tariff issue multiple times during the press conference, stating that tariffs have brought uncertainty to the outlook, particularly as it relates to inflation. Likewise, the policy statement asserted that “Uncertainty around the economic outlook has increased.”

With the Committee members now expecting larger tariff increases, the outlook for economic growth and employment this year was downgraded, while the forecast for inflation was marked up. Officials now see the economy growing at just a 1.7% rate this year, 0.4 percentage points lower than its last forecast in December, with the unemployment slightly higher at 4.4% compared to 4.3%. On inflation, core personal consumption expenditure prices are expected to rise at a 2.8% pace in 2025, 0.3 percentage points higher than previously expected.

Despite expecting tariffs to result in prices rising more rapidly this year than previously expected, the Committee anticipates that any price hikes from tariffs likely will be short-lived with core consumer inflation expected to recede to 2.2% in 2026 and 2.0% in 2027. With Federal Reserve officials not expecting any lasting inflationary burden from the tariffs, the Committee’s rate projection still called for two rate cuts in 2025, the same as in December. Chair Powell reasoned, “It can be the case that it is appropriate sometimes to look through inflation if it is going to go away quickly without action by us. And that can be the case in the case of tariff inflation.”

While the Committee’s median forecast of two rate cuts this year was unchanged, the new projections showed that 11 of 19 policymakers expect the central bank to cut rates at least twice this year, down from 15 officials who had penciled in at least two rate cuts in December. The forecast also showed that eight policymakers are looking for only one rate cut in 2025, or none. It likely will be critical that inflation expectations remain anchored if reported inflation rises with tariffs for the Federal Reserve to move ahead with any rate cuts this year.

For the central bank to cut rates two times in 2025, the tariffs would need to result in only a one time price adjustment without creating any lasting inflationary pressures. Given pricing pressures from tariffs, the 30 to 60 basis point rise in inflation expectations embodied in Treasury yields over the past six months, and more Committee members not expecting two or more rate cuts this year compared to December, the possibility of two rate cuts in 2025 will require a significant deterioration in the labor market over the next couple quarters.

Following the announcement of 25% tariffs on global automotive imports to the U.S. and data pointing to weak consumer spending over the first two months of the year, the federal funds futures market priced in a high probability of three rate cuts this year. With the two-year Treasury yield closing March at 3.90%, the Treasury market is looking for two rate cuts in 2025.

In addition to leaving rates unchanged, the Federal Reserve announced that beginning in April the central bank will again slow the pace of reducing the size of its $6.8 trillion securities portfolio. The pace of Treasury security runoff will be lowered to just $5 billion per month from $25 billion. That is $20 billion fewer Treasury securities that the market will need to absorb each month. However, the central bank will continue to allow $35 billion in mortgage-backed securities and agency debt to mature each month without reinvesting the proceeds into new securities.

With recent economic data pointing to a slowing in the economy due to progress on lowering inflation stalling, and policy uncertainty very high with the Trump administration still in the process of rolling out its tariff agenda, the Federal Reserve plans to wait patiently on the sideline and watch how this all plays out. The economic data, and to a lesser extent the markets, will signal to the Federal Reserve which policy adjustments will be appropriate, as well as the timing. It is telling that Chair Powell said, “No one is highly confident in their forecast currently.”

Market Pullback Providing Long Term Investors with a Buying Opportunity

In a completely unexpected twist, the first round of Trump administration policies has driven Treasury yields lower, while common stock prices have pulled back from their mid-February highs on the S&P 500 and the NASDAQ Composite. The rally in bonds and the struggles in the stock market arose in part from worries over the negative impact President Trump’s tariff policies will have on the economy’s growth rate, directly opposite of the consensus view at the beginning of the year that the new administration’s pro-business stance would ramp the economy’s growth rate higher.

The markets were expecting the tariffs to flame inflationary pressures, but now the focus has turned to their potentially deleterious impact on growth. The 58 basis point drop in ten-year Treasury yields since mid-January has arisen from a complete shift in the tone of the market. Consumers are turning defensive as they fear job losses with the economy slowing and higher prices from tariffs. Businesses are increasingly hesitant as tariff uncertainty makes hiring and investment decisions more difficult, while housing continues to struggle with unfavorable affordability conditions. Households, businesses, and investors do not know which tariffs will be implemented, at what level, and for how long.

At the start of the year with expectations that the pro-business agenda of the Trump administration would provide the economy with a further boost, we expected the major risk to stock prices over the next year or so would be the Federal Reserve needing to shift policy to a more restrictive stance to fight a rekindling of inflationary pressures. That risk has clearly shifted to the economy’s growth rate stalling, or even falling into a mild recession, following President Trump’s unconventional approach to policymaking.

The markets are struggling to price the near term future given the policy uncertainty in Washington and accordingly have reset common stock prices lower. However, the proposed policies which are intended to be supportive of long term growth are positive — namely low tax rates, a level playing field on tariffs with U.S. trading partners, cutting regulatory burdens, and shrinking the size of the federal government. These policies are intended to boost productivity, efficiency, and the economy’s underlying growth rate. However, some of the policy adjustments that will boost long term growth can cause significant disruptions in the short run.

We continue to anticipate that with a president that tended to keep score during his first term on the basis of economic growth and stock prices and with a strong incentive to have a strong economy and higher stock prices going into the mid-term elections in 2026, the Trump administration policy mix will ultimately be positioned and implemented in a manner that is beneficial to the economy, earnings, and common stock prices. Echoing Chair Powell’s comment on forecasts at the recent FOMC meeting, however, the policy uncertainty gives any outlook an inherently wider error band currently.

