We entered the second quarter with an already tariff-leery stock market having sold off 9% from the February highs when President Trump's April 2 "Liberation Day" announcement of reciprocal tariffs sent the market into a near freefall. The April 2 announcement included 10% baseline tariffs on imports across the board as well as much higher rates for many nations that run trade surpluses with the U.S. From Liberation Day to April 8 (four trading days), the S&P 500 declined 12%, resulting in an overall correction of just over 19% from the highs. Fears of a trade war-induced global recession filled the headlines and gripped the market during that short period.
What followed was a remarkable reversal as President Trump announced a 90-day suspension of most of the reciprocal tariffs, save for the 10% universal levy as well as the tariffs against China. A market rally ensued which, according to Ned Davis Research (NDR), led to "the biggest intra-quarter decline to be erased within the quarter since at least 1928." NDR adds, "Starting at the February highs, the rebound was the quickest back to an all-time high from a correction of at least 15%."
By the end of the second quarter, the S&P 500 would finish up 11% for the period, but with much dispersion among sectors. In what has become a near Pavlovian response to market selloffs, money flowed most into technology stocks, which rallied over 40% from the lows, while defensive sectors lagged significantly (for example, the S&P Health Care Sector was up only 1% from the market lows through quarter end). Despite the global trade uncertainty (as well as an attack by the United States on Iranian nuclear facilities), the S&P 500 ended the quarter at a record high.
So, is the stock market being pollyannish? To us, it certainly feels like the overall market is pricing in the most optimistic assumptions, and ignoring many of the potential risks. Seemingly every economic release not indicating a significant slowdown to the economy, or uptick in inflation has been cheered, as have the continued delays to implementing many of the announced tariffs. To be sure, the U.S. economy, thus far, has been resilient, and the labor market strong with the June unemployment rate coming in at 4.1%. We would simply warn… It's still early. The impact from currently enacted tariffs will take time to be felt but could ultimately have significant impacts on the economy. Additionally, despite deadlines for negotiations being pushed multiple times (currently, to August 1), very few trade deals have actually been agreed upon to date.
Meanwhile, we think this quote from the executive director of the port of Los Angeles, during a recent Bloomberg TV interview is emblematic of what many are feeling: "CEOs are telling me, ‘hit the pause button’. Hiring, off the table for right now. Capital investment, pause. And the retailers are telling me that even 10% (tariffs), ‘I’m going to have to pass it on to the consumers’."
The potential inflationary effects could also take time, as referenced recently by the CEO of Hasbro: "I would expect if prices are going to be raised across the industry, the consumer will probably start to see them in the August through October timeframe, just based on the production timelines associated with toys."
Additionally, we believe many investors assume tariffs are a negotiating tactic by the president in his effort to rebalance trade and act as a prod to bring manufacturing to the States. However, as can be seen in the chart above, not only are the current average effective tariff rates of around 15% the highest since the Smoot-Hawley tariffs of the 1930s, but we take the administration at their word that tariffs are a way to fund the recently passed "One Big Beautiful Bill," which, the CBO estimates could add $3 trillion to the deficit over the next decade.
One example of this sentiment coming from the administration came from Treasury Secretary Bessent in June: "What we’ve seen is we keep hearing from the CBO that there’s going to be a large deficit from the bill, which we disagree with. But using the CBO scoring, they came out and scored the tariff revenue. We think it will be a minimum of $2.8 trillion over the ten‐year window, which actually puts the bill in surplus if you include the tariff revenue—which they won’t do." We believe tariffs are here to stay, and in a significant way.
Does that mean what we see ahead is doom and gloom? In short, no. While we do believe there has been some overexuberance in certain sectors recently and are concerned about the overall valuation of the S&P 500 (as shown in the chart below), we are not forced to own the market. There continue to be out of favor stocks and sectors where we are finding attractive opportunities, as well as sectors (for example, banks, which we go into further below) that have recently caught favor, but we believe continue to be set up well for future outperformance. While we are mindful of tariff uncertainty and the potential detrimental impacts to the economy, we currently do not see a significant downturn in the near term. However, should one occur, we are comfortable with your portfolio’s high-quality long holdings, and conversely, feel the Fund’s lower-quality short positions should underperform in that environment.
Following last November's election, with President Trump retaking the White House as well as both houses of Congress, many predicted that the administration's pro-business policies would initiate a wave of mergers and acquisitions (M&A). We count ourselves among those who held that view. However, we believe uncertainties surrounding the ongoing trade war as well as what would ultimately be contained within the massive, recently passed tax and spending bill caused companies to take a wait-and-see approach, remaining on the sidelines until those situations were resolved.
We continue to believe we will see a significant pick up in acquisition activity, and in particular, within the banking industry where scale is more important than ever given constantly advancing technologies, complex risk management, as well as regulatory compliance requirements. Notably, the stage is being set from a regulatory perspective to foster increased M&A within the sector, in our view.
Objectively, the environment under the Biden administration was less than friendly when it came to bank consolidations. By way of reference, according to a recent report issued by Hovde (which included the chart above), "From 2010 through early 2020, deals took ~145 days to close, on average. Over the past five years, that figure is closer to 190 days, with several quarters' worth of closings in the ~250 day range."
