Markets Rerated Change
Investors adjusted expectations in February, as they attempted to decipher how tariffs, government austerity, and unresolved regional wars affect their investments and portfolios. As a result, market interest rates and equity prices declined based on how investors think those broader themes change future investment returns
This year started differently than most in US equity markets. Specifically, US stocks have underperformed foreign stocks. Foreign stocks have offered investors favorable returns over two-months, while US stocks align closer to breakeven with beginning year levels. This early-stage performance gap between the two markets seems informative and meaningful for several reasons. For one, relatively high US stock market valuations may have pushed investors away to other places, like foreign stocks or fixed income. Secondly, fiscal policies aimed at government budget cuts, while the Federal Reserve retains strict monetary policies, increase economic concerns.
Diversified investment portfolios receive returns based on risks they cannot diversify away. This is what investors call systematic portfolio risk. Geopolitics contributes to systematic portfolio risks, and the current geopolitical environment seems heightened due to trade tariffs, government austerity, and unresolved regional wars. Specifically, tariffs can produce economic challenges through increased global prices, lost consumer surplus, and business contractions in export-driven markets. However, policies favoring US tariffs may represent a broader plan to reduce generationally large trade deficit and dependency on foreign credit, which finances trade deficits. In the long term, trade tariffs could strengthen the US’s competitive and economic position as it deleverages from the rest of the world.
Another key takeaway from February was investors saw more downward pressure on US government interest rates. Government interest rates matter because they create the floor for many other loan types, such as home, consumer, and business. Some investors credit the US government’s latest financial austerity and effort to restore bond investor confidence as reasons why interest rates lessened. Bond investors need assurances their government will not debase their prior investments with uncontrolled spending. The current federal administration may be signaling it won’t with its current austerity plans unless its plans begin to do more economic harm than good.
Unfortunately, fiscal austerity has downsides. Austerity means removing economic expenditures from the economy. That can translate into slower growth, lower output, and less GDP per capita. More importantly and sadly, it can create job losses and higher unemployment. Many of these austerity repercussions are recessionary forces unless expenditures increase elsewhere, such as in consumer and business economic sectors. However, economic slowdowns can create even more downward pressure on market interest rates, which the US government could use. The US Treasury will soon refinance about one-fifth of its national debt over the next three years. It requires lower interest rates to sustain its economic budgets and prevent losses of other essential services the federal government provides.
One subject that likely makes investors confident is the stock market’s ability to earn profits. Even though geopolitical risks may have elevated, the business environment looks better, given the innovation wave that has swept through. As new technologies enter broader markets, they are expected to sustain and grow stock market profits. Profits are necessary because corporations use them to pay dividends and buyback shares. In addition, robust profits help support market valuations in the broader context of stocks.
Recent interest rate and stock market volatility could offer important information. Interest rate declines might signal confident bond investors, which may draw new investment to bonds before there is a chance for rates to go lower. Further, investors will likely find it hard to avoid stocks as volatility will likely cause stock dividends and share buyback yields to rise. It is important to exercise patience and self-control to realize the long-term benefits of a thoughtful and appropriate portfolio allocation. Although it can be difficult to look past daily market mechanics or volatility, investors should strive to focus on the fundamental qualities of their investment yields or growth in the broader context of their financial plans.
