“Our new Constitution is now established, and has an appearance that promises permanency; but in this world, nothing can be said to be certain, except death and taxes.”
– Benjamin Franklin, in a letter to Jean-Baptiste Le Roy, 1789
May saw a continuation of the positive developments for the global economy and capital markets that began in mid-April. Pressures from various fronts are forcing the U.S. administration to alter its course on tariffs and the budget. Bond markets were soft and global equity markets added to their late-April rally. For the month and year to date, the S&P/TSX Composite rose 5.4% (5.9% YTD), the S&P 500 was up 6.2% (0.5% YTD), international developed markets (MSCI EAFE Index) were up 4.0% (15% YTD), and emerging markets (MSCI Emerging Markets Index) rose 4.0% (7.6% YTD).
Big beautiful bonds
The bond market continues to provide critical feedback. While declining equity markets are a peripheral sign of trouble, rising bond yields are the equivalent of a flashing red warning light because higher borrowing costs impact government finances. As the U.S. budget bill (OBBB for One Big Beautiful Bill) moves through the system, for only the second time since the 2008 Great Financial Crisis yields on 30-year U.S. Treasury bonds crested 5%. They then retreated after politicians acknowledged what was happening.
More checks and balances
Other feedback loops we have highlighted in the past also began clamouring for attention. Public sentiment and opinion remain weak (but less downbeat), and industries suffering from negative tariff impacts continue to lobby. Most notable, checks and balances, foundational to the U.S. system of government, began to stir to life. A U.S. trade court ruled that President Donald Trump had overstepped his bounds on some tariffs. However, these legal battles are just beginning.
Big Deals
As we saw in April, additional feedback motivated the U.S. administration to alter its agenda and adjust or pause policies. Each day brought more discussion of trade deals, including surprisingly constructive meetings between Chinese and U.S. negotiators that resulted in a temporary reduction in tariffs. President Trump’s trip to the Middle East went off without incident, as did the meeting with Mark Carney, the new Prime Minister of Canada, which is the top export destination for the U.S. By month end, bond markets settled down, although the feedback comes at a price for all investors – not just the government (and borrowers in general). U.S. bond benchmarks fell 0.72% for May. In Canada, the FTSE Canada Universe Bond Index was flat, but sits up 1.4% for the year.
Stocks laud the bond markets’ impact
Equity investors shrugged off higher bond yields (which are not usually a friendly development for stock markets), appreciating the positive impacts rising bond yields are having on policy choices. There are limits to this appreciation; for now, investors are celebrating the tariff reprieve instead of worrying about the weight of higher bond yields. Investors may view the higher yields as temporary, hoping that they will retreat once the government receives the message, passes the OBBB, ends the disruptive on-again, off-again seesaw of tariffs, and eventually settles on policy stances that everyone can tolerate. We note that tolerate isn’t the same as embrace; this semi-steady state may take time to develop (months, for sure, possibly several quarters). Negotiation and compromise will be required on domestic priorities in Washington and trade priorities in capitals worldwide.
Swapping taxes for tariffs
While developments on the trade front are less dire, the situation is far from reassuring. The bond market isn’t just sending a signal on tariffs: bond investors are also as interested, if not more so, in the U.S. budget outcome. Here, the balance between tariff levels, tariff revenues, and their interaction with the economy needs to be carefully navigated. Lower tariffs equal less revenue yet likely less damage to the consumer (and hence the economy).
But aren’t tax cuts predicated on tariff revenue replacing tax revenue? There is an interplay among all these factors: price times volume, multiplied by the tariff rate, all change depending on the tariff rate. For example, tariffs of 145% on China would drive volumes to zero for some items; no trade volume means no tariff paid. In a similar vein, it is difficult to see how a 50% tariff on steel and aluminum won’t damage the U.S. economy. The U.S. can’t quickly self-source just the amount of these metals it imports from Canada, which accounts for about a quarter of steel imports and about half of aluminum imports. There are far more U.S. jobs in industries that purchase these commodities as inputs than there are jobs in plants that might produce them. It is unlikely tariff revenue will offset the loss of income taxes and increased unemployment benefits to the workers laid off in these other industries. No wonder Wall Street traders coined the phrase “TACO trade” (Trump Always Chickens Out). Market participants are starting to ignore threats like these, viewing them as negotiating tactics; some of Trump’s cabinet members are confirming this stance.
Back in black, yet not out of the woods
Total returns for a typical, balanced, well-diversified Canadian investor now sit at roughly 3.5% in Canadian dollars year to date. Further gains for capital markets will require the White House to continue its more reasonable tone, as opposed to the “move fast and break things” approach that culminated in the Rose Garden on April 2.
It would be naïve to think the path forward will be smooth; indeed, many hurdles remain. Striking down of some tariffs introduces additional uncertainty as the administration pivots to other methods to achieve its goals. However, we can see from recent results that when the tariff threat is reduced to a reasonable level, capital markets believe the global economy is healthy enough to absorb the shock.
We have said that things can get back on track. Despite the volatility thus far in 2025, there is no deep hole to dig out of right now. At the beginning of the year, our 2025 Capital Markets Outlook was optimistic. The faster the world can get to some reliable understanding of the rules of the game on trade, the less damage will be inflicted, and the better the outcome will be for capital markets.
