The Market's Spring "Break"

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights into the new tariffs and their impacts on the economy and markets, Fed expectations, and opportunities in fixed income. We finished with a random round of questions and personal reflection.

Market Performance: Total Return

Many U.S. stock and bond indices were down in March, but international equities ended the month higher. What happened?

Increased tariffs and concerns regarding federal spending cuts initiated by the Department of Government Efficiency (DOGE) continued to weigh on markets. I do believe the DOGE/austerity mindset will have a long-term effect on growth. Given that, the markets are positioning for near-term slower growth, higher unemployment and higher inflation. As a result, the S&P 500 Index was down about 5.5% in March. However, the S&P 500 Equal Weight index is down only about 0.61% for the year, so overall, your average stock has hung in through March.

And fixed income?

Year-to-date, bond returns are outperforming equity returns. It’s been a flight to quality—risk is underperforming, and safety is outperforming.

The Lag 7 (or Not-So-Magnificent 7)

What about the Magnificent 7, which some people are now calling the Lag 7?

March was definitely a challenging month—all seven stocks were down—which matches the challenging quarter. Those stocks were down an average of nearly 16%, even before the latest round of tariffs were announced. If you look at why the S&P 500 is down this year, the Mag 7 is the primary reason. Telsa alone is down nearly 36% over the past three months for a variety of reasons.

10-Year Treasury Yields Remain Range Bound

U.S. Treasury yields fell for intermediate maturities, but they rose at the long end of the curve. Anything to note?

It is a very tricky situation to underwrite. When you think about what’s driving the short-term market participants on the flight to safety, it is primarily tariffs. Underwriting the length and depth of tariffs right now is extremely difficult. At the same time, underwriting the length and severity of the impacts from the DOGE cuts is also difficult. I think the DOGE impact could have more of an effect on the economy than tariffs over the long term. When you look at the 10-year Treasury, we closed the month at 4.23%, and it’s now around 4%. I still think 3.25%, which we saw just a couple years ago, feels very low. We’re seeing is a flight to safety and the 10-year is essentially reflecting it.

Fed Futures: Accelerating Timing of Rate Cuts

The Federal Reserve’s FOMC met in mid-March and kept the fed funds rate unchanged. What’s your take on the Fed latest moves?

Last month, the market was expecting one or two interest-rate cuts for the year. Now, we’re looking at three to four cuts with a 90% chance of the first one happening in June. Three or four cuts this year would take the fed funds rate down to the low threes. This scenario is going to be tested due to tariffs dynamics. Tariffs are essentially a monster tax on goods. That increases the cost, but that could be offset as demand starts to wane. The result may be slower growth and higher unemployment. The Fed’s dual mandate—stable prices and maximum employment—will continue to be tested in my opinion.

Now, some critics said the monthly reduction in U.S. Treasury runoff from $25 billion to $5 billion was a step towards easing. Do you think there’s merit to that statement?

It is certainly a small step towards easing. The technical pressure from Treasuries will diminish. As opposed to them selling $25 billion a month, they’re now selling $5 billion. That’s mostly a “so what” in Treasury land, but I find it interesting that it’s a side door to ease monetary policy without generating many headlines from cutting interest rates.

Aristotle Funds' Economic Dashboard

Warren Buffet once said, “Forecasts usually tell us more about the forecaster than the future.” Right now, there seems to be a battle between hard and soft data about the state of the economy. What’s the hard data tell you?

The data through March shows much of the economy looks stable but weakening. However, when the increased tariffs were announced on April 2, the economic outlook has been scrambled, and we’re waiting to see how it all unfolds. There have been some warning signs. At the end of February, the Atlanta Fed’s GDPNow forecasted growth above 2% for the first quarter. Now, little more than a month later, that forecast has dropped to -3.7%. That’s an extraordinary swing. As for inflation, it sits at 2.8% right now. Which direction it will go from here is difficult to predict with the uncertainty surrounding the tariffs. On the job front, I expect between the DOGE initiatives and tariffs, the non-farm payroll numbers will start to weaken and maybe weaken substantially.

Consumer Sentiment Plunged in March

Consumer sentiment dropped precipitously in March.  What’s behind that?

Again, the short answer is DOGE and tariffs. On the tariff side, it is causing substantial pain from a forecasting standpoint. And when forecasts are less certain, there’s more fear in the marketplace. I think adding to this is the depletion of COVID dollars, meaning the extra discretionary money consumers have had has largely disappeared. There’s also worry about job losses, which is exacerbated by the hundreds of thousands of federal employees who have been recently laid off. That all translates into a large drop in consumer sentiment. Let’s hope it’s temporary.

