Nobody Knows - MMM v6-16

Uncertainty is the best word to describe the current outlook for the economy, stocks, bonds, and everything else in our world. Yet we continue to hear from 'experts' confidently declaring that they know what the next few weeks, months, or even years will look like. Often times you will get conflicting information and advice. What you will not hear because it will not make good television (or views on social media) is an honest answer:

I have no idea what the outcome of this will be.

We are dealing with very complex economies and leaders in both China and the US who are HUMAN. Humans will often make irrational decisions especially when we have complex situations with major consequences. Often you can learn from history to help form your decisions, but unless you are over 90 years old, you have no memory of a full on US driven trade war. Most of us did study the outcome of that trade war in history (and economics) class – the Great Depression.

I'm not saying we are going into another depression. There were obviously many other drivers that all had to fall into place to cause the depression, but it could happen if the wrong decisions are made. We could also have a very positive outcome. The key is this:

NOBODY KNOWS!

Explaining the Trade War to a non-finance person

One reason we started "Money Talks with Dad" was to explain finance topics to people who do not have a finance background, but want to learn more about how the economy and finance works. Two weeks ago we saw the market move so much that it was the lead story on our local news. This led my daughter to have all kinds of questions which we recorded in the latest episode of Money Talks with Dad:

In the episode we go way beyond tariffs and answer questions many people may have. We even got down to explaining what a "bond" is and what in the world is the Dow. It was a fun topic and one I hope helps "normal" people better understand what is happening.

Powell rattles markets, by speaking the truth

In a speech last Wednesday, Fed Chair Jerome Powell spoke candidly about the dilema the Fed is facing with the trade war. He said:

1) The FOMC was surprised by the size and scale of the Trump tariffs.

2) As such, the tariffs will put more upside risks on inflation than previously anticipated.

3) The tariffs are likely to put downward pressure on future economic growth prospects as demand is being pulled forward at an immeasurable rate (this was evident in the Retail Sales data)

4) The Trump administration’s tariff policies are threatening to put the components of the Fed’s dual mandate “in conflict,” which raises significant concerns about future Fed policy and stagflation risks.

This of course led to some harsh comments from President Trump:

• April 17: Trump stated that Powell's "termination cannot come fast enough," criticizing him for not lowering interest rates in line with the European Central Bank's actions. ​(Source: Reuters)
• April 18: Reports indicated that Trump is exploring the possibility of dismissing Powell, with economic adviser Kevin Hassett confirming that the administration is examining legal options for removal. ​(Source: Los Angeles Times)
• Trump accused Powell of "playing politics" by not reducing rates, implying that the Fed's decisions are influenced by political considerations. ​Source: The London Times)
• On Truth Social, Trump labeled Powell as "always TOO LATE AND WRONG," expressing frustration over the Fed's monetary policy stance. ​(Source: Fox)

The Fed Chair's term is up in May 2026, so unless the President can find cause for termination. Not supporting the President's agenda is not something he can be fired for. In fact, the independence of the Federal Reserve is critical in maintaining financial stability, which is important, especially given the uncertainty the global economy is facing right now.

This reminds me of a TikTok video we posted in 2022 after President Biden was critical of the Fed and was blaming them for causing the big spike in inflation:

I would argue a good Fed chair offends BOTH political parties because the Fed DOES NOT have a political agenda.

Trade War Continues to Escalate

It wasn't just Jerome Powell causing more large fluctuations last week. The trade war headlines again caused more concern for the markets.

In addition to matching the US retaliatory tariffs, China has also imposed additional trade restrictions on rare earth element exports which are critical for the US defense and tech industries. China also banned imports of Boeing aircrafts and said they were returning some aircraft recently purchased.

You would think at some point this would lead to a decline in expected earnings, but thus far that is not the case.

An alternative reality?

Earnings estimates for the S&P 500 have barely come down. Just this week, 2 blue chip companies announced major changes to their outlook.

• Nvidia projects $5.5 billion loss in revenue – 10% of 2024 total. 
• AMD announced they expect an $800M hit related to inventory, purchase commitments and reserves. For reference, they earned $1.6B in 2024, so this is half of last year's earnings.

What is interesting is on a quarterly basis it does look like analysts are changing their outlooks a bit:

However, the calendar year estimates are barely down – just $4 for 2025 and $9 for 2026. Analysts expect earnings to be UP 13% in 2025 and another 14% in 2026. The long-term average growth is 10%.

What are we missing? Is the Trump trade war going to produce ABOVE average growth the next 2 years? If the answer is 'no' then we have a problem because the artificially high estimates makes stocks look more "attractive" than they really are. Assuming 13% 2025 growth and 14% 2026 growth, the current forward P/E is right at the long-term median of 18.

What if 2025 growth is flat and 2026 growth is up 10%? Now the FORWARD P/E would be 21, which means instead of stocks being "fairly" valued, they would still be OVERVALUED.

