US equities have retreated from their record highs of mid-February. The pullback is still relatively small in absolute terms, at just over 4.5% at the time of writing (28/02).
US stocks were looking overextended with a gain of 23% over the last 12 months (to Feb 19), with valuations close to 25-year highs (see figure 5). Sentiment & positioning were quite extended, so our view was that equities were overdue for some sort of correction.
There has been an emerging concern that the welter of Federal government policy announcements in the US is creating business and consumer uncertainty, which may cause them to defer spending and investment decisions. The market had until very recently been “glass-half-full” on the Trump presidency, but the reality of a weekly barrage of policy announcements (often only partially formulated) has begun to weigh on investor exuberance.
There have also been some tentative signs of weakness in the economic data prints - albeit mostly second line data such as confidence surveys. This has fed into the narrative that uncertainty might begin to weigh on the US economy. The recent US reporting season was, in general, quite strong in aggregate, with 16% growth for the quarter. This may have helped prolong the rally into February, but uncertainty over government policy and full valuations has seen the rally finally run out of steam.
Market Dazed and Confused on Trump
Uncertainty surrounding government policy is unquestionably elevated. This may not prove to be a sustained negative for equities and the US economy if some clarity emerges.
However, it is not surprising that the surge in equities has lost some momentum. It is consistent with our starting view that 2025 would be a more volatile and constrained year than 2024 and 2023.
It is also interesting that perceived “tail risks” flowing from the Trump policy agenda have shifted from the perceptions of just over a month ago. In January, equities came under some brief pressure due to the concerns that Trump’s policies risked overheating the economy, reigniting inflation and worsening the budget deficit. This coincided with US 10-year bond yields surging to 4.8%. Just a little over a month later, the market now looks to be worried about a Trump induced slowdown - with bonds falling back sharply to 4.25%.
First tier macro data over the next month will be important
At the time of writing the US Core PCE (inflation) for January is due Friday night. This will be interesting in the context of the “hot” January CPI released in mid-February. While the US has two versions of inflation released each month, ultimately the US Fed is more inclined to focus on the core PCE, though the mid-month “CPI” tends to move the market more as it is the first read each month.
On the growth front, February non-farm payrolls data is due for release in early March. The strong January payrolls print (266k) also stoked some overheating concerns. However, in the space of a few weeks the market narrative has shifted to the potential impact of DOGE layoffs on Federal civil service jobs and the related contractor industry. Our take at this point is that DOGE layoffs are set to turn the government sector from a jobs tailwind to a moderate headwind, but we don’t think it is enough to cause a significant downturn in the labour market by itself. However, the next monthly payrolls print alongside weekly jobless claims will be closely watched.
The New Normal of Watching Government Policy
Perhaps even more important to market sentiment than this normal flow of “first tier” economic data is the arrival of Trump’s tariff policy review due on April 1. Whether the detail on tariff proposals is better or worse than feared could have a significant influence on equity market sentiment - notwithstanding the ongoing importance of real time fundamental data on the state of the US economy.
Will tariffs prove a reality check for rallies in Europe and China?
Apart from the absolute pullback in US equities recently, it is noteworthy that the US has been underperforming for all of this year in relative terms. European and Chinese equities are enjoying something of a renaissance, despite the looming spectre of US tariffs.
Once again, context is important. The US has been a huge outperformer over the last two years, and indeed over the last 10 years. There have been several false dawns for European and Chinese equities in recent years, but it’s possible that this absolute and relative revival is the start of something more significant.
A “better than feared” tariff outcome in early April could extend the performance of Europe and China, although it would also likely see the US market move up. The converse of draconian tariffs would likely see the US correct, but Europe and China would arguably be even more vulnerable.
Watching the Economy and Watching Trump
For some time, we have remained positive on US equities despite seemingly full valuations, due to a supportive macro-base case backdrop of: solid growth, easing inflation, and a supportive Fed.
Our view has been that the high quality US corporate sector would be able to grow strongly against this backdrop. This was once again evidenced in recent company reporting. Profit growth also looks to be broadening, supporting less tech exceptionalism in performance terms. The Index has only pulled back 4%, so we believe the selloff could extend, albeit our base case is the market should level out fairly soon if macro data proves benign.
Is the Trump policy “revolution” enough to derail the US economy?
After a bullish initial response to Trump’s presidential win, the US market is weighing up the implications of Trump’s evolving and somewhat erratic policy platform. However, the price action of bonds and equities in recent months suggest it is not entirely sure where the tail risks lie. What is hard to argue with is that government policy uncertainty is unusually high. Near-term macro data flow (inflation and labour market) could calm concerns, although the April 1 tariff review is also a key event to monitor.
We remain neutral global equities. We see better risk-adjusted returns in fixed interest/credit and alternative assets.
We plan to review our underweight in Australian equities next week. We do see the pullback in the local market during reporting season as healthy, after the market came into results priced very optimistically. A moderate rate cut cycle should help the earnings cycle, although we continue to favour mid and small caps over the earnings constrained large cap index.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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