Confused?
Let's dissect the often-contradictory signals emanating from the global economy, a task crucial for discerning the underlying truths that will shape our investment strategies at Davis Rea.
First, a sliver of positive news amidst the persistent trade tensions. As I previously noted, echoing a sentiment of overdue common sense – 'The Emperor Has No Klingons' – we've witnessed a tentative easing of the strained relationship between the US and China. Their decision to temporarily suspend those frankly absurd extra tariffs for 90 days has, predictably, been met with market relief. The S&P 500, our reliable gauge of major US companies, has responded with an encouraging 4.5% climb since last Friday. This rebound has impressively recovered 20% from the lows following Trump's April misstep, which swiftly erased 12% of valuations.
This positive sentiment extends to credit markets, often a more grounded reflection of economic realities. The narrowing yield spread between safer and riskier corporate debt suggests a lessening of immediate fears regarding a sharp economic downturn.
However, a crucial caveat from Davis Rea: we must temper enthusiasm with realism. While this tariff pause is welcome, we cannot ignore the significant prior damage. Tariffs remain four times higher than before this trade dispute, a substantial drag on global commerce. Investors' relief that policy isn't actively harming the economy shouldn't be mistaken for a full recovery. We are merely in a respite period, the long-term consequences still unfolding. The true extent of the damage and the path forward remain to be seen.
On a brighter note, this temporary tariff cessation suggests a reduced likelihood of a sudden collapse in international trade and a sharp rise in unemployment. Nevertheless, our outlook remains one of sluggish growth, persistent inflation, and continued trade uncertainty. While the immediate US recession risk may have slightly receded, underlying vulnerabilities persist.
Adding complexity is investors' continued caution regarding valuations. The erratic policy decisions and rapid economic disruptions from trade tensions have created trauma/ unease. Compounding this is the US government's unsustainable fiscal path, with spending exceeding revenue by a staggering $2 trillion annually, casting a long shadow on long-term economic health.
Looking ahead, a significant 'if' hangs in the balance: the reinstatement of the past 80 years of international economic integration. If achieved, markets should see further calming. However, the recent instability will likely accelerate nations' efforts to reduce relianceon others for strategic goods, potentially leading to more frequent andpersistent supply shocks, as the Federal Reserve Chair aptly noted – achallenge for both the economy and central banks.
These potential supply shocks, the costlyrebuilding of supply chains, and navigating less amicable internationalrelationships are hardly conducive to strong business confidence. A more fragmented global landscape implies pressure on profit margins and slower growth, not ideal for robust market returns.
Adding another layer is the perplexing divergence between plummeting US Consumer Sentiment and surprisingly resilient US Retail Sales (+4.8% year-over-year). This begs the question: genuine economic health or a temporary blip from pre-tariff buying? True strength lies in healthy consumer purchasing power, not artificial boosts masking deeper issues. Time will reveal the truth.
The good news.
Beyond near-term uncertainties, Ai's transformative potential offers a compelling long-term narrative. David Sacks' bold projection of a million-fold AI power increase in four years, while seemingly futuristic, highlights the undeniable exponential growth trend. Even a fraction of this could yield significant productivity gains, a key focus for Davis Rea's long-term investment perspective.
Recent earnings reports corroborate this bullish AI outlook. Companies are reporting exceptionally strong and accelerating demand for AI infrastructure, often supply-constrained, countering broader market pessimism. This demand is driven by AI inference and increasing enterprise adoption, evidenced by substantial order volumes. As Morgan Stanley's Brian Nowak noted, negative AI data is increasingly scarce, posing the question: why the disconnect between AI enthusiasm and some investors' caution? We shall see.
The strong rebound of mega-cap tech companies, now boasting trillion-dollar valuations, diminishes the likelihood of a significant market crash and a return to April's lows, suggesting the 'negative wealth effect' is waning.
The mood of the Market
The market's continued need for definitive 'confirmation' of the recent rally – scrutinizing Federal Reserve pronouncements, inflation data releases, and the preoccupation with the 10-yearTreasury yield level – underscores a persistent underlying skepticism. However, as experienced investors understand, the pursuit of absolute certainty in the inherently uncertain realm of markets often results in missed opportunities.
So, why the confusion and caution? While we remain very positive over the longer-term, the reality remains as we stated in our last report, significant risks remain. Just this past week Trump said:
So, at a certain point over the next two to three weeks I think Scott and Howard will be sending letters out essentially telling people…. what they'll be paying to do business in the United States...I guess you could say they could appeal it."
Why would these countries NOT look to replicate the “Chinese model” of playing-hardball in negotiations with the Trump admin and force him into market-driven capitulation, again? It worked for the Chinese!
So, the reality is the "Macro Bear" case remains fully intact. The economy is already suffering under the highest tariff levels in 90 years (around 17%, up from roughly 2% last year), evidenced by the potential "Capex Crash" due to corporate investment uncertainty regarding tariff policy, and the negative impact of higher prices on both consumer spending (as seen in potential retail sales disappointments and Walmart's commentary) and corporate margins. All suggesting a tangible rollover in hard economic data could materialize. All this is occurring while the long- term interest rates are rising, substantially tightening financial conditions. This suggests that by July, this "Harder Growth Slowing" could indeed become more pronounced, all while the ‘Lets Make a Deal Show’ will be coming to a head.
Markets tend to sniff-out trouble/ good news months in advance, so tactically, we remain highly alert and defensive. In the end, no one knows the short term, but experience tells us that when markets are in transition, and when dealing with highly volatile inputs, head-fakes are common.
In conclusion, the current economic and market environment presents a complex interplay of conflicting signals. While the positive divergence between consumer sentiment and retail sales warrants careful scrutiny, the undeniable momentum and transformative potential of the Artificial Intelligence sector offer a compelling narrative for future growth. Navigating these turbulent waters requires a balanced, discerning and humble perspective,acknowledging both potential headwinds and significant opportunities. Our commitment at Davis Rea remains steadfast: to focus on world-leading businesses that consistently invest in their future, ensuring their ability to deliver world-class products and services, regardless of the shifting sands of the global landscape.