It was easy to feel a touch stunned by the pullback in stock prices since February 19 as the decline from an all-time high on the S&P 500 to a -10.1% correction by March 13 took only sixteen trading days, one of the quickest reversals from a record high. The good news is that there have been five other corrections off an all-time high that took place in less than one calendar month and relatively quick rebounds were quite common, with an average return six months later a little over 14%.

Tariff clarity and resolution will eventually arrive, and combined with the Federal Reserve pursuing a more accommodative monetary policy, oil and gasoline prices falling, and Treasury yields off their recent peaks, the dynamics for a rebound in common stock prices have been developing for the past couple weeks. Additionally, it seems to be fairly risky for long term investors to bet against an array of outcomes which could boost investor sentiment in the near term, including the Federal Reserve restarting the rate cutting cycle, more benign and supportive tariff policies with the major trading partners of the U.S. than expected a month or so ago -- except for China -- and a cease fire in Ukraine.

As for the economy and earnings, at worst, we still anticipate a somewhat bumpy, soft landing for the economy. The real GDP reports could include a quarter or two of small negative quarterly growth rates similar to 1Q 2022 when a deterioration in the trade deficit pushed the economy’s quarterly growth rate into negative territory, although the overall economy did not slip into recession. The key in the near term is that the labor market and consumer spending hold up, providing the foundation for the economy to keep the expansion intact. A growing economy should support earnings growth for the foreseeable future.

It has been unsettling to watch the drop in stock prices since mid-February and further down-side could be ahead based on how the markets respond to the roll out of reciprocal tariffs on April 2. However, the long run fundamentals for the U.S. economy have not deteriorated and there is a good probability that the currently disruptive Trump tariff agenda will improve the economy’s long run growth potential.

In that regard, the current pullback in common stock prices is providing long term investors with an opportunity to put uninvested cash to work at much more attractive prices. Given the extremely high level of uncertainty, averaging the funds into the market would appear to be a prudent move.

Fixed Income Markets

Treasury Yield Curve Steepens a Touch

The Treasury yield curve steepened by 10 basis points during March to 31 basis points, roughly matching the degree of steepness in mid-January. These readings represented the steepest readings for the Treasury yield curve since 1Q 2022, prior to the Federal Reserve embarking on the most aggressive tightening of monetary policy since the 1980-81 period. A steeper Treasury yield curve is generally associated with financial market conditions that are conducive to a growing economy.

The steepening of the Treasury yield curve last month resulted from a -10 basis point drop in two-year Treasury yields to 3.90% from 4.00% and no change in ten-year Treasury yields. The -10 basis point drop in two-year Treasury yields resulted from the real yield falling -13 basis points on the month, while the inflation premium rose 3 basis points. While these were modest shifts, it is interesting that the decline in real yields dominated, in line with growing concerns about the outlook for the economy.

The dynamics behind the unchanged level of ten-year Treasury yields did not show much of a longer term concern about the economy with the real yield lower by -5 basis points while inflation expectations rose 5 basis points. So, again, a small nod to concerns about continued growth in the economy with a relatively small rise in ten year inflation expectations to 2.36% from 2.31% at the end of February.

Credit Yield Spreads Remain Well Below Average

Yield spreads on both investment grade and non-investment grade corporate securities to Treasury securities have widened a touch over the past 45 days as signs of the economy’s growth rate slowing have emerged, however, they are not flashing alarming warning signs of a recession. Once fixed income investors sense a serious recession is ahead, the extra yield required on both investment grade and non-investment grade corporate debt over Treasury yields increases to compensate investors for the higher level of default risk that needs to be reflected in corporate yields.

While yield spreads on corporate debt have widened a touch since mid-February, they remain well below the average yield spread. Namely, the current yield spread on investment grade corporate debt is 97 basis points, a little higher than the 79 basis point spread in mid-February, but remains well below the 152 basis point average yield spread since December 1996.

Likewise, the yield spread on non-investment grade corporate debt is currently 355 basis points, 93 basis points higher than the 262 basis point yield spread in mid-February, but remains well below the 542 basis point average yield spread since December 1996. We would be far more worried about the path ahead for the economy if credit yield spreads were running above their longer term averages, but that is not the case currently.

Additionally, the four week moving average of initial claims for unemployment insurance is 224,000, right in line with its average since December 2021. While recession risks have risen a touch since the beginning of the year, we do not see a serious recession in the near term as the most likely outcome. We view the economy as going through a downshift in its forward momentum in response to the policy uncertainty flowing from Washington, particularly as it relates to tariffs.

In this environment, investors should continue to benefit by embracing a barbell approach by taking advantage of still high yields on the short end of the yield curve because the Federal Reserve has not yet brought inflation down to the 2% target, while also modestly extending duration to lock in yields on intermediate term -- four to seven year -- fixed income securities.

Even though yield spreads on both investment grade and non-investment grade corporate securities to Treasury securities are below average, it appears to be worthwhile to increase corporate bond exposure given the recent modest widening of credit yield spreads. Additionally, we expect the soft landing scenario to continue to play out, with the economy in the early to middle stage of an elongated economic cycle. In this environment, yield spreads are not likely to widen to any significant degree.