Will The Growth Scare And Tariffs Continue To Sink Stocks?

Since its mid-February high, the S&P 500 has fallen by 7%, with 3% of that decline coming last week. 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 retreat of almost 16% since mid-December. The proximate cause of the pressure on stocks has been an economic growth scare and policy uncertainty surrounding tariffs.

The Growth Scare

The Atlanta Fed is currently forecasting a decline in U.S. economic growth in the first quarter. Much of the negative revision of its GDP forecast was due to higher imports, which likely spiked to front-run any expected tariffs on imported goods. Thus, this drag is likely to moderate over time.

The St. Louis Fed uses a different methodology, and its GDP estimate for this quarter is 2.5%. Thus, investors are left with a mixed picture in any case.

Economic Hard Data

Jobs are the ultimate center of the economy. Generally, if people have jobs, salaries are sufficient to support consumer spending and, thus, economic growth.

The monthly payroll report is considered the gold standard for judging the labor market’s health. Last Friday’s data showed that nonfarm payroll jobs grew by a below-consensus 151,000 in February. Perhaps a sign of creeping underlying weakness, hours worked remained at a 5-year low despite moving past the L.A. wildfires and challenging January weather conditions. The unemployment rate rose to 4.1% from 4.0%.

The four-week moving average for initial unemployment benefits claims has been rising. In addition, continuing claims for unemployment benefits are pushing on multi-year highs, indicating that those losing their jobs are having a more challenging time finding employment again.

The data indicates a softening labor market but is not yet weak enough to signal an imminent recession. Notably, the Sahm Rule has had no false alarms in predicting a recession and remains below the trigger level. The Sahm Rule uses a half-percentage point rise in the three-month average unemployment rate over the low of the previous twelve months to predict an economic downturn.

Economic Soft Data

The weaker economic data seems to be coming from soft data, like consumer confidence data. The University of Michigan consumer sentiment reading has fallen to its lowest level since 2023. Unfortunately, survey data can be unreliable as consumers often do differently than they say. On a positive note, the reading has reached these low levels previously without triggering a recession.

Further complicating sentiment data, political affiliation seems to significantly impact the results. Democratic consumer confidence has plunged since President Trump’s election. This is not abnormal because consumer confidence among Republicans was even worse during much of President Biden’s term.

Policy Uncertainty: Tariffs

While the tariffs on Canada and Mexico have been mainly postponed as of this article’s writing, higher tariffs seem likely to follow. China, steel, and aluminum have already been hit with higher levies.

Taken together, China, Canada, Mexico, and the European Union account for almost 50% of imports in the U.S. Interestingly, following Covid and the last trade war, supply chains have diversified away from China.

While supply chains have reduced their dependence on China, it still has the largest trade surplus with the U.S., which makes it a large target for increased tariffs. Mexico and Canada also have large trade surpluses, so they may remain targets. Notably, the U.S. has significant leverage with Canada and Mexico; their exports to the U.S. make up a large enough portion of their GDP that sizable tariffs from the U.S. would likely force their economies into recession.

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. Reciprocal tariffs are meant to place U.S. tariffs equal to those experienced by U.S. goods imported into that region.

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. Lastly, the administration can withdraw or focus the tariffs more narrowly if the costs elevate recession risks sufficiently.

Stock Market Signals

The more economically sensitive cyclical stocks have recently been underperforming the less economically sensitive defensive stocks. This further bolsters the argument that an economic growth scare is one cause of the recent stock weakness. While it should continue to be monitored, the relative weakness of cyclicals isn’t at the level seen before past recessions.

Bond Market Signals

Some believe the bond market is a more accurate forecaster of economic fortunes, but it should undoubtedly be part of the mosaic to monitor the economy’s health. While the spreads on high-quality investment-grade corporate debt and high-yield junk bonds are above recent lows, the increase is insufficient to trigger substantial fear of any impending economic downturn. The spread is the yield investors demand beyond U.S. Treasury bond rates to compensate for the default risk from buying corporate bonds.

The nominal 10-year Treasury note yield ended last week at 4.30%, down from 4.79% in mid-January. This yield decline generally signals declining economic growth expectations or a flight to safety. Looking at a decomposition of the yield, most of the decrease in yield was driven by the real, after-inflation component of the yield, which fell from 2.33% in mid-January to 1.96% and points to economic growth concerns.

Fed Rate Cuts Coming

As the growth scare has played out, markets have begun to expect more Federal Reserve (Fed) rate cuts in 2025. In early January, expectations for Fed cuts fell to only one for the year but have increased to three, with the first cut expected in mid-June.

What To Watch This Week

Though it is released with a significant lag, Tuesday’s JOLTS job openings data will be closely parsed for clues as to how quickly the labor market is deteriorating.

The February consumer inflation (CPI) release will be crucial as inflation has been running hot recently. Some inflation relief could more easily open the door for Fed rate cuts. Consensus and Cleveland Fed estimates are forecasting some improvement, which markets would welcome.

Lastly, the University of Michigan consumer sentiment is scheduled for Friday. Sentiment is expected to deteriorate further, but this should be taken with a grain of salt.

Conclusions

While never pleasant, the recent 7% decline in stocks from the peak is well within the average intra-year decline of 14.6% experienced by the S&P 500 over the long term. If the bond market is correct, this is a growth scare and not the beginning of a real economic downturn. The policy uncertainty caused by the threatened tariffs seems likely to drive market volatility. All other things equal, uncertainty lowers the valuation investors are willing to pay for risk assets such as stocks. Typically, if the uncertainty drags on long enough, markets eventually become numb to the perceived threat. Notably, unlike in 2022, bonds have provided a safe haven as stocks have declined, which can help cushion the impact of a portfolio.

Forecasting stock swings in the short term is a mug’s game, so the recent stock declines provide a reminder to keep enough safe assets to fund short-term liabilities. While stocks offer the highest annualized return long-term, they are subject to the whims of sentiment and animal spirits, so they are unreliable for funding short-term needs. Warren Buffett’s recent annual letter did a fantastic job describing the benefits of investing in great companies as a long-term hedge against inflation to retain purchasing power.