Blurred Lines

Sewing Circle: Chaos theory normally describes the force applied by small events having an outsized impact on complicated systems. So, what happens when actual chaos is introduced? This describes what we are currently enduring, as financial and political structures are being sewn with chaos. It is difficult enough to invest in markets under typical uncertainty, but impossible to stay invested as instability is being woven into the current economy. If things are bad, you can short, if things are good, you can go long; if you can’t discern the near-term outlook, you can go to cash. It is no surprise that investors are moving to the sidelines until there is greater clarity or moving to other places, such as Europe or Emerging Markets where there is slightly more visibility. The pace of chaos must slow for markets to regain their footing. Until then, expect more of the same.

Tug of War

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Everything is transitioning, and Canada’s new Prime Minister Mark Carney stands as a prime example: he has plans to go to the UK and France this week and has yet to make any plans with President Trump. He declared, ”We will create new trade corridors with reliable partners.” Central Banks around the world are repositioning monetary policy to reflect stagflationary consequences. Investors have transitioned from euphoria over slow-to-implement tax and deregulation policy to fear over easier-to-implement tariff and immigration measures. Capital is transitioning out of US equity into money markets and bonds. Depressed investment themes for Europe and China have suddenly become engaging, thanks to improving fundamentals supported by aggressive fiscal policy.

President Trump expects tariffs to reverse the decades-old transition away from U.S. manufacturing. The lags involved with this promise are ominous because foreign direct investment plans will evaporate if the tariffs generate a global slowdown. Intel postponed the opening of its Ohio plant by six years due to faltering sales and a plummeting stock price in 2024—if tariffs are the tool incentivizing countries to shift production here, can it dominate the incentive to curb costs in an economic downturn caused by those very tariffs?

Fear that tariffs will undermine this manufacturing renaissance may have contributed to the current bearish backdrop. How soon can we move back to bullishness? For the answer, look toward small cap equities. The Russell 2000 companies are levered to the U.S. economy and carry three times the debt to earnings ratio of S&P 500 companies. For those reasons small caps historically outperform when U.S. business prospects brighten. We will wait for small cap outperformance as the sign that investors are beginning to look through the gloom.

Update: Too Much of a Bad Thing?

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Things are so bad we can only hope that’s good. The US consumer outlook is far from rosy: the preliminary March survey of University of Michigan Consumer sentiment dropped more than 10%, with the key expectations component falling 15% on the month. Even among Republicans, whose mood about current economic conditions somehow rose, their feeling about the economic outlook fell an outsized 10%. Across all consumers, sentiment has dropped each month this year and is down a dramatic 22% since December. Notably, 5-year inflation expectations increased this month by the largest amount in three decades, jumping from 3.5% to 3.9%, and have risen almost a full percentage point since December. There is a glimmer of hope with the New York Fed’s 5-year inflation expectations data holding steady at 3.0% for February, but we are concerned it will make a new high when the March data is released in a few weeks. Inflation expectations of 4% will stop the Fed dead in its tracks and flip the conversation toward tighter monetary policy in hopes of talking down these troubling inflationary views.

Sentiment toward the stock market fell through the floor. In its 40-yer history, the American Association of Individual Investors’ AAII Investor Sentiment Survey has never had three weekly consecutive readings with bearishness this high and bullishness this low. Consumer and investor sentiment at this degree of pessimism should mark a major stock market low, but we may face a major corporate retrenchment while equity valuations are still too high. This makes the sustainability of any rally questionable. We will watch near-term price action for positioning clues.

BoC Plain Talk

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We certainly can’t say that Bank of Canada Governor Tiff Macklem beats around the bush. Last week, he said the BoC’s focus is to keep inflation expectations anchored, but there is “Nothing monetary policy can do to avoid the inevitable weaker demand for our exports and the inevitable weaker manufacturing pressures that could lead to layoffs.” The result is that consumers are saving more and spending less, and companies are scaling back hiring plans and future capital spending. He described the inflation pressures realistically: “retaliatory tariffs add costs to imports from the U.S., and the Canadian dollar is depreciating, so all imports are more expensive. Manufacturers are looking for new markets to avoid tariffs, which entails extra costs. Concern over supply chain problems is causing businesses to hold more inventories. All these costs get passed through to the consumer.” His Senior Deputy Governor Carolyn Rogers is a kindred spirit, adding: “We are seeing the equity markets…react to trade policy…reality is sinking in.”

The Bank of Canada stated flat out they cannot lean against a growth downturn and inflation simultaneously. They drew a parallel between today and the pandemic supply shock of 2020 because a trade war also creates supply chain pressures. However, back then, fiscal stimulus created a surge in demand, and firms were able to pass on cost increases quickly. Presently, increased production costs may not be able to be passed on as easily given the softer consumer demand environment. While this is good news for inflation, it is horrible for business margins, and that could drive unemployment up and stocks down.

We will see whether Jerome Powell takes a lesson from his Northern neighbors and gives a sober assessment when he speaks to the press after the Federal Open Market Committee (FOMC) meets Wednesday. This will be a test of Powell’s recent optimism. He has helped the markets in the past, so we would not be surprised by a positive spin.

What to Look for This Week

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1. Monday, March 17 at noon D.S.T. Atlanta Federal Reserve’s GDPNow estimate. The Atlanta Fed’s running estimate for real GDP growth for Q1 has captured the market’s attention after it plunged as low as -2.8% based on weak consumption and net export data. The most recent level is -2.4% on March 6. The NY Fed’s Staff Nowcast has also fallen since February, but only from 3.1 to last Friday’s 2.7%, so there is a chance for a rebound in the Atlanta Fed’s data.

2. Wednesday, March 19 at 2:00 p.m. D.S.T. the FOMC rate decision statement is released, followed by Chair Powell’s press conference 30 minutes later. It is as certain as it can get for no change in rates, but the press conference will look for references to the uncomfortably high 5-year inflation expectation jump to 3.9% from the University of Michigan preliminary survey. The major market mover could be the Summary of Economic Projections. We are focused on the median core PCE forecasts for year end to compare it to December’s 2.5% forecast for 2025.

3. Thursday March 20 at 8:30 a.m. D.S.T is the Q4 Current Account release. Normally not a market mover, but it is projected to go from a deficit of $310 billion to $390 billion. If it crosses above $400 billion, that may elicit angry tariff talk out of Washington. 

FOMC Voters Speaking: After the blackout period ends for the March 18-19 FOMC meeting, NY Fed President John Williams is the first voter to talk on Friday March 21 at 9;05 a.m. D.S.T. The BoJ and BoE interest rate decisions are out Tuesday March 18 at 11:00 p.m. D.S.T. and 8:00 a.m. Thursday March 20, respectively. Similar to our expectation for the FOMC, rates should remain unchanged, but what matters is any mention of tariffs weighing on future policy decisions.