A Strong Economy, a Broadening Market
Throughout 2024 and entering 2025, there has been a growing sense of optimism about the U.S. economy, which we share. The economy has remained resilient with steady GDP growth, cooling inflation, and a robust labor market.
A resurgence in inflation seems to be the market’s primary concern at the moment, with worries that it (along with an accompanying rise in interest rates) could derail economic activity, pinch consumer spending, and send the market falling. While this is a real risk, there are certain drivers that could make this less of an impact than the market believes.
That said, we do think it’s important to be cognizant of the risks that are present. The economy and the stock market, while related, are not the same. What matters for markets isn’t just the absolute level of economic growth, but how expectations align with reality, and we think valuations in some parts of the market may have gotten ahead of themselves.
Evolving Market Leadership
For much of 2024, market strength was concentrated in a handful of the largest technology stocks, the so-called “Magnificent Seven.” As the year progressed, that dynamic started to shift. Market breadth improved, and some long-ignored sectors began to find their footing. But the core issue remains: stock market valuations, particularly in the U.S., are still high by historical standards.
When starting valuations are elevated, future returns tend to be lower. It’s not an ironclad rule, but historical analysis suggests that markets trading at these levels typically deliver muted long-term returns.
And while we think the chorus of comparisons to the 2000 Tech Bubble are misplaced, last week’s headlines about Deepseek (China’s ChatGPT competitor) illustrate the risks of such concentration as well as the diversification benefit of having exposure to companies outside just the largest companies.
Tariffs, Volatility, and Inflation
To add further complexity, the recent announcement of broad tariffs on Canada, Mexico, and China has quickly become a primary concern for investors. The Trump administration has announced a 25% tariff on imports from Canada and Mexico, two of its largest trading partners, along with a 10% tariff on imports from China. This announcement has begun to raise serious questions about the future of trade relations, inflation risks, and overall market stability.
In the near term, we expect market volatility as investors work to interpret the potential economic impact of these tariffs. Markets are not only digesting the immediate effects of the policy but also trying to determine whether this is a negotiating tactic or the start of a prolonged trade conflict. The uncertainty surrounding how U.S. trading partners will respond, and whether further tariffs will follow, adds to the potential for market swings in the months ahead.
One of the primary concerns stemming from this announcement is the potential for higher inflation. Tariffs generally raise the cost of imported goods, which can ultimately flow through to consumer prices. Given that Canada and Mexico account for a significant portion of U.S. imports, this has led to growing fears that inflation could accelerate, forcing the Federal Reserve to keep interest rates higher for longer and diminishing purchasing power and consumer spending. However, while this is a real risk, we believe there are certain trends that could work towards dampening the impact on inflation:
- In housing, rising home prices have been a major contributor to inflation over the last few years, but this dynamic could change. Affordability has deteriorated with mortgage rates back above 7%, slowing housing starts, and relatively high levels of inventory. It’s possible we could see home price growth flatten out this year, which would have a dampening effect on overall inflation.
- Manufacturing activity (or more accurately, the slowdown of manufacturing activity), could also be a contributor. Legislation like the CHIPS Act and the Inflation Reduction Act unleashed a wave of investment in domestic manufacturing, with hundreds of billions of dollars pouring into new factories and supply chains over the last few years. But as this investment cycle matures and spending slows down, digesting this excess capacity will likely exert a deflationary impulse.
- While tariffs are often assumed to be inflationary, both Treasury Secretary Scott Bessent and economist Stephen Miran (Trump’s nominee for Chair of Council of Economic Advisors) have suggested that their actual impact on inflation could be more limited. In a recent letter, Miran explained that the effect of tariffs on inflation could be minimal if currency markets adjust accordingly. Both he and Bessent have reinforced the view that Trump sees tariffs primarily as a negotiating tool, rather than a structural shift in trade policy. While Trump remains a (significant) wildcard, this suggests that there are scenarios where tariffs may not be as inflationary as many assume.
While tariffs and trade conflicts can create short-term volatility, history suggests that markets are resilient, with the 2018–2019 U.S.-China trade war serving as an important case study. During that period, equity markets sold off sharply following tariff announcements, as investors feared the impact on global growth and corporate earnings. However, stocks rebounded as businesses adjusted their supply chains, negotiations evolved, and currency markets adapted to offset the effects of tariffs. Ultimately, the S&P 500 produced a 29% return in 2019 despite the turmoil of the ongoing tit-for-tat tariffs.
What This Means for Portfolio Positioning in 2025
While we are closely monitoring developments and stand ready to adjust positioning if needed, your portfolios are already structured to handle shifting market conditions. The current market environment—characterized by high equity valuations, shifting leadership, and the uncertainty surrounding tariffs—reinforces the importance of a diversified, balanced investment approach.
Our portfolios are designed to be well-diversified across company size, geography, and valuation, providing built-in defense against risks like the concentration of market leadership and the impact of tariffs on specific sectors or regions. In particular, your allocations to small and mid-cap stocks as well as value stocks will offer a more balanced risk-reward tradeoff and adds diversification to portfolios.
Valuations outside the U.S. remain significantly lower than domestic markets, presenting a potential opportunity for long-term investors. Additionally, maintaining exposure to international equities helps reduce reliance on a single economy, providing diversification benefits that can help balance portfolio risk over time.
With interest rates at historically high levels, bonds also offer attractive income and the potential for solid risk-adjusted returns. Current yields provide a meaningful opportunity for income-oriented investors, particularly as bonds continue to serve as an important diversifier against stock market volatility. However, we remain mindful of inflation and policy risks, particularly as trade uncertainty and fiscal policy could put upward pressure on rates. For this reason, we favor shorter-duration bonds, which help reduce exposure to rising interest rates while still benefiting from today’s elevated yields.
Closing
The tariff announcement is a reminder of just how quickly market conditions can change. While we are closely monitoring the risks tied to trade policy, inflation, and shifting market leadership, we are not making reactive moves based on short-term policy shifts. Instead, our focus remains on long-term fundamentals and ensuring portfolios are built to withstand a range of economic environments.
Our investment approach is designed to balance risk and opportunity, maintain diversification, and adapt as needed—without being swayed by short-term uncertainty. By staying disciplined and focusing on portfolio resilience, we aim to protect and grow your capital over time, regardless of near-term market fluctuations.
As always, we encourage you to reach out if you’d like to discuss how these themes may impact your portfolio. We appreciate your trust and look forward to the year ahead.
