Despite headlines fixated on tariffs, the true culprits behind market turbulence lie elsewhere, says Garrett Melson, Portfolio Strategist at Natixis Investment Managers. In this analysis, Garrett unpacks how unwinding crowded trades, cooling growth, and policy uncertainty are shaping the economic landscape — and why a second-half rebound may still be on the horizon.
Tariffs, tariffs, tariffs! Not even one quarter into 2025 and tariff is already proving to be the word of the year. And while tariff risks and the administration’s admission of the potential for some pain during a transition period are garnering plenty of attention, tariffs are more of a sideshow than anything. Since the market peak on February 19th, a basket of tariff exposed companies has only underperformed the S&P 500 by just over 0.5% and has in fact outperformed the Nasdaq by 3.7%. On Monday’s slide, those same tariff exposed names in fact outperformed both the Nasdaq and S&P 500. Not what one would expect if the key concern was tariffs. Yes, the market’s focus appears to be shifting from tariffs themselves to the broader effect on the economy, and to be sure, tariff risks and general policy uncertainty are a part of narrative, and the longer that uncertainty persists, the more it erodes the animal spirits that had built in the wake of Trump’s election victory. But for those worried about markets and the growth outlook, it’s not the tariffs and policy uncertainty that investors should be blaming, but rather the underlying trend of cooling that has been underway for months.
Tariffs have certainly weighed on investor sentiment, but the greatest pain in equities so far has been more a function of unwinding crowded beta and momentum trades: Long US Equities, long US Tech/AI, long BTC. In other words, the worst performing assets are the names that have outperformed over the past year, drawing in assets and pushing up valuations. The risk facing markets now, is that this unwind of crowded trades morphs into a broader and deeper correction as a growth scare materializes. Precisely what now appears to be emerging. Markets entered the year overly optimistic on the growth outlook and overly pessimistic on the inflation backdrop and are now faced with a backdrop that increasingly suggests further cooling in both growth and inflation. To be clear, it’s quite premature to suggest that recessionary dynamics are taking root, but downside risks are evident and growing as growth cools from elevated above trend levels. The pillars that have supported robust economic growth in the US over the past few years are all weakening. Real incomes are slowing as labor markets continue to soften, which suggests consumption will cool as much of the strength in consumer spending over the past few quarters has been fueled by a falling saving rate. Federal government spending is set to cool, even in the absence of Elon Musk’s DOGE initiatives as defense spending has been running at unsustainable levels. More importantly, state and local government budgets are tightening after years of strong contributions to economic growth. And the housing market remains frozen as rates and affordability have sidelined demand once again, with activity set to get worse before it gets better for a key driver of growth and employment in the economy.
All of this is occurring against a backdrop where recession expectations had all but evaporated and the Fed is once again more concerned with upside risks to inflation than downside risks to employment. Policy uncertainty, on both the trade and fiscal front, is indeed a problem for growth, though not so much in that it depresses sentiment and activity, but rather that it translates to further passive tightening as it keeps the Fed sidelined as growth continues to cool. The market’s reaction function is more nimble than the Fed’s, and while the Fed will eventually pivot as growth risks become more evident, the door is wide open for markets to overreact in the interim as growth fears continue to take hold. And with neither Chair Powell nor President Trump showing much concern with the slowing trajectory of employment, it appears that growth will likely slow further before a policy response arrests that cooling. But it’s not all doom and gloom – any correction as we move through the seasonally weak period of Q1 and early Q2 will likely prove to be an attractive entry point for second half gains as uncertainty gives way to answers, the Fed pivots to defending labor markets, and growth ultimately proves resilient, albeit more modest.
