by Paul Hoffmeister, Portfolio Manager and Chief Economist
Summary: The FOMC left its fed funds target range unchanged at 4.25%-4.5% at its last meeting on January 29th, as year-over-year CPI stands at +2.9% and unemployment remains low at 4%. Interest rate futures currently expect the funds rate to be lowered to approximately 4% by year-end, whereas in last September, markets were expecting it to be cut below 3%. Stubborn inflation has compelled the Fed to be on pause for the foreseeable future, but policy is still expected to loosen a bit later this year as the economy appears to be slowing ever so slightly… With the Fed variable stagnant for now, the dynamics of the market appear to be focused on the massive policy changes coming from Washington, as well as within the AI sector. Below, we provide updates on the outlooks on trade, taxes and geopolitics, as well as AI – all of which seem to be creating for more volatile market conditions.
Volatility & Major Policy Changes: In last month’s client letter, we explained how an influx of major policy changes by the new Trump Administration would lead to increased market volatility – both positive and negative. And indeed, February 2nd and 3rd were a good example, as the major US stock index futures traded lower Sunday evening by -1.5% to -2.5% following news that President Trump would soon implement 25% tariffs on Canada and Mexico, and 10% tariffs on China. By the end of the market close the following day, stock indices recovered some of those losses as it became clear that the Canada-Mexico tariffs would be paused for 30 days. The reprieves were granted in exchange for stronger border and drug enforcement measures. At the moment, however, President Trump’s threat of new China tariffs remains, and the Chinese government has countered that it will impose retaliatory tariffs of their own on 80 different manufactured and energy products from the United States, including coal and liquified natural gas. We expect China to play more hardball.
Policy volatility and the corresponding ups and downs in the market are what we expect this year as major policy changes emerge and take shape. Of course, forecasting the policy changes and their implications is made even more challenging because, in keeping with the unique style of President Trump, the policy announcements or actions themselves can often be part of a public negotiation, sometimes with and sometimes without a clear timeline.
So, what major announcements or actions should we additionally expect during the coming months? This week, the White House has pledged 25% tariffs and steel and aluminum imports, as well as reciprocal tariffs on many countries. We also expect to hear more details of additional tariffs against European countries within the next month. And clearly late this month, we may hear more about the planned tariffs against Canada-Mexico as well as China.
More information is also emerging about President Trump’s tax plans. According to White House press secretary Karoline Leavitt, the priorities will be to extend the 2017 tax cuts, eliminate taxes on tips and social security benefits, increase the limit on state and local tax deductions, reduce taxes on “Made in America” products, and close loopholes for private equity (carried interest) and sports team owners. We continue to expect new tax legislation to be completed by May or June, at the earliest.
Our big questions about the emerging tax law changes are: will the 2017 tax cuts be temporarily or permanently extended, and will there be any tax cuts on capital (such as capital gains and dividends)? Arguably, a permanent extension would be more stimulative than the current proposals, and tax reductions on capital gains and dividends (even inflation indexation) would be even much more pro-growth than current proposals -- and enduring in their stimulative effects.
Of course, with any tax legislation, the devil will be in the details. If Republicans plan to pass it via the budget reconciliation process, it will need to be scored revenue neutral by the Congressional Budget Office. Some estimate that the current tax proposals will cost at least $5 trillion. What revenue raisers will be used to “pay for” the tax cuts? The anticipated savings from newfound government efficiencies and spending cuts (Elon Musk’s “DOGE”) and new tariffs will likely be critical. But will there be significant tax increases that the market is not yet aware of?
Beyond economic policy, we expect to learn more about President Trump’s Ukraine peace plans at the Munich Security Conference between February 14-16. Bloomberg reported that General Keith Kellogg, the President’s Ukraine envoy, will outline the Administration’s initial proposals. Again, this will likely be the starting point of negotiations, that will be both public and private in nature. Over the weekend, the NY Post reported that President Trump said he’s already spoken with Russian President Putin. On Sunday, Kremlin spokesman Dmitry Peskov stated that he could neither confirm nor deny the report. The following day, Russian deputy foreign minister Sergei Ryabkov suggested that an announcement on talks could be forthcoming, while adding that US-Russian relations were “on the verge of rupture.”
If all these things weren’t enough, markets and investors alike will be anxiously awaiting further details about the President’s early plans to combat drug cartels, given last month’s executive order designating them as foreign terrorist organizations, as well as Middle East peace efforts.
DeepSeek Shock & Threat: News of major breakthroughs by Chinese AI developer DeepSeek sent shockwaves through markets on Monday, January 27. The Nasdaq declined -3.1%, the SOX semiconductor index fell -9.2%, and AI darling Nvidia collapsed -17%, losing almost $600 billion in market cap [1]. The collapse in equity prices stemmed from fears that DeepSeek’s innovations would enable competitive AI capabilities but with less power and cheaper, less exclusive semiconductors.
While AI-skeptics and market bears pounced on the news and may have felt vindicated, AI-bulls have argued that these innovations will only spur further AI usage and adoption, which should only support the budding technology and emergent industry. During the last two weeks, many of the DeepSeek-related market losses have recovered.
It seems to us that in the long-term artificial intelligence is indeed transformational for many industries. But in the short-term, innovations and surprises like these can turn some companies’ prospects and stock prices upside down in a hurry, especially when equity valuations are arguably so expensive. It also raises questions about the ROI of massive AI-related investments, and whether the spending will continue at this torrid pace. Morgan Stanley, for example, forecasts hyperscaler capital expenditures may reach as much as $300 billion this year.
Resilient Economy for Now: Overall, the U.S. economy is “holding up”. Real GDP grew 2.5% in Q4 2024, and the unemployment rate ticked down to 4.0% last month [2]. But there appears to be weakness at the margins. Real GDP has been slowly trending lower since its recent high of 3.2% in Q3 2023, and the unemployment rate is up from a recent low of 3.4% in Q2 2023 – which is a little lower from its November 2024 high of 4.2%.
As we’ve shared before, the resilience of the labor market appears to be a major factor in keeping the economy out of recession. Historically, corporate earnings and stock prices indices tend to struggle if the unemployment rate jumps significantly. So far, as the unemployment rate remains low and continues to avoid escape velocity higher, stock indices have been proving the market bears wrong.
Historically, manufacturing and construction have been early warning indicators of labor market health. Therefore, it continues to catch our attention that job openings in both sectors continue their downtrend. If this signal deteriorates further, it would further substantiate concerns about the health of the economy as well as the earnings and equity outlooks.
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[1] “Nasdaq drops 3% as China’s DepSeek AI model hits tech shares”, by Caroline Valetkevitch, January 27, 2025, Reuters.
[2] According to the Bureau of Economic Analysis and Bureau of Labor Statistics, respectively.
Paul Hoffmeister is Chief Economist and Portfolio Manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors (CEDA), and co-portfolio manager of the Camelot Event-Driven Fund (EVDIX • EVDAX).
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