Welcome to the latest installment of our series, "A Piece of the Puzzle," where we pause to share our insights on what we can anticipate in the markets and the economy for the upcoming month.
Welcome to the first edition of “Piece of the Puzzle” for 2025! In this edition, we discuss three topics: (1) Trump’s Tariffs and the Effects on Inflation and Positioning One’s Portfolio, (2) The Outlook for Interest Rates, and (3) The Case for International Diversification.
Since he reassumed the Presidency on January 20th, Donald Trump has upheld his campaign directive to enact tariffs with several major trading partners, in particular Mexico and Canada.
Here is a look at the various tariffs that Trump has threatened or actually brought to fruition:
Summarizing the tariffs above along with side effects of the base tariffs shows a significant effect on the potential tariff rate, according to Goldman Sachs Global Investment Research:
Source: Goldman Sachs
Taken together, these tariffs would spike the weighted-average tariff rate to levels not seen since the Great Depression nearly 90 years ago:
Source[2]: J.P. Morgan Asset Management, United States International Trade Commission, U.S. Department of Commerce.
While Trump often cites tariffs as penalties assessed on exporting countries, many economists say the situation is much simpler: that of rising prices. So, could the Trump Tariffs ignite inflation?
One answer may come from what the Federal Reserve has to say. In the release of its January meeting minutes on February 19, the Federal Reserve noted the following:
Although the resulting inflation from tariffs may sound ominous, viewing inflation from a more quantitative point of view, the Trump tarrifs would add less than ½ of a percent to the U.S. inflation rate and less than ¼ of a percent for all non-U.S. countries, according to Goldman Sachs Global Investment Research:
Source: Goldman Sachs Report
While some market participants believe tariffs are an inflationary issue, others perceive this to be that of a tax increase. From this perspective, the Trump Tariffs would be the largest tax hike by dollars since 1993:
Source: Tax Foundation
So how would this affect financial markets and what should investors do? It’s hard to say as currently “uncertainty is the only certainty[3],” but we already have some data showing how markets reacted to the tariff announcements, with the response mostly muted in U.S. equities, positive for Non-U.S. equities, and a significant drop-off in Treasury bond yields:
Source: Bloomberg, Goldman Sachs GIR.
Putting this all together, how should investors position their portfolios?
Understand the Motivation Behind the Tariffs: Do the tariffs really represent a fundamental change to U.S. economic policy or are they merely a negotiating tactic? Trump has been noted for being one to “drive a hard bargain,” and these tariffs could simply be interpreted as a negotiating tactic rather than a longer-term strategic change. If the tactics achieve their intended goals and Trump rescinds the tariffs, then the long-term effect is likely to be negligible and hence will unlikely have a meaningful change on portfolios.
Remain Diversified: As noted by Northern Trust, “We anticipate that political uncertainty is likely to remain high during the first few months of the new administration due to lack of policy details announced during and after the election campaign. We believe that diversified portfolios represent an effective tool to shield investors from increased volatility in markets. Investors should seek to identify sectors[4] that are very exposed to tariffs risk and retaliatory measures.”
Have an Appropriate Time Horizon: Equity markets have had a remarkable resiliency when encountering all of the adverse events thrown at them when given the power of time. There is no doubt that market volatility may be elevated while there is uncertainty about the implementation and resulting effects of the tariffs in the short run, but those who have the patience to withstand that volatility should be rewarded in the long run.
Before the beginning of the year, many market participants were eagerly anticipating further decreases in the Federal Funds Target Rate (“FFR”) after the Fed making three rate cuts last year (50 basis points, or 0.50%, on September 18, 25bp on November 7, and 25bp on December 18), resulting in a full percentage point decrease in the FFR, which currently stands at a target rate range of 425bp to 450bp (or 4.25% to 4.50%). (The Fed made no change to the FFR in its first meeting of the year last month).
Given that the Federal Reserve’s own models show a long-term FFR rate closer to 3% by next year, many market participants at the beginning of the year were optimistic that we would see three to five or even more 25bp cuts this year. Alas, that optimism has subsided in recent weeks, with the median market participant forecasting only two 25bp rate cuts by the conclusion of the final Fed meeting of the year. There are even some participants, about 1 in 20, who believe we may see no further rate cuts at all.
Source: CME Group
So, what is primarily driving the less optimistic outlook for lower rates? In short, inflation concerns are percolating now where they were much more muted three months ago and the U.S. economy is still performing strongly. Both of these reasons – in the eyes of the Fed – weigh in favor of keeping rates higher rather than lower.
For instance, Federal Reserve Chairman Jerome Powell, in testimony to the Senate Banking Committee on February 11 that he and his colleagues “do not need to be in a hurry” to cut interest rates. Moreover, Powell has insisted that the Fed will maintain its independence and will make decisions based on what is happening in the economy, not what the President says.
Source: AP News
Powell is not alone in the belief that a slower pace of rate decreases is merited. Fed Regional Bank Presidents have expressed similar sentiments: Neel Kashkari, President of the Minneapolis Federal Reserve Bank, has said that rate cuts over the next several quarters would be “modest,” while Raphael Bostic, President of the Atlanta Federal Reserve Bank,” said that he would be “very satisfied” to wait for a while before making a decision on how the Federal Open Market Committee (“FOMC”) should move.