"Pursuing Reciprocity to Rebuild the Economy" —President Trump

The U.S. has essentially declared a trade war, basically putting an additional 10% tariff on all U.S. imports along with reciprocal tariffs. How do you see this playing out?

I think it’s important to understand the intent behind the tariffs. What I found interesting is something Treasury Secretary Bessent said: “My advice to every country right now is: Do not retaliate. Because if you retaliate, there will be escalation. If you don’t retaliate, this is the high-water mark.” To me, that’s a signal that the higher tariffs provide merely a starting point for negotiations, though I think the Trump administration is going to be less flexible with the Chinese and I believe the floor will be 10%. This will create another dynamic that’s hard to underwrite. If other countries act favorably toward us, they may get pressure from China. I think that is an important undercurrent.

Tariffs: U.S. Effective Tariff Rate

Can you put the size of the new tariffs into historical context?

We have not seen these levels of tariffs since the early in the Great Depression nearly a century ago. But since the 1950s, the effective tariff rate has ranged mostly between 2% and 7%. In 2024, it was 3%. The Trump tariffs, as they stand now, would put the rate at 22.5%, higher than the tariffs generated by the 1930 Smoot-Hawley Tariff Act.

Why have the tariffs created so much uncertainty?

One reason is President Trump imposed the tariffs through an executive order under the International Emergency Economic Powers Act, which means the tariffs are in effect until Trump declares otherwise. Basically, it’s open-ended, and Trump can raise and lower tariffs at will. This means there is a wide continuum of possible outcomes, and markets really dislikes uncertainty. These tariffs would be adjusted next week or next year or not until Trump is out of office. This forces the market to attempt to under- write a situation that is very difficult to underwrite.

Early Tariff Impacts?

Can you give us an example of how the uncertainty has affected a company?

Let’s look at two companies: Harley-Davidson, which of course manufactures motorcycles, and Brown-Forman, which produces Jack Daniels and other spirits. The companies offer two different products and two price points, but both stocks since election day have dropped by about 20%. In March, Canada imposed a 25% tariff on U.S. goods and removed American alcohol brands from its government-run liquor stores, the latter which Brown-Forman said will hurt more than the increased tariff. And the EU went one better, announcing a 50% tariff on $28 billion worth of U.S. goods. In 2024, 21% of Harley-Davidson retail sales came from the EU and Canada. That’s going to hurt if sustained.

S&P 500 Performance and Tariff News

Do you think that 2025 is going to be a rerun of the 2018 trade threats by the first Trump administration?

I feel like the current administration is much more emboldened today. They have much more political capital and, I think, resolve than in 2018.

How does the stock market’s reaction to the tariffs today compare to 2018?

In 2018, the S&P Index returned -2.76% when the tariffs went into effect but then climbed steadily as negotiations got underway. This time around, I think the markets want to see encouraging signs that negotiations are ongoing. If everyone acts against their collective best interests, everyone loses. But if all cooperate, it creates a better outcome. As I indicated before, I believe the U.S. is signaling, “Come to the table and let’s negotiate.” What’s important here is how other countries will respond. That’s what the market wants to see.

To calculate the size of the tariffs, the Trump administration used formula that included dividing the U.S. trade deficit with each country by the country’s exports to the U.S. Why take this approach?

The thinking is a country may charge lower tariffs than we charge them, but because the U.S. buys far more goods, we’re getting hit more. I don’t think that signals fair negotiation, but the big bet is that our consumption matters more to our trading partners than it does to us, so they’re incentivized to come to the table.

In the end, I think Trump’s looking to do deals. And if you’re willing to play ball early, you might be able to cut a better deal. However, I would be surprised if the tariffs go below 10%. I think there’s a fundamental belief in the administration we should have some level of tariffs.

Fixed-Income Yields and Year-to-Date Returns

What possible pitfalls may the tariffs create for average Americans?

One goal of the tariffs is to raise money to fund tax cuts. But I think if the U.S. goes into tariff-sparked recession, the tax plan falls apart because revenue drops. The tariffs may also hurt retirees especially hard. In theory, the tariffs will encourage onshoring manufacturing, which will protect American jobs and be beneficial over the long term. But if I’m retired and out of the workforce, I’m paying more for goods due to inflation caused by the tariffs.