Macroeconomics – particularly the trade, monetary, and fiscal policies of major economies – remains a significant influence on capital market outcomes. Yet regional, sector, and company specifics still matter. In the current environment, active investment management can shine.
Monetary policy is divergent between the U.S., which is staying restrictive for now, and much of the rest of the world, which is more eager to ease. All governments are set to keep spending a lot of money. This presents investment opportunities in defence industries, infrastructure and key industries being targeted by amped-up government industrial policies. Corporate earnings growth is coming in solid and better than expected, illustrating that corporations (and, by extension, consumers) face this trade shock from a position of strength.
We believe the most aggressive policies of the new U.S. administration are not aligned with accomplishing its goals – a reality that is becoming apparent to key individuals. The U.S. needs to borrow money in the bond market. In fact, the U.S. economy is profoundly beholden to the bond market. Administrative actions are bringing negative consequences in the bond market that are, in turn, motivating change. The administration’s earlier approach raised fears of tone deafness to these realities, a condition that could inadvertently drive the economy off a cliff. It is a welcome development that policymakers now see that policies will have to be acceptable to bond investors. We expect market volatility as the cycle of actions/consequences/reactions plays out. Nevertheless, we maintain a positive view that the feedback loops will temper actions in a manner that allows the world to digest and adapt, and capital markets to soldier on.
Our strategy – Balanced, still an equity bias after taking some profits
A commitment to diversification is our creed; it empowers us to remain patient in the face of uncertainty and strained emotions. Our well-balanced and well-diversified portfolios are performing well amidst the recent volatility. This proves once again that our approach stands the test of time and weathers all manner of circumstances.
When confronting uncertainty or a perceived threat, we humans often fall back on our fight-or-flight instincts. Here, the best course of action for the well-balanced and well-diversified investor was to do nothing, given the on-again, off-again, unknowable fluidity of the last few months. Our trading was limited and never reactionary or panicked.
May saw capital markets move in a more unidirectional fashion. Thankfully, it was a positive direction for stocks, affording us the opportunity to assess where the dust has settled for now. Guided by our process and discipline, we have executed asset-mix changes in portfolios where the opportunity presented itself. Asset-mix changes in any given portfolio are tailored to individual client circumstances. We traded a large swath of portfolios to harvest profits in areas that have generated strong relative performance, namely Canadian, international, and emerging markets equities. Proceeds from these sales were deployed across a variety of fixed income solutions, resulting in a general de-risking of our positioning.
De-risking doesn’t mean we are defensive or worried
De-risking is simply a reflection that, yes, the environment has changed, but so have prices for various assets, and plenty of hurdles need to be overcome on the path forward.
We are now targeting a small overweight position in stocks, treating Canada as our most-favoured market, followed by the U.S. We have trimmed our international and emerging markets exposures back to neutral. We are underweight fixed income, just less so than before, with a well-diversified blend of government, investment-grade corporate and high-yield corporate bonds, plus some custom-built, income-oriented structured notes from our industry-leading partners in these assets at BMO Capital Markets.
The last word – Thoughts on a reasonable path forward
Two macroeconomic themes are dominating the headlines: tariffs and government deficits. The path these take and where they land in six months or a year will matter. This is not just a U.S. story. The fiscal situation in Europe, Japan, Canada and elsewhere, plus retaliatory (or reciprocal) tariffs, also matters. Although everything might seem overwhelming, there is a way forward.
It is conceivable that governments will re-prioritize spending and focus on productivity-enhancing investments, such that bond yields stay in check (a sub-5% rate is a key threshold for U.S. 10-year yields). Retaliatory tariffs, many of which have been tempered responses so far (Europe and Japan very little, Mexico none, Canada backed off), remain reasonable or may even disappear under a true reciprocal arrangement (you drop yours; I drop mine).
For the U.S., where tariff impacts and government spending are most acute, some level of tariffs, and hence tariff revenue, is to be expected at this point. While not our recommended policy approach (or that of most economists), an average tariff rate under 15% would generate significant revenue, and the U.S. and global economies could adapt. Currency movements will mitigate some of the impact (this could be construed as foreigners absorbing the cost). Ultimately, the U.S. consumer will bear the brunt (Trump’s admonishment to Walmart to “eat the tariff” is proof that he understands someone must pay). A 10% to 15% tariff on imported goods alone is akin to some single-digit level of a federal sales tax – something that exists in every G20 country except the U.S.
Tariffs are inefficient; they bring uncertainty because they are subject to change and invite retaliation. They are vulnerable to special carve-outs and it’s tempting to use them as a weapon (even domestically). Basically, tariffs distort the allocation of capital. Levying a federal sales tax in the U.S. appears to be politically impossible. Therefore, a reasonable tariff level can thread the needle between balancing the U.S. budget deficit and keeping the global economy on track – allowing Americans and the rest of us to still go to work to pay for it all.
In the end, nothing is certain except death and taxes, a truth that endures more than two centuries after Benjamin Franklin’s observation.