I don't know the answer — NOBODY KNOWS, yet I've heard many "experts" cite the current forward P/E as being 'attractive'. It's only attractive if we have above average growth of 13% in 2025 and even higher growth of 14% in 2026.

Who "wins" in a Trade War?

We all like to think everything is a zero-sum game. We have one winner and everybody else loses. Unfortunately that is not the case and a lot can go wrong. The real answer is NOBODY KNOWS, but here are some thoughts.

📉 Economic and Market Outlook

🔻 Short-Term Losers: Both Countries

Consumers pay more, companies face uncertainty, and markets get volatile.

• Tariffs led to higher prices for U.S. consumers, not Chinese exporters.
• GDP losses for both countries, with especially notable drops in U.S. farm and manufacturing exports.
• Tariffs act as a tax. The importing country (in this case, the U.S.) generally bears the brunt of the cost through higher prices. Exporters lose market share. Both economies lose efficiency.

Sources: Peterson Institute for International Economics & World Bank / IMF

🏗️ Long-Term Winner Depends on Three Factors

🔄 Ability to Restructure Quickly

• China's advantage: Centralized state control allows for rapid policy redirection (e.g., stimulus or reallocation of exports).
• U.S. advantage: Economic flexibility through market-driven innovation and capital mobility.

Source: McKinsey Global Institute: “China and the world: Inside a changing economic relationship” (2020)

🚀 Investment in Innovation and Self-Sufficiency

• U.S. leads in AI, semiconductors, biotech.
• China is catching up, especially in EVs and clean energy.

Sources: Carnegie / Business Insider / Center for Strategic and International Studies (CSIS)

🌐 Global Trust and Alliances

• The U.S. maintains strong alliances via NATO, G7, and major trade pacts (like USMCA).
• China's global image has been challenged by Belt & Road debt issues and tensions in the South China Sea.

Sources: Brookings Institution – U.S. as a “systemic hub” of global capital and trade / Economist Intelligence Unit (EIU)

That might lean toward the U.S. due to its flexibility, capital markets, and global alliances—but only if it avoids prolonged protectionism that stifles growth.

China needs us more than we need them 

I've heard from several people the past couple of weeks who are fearful that China could destroy our economy if we push them too hard. China most certainly has ways to “retaliate” and hurt the US. During a war between two proud men and proud countries, there are most certainly risks this could spiral out of control. 

That said, I will continue to say what I have said for the past 15 years:

• China needs the US more than the US needs China
  • China’s overall population is declining
  • China’s elderly population is ballooning
  • China built their economy to sell to the US and other Western countries
• If China does anything to damage the US financially, it will hurt them. Selling US Treasury bonds would cost them money
• The US has more flexibility to move away from Chinese manufacturing
• Not selling rare earth materials to the US would also damage their economy since US based companies are the number one user of these materials (see first bullet point)

John Mauldin in his Frontline Thoughts had two enlightening charts illustrating how much China depends on the US:

A very large portion of China's GDP comes from the US while a much smaller portion of our GDP is sold to China. These charts also illustrate what President Trump has been saying – China is taking advantage of the US and has for decades. While I don't agree with punishing every country that runs a trade deficit with the US, I do agree with his stance on China.

We learned during COVID what happens when we rely too much on one country and we’ve already started the process since then to reduce that reliance. I don’t mean to write this off as not being a concern, but we have to remember China is a communist country who hides the truth from both their people and the rest of the world. The insider reports we’ve seen tells us they have much more debt, much more poverty, and much weaker stability than they publicly report. This trade war will threaten their government much sooner than it would threaten ours.

How the US wins

the only way the US can truly win is to find a way to shift manufacturing to the US in a way that does not destroy companies, create mass unemployment, or erode our standing in the world. Saying we want to make more stuff here is one thing. Doing it is another. China being a centralized system has more flexibility to shift their economy than the US. Trump most certainly can reduce regulations and he has promised to do that, but we still have a complex legal, regulatory, and political system along with sophisticated capital markets than China does. Which brings me to this thought:

 **Who is going to finance the build-out?**

Moving manufacturing takes a great deal of time and more importantly MONEY. The problem we are facing is the Trade war has made the cost of capital significantly more expensive because:

• Trust in the US markets has been eroded
• Profit margins are being squeezed
• Investment losses are piling up
• Mass uncertainty exists

This means if the President truly wants to move manufacturing here he must do more than penalize companies, but offer both incentives and cheap financing. Some sort of public-private partnership needs to be created where the US government assists in creating bonds designed for the building of manufacturing facilities in the US. They could use "war bonds" or the other federal bonds used to finance the "New Deal" as an example. Offer tax free income backed by the federal government at rates that are more attractive to corporations than the capital markets are offering right now.

Without that, many corporations may choose to simply wait until a new administration is in place rather than spend the billions of dollars on multi-year capital improvement projects.

What happened to Treasuries?

