Investment puzzle

Equities outperforming despite weight of tariffs

Trying to make investment decisions amidst so much geopolitical uncertainty is like trying to win at poker with a deck that keeps reshuffling itself mid-hand. A stray comment from a central banker, a vague tweet from a billionaire president, haphazard tariff headlines and trade deals that are more about strategy than substance have sent U.S. equity markets reeling or surging.

The latest in this fear/greed playbook was an agreement between the U.S. and China to reduce their embargo style tariffs by 85% for 90 days so the parties could open negotiations for a comprehensive trade deal.

That was welcome news for Chinese factories and U.S. importers. It also reset third- and fourth-quarter earnings expectations and spurred a massive rally in U.S. and Chinese stocks. At the end of trading on Monday, May 12, U.S. equities had recovered all the losses that were triggered by President Trump’s April 2 “Liberation Day” levels.

At the time of writing, U.S. equity markets were still below 2024-year-end levels (see chart below) but had made a remarkable recovery from the post-liberation day selloff. Perhaps more remarkable is the year-to-date performance of the Canadian market as measured by the iShares S&P/TSX 60 Index ETF (TSX: XIU), that is up 3.00% since the end of 2024.

There is a puzzling divergence between hard and soft economic data as well as the uncertainty triggered by President Trump’s haphazard approach to tariffs. The problem lies in trying to decipher why equity markets are paradoxically performing better than expected in light of the largest corporate tax hike in U.S. history.

On a positive note, first-quarter earnings have come in better than expected. However, in keeping with our uncertainty barometer, forward guidance had all but disappeared. That’s problematic for experts trying to predict outcomes across forward-looking equity markets. How can analysts assign reasonable probabilities to outcomes when corporate insiders cannot?

We believe the performance of equity markets over the next six to nine months will come down to macroeconomic conditions rather than company-specific events. Perhaps, given the rally on May 12, investors have come to believe that Trump’s tariff policies will deliver the results that he has been promising. A little pain now for a better economy later.

Our view based on trading volumes and frequency of buy and sell decisions is that gyrations in the U.S. equity markets are being propelled by long-short hedge funds and retail day traders. And while we never discount the premonitions of the retail investor collective, one must ask if we are experiencing a classic fakeout boosted by misguided optimism. One thing is certain, the May 12 rally has diminished the outlook for any near-term rate cuts.

We know that the U.S. economy did not feel the pinch of tariffs in the first quarter. There is also a view that consumers and companies attempted to front run the tariffs by stockpiling supplies and inventory. That would explain the better-than-expected profits during the first quarter.

The hard economic data provides additional support to that thesis. There is clear evidence that the U.S. economy is declining. U.S. GDP decreased at 0.3% in the first quarter (January through the end of March), according to the advance estimate released by the U.S. Bureau of Economic Analysis. In the fourth quarter of 2024, real U.S. GDP increased 2.4%.

The decrease in real first-quarter GDP was driven by an increase in imports, which are subtracted from the GDP calculation, and a decrease in government spending. These movements were partly offset by increases in investment, consumer spending, and exports.

Consumer spending and private investment remained steady, increasing by 3% in the first quarter, compared with 2.9% in the fourth quarter.

Private investment is a more challenging statistic. It may be the result of companies investing to onshore their production to avoid future tariffs. Or it could be projects that were underway but may not necessarily imply future expenditures.

Inflation is also sticky. The year-over-year price index for retail consumption increased 3.4% in April, compared with an increase of 2.2% at the end of the fourth quarter. The personal consumption expenditures (PCE) price index (the Fed’s favorite inflation barometer) increased by 3.6%, compared with an increase of 2.4% in the fourth quarter.

Excluding food and energy prices, the PCE price index increased 3.5%, compared with an increase of 2.6% in the fourth quarter of 2024. These numbers point to a worrying rise in prices which requires the U.S. Federal Reserve (Fed) to question whether the inflationary impact is transitory or more deep-rooted.

Interestingly, the inflation data seem at odds with an upbeat employment report. Non-farm payroll employment surprisingly rose by 177,000 in April, roughly in line with the average monthly gain of 152,000 over the prior 12 months. Employment continued to trend up in health care, transportation and warehousing, financial activities, and social assistance. Federal government employment declined.

The total non-farm employment change for February revised down from +117,000 to +102,000, and the change for March was revised down from +228,000 to +185,000. On net, employment over these months is 58,000 lower than previously reported. 

Average hourly earnings for all employees on private-sector payrolls rose by 6 cents, or 0.2% in the month of April. So far this year, average hourly earnings have increased by 3.8% which is above the prevailing inflation rate.

Clearly, the stronger-than-expected labor market was one catalyst that supported the upward momentum in equities. And that may continue if the labor market remains buoyant and the upward bias of employment income persists. Unfortunately, neither scenario is predictable.

The soft economic data paints a very different picture. Surveys taken during March 2025 showed a marked decline in sentiment. According to the U.S. Conference Board, the Consumer Confidence Index declined by 7.2 points to 92.9, marking a 12-year low in consumer expectations for the future. This decline Is reminiscent of the fallout during the covid pandemic and reflects ongoing concerns about the economy. Consumer confidence has declined for four consecutive months.

If the soft data hold, it means the future will not look anything like the recent past.

Next time: Tariff guesswork, the Fed’s uncomfortable position, and outlook for Canada

Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.

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