As mentioned earlier, inflation data has been looking more ominous recently. Some of the information, such as egg price inflation, are being caused by more idiosyncratic reasons (e.g. Bird Flu) rather than Fed policy.
In the most recent monthly inflation report, the Consumer Price Index rose three percent compared to January 2024, with 0.5% of that 3.0% figure coming from January 2025 alone. This is a full one percent higher than the Fed’s targeted inflation rate of two percent.
Source: U.S. Bureau of Labor Statistics
In general, the Consumer Price Index will have minor fluctuations month-to-month even when the inflation rate is stable. More concerning however is when there appears to be a consistent trend. For the past four consecutive months inflation has increased, and perhaps coincidentally (or not), this increase in CPI corresponded to the Federal Reserve’s lowering of rates a total of one percent as noted above.
Source: U.S. Bureau of Labor Statistics, CNN Business
In summary, investors should be prepared for the prospect of few, and perhaps no, FFR decreases this year as long as the inflation data and strength of the economy remains where it is today.
In recent years, the United States has remained the king of the equity markets around the world, with U.S. Large-Cap stocks in particular taking pole position. For the five year period from 2020 through 2024, here are how several major equity asset classes[5] performed on an annualized basis:
Indeed, here at First Foundation Advisors, this is a comment that we often hear about: the idea that the only necessary investment is in U.S. Large Cap stocks.
So, given the strong performance of U.S. stocks, why might an investor yet again consider investing outside of the United States? There are several reasons:
*(Note: We are not recommending that investors shift all their capital to Non-U.S. stocks; rather that having 100% of one’s Equity capital within the U.S. may not be ideal.)
Diversification: Often said to be the only free lunch in investing, diversification is paramount, especially when it comes to geographical diversification. While it is true that U.S. equities have been the top performer in seven out of the past ten calendar years, during longer periods of time the performance of U.S. stocks has not been so stellar. In fact, there was a 13-year stretch where the U.S. equity market did not have a single year in which it was the best performer (1998 through 2010). The period from 2000 through 2009, in particular, has been called the “Lost Decade” for U.S. stocks and for good reason.
Source: Visual Capitalist
Valuations: Many believe that U.S. companies holistically merit a premium over non-U.S. companies for various reasons: A better environment for business, Higher Productivity, Ease of Doing Business, Innovation, etc. From an investing perspective, however, we believe what ultimately matters is how valuations are relative to history. And from this perspective, Non-U.S. stocks are historically cheap relative to their U.S. counterparts. In fact, as of the end of last year, U.S. Large-Cap stocks (with a Price-to-Earnings Ratio of 21.5) are more than two standard deviations more expensive relative to history than Non-U.S. stocks (with a Price-to-Earnings Ratio of 13.3). This two standard deviation mark indicates that U.S. stocks are currently more expensive than all but approximately 2% of the time over the past two decades!
Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management, Guide to the Markets – U.S. Data are as of December 31, 2024.
Interest Rate Environment: Historically there has been a premium for U.S. equities over Non-U.S. equities when interest rates are higher, especially when the 10-Year Treasury yield is in excess of 5%, which has been the case for much of the last three years. As we move into a lower interest rate environment in which yields are closer to the 3%-4% range, we would expect to see some convergence in the returns between U.S. and Non-U.S. equities:
Source: J.P. Morgan Asset Management, as of 12/31/2024
One Final Note: Although this isn’t necessarily a specific reason for a stock investor to allocate capital outside of the United States, one should at least be cognizant of the amount of global equity markets that exist outside of the U.S. Consider the MSCI All Country World Index (ACWI), a representation of global equity markets that includes 23 Developed Markets and 24 Emerging Markets. In total MSCI ACWI covers approximately 85% of the global investable equity opportunity set.
The United States has a weight of approximately two-thirds of the MSCI ACWI (as measured in U.S. Dollars). So put another way, investors who shun Non-U.S. Equities are potentially missing up to a third of global market capitalization!
Source: MSCI ACWI Fact Sheet
We hope you have enjoyed this edition of Piece of the Puzzle. As always, should you have questions about the information presented above or are interested in learning more about the services that First Foundation Advisors may provide, please reach out to us.
[1] Source: Reuters 2/26/2025. https://www.reuters.com/world/us-announce-25-tariff-eu-very-soon-trump-says-2025-02-26/
[2] As of 1/31/2025. Imports for consumption: goods brought into a country for direct use or sale in the domestic market. *Estimate is by the Tax Foundation as of October 2024 and assumes a 20% universal tariff as well as a 60% tariff on Chinese imports. May not be updated as of the latest announcements regarding tariffs and U.S. trade policy and is subject to change. Forecasts are based on current data and assumptions about future economic conditions. Actual results may differ materially due to changes in economic, market and other conditions.
[3] Credit to Goldman Sachs for coining this expression.
[4] According to Investopedia, some company types expected to do well include those who manufacture Paper Clips, Canned Tuna, Tobacco, and Sneakers.
[5] U.S. Large Capitalization = Standard & Poor’s 500, U.S. Broad Market = Russell 3000 Index, Global Equities = MSCI All Country World Index ex Div (USD), International Developed = MSCI EAFE Index ex Div (USD), Emerging Markets = MSCI Emerging Markets Index ex Div (USD). One cannot invest directly in an index. Past performance is no guarantee of future results.