Given all we’ve discussed, would you say the economy is breaking or is this just a pause?

Since I’m in the camp that President Trump is signaling he wants to negotiate and do deals, to me there’s not going to be a break in the economy unless other countries start to escalate the tariff war.

Where do you see opportunities in fixed income today?

Safety and duration. We’ve seen outperformance with the Agg and U.S. Treasuries—that’s a flight to safety. That’s going to probably continue in the short term, unless we have a pivot on the tariffs at some level. If we end up going into a recession—which I don’t believe will be the case near term—then we’ll have lower rates, and investment-grade bonds should do well. At the same time, there’s a chance that inflation remains sticky, so it would be wise to diversify. I believe in going with a little more duration, and I’d still have bank loans in the portfolio. Right now, I’d lean toward more safety given the uncertainty of things. You could argue U.S. Treasuries at this point, but it’s so hard to position long-term for Treasuries when economic conditions could change so quickly.

Let’s do a random round where I provide a word or phrase, and you tell me what immediately comes to mind. First: German stimulus.

They want to protect their borders and defend Europe, which means they’re going to spend a lot more because of their concerns about the U.S. and its traditional support of Europe.

Panama port deal.

This is about two superpowers—two of the big kids on the playground—battling it out. The Trump administration feels China has too much control over the Panama ports and wants to diminish their influence and reaffirm America’s power on that important strategic thoroughfare.

SpaceX bringing home the stranded astronauts.

I think it’s awesome. I’m glad they’re home.

Department of Education.

It takes 60% of the U.S. Senate to confirm an abolishment of an agency. So, the Trump administration’s proposal to shut down the Department of Education has a high hurdle to clear.

Egg prices.

I believe egg prices have spiked and are returning to normal. It’s amazing how the price of an egg became a popular economic indicator.

Let’s close with a personal reflection.

I’ve been amazed that in a world of eight billion+ people, there are three who have such an oversized influence: President Trump, Chinese President Xi Jinping and Russian President Putin. We’re in a trade war now with all its inherent complexities, but I think an old adage comes into play here: You’ve got to “play the man.” In other words, you need to understand and influence the person you’re trying to make a deal with. It’s clear to me that President Trump and his team have been signaling the new tariffs are a starting point for trade negotiations. So, in this case, if global leaders want tariffs lowered, they need to play the man—give Trump a “win” and recognition for putting it together. I think from the standpoint of an investor, a company or a government, that’s just what you have to do at this point in time.

Definitions

The 10-year Treasury note is a debt obligation issued by the U.S. government with a maturity of 10 years upon initial issuance. It pays interest at a fixed rate every six months and pays the face value to the holder at maturity.

The 10-year Treasury yield is the interest rate the U.S. government pays to borrow money for a decade.

The Atlanta Fed’s GDPNow is a forecasting model that provides a "nowcast" of GDP growth.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level.

Basis points, also known as bps, are a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form.

A bond is a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time. The entity repays individuals with interest in addition to the original face value of the bond.

The Consumer Confidence Index (CCI) is a monthly report that measures how optimistic consumers are about the economy, labor market, and their finances.

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.

Consumer sentiment is a statistical measurement of the overall health of the economy as determined by consumer opinion.

A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Clipping coupons refers to the practice of earning income through interest payments from bonds.

Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk. The shorter a fund’s duration, the less sensitive it is to interest-rate risk.

Effective tariff rate measures the actual protection afforded to domestic producers, considering tariffs on both the final product and imported inputs.

Fed funds futures is a tool used by traders and institutions to hedge or bet on changes in the federal funds rate, which is key to U.S. monetary policy.

The federal funds rate is the target interest rate set by the Fed at which commercial banks borrow and lend their extra reserves to one another overnight.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System that determines the direction of monetary policy and is responsible for raising or lower interest rates.

Fixed income refers to assets and securities that pay a set level of income to investors, typically in the form of fixed interest or dividends.

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. The nominal GDP growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Real GDP is GDP adjusted for inflation.

High-yield bonds are debt securities, also known as junk bonds, that are issued by corporations.

Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.

The Personal Consumption Expenditures Index (PCE) is a measure of consumer spending and includes all goods and services bought by U.S. households. Core PCE excludes the prices of food and energy.

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return.

Spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, represented by treasury bonds. Spread income refers to the additional income from this difference.

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.

Yield is the income returned on an investment, such as the interest received from holding a security.

A yield curve plots the interest rates of bonds that have equal credit quality but different maturity dates.

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Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund’s performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

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