Policy Chaos Should Give Way To Better Growth, Broader Bull Market

The Current Market Landscape: Navigating Volatility and Uncertainty

The U.S. equity markets have been navigating a period of volatility and range-bound trading since the election, with the S&P 500 Index oscillating within a roughly 175-point range. This lack of direction reflects an ongoing tug-of-war for market leadership, leaving many investors questioning whether the current rally has reached its peak. The uncertainty has been further compounded by a lack of decisive momentum, raising concerns that the best days of the rally may now be behind us.

This period of market rudderlessness has coincided with an emerging economic soft patch, driven in part by heightened policy uncertainty, particularly around tariffs. The post-election optimism reflected in consumer surveys, such as those from the Conference Board and the University of Michigan, has largely dissipated. Additionally, near-term inflation expectations have climbed, as evidenced by the 1-Year zero coupon inflation swap reaching its highest level since March 2023. These developments have added to the sense of unease among investors, who are grappling with a complex and uncertain economic landscape.

Economic Challenges and Policy Uncertainty: Understanding the Soft Patch

The economic soft patch has been fueled by a surge in policy uncertainty, particularly on the tariff front. This uncertainty has had a direct impact on consumer and business confidence, as reflected in the retracement of post-election gains in consumer surveys. The potential for higher prices has further exacerbated inflation concerns, with both survey data and market-priced instruments indicating a rise in near-term inflation expectations. For instance, the 1-Year zero coupon inflation swap reached levels not seen since March 2023, when CPI inflation was still at 5% and the economy was recovering from the 9.1% peak in inflation just months prior.

Despite these challenges, it is important to maintain perspective. While the current environment is undoubtedly uncertain, the fundamentals do not yet suggest a significant downturn. For example, the rise in initial jobless claims in late February, while concerning, does not appear to signal widespread layoffs or a broader economic slowdown. Furthermore, the internals of key economic reports, such as the ISM manufacturing survey, provide a mixed picture, with some components reflecting weakness while others remain resilient.

Investor Sentiment: A Contra Indicator?

Investor sentiment has also taken a hit, with the AAII Bull-Bear Spread recently notching one of its 10 worst readings in its nearly 40-year history. This level of bearishness might seem alarming at first glance, but history suggests that such extremes can often be a contra indicator. In fact, when the AAII survey has been in the bottom decile of bearish sentiment, the S&P 500 has historically delivered an average return of 13.6% over the subsequent 12 months. This underscores the importance of maintaining a long-term perspective and not letting short-term sentiment swings dictate investment decisions.

That said, the current market choppiness was not entirely unexpected. Following the strong performance of 2024, many market participants, including ourselves, anticipated a period of digestion and consolidation. This digestion has been accompanied by a broadening of market participation, as evidenced by the outperformance of the S&P 500 equal weight index relative to its cap-weighted counterpart. This dynamic is encouraging for active managers, as a broader participation base often presents more opportunities for stock picking and alpha generation.

Policy and Economic Outlook: Looking Beyond the Noise

Looking ahead, we expect the policy uncertainty that has driven much of the recent market volatility to ebb in the coming months. The new administration’s agenda, particularly its focus on deregulation and tax cuts, is likely to provide a more supportive backdrop for investors. While the sheer volume of policy headlines has been overwhelming, it is important to cut through the noise and focus on the underlying fundamentals. For example, while the Department of Government Efficiency buyout has prompted concerns about government workforce reductions, the scale of these reductions thus far appears manageable and unlikely to significantly derail the economic recovery.

Moreover, the recent jump in initial jobless claims, while worth monitoring, does not yet signal a broader labor market slowdown. The rise in claims does not appear to be linked to widespread layoffs in sectors impacted by government spending cuts, and the overall labor market remains resilient. This resilience, combined with the strong financial health of consumers, suggests that the economy is well-positioned to withstand the current soft patch and resume growth in the months ahead.

Consumer Resilience: A Silver Lining in the Economic Outlook

Despite the challenges posed by policy uncertainty and economic softness, the U.S. consumer remains on solid footing. Supported by a strong labor market and healthy individual balance sheets, consumers have been able to weather the current economic uncertainties. While confidence has taken a hit, spending has remained robust, a trend that has been consistent in the post-pandemic world. This divergence between sentiment and actual behavior highlights the importance of looking beyond survey data and focusing on hard economic indicators.

Additionally, the impact of extreme weather, including the coldest January since 1988, has likely distorted the true pace of U.S. economic momentum. As the weather normalizes and policy clarity improves, confidence is likely to rebound, and economic growth expectations should improve. The extension of tax cuts and other investor-friendly policies could provide an additional boost to both consumer and business sentiment, setting the stage for a more positive economic outlook in the second half of the year.

Conclusion: Staying the Course Amidst Uncertainty

In conclusion, while the current market and economic environment is undeniably challenging, it is important to maintain a level-headed and long-term perspective. The recent volatility and softness do not necessarily signal a permanent shift in the economic trajectory, but rather a period of digestion and adjustment. Investors should avoid making knee-jerk decisions based on short-term sentiment swings, as history has shown that extreme bearishness can often be a contra indicator.

As policy uncertainty begins to ebb and the more supportive elements of the new administration’s agenda take hold, the stage is set for improved economic growth and market performance. The resilience of the U.S. consumer and the broadening participation in the equity markets are encouraging signs that should not be overlooked. While the road ahead may be bumpy, the underlying fundamentals remain supportive, and investors who stay the course are likely to be rewarded over the long term.

This summary is based on insights provided by Jeffrey Schulze, CFA, Director and Head of Economic and Market Strategy at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.