Two weeks ago Treasury bonds unexpectedly spiked from a low of 3.8% to as high as 4.5% in a couple of days. There were reports this was driven by Chinese selling, but analysis of what truly happened has been completed. The selling seemed to come mostly from the unwind of some "basis spread" trades put on by large hedge funds and other alternative funds. After the election everyone on Wall Street started betting on one specific outcome: high growth, low inflation.

If correct, this would lead to long-term rates trending down, which leads prices to go up. This would mean investments in futures contracts for Treasury bonds would be appreciating in value more than current Treasuries, so these funds went 'long' Treasury futures and 'short' cash Treasury bonds. By design futures require leverage, but of course the more leverage you use the more potential returns you can make, so thinking this was an "easy" trade, these funds used mass amounts of leverage to put them in place.

Well, we now know that at least for now, the high growth, low inflation environment is not happening, which means these bets are losing money. That also means "margin calls" where funds are required to put up a bunch of additional money to keep the leverage ratios at the pre-agreed upon level with their brokerage platforms. Following the Liberation Day announcement and the 12% drop in stocks, Treasury bond yields went DOWN, giving these funds a reprieve. Nobody is sure what happened to cause the initial selling the next week, but when it started the unwind of this "easy" trade began.

We talked to some of our fixed income managers, some of the biggest names on Wall Street about this and they all agreed this is what they saw – a simple, yet scary margin squeeze from a trade that everybody seemed to think was easy money. For now, it appears the unwind is over (or at least everyone's margin positions are back in alignment.

Bloomberg's Odd Lots, as they typically do summarized the trade in great detail, including providing some interesting charts to illustrate the size of the trades, and the instant seizing up of the financing behind the trades.

I also asked ChatGPT to come up with a graphic to illustrate the trade using the details from the Bloomberg article and this is what it gave us. Not sure if it helps, but I'm continuing in my attempts to find ways to use it for more productive work.

I chalk this up to another example of Wall Street being Wall Street. For now, it appears yields have stabilized, but things can change.

Market Charts

I think I might eventually title this chart, "things do not always work like you'd expect". Stocks are now down 8% since election day. This chart does show the attempt to climb out of the Liberation Day lows.

Bigger picture, the S&P 500 is down about 14% from its high since the Trade War heated up, but still up 28% since late October 2023. On an annualized basis, the S&P 500 is up 20% since the Fed announced they were done raising interest rates.

From a trading standpoint, it looks like a move below 5250 could hint we are going to retest the lows around 5000, but a move above 5400 could cause a sharp spike higher.

The losses last week took the S&P down to a -10% return for 2025, with small caps remaining the worst performer.

As mentioned above, yields are attempting to stabilize.

Corporate spreads are still not showing any sign of significant stress.

And the labor market appears to still be holding up with initial unemployment claims actually dropping last week.

All of this means we did not have any changes to our overall allocations as noted below.

SEM Model Positioning

No changes were made after our sell signals on 4/3 & 4/4 as noted below. At least according to the data, we are in a "wait and see" mode.

-Tactical High Yield sold high yield bonds on 4/3/25 after 9 weeks in these funds. All proceeds were moved to money market or short-term bonds, with a yield around 4.1% in money markets.

-Dynamic Models are 'neutral' as of 6/7/24, reversing the half 'bearish' signal from 5/3/2024. 7/8/24 - interest rate model flipped from partially bearish to partially bullish (lower long-term rates).

-Strategic Trend Models received 1/2 of the trend sell signal on 4/5/25

SEM deploys 3 distinct approaches – Tactical, Dynamic, and Strategic. These systems have been described as 'daily, monthly, quarterly' given how often they may make adjustments. Here is where they each stand.

Tactical (daily): On 4/3/2025 our tactical high yield model sold out of high yield bond into money market.

Dynamic (monthly): The economic model was 'neutral' since February. In early May 2023 the model moved slightly negative, but reversed back to 'neutral' in June. This means 'benchmark' positions – 20% dividend stocks in Dynamic Income and 20% small cap stocks in Dynamic Aggressive Growth. The interest rate model is slightly 'bullish'.

Strategic (quarterly)*: One Trend System sold on 4/4/2025

The core rotation is adjusted quarterly. On August 17 it rotated out of mid-cap growth and into small cap value. It also sold some large cap value to buy some large cap blend and growth. The large cap purchases were in actively managed funds with more diversification than the S&P 500 (banking on the market broadening out beyond the top 5-10 stocks.) On January 8 it rotated completely out of small cap value and mid-cap growth to purchase another broad (more diversified) large cap blend fund along with a Dividend Growth fund.

The * in quarterly is for the trend models. These models are watched daily but they trade infrequently based on readings of where each believe we are in the cycle. The trend systems can be susceptible to "whipsaws" as we saw with the recent sell and buy signals at the end of October and November. The goal of the systems is to miss major downturns in the market. Risks are high when the market has been stampeding higher as it has for most of 2023. This means sometimes selling too soon. As we saw with the recent trade, the systems can quickly reverse if they are wrong.

Overall, this is how our various models stack up based on the last allocation change:

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