Economic Commentary – Looking For Clarity

The U.S. is not on a precipice, nor is it staring down an imminent recession, nor is it facing a looming economic crisis. In short, our economy is not on the verge of anything. As strange as it may sound, that’s the problem; nobody seems to feel as though they know which direction we’re going.

The economic data seems to be quite strong, while at the same time, we have a new administration using new methods to change the economic order they inherited. Of course, throughout our history, new administrations have sought to change the economic situation they inherited. This is as newsworthy as a “Dog-Bites-Man” story.

The difference is that this administration isn’t following the standard, if unwritten, Washington rules for how things are supposed to be done. From tariff threats to Cabinet appointments to executive orders to social media pronouncements, this administration is doing things differently.

We’ve said before that the economy’s health is determined by the wealth (economic activity) being generated. The health of the markets tends to track closely the health of the economy as determined by the market’s ability to predict, measure, and then value the profits created by all this economic activity.

There is a legitimate sense of chaos, even if there is no sense of whether the chaos will lead to good or bad outcomes. It’s no surprise, therefore, that institutional investors and the market in general are reacting at each moment to things they haven’t had to deal with for quite some time. We should expect a pattern of market volatility for a while as the overall direction is determined.

The Economic Data

The economic data seems remarkably positive, as the following quick summary stats show:

The service sector index remained positive at 52.8 for January. While lower than a previous measure, the lower reading seems to have simply reflected some weather-related interruptions.
The manufacturing index came in at 50.9, signaling economic expansion.
The ADP private payroll measure showed a 183,000 increase while non-farm payrolls also increased, and unemployment remained steady at 4.1%.
Overall trade (exports plus imports) grew by 5.4% in December and closed the year 8% higher for all of 2024.
Personal income was strong in December and grew 5.3% for all of 2024, while personal spending also increased broadly.
Put it all together, the U.S. economy grew at a 2.3% annual growth rate in the 4th quarter, slightly greater than the recent 20-year average annual rate of 2.1%.

These are not the signs of a recession, crisis, or precipice. These and other data points indicate that we continue recovering and growing from the Covid shutdown-induced recession. Optimism is justified.

The Wildcard – Tariffs

Depending on how you read President Trump’s tariff campaign promises and the ones recently imposed on Mexico, Canada, and China, there are reasons to be pessimistic. If he means them to be broad-based, long-term, and specific policy goals in and of themselves, the economy will suffer. Tariffs increase the costs of the goods targeted, increasing their prices and correspondingly decreasing the prices for other items. They reduce economic efficiency and growth.

However, tariffs do not affect all countries in the same way. Countries whose economies heavily depend on access to American markets will suffer more than countries that are less dependent.

Accordingly, tariffs can be an extremely effective bargaining tool with countries where that dependence on the American market is substantial. Without attempting to debate the policy merits of what the administration wants from Mexico, Canada, and China, using a tariff or a real threat of one is not necessarily an illogical act.

It is, however, a powerful and therefore dangerous tool to use. If tariffs induce reciprocal tariffs against U.S. exports, and if the level of all tariffs rise to significant levels, then the global and U.S. economies would all be hit.

So, the question remains whether tariffs are simply a negotiating tool or a policy prescription in their own right.

The Wildcard – Inflation

Despite some claims to the contrary in national media, tariffs do not cause inflation. Inflation is and has always been a monetary phenomenon. We’ll delve into that in a moment, but the effect of tariffs is to increase some prices while they reduce other prices. Inflation is a rise in the general level of all prices. Tariffs don’t do that.

Tariffs increase the prices of the goods being tariffed, but that leaves companies and consumers who buy tariffed goods less money to spend on other items, and the prices of those other items decrease.

Inflation – a rise in the general level of all prices – is caused when too much money is printed and put into circulation. Part of the government’s solution to the Covid-induced lockdowns was putting more money into circulation.

As the chart below (courtesy of Scott Grannis) shows, the amount of currency in circulation was on a roughly 6% annual growth rate up until the Covid era. The “bump” in the blue line shows how dramatically currency was expanded from 2020 through 2023, when it finally started to fall.

Cumulative inflation for the period 2020 through 2024 was 22.9%. The annual rates within this period ranged from 1.4% to 7%, but the cumulative impact has been significant.

The currency chart does show that the money supply started to contract in 2023 and is very close to returning to the 6% long-term trend line. That is good news, but it doesn’t mean we’re out of the woods yet.