This dragged-out approval process likely acted as a deterrence for banks who would otherwise aim to pursue business combinations. For all their benefits, M&A transactions invariably cause some level of disruption, even for the most skilled acquirors, and extending the length of time until closing not only risks more significant disruptions to the business but also exposes the companies to significant economic or interest rate changes while they wait. These changes could have potentially material impacts on the attractiveness of the transaction.
There is much reason for optimism on that front, however. In a recent, June 6 speech, Federal Reserve Vice Chair for Supervision, Michelle Bowman specifically discussed the desire for a softer regulatory framework for banks. Among the changes she indicated included streamlining bank merger applications. Quoting from Bowman's speech: "The process to file an application and receive regulatory approval…[for] institutions seeking to merge…should reflect both (1) transparency as to the information required in the application itself, and the standards of approval being applied, and (2) clear timelines for action…Similar problems have affected bank mergers and acquisitions, where there have been lengthy processing delays. We need to rethink whether many of the additional requests for information can be addressed through better application forms or relying on information that is available from bank examinations.”
Another noteworthy turn of events came recently when the FASB voted in favor of ending what's known as "CECL double counting." By way of background, the CECL (Current Expected Credit Loss) accounting rules came into effect between 2020 and
2023 (depending on the size of the bank) and were a reaction to the 2008 financial crisis. The new standard required banks to estimate all expected loan losses upfront, rather than waiting until they actually incurred a loss. Unfortunately, the rule effectively caused a double counting of loan loss reserves when banks entered into merger agreements given they were forced not only to mark loans to fair value (which implicitly includes a markdown for any loss reserves needed) but also take a loan loss reserve for the same losses - effectively penalizing capital twice for the same estimated future losses. In some instances, these marks could be material, making potential deals less attractive. The FASB revision should make M&A more financially attractive.
Also during the June 6 speech, Ms. Bowman referenced the adverse rating environment for large banks and the detrimental impact it has had on the M&A environment, as banks feared being downgraded should they enter into a transaction. In early July, Bowman would later issue a proposal to adjust the ratings framework. The statement included the following: "Under the current LFI framework, nearly two-thirds of the large financial holding companies are not ‘well managed’ despite having capital and liquidity levels substantially above regulatory requirements. This is because the LFI framework currently assigns a firm's ‘well-managed’ status based on a single deficiency in any one rating component, rather than taking a complete look at the financial and managerial health of a firm. The proposal would generally require a deficiency in either a large bank holding company's capital or liquidity ratings, in addition to a deficiency in its governance and controls, in order to be classified as not well-managed."
In the interest of brevity, the above concentrates on some of the regulatory actions which should be most helpful to spurring bank M&A. There have been numerous other proposals and actions (such as the recent proposal to loosen the leverage restriction on Global Systemically Important Banks, potentially freeing up hundreds of billions in capital for these banks) which are also beneficial to the sector. While some of these proposals will take time to be enacted, it is clear the environment should be much more conducive to bank M&A. The Fund holds long positions in several banks with differentiated deposit franchises, conservatively-capitalized balance sheets, above-average management teams, and prudent credit underwriting cultures - the attributes acquirers would also likely deem attractive. Thus, we are optimistic your portfolio will benefit from this more favorable regulatory environment and any potential M&A wave to come.
Much has changed in a few short months. The new administration entered the White House with the goal of an “economic renaissance” marked by a revival in American manufacturing, tax cuts and deregulation. The early focus on U.S. trade deficits and the aggressive use of tariffs as a tool caused sharp moves in world currencies, equity and fixed income markets. And while the sharp rebound in equities and corporate fixed income indicates investors have shifted their focus to the fiscal stimulus and deregulation to come, many uncertainties related to the global trade war remain. In our view, the risk of a potential systemic shock is heightened in this environment. The Federal Reserve is likely to refrain from acting until there is more clarity over trade disputes, but stands ready to provide liquidity and other support should the need arise.
We expect continued housing market pressures as a result of higher interest rates and affordability concerns. However, the shortage of housing after over a decade of underinvestment following the Great Financial Crisis should prevent a disastrous decline in home prices. Lower-income consumers have been most impacted by the recent inflationary environment, but consumer balance sheets remain generally healthy for the majority of Americans, and consumer credit quality remains strong at the moment. The short-term inflationary impacts from tariffs will likely be detrimental.
What we see argues for a more inflationary and higher interest rate environment than seen in the past ten years, and risks for a recession are heightened in this uncertain environment. As always, with our bias towards quality, we strive to mitigate any downside, while also participating in the upside. Ultimately, we are optimistic the new administration in Washington will lead to less regulation and a more favorable merger & acquisition environment.
We continue to find opportunities to invest in quality businesses with solid balance sheets and cash flows, whose share prices have detached from our assessment of the fundamentals. The bargains inherent in your portfolio should attract acquirers and other investors over time.
Steadfast, we remain committed to helping you meet your financial goals while preserving your wealth.