Post inauguration wobble in stock markets
The S&P 500 index had a tough ride in February as investors evaluated the inflationary impact of the looming tariffs and the earnings reports of ‘Magnificent 7 companies’. Increased uncertainty about the precise date and implementation of tariffs increased the volatility of the market. February was the S&P’s worst month since December and the Nasdaq’s worst month since April. The S&P 500 index ended the month at 5955, -1.4 percent down from the end of January.
The possibility of peace talks for the war in Ukraine and the ceasefire in Gaza can be considered as easing in the geopolitical tensions. The WTI Crude ended the month below USD 70. The fall in the oil price was caused by increasing US oil inventories as demand weakened and the anticipation of a peace deal between Ukraine and Russia. We believe, falling energy prices can potentially more than compensate for the inflationary impact of the tariffs.
Despite better than expected earnings by Nvidia and Microsoft, Google and Tesla’s results were disappointing. Meta and Amazon were citing the strength of the dollar as a concern for future earnings. The stock prices of the ‘Magnificent 7 Club’ are highly correlated with the S&P 500 index. Weaker domestic consumer sentiment and the strong dollar are the challenges facing these companies. Furthermore, there has been some rotation out of technology growth stocks into value stocks dampening the performance of the S&P 500 index.
Uncertainty over tariffs
President Trump imposed 25% across-the-board tariffs on Mexico and Canada, and a 10% tariff on all goods from China on February 1. He also confirmed 25% tariffs on European autos. The tariffs on imports from Mexico and Canada with an additional 10% tariff on Chinese imports were announced to be effective from March 4. The China policy move doubles up on the previous 10% additional tariff Trump placed on Chinese products at the beginning of February.
China responded to the first round of tariffs with retaliatory duties and is likely to do so again when new U.S. tariffs are imposed. For the stock markets, there has been uncertainty about the timing of the tariffs. Currently, it is not certain that the tariffs on Mexico and Canada will take place on March 4. They may be delayed till April. Consequently, the ongoing uncertainty causes volatility in the stock markets. Investors try to second-guess the Fed’s monetary policy with these uncertain inflationary pressures.
As the charts below show, the US (average) import prices, depicted by the import deflator, follow a close path to US inflation. That said, the main driver of the import deflator growth is the changes in oil prices. The correlation between the oil price and the import deflator is 0.90. Furthermore, the US import deflator and inflation showed a high correlation for the considered period (0.7). Tariffs can affect the prices of all goods and services. However, if they are limited to certain products, with falling energy prices, the final impact on inflation may be small.
PMI improves from January but consumer outlook deteriorates
The Chicago Purchasing Managers’ Index (PMI) increased to 45.5 in February from January’s 39.5. This was well above the market anticipation of 40.6. The index’s long-term average from 1967 to 2024 is 54.7. Hence the current value still indicates a contraction in business activity.
The Conference Board’s consumer confidence index declined by 7.0 points in February to 98.3 (1985=100). The Present Situation Index—based on consumers’ assessment of current business and labor market conditions—fell sharply to 136.5 (1985=100) from 139.9 in January. Furthermore, the Expectations Index—based on consumers’ short-term outlook for income, business, and labor market conditions—fell to 72.9 (1985=100) from 81.2 in January
A reading below 80 for the Expectations Index would indicate that consumers are concerned about a recession. The index was over 80 in the last couple of months. Therefore, the monthly deterioration is significant. We think the recent fall in consumer confidence indices reflects concerns about the business conditions and the weakening in the labor market.
Inflation cools slightly, growth slightly disappoints
The Federal Reserve’s preferred metric — the personal consumption expenditures price index rose 2.5 percent in January, edging down from 2.6 percent in December, in line with the market analysts’ projection.
The US economy slowed down in the last quarter of 2024 according to the second estimate. US GDP growth for 2024 Q4 was 2.3 percent, down from 3.1 percent in the previous quarter (Source: The Bureau of Economic Analysis.)
Although growing slower, the US economy remains on solid footing with unemployment rate dipping to 4.0 percent. Fed did not meet in February and a rate cut in March is unlikely. The fact that the US inflation remains tame but not approaching the Fed’s target of 2 percent, the Fed’s future rate cuts are likely to be delayed until the end of the second quarter.
S&P 500 index remains overvalued
According to Factset Insights from February 28, the forward 12-month P/E ratio for the S&P 500 is 21.2. This P/E ratio is above the 5-year average (19.8) and above the 10-year average (18.3).
We believe the S&P 500 index remains in overvalued territory. After the three consecutive interest rate cuts in 2024, the Fed’s stance in 2025 remains cautious. The data-dependent policy implies that the policy makers will evaluate the consequences of President Trump’s protectionist policies. Currently, there seems to be no urgency in cutting the interest rates as the economy remains on strong footing, despite some loosening in the labor market.
Our monthly S&P 500 forecast is a model-based fair-value estimate. Based on the economic fundamentals, our forecasts indicate a 1.85 % drop in March. Irrational momentum-driven rallies are beyond the scope of our model.
The possible impact of geopolitical tensions is fed into the model through keyword searches (Google clicks) and the advanced retail sales index. However, these variables perform better in normal times. Our quarterly S&P 500 forecast discusses these issues in more detail.