Inflation is a lagging phenomenon. We feel it after the money supply has increased. Even though we can see that the money supply has decreased, the job is not been finished. In fact, as surprising as it may be, the inflation rate has spiked a bit in the last several months.

The Fed’s goal is to maintain a 2% annual inflation rate, and progress toward this goal seems to have stalled. There are multiple measures of inflation, but we have seen increases across the board.

The Fed’s favorite measure is PCE prices; this measure increased to 2.6% in 2024. Another measure called Core prices increased 2.7% in 2024, and Supercore prices rose 3.5% in 2024, which was actually higher than the 2023 rate.

The Fed has made progress in dampening inflation – certainly in bringing it down from 7% in 2021 – but needs to finish the job. This is where it gets tricky and, therefore, uncertain and lacks clarity. In a series of recent moves, the Fed brought interest rates down 1.00% but has now paused those moves because of the inflation data.

As much as inflation lags after changes in the money supply, economic activity lags even more after that. Economists have estimated the delay to be anywhere from 6 months to 18 months, depending on the specific circumstances. As we write this commentary in February 2025, we may not have seen all the economic ramifications of the Fed’s inflation fight.

We may see some additional slowdown. High interest rates have a negative effect on business investment and consumer spending. It is possible we’ll still see an economic contraction, but we do not envision a significant recession – if one at all.

The danger is an overreaction from the Fed. If economic data begins to slow down again, the Fed will have to judge whether to leave interest rates as they are or to decrease them to goose the economy. How that plays out in conjunction with the administration’s use of tariffs and the administration’s promises to reduce taxes and regulation (which would increase economic profits) will determine the true course of the economy in the months ahead.

Investment Implications

The lesson to draw from all this is that we cannot predict and prepare for the next economic event. Hopefully, the information above demonstrates that nobody knows exactly what the future holds. But even if we could predict the next economic event, the challenge is to predict the one after that, and then the one after that, etc.

Market timing can sometimes seem like a no-brainer, but that is almost always because you’re focused on the immediate future. The consistent problem with market timing is knowing when the current dynamics are going to change. Let’s consider an example from recent history.

The S&P 500 hit a high very close to December 31, 2019. Everything looked rosy. Then came Covid and the lockdowns. Let’s pretend you knew that was coming and you got out of the stock market. You would have avoided the 19% loss in the first quarter of 2020. But what else would you have avoided?

Remember how dour the circumstances and the news were in March, April & May of 2020. Covid was raging, and the economy was locked down. But the markets saw the recovery before anyone else did. The 2nd quarter of 2020 (April, May & June) generated a 20.58% positive return for the S&P.

Subsequent quarters saw returns of 8.8%, 12.1%, and a slew of others until 2022 when inflation was no longer “transitory,” and the market dropped. The pattern of unseen negative economic events and unseen positive recoveries was repeated.

But what about the real losses bailing on the market could have caused? Very few people think about the opportunity costs, and yet they are very real.

Again, assuming someone was clairvoyant enough to see the Covid recession coming, we have compared the cumulative effects of several positions that could have been taken from 2020 through 2024. Remember that the cumulative inflation over this period was 22.9%. If you bailed completely, you would have lost 22.9%. That’s not hypothetical; it’s a real loss.

Positions You Could Have Taken:

Those results are probably surprising. Weathering the recession and the stock market’s quarterly volatility would have generated a 73.9% real cumulative return after inflation. This is not an argument to hold a portfolio of 100% stocks. That might be right for some accounts for some people, but it’s not a prescription for everyone. The key point is that opportunity costs are very real, and trying to avoid one situation may actually cause more harm than what you were trying to avoid in the first place.

Portfolios must be designed with a target return in mind, with a keen understanding of your risk tolerance, and an accurate assessment of your liquidity needs so you can withstand market volatility and still meet your goals – both near-term and long-term.

With time, clarity will come. If you still have any concerns about the future, the best way to address them is to review your portfolio design with all of the above elements in mind. There are potential losses at both ends of the spectrum. Stocks are volatile, but their losses are usually temporary. Inflation is usually more gradual, but its effects are permanent. The best portfolio construction is designed to protect you from both losses while growing over the long term.

Executive Summary

We live in volatile times; all eyes are on Washington to determine what the new policies will be, but many of the old unwritten rules of how things are done in Washington are being jettisoned. The economic data remains strong, but threats remain, and the market is looking for clarity. Ultimately, wise portfolio construction still offers the best protection from all these risks while allowing you to still achieve your investment goals.

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