Intermission

Markets today mirror Broadway’s three-act structure perfectly. The opening act featured tariff-induced turbulence, with volatility spiking as policy uncertainty rattled investors. Now we are experiencing a deceptively calm intermission, a temporary reprieve where hope and complacency return. Don’t be fooled. Based on our analysis, the final act approaches when debt ceiling brinksmanship, tax cut expirations, and a flood of tariff-driven price increases will converge to deliver the dramatic climax that markets are not fully prepared for.

The Opening Act
The administration promised that their trade policy would deliver three things: (1) meaningful revenue gains, (2) strong near-term growth, and (3) manufacturing onshoring. So far, tariffs have reversed capital flows in the US dollar, weakened business and consumer confidence, and given US companies an excuse to raise prices, amplifying future inflation expectations and macroeconomic uncertainty.

The opening act climax was “Liberation Day” (April 2), and the US stock market fell 19%. Since the April 8 pivot, the stock market has rallied 14%, with the S&P 500 retracing 50% of the tariff decline.

Intermission
We expect the intermission to last between now and just past Memorial Day. Trade deals will be discussed. Washington will pretend that April’s debacle did not permanently damage America’s international standing. It did. Allies will make other plans. We expect the Fed to stand firm (no rate cuts on May 7), and more pressure and interference on monetary policy from the White House.

According to Strategas, May 13th will be one of the most important days yet in the legal pursuit to stop the president’s tariff agenda. The United States Court of International Trade (CIT) will hear oral arguments on V.O.S. Selections Inc. v. Trump – one of seven outstanding lawsuits against the tariffs – considering the plaintiffs’ request for a preliminary injunction. What’s at stake? Potentially, a nationwide injunction on the president’s use of IEEPA tariffs imposed on China, Canada, and Mexico, along with the 10% universal and reciprocal tariffs imposed on “Liberation Day”.

If the CIT imposes injunctions, the case will be fast-tracked to the Supreme Court.

The administration has a backup plan on tariffs. If the court issues a durable injunction, the administration can impose tariffs under other tariff-specific authorities (Section 338) while the cases play out and likely end up at the Supreme Court.

The Final ActWhile tariffs dominate the first act, we believe the final act will quickly pivot towards what truly represents the administration’s policy crown jewel: extending the 2017 Tax Cuts and Jobs Act. The final act carries far greater economic implications and political stakes.

Our base case is that this government will be unable to secure tax legislation until after Labor Day, which we expect to be a major disappointment compared to the market’s current expectation of a July 4 completion date. This view is based on (1) Republican infighting over spending cuts, (2) the administration’s approval rating is at 40% and declining, and (3) Congress’s proclivity for creating and navigating fiscal cliffs, delaying action until the last possible moment.

The debt ceiling situation adds urgency despite investor complacency. Treasury General Account projections show reserves falling to a dangerously low $20 billion by late August. This will likely prompt Secretary Bessent to declare early August “X-date.” This is important because the “X-date” is when the Treasury runs out of creative accounting measures (and money) to keep the U.S. government open, creating pressure for Congress to act.

If we are correct, and based on historical precedent, we expect two potential outcomes. First, there is a rising probability of a major credit rating agency downgrading US government debt due to political dysfunction and insufficient fiscal reforms (similar to the 2011 episode). Second, we would expect significant market volatility.

During the 2011 debt ceiling crisis, markets remained calm leading up to the X-date but in the three weeks following the resolution, the S&P 500 fell by more than 12%, 10-year Treasury yields declined 70 basis points, and high yield bond spreads widened by more than 160 basis points (source: Morgan Stanley). Short-term Treasury markets typically show the first signs of stress, and the VIX futures curve shows increased expectations for volatility around the projected X-date.

Despite the “v-shaped” stock market recovery in April, we believe patience will pay as the summer wears on and the administration’s attention pivots away from tariffs to the policy crown jewel: passing the largest fiscal package in decades.

Investment ImplicationsEquities

Let us clarify our current views on equities.

We downgraded equities from neutral at the beginning of the year to underweight in March and raised cash. Our technical signals never confirmed a bottom, and earnings forecasts are drifting lower. Thus, we remain underweight in US equities (-2.9% YTD) and are neutral in international equities (+11.0% YTD).

The countertrend rally since April 8 has caused the S&P 500 Index to retrace to 5,687, which is 50% of the decline from peak (6,160) to trough (4,983). Based on analysis from 3Fourteen Research, in 13 of the past 18 bear markets, the market retested the initial lows within four months of the initial low. We do not think the “v-shaped” recovery has reached escape velocity. We advise patience before adding more equity risk to portfolios.

Since the trade war began in March, consensus expectations for growth and inflation have been revised. Lower growth and higher inflation is the textbook definition of stagflation.

Under stagflation, with higher rates and slower growth, investors should avoid growth equity and growth credit, improve their quality, and invest in companies with earnings to protect against the downside risk of a recession.

This also happens to be how investors in public markets are positioned. Short interest in small-cap companies is at the highest level in many years. This is not surprising, as 40% of companies in the Russell 2000 have negative earnings, and middle-market and small-cap companies are hit by the triple whammy of higher tariffs, slower growth, and higher rates because inflation stays higher for longer.

We see the S&P 500 Index with an upside of 5,700 and a downside of 4,600.

Bonds

Since the beginning of the year, we have been underweight fixed income and duration risk and overweight cash in our model portfolios. YTD, the 10-year Treasury (+3.6%) has outperformed investment grade (+1.6%) and high yield (+1.4%) credit.

A view circulating among the investment community is that falling growth (and a potential recession) is a larger risk than inflation. We are not so sure.

We think a big bond risk lurks in the upcoming tax bill. The current deficit is already extreme for a non-war economy (7% of GDP). If the administration and Congress push the deficit higher, they risk a sharp rise in the term premium. The term premium is the additional yield that investors demand as compensation for the risks associated with owning long-term bonds.

In past stagflation regimes, the yield curve generally flattened/inverted and then normalized (returns to an upward slope) by the time an actual recession arrived. Today, the 2y10y curve is at 48 basis points, above the YTD average of 35 bps.

The 10-year yield (4.31%) continues to bounce along the lower band of an upward sloping trading range between 4.0% and 5.0%.

Looking ahead to 2H25, we expect debt ceiling turbulence and deficit concerns to raise the term premium and push the yield curve higher.

If we see the 10-year yield break below 4.0% and stay there for an extended period, we will reconsider our positioning and move to neutral fixed income.

Conclusions

• Underweight US equities with a defensive sector tilt
• Neutral international equities
• Underweight bonds and duration
• Overweight cash and diversifiers (infrastructure)
• The base case is for tariff talk to give way to concerns about the debt ceiling and legislative agenda, with turbulent markets and increased volatility during 3Q25.

Note: All market data referenced above is sourced from Bloomberg unless otherwise denoted.