A welcome reprieve
The S&P 500 has stabilized but our call has not changed:
Use strength to reduce risk in portfolios.
Investors dodged a bullet when Trump recently paused the imposition of extremely high tariffs on most trading partners. To use an extreme example, Madagascar was in the firing line for 47% tariffs. This struck us as both absurd and sad for its impoverished people. As widely reported in the media, it was the outsized weakness in the U.S. Treasury bond market which may have convinced the Trump Administration to relent for now. And for good reason. The fact that U.S. stocks, bonds and the U.S. dollar all went down in unison was a clear sign that the U.S. is losing some of its safe haven halo. This is in stark contrast to what we saw at the height of the financial crisis in 2008, when U.S. Treasuries fulfilled their role as a safe asset class, thus helping mitigate the damage in well diversified portfolios.
A second bullet was dodged when Trump stated he had no intention of firing Federal Reserve (“Fed”) Chairman Jerome Powell after all, despite threatening to do so repeatedly. Had he carried through on his threats, it would have been a very negative catalyst for the market. In our opinion, U.S. stocks, bonds and the greenback would have gapped down again significantly as investors (particularly on the fixed income side) would have to price in higher potential inflation and a further erosion of credibility. In such a context, “forced” Fed interest rate cuts would likely be totally ineffective in stabilizing risky assets like stocks and high yield bonds. As our BMO Economics partners noted: Central bank independence is critical for maintaining long-term stability of both inflation and growth. The Fed’s credibility is easier to uphold when investors, businesses and consumers believe it is fully committed to price stability and insulated from political interference. Under these conditions, inflation expectations are more likely to remain anchored to the inflation target, reducing the need for aggressive actions.
Since then, many traders have rallied around the notion that we may have reached peak tariff uncertainty and that trade deals being struck – for instance, an agreement with India seems likely in the short term – will act as positive catalysts for the market. We are already seeing this positive effect with the market having recovered a lot of ground. Recent reports suggest that the U.S. and China are both taking steps to begin de-escalating their trade war. On that front, our Technical Analyst, Russ Visch, thinks that the bias for equities should remain to the upside over the next few months. However, his long-term timing model remains negative after giving a new sell signal in the first quarter, meaning that the second half of the year does not look nearly as rosy from a technical perspective. While any marginal improvement from a very precarious macroeconomic position is welcomed, we strongly believe that reducing risk on strength is the right approach ahead of what could be a more challenging environment in the back half of 2025.
The question at this point is whether the immense damage already done to the credibility of the most powerful country on earth can be reversed. We think it can, but it will take considerable time and effort. In the meantime, our recession probability model continues to show increasing risk to the economy, and that is even before the real impact from tariffs has been felt. To be more precise, we now see about 55% odds of recession within 12 months, up from under 40% at the end of last year.
Corroborating our data, the University of Michigan Consumer Sentiment Survey recently fell to a 45-year low south of the border, and the vast majority of corporate executives expect a recession this year. To us, this looks like a recipe for cash conservation behaviour rather than big corporate or personal investments/expenditures. Perhaps even more problematic, the outlook for inflation over the next year rose from 5% to 6.7% (the highest since November 1981), and the inflation outlook five years out, which is what the Federal Reserve looks at most closely, hit 4.4% (the highest since June 1991). This will make it tougher for Jerome Powell and Co. to cut rates and stimulate the economy.
The U.S. earnings season has seen some notable beats (e.g., Microsoft, Meta) but also several very cautious comments with guidance being lowered or withdrawn across a range of industries due to tariff uncertainty. This tells us that corporate earnings will continue to be pressured to the downside. We started the year at $274 of operating earnings and are now at $264 with a strong downward trend.
A brief history of tariffs
Even with the postponement of full reciprocal tariffs, the average tariff rate is back to levels not seen since the beginning of the 20th century. Clearly, the lessons of history have gone unlearned. This round of unprovoked trade aggression hearkens back to the Smoot-Hawley tariffs of 1930. In a nutshell, that was the year U.S. President Herbert Hoover imposed punishing tariffs on 20,000 imported goods. In May 1930, Canada, the country’s most loyal trading partner, retaliated by imposing new tariffs on 16 products that accounted altogether for around 30% of U.S. exports to Canada. Canada later also forged closer economic links with the British Empire via the British Empire Economic Conference of 19321. Economists generally agree that these trade actions, while not causing the Great Depression, made it far worse than it would have been otherwise.
On a more positive note, investors should also remember that there are a number of high-quality Canadian companies that have strong balance sheets and resilient cash flow streams. Most importantly, they have a proven track record of successfully navigating volatile macro environments and exogenous shocks. Our team has identified many high-quality stocks and bonds which can weather volatility and lead to outsized gains for patient long-term investors, particularly when bought on weakness.
Technical analysis
This month, we’d like to start with a review of our medium- term timing model (which measures 3 to 6+ month trends) to get a sense of how the remainder of the second quarter is likely to play out. You may be surprised to learn that despite all the uncertainty surrounding U.S. tariff policies, these indicators are actually constructive and supportive of more upside. For example, weekly momentum gauges are now very close to being “4 for 4” bullish for both the S&P/ TSX Composite and the S&P 500 after giving new buy signals in recent weeks – the first such combined buy signal since the 2022 bear market low. It’s also important to note that most of the indicators in our momentum timing model are giving new buy signals from levels that only occur as equity markets are transitioning out of cyclical bear markets and into new cyclical bulls.
Breadth indicators measure the quality of a market rally in terms of the number of stocks participating, and in that regard, there is very good news. In late April, a “breadth thrust” occurred, a rare signal with an enviable track record. Its purpose is to identify those moments that occur after a bear market where investors stampede back into equities; there have been 18 buy signals over the past 80 years. The average six-month return of the S&P 500 following a signal is +15.3%. The average 12-month return is +24%. The signals that have occurred since the credit crisis are even more amazing. Since 2009, it has given seven signals (with five of the seven coming at/near the end of secular or cyclical bear markets) with an average twelve month return of +35.25%.
Last but not least is sentiment. Surveys out recently were uniformly higher yet again, resulting in another solid uptick in our Composite Sentiment indicator which, like most of the indicators in our medium-term timing model, is also turning positive again from the deepest pessimistic extremes since the 2022 bear market low. Expanding bullish sentiment means more money being put to work in equities, which is clearly a good thing.
Based on this, the bias for equities should remain to the upside into the end of the second quarter at least. There are minor resistance levels along the way for the S&P 500, but the main level to pay attention to is its early 2025 peak at 6,147. A breakout there would shift the long-term trend back to bullish and open a new upside target that measures to 7,460. The next major target/resistance for the S&P/TSX Composite is the all-time high at 25,875. A break above that level would open a new upside target that measures to 29,523. At face value, those targets seem pretty great, but they do seem a bit ambitious given the state of our long- term timing model, which remains negative after giving a new sell signal in the first quarter.
This model has an enviable track record as an early warning system for cyclical bear markets and tends to roll over and go negative six-to-seven months on average ahead of cyclical bear markets (i.e., we could see more volatility at some point in the second half of the year following what should be a solidly positive Q2).
Please speak to your BMO Nesbitt Burns Investment Advisor if you have any questions or would like to discuss your portfolio.
1 The Imperial Economic Conference, StatCan
