Four major factors driving market volatility
Review the latest Weekly Headings by CIO Larry Adam.
Key Takeaways
- Recent tech underperformance is inconsistent with fundamentals
- Despite growth scare, U.S. economy remains on solid footing
- Government shutdowns typically only lead to short-term volatility
What a whirlwind! In the five weeks since President Trump began his second term, he has issued an extraordinary number of executive orders, threatened and imposed tariffs, and initiated sweeping changes across nearly all levels of government. He is also attempting to deliver on his campaign promise to make the government more efficient. The rapid pace of decision-making has been unnerving, particularly for financial decision-makers and markets that thrive on stability. This has also posed challenges for Fed policymakers as they navigate the economy through a lens of increased uncertainty. As a result, equity market volatility has picked up in recent weeks. Below, we detail some key factors driving the recent market volatility and provide our perspective on how we believe these events may unfold and impact the economy and financial markets.
- Tech Stumbles | Following the release of cheaper AI models from China, the Tech sector has faced significant pressure in 2025. After strongly outperforming the S&P 500 in both 2023 and 2024, with a cumulative outperformance of 58%, the Tech sector has lagged the S&P 500 by 5.6% YTD. This marks the worst underperformance at this point in the year since 2008. Given that Tech holds the largest weighting in the S&P 500 at 31%, this recent underperformance has raised questions about whether the market can continue to rise without Tech's leadership.
Our View: We believe the recent weakness in the Tech sector is misguided. Beneath the surface, the sector's fundamentals remain robust, with Tech expected to achieve the highest EPS growth (+21%) and margins (+27%) of any sector in 2025. Additionally, although there were worries about a potential slowdown in AI investment, a record number of companies have mentioned AI on their conference calls. Furthermore, many mega-cap tech companies have raised their full-year 2025 capex forecasts, indicating that AI investment should remain strong this year.
- Policy Uncertainty Has Created Another Growth Scare | The economy entered 2025 on solid footing, but recent economic data releases (such as retail sales, ISM Services, and housing) have been disappointing. The Citi Economic Surprise Index, which measures how economic data compares to market expectations, has fallen to a five-month low. While enthusiasm for tax cuts and deregulation boosted growth expectations following the election, the sequencing of President Trump’s policy initiatives—starting with sweeping tariff announcements, immigration policies, government layoffs, and cost-cutting efforts—has taken a toll on confidence. These factors have raised questions about the broader economic outlook, causing some jitters in the financial markets.
Our View: After a series of 3% real GDP growth rates in the second half of 2024, the economy's momentum was expected to slow, aligning with our 2.4% GDP forecast for 2025. We are not overly concerned about the recent soft patch, as unusually cold weather at the start of the year likely dampened economic activity. Furthermore, with consumer fundamentals such as employment, income, and household wealth expected to remain strong, this soft patch should be short-lived. The recent decline in longer-term interest rates could provide a boost as well.
- Tariffs Concerns Are Front And Center | Concerns over tariffs have unleashed a wave of uncertainty, prominently featured in 4Q24 earnings calls, eroding confidence and heightening inflation anxiety. Despite all the tariff discussions, only China’s 10% tariffs have been officially implemented so far. This week, we found out that the delayed tariffs on Mexico and Canada will go into effect on March 4, and Trump plans to impose an additional 10% tariff on China. Additionally, the coming weeks should bring news on the proposed reciprocal tariffs at the country level and sector-specific tariffs (e.g., steel, autos, pharma, and chips), keeping economic and trade policy uncertainty elevated.
Our View: Some of the proposed tariffs are likely to stick (e.g., China, Europe), while others (e.g., Canada and Mexico) may not be long-lasting. Our base case assumes a 5% increase in the effective tariff rate, which could reduce growth by ~0.5% to 0.6%, all else being equal. While this would be a meaningful drag on 2025 growth (from 2.4% to 1.8%), it is unlikely to push the economy into a deep downturn. For equities, the drag will likely weigh on S&P 500 EPS growth by ~1%. Despite this headwind, 2025 S&P 500 EPS growth is still expected to be a healthy 11% YoY.
- Government Shutdown in Focus | Despite the narrow majority in the House (currently only one seat), Republicans managed to pass budget guidelines proposing $4.5 trillion in tax cuts and a $4 trillion increase in the debt limit. While the Senate had already passed its own scaled-down version of a budget resolution, the two chambers now need to agree on a unified version. Notably absent in both versions is a plan to avoid a government shutdown, which is fast approaching with the funding deadline just 14 days away on March 14. With betting markets still pricing in a ~50% chance of a shutdown, political uncertainty has led to increased market volatility.
Our View: While government shutdowns have led to increased volatility, the average market performance during the last 20 shutdowns since 1976 has been flat. More importantly, shutdowns have not halted the market's long-term upward trajectory. In fact, in the 12 months following a shutdown, the market has risen by an average of 13% and has been positive 80% of the time. With economic and earnings growth remaining solid, fundamentals should continue to drive the equity market in the long term, while actions in Washington are likely to be short-term noise.
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