The only certainty in this noisy headline driven world is that by the time you read this, things may very well have changed. Then again, by the time you finish reading this note, things may have changed yet again. Even with this weekend’s announcements, the level of uncertainty remains high. Details on the response, then potential responses to responses, mean February is going to be bumpy.
President Trump’s second term has certainly started off with a lot of action via executive orders. It would appear the strategy is to get it out there and then deal with legal challenges or other backlashes. This is reminiscent of his first term. Many things were said, sometimes those things would just fade away (haven’t heard much about Greenland lately), while others would persist and potentially become policy.
But even things that became policy were often softened or adjusted. And some were reversed, with blame being thrown upon a cabinet member who would be let go as the source of the mistake. Only a few cabinet members lasted the full duration of his first term.
We do know President Trump is rather fond of using tariffs. Is the 25% blanket a negotiating tool or is it a desire to reduce trade deficits? Everyone echoes the facts and logic: tariffs raise costs for consumers. And most of Canada’s exports are energy, so tariffs would have a really quick impact on U.S. inflation. Take out energy and we are net importers from the U.S. But do logic or facts matter? This is the reason that, while we can all agree on the negative impacts of tariffs, it sure sounds like we are about to live out an economic experiment.
Estimates of these tariffs have them throttling back Canada’s economic growth by about 2%. Given current estimates of 1.9% growth in 2025, it doesn’t take much math to figure out that is a bad outcome. Potentially recessionary. Countering this would be the fiscal/monetary response. We can expect more rate cuts, which will not be supportive of our already cheap dollar. A drop in the dollar does somewhat shield exporters from the tariffs, but it also adds more inflation to our economic system. Fiscal spending would likely ramp as well, and that would also soften the economic blow.
On a positive (figure we need some positives this week) note, our consumer does appear to be improving from a good base. Rate cuts have helped. Surplus savings over the past few quarters and a record wealth level are all supportive. Housing enjoyed a bit of a recovery in 2024, and that does appear poised to continue. Rate cuts again are helping along with pent-up demand. However, affordability remains a challenge. 2025 will likely be another year of a slow recovery following the 2022 highs.
Even with pockets of improvement within the Canadian economy, this tariff war could easily overwhelm. While the impact is more acute for some industries, it also impacts decision-making by companies for hiring, investing, etc., across the economy. So why has the currency market taken tariffs seriously, while the equity market is only reacting after the news?
The Canadian dollar, hovering at just $0.68 this morning, is clearly pricing the impact these tariffs enduring and the likely policy response of lower rates from the Bank of Canada. And yet the TSX was pretty much at its high last week, rising +24% over the past year and up more than the S&P so far this year. Is the currency market right or is it the equity market, which is not taking tariffs too seriously?
The fact is the currency market is currently dominated by relatively short-term interest rates, and, given those historic spreads, it has the CAD trading down at these levels. The TSX is based on the value of its index members. Those company values are based on the values of future earnings. Yes, tariffs will hit those earnings – more for some, less for others, and none for some. But for a month, a quarter, a year, two years? If a company is truly valued based on its lifetime projected earnings, perhaps a brief tariff-induced bump to the earnings isn’t a huge deal.
In the first chart above, we included the relative spread between two-year yields in the U.S. vs. Canada. Usually, the Canadian dollar’s moves are dominated by relative two-year yields and the price of oil. Today, it is 100% yields that matter, as the anticipated policy/economic response to tariffs has furthered divergence between central banks and economies. Today, the spread is 1.54. We had to look back to 1998 to find a similar spread.
The TSX is finally falling on this tariff war news, as it is a negative. A few things to keep in mind: over 40% of TSX earnings come from financials, which are not directly impacted – at least initially, unless the economic hit leads to bankruptcies. One could argue this tariff war is worse for the economy than the TSX. There are just not that many TSX index member companies, outside energy, that have material over-the-border trade.
Even with the recent announcements, uncertainty remains really high. Will negotiations find a better path before actual implementation or shortly afterwards? Will the policy response help or create a more challenging relationship? Will companies adapt to reduce the impact?
Perhaps of great importance is the impact on portfolios. Our strategy has been more of a steady-hand approach. Certainly listen to what is being said/proposed, but remember the end result is often very different than what is said or announced. Or even more simply, should you change your portfolio whenever a headline hits that may or may not have longer-term ramifications on asset prices? The following framework from our Portfolios with a Purpose publication may help differentiate the approaches to headline news, and why we are the one on the left.
Listen to what is being said or proposed and look for a potential market overreaction. This is our playbook.
Where Could the Market Be Over- or Under-reacting?
We believe the currency market is fully pricing in tariffs and implying tariffs remain in place for an extended period. $0.68 is very cheap for the Canadian dollar, even with a prolonged tariff war. Our readers likely know we thought it was cheap at $0.70 cents, but we had the caveat upon announcement could spike lower. Perhaps that is what we are seeing today.
The equity markets had been under-reacting to the tariff risk up until late Friday, and sure enough are reacting so far today (Monday morning, February 3rd). Worth noting is that, at the time of writing, the S&P futures are down more than the TSX, not that -1.4% vs -1.7% is anything to celebrate. It's a reaction, but not an overreaction at this point.
If the equity market continues to move lower, that could prove an opportunity. For one, President Trump has reversed or changed policy when equity markets reacted poorly in the past. Plus, the noise from state Governors, Congressmen and Senators will likely grow louder when companies/consumers start to notice many input prices have moved higher. That may start to open the door to a better path forward.
Or it will persist. In which case there is likely more risk of recession or stagflation (higher prices + poor growth). Lots of moving parts and unknown paths forward. But at this point, we don’t see enough of a market overreaction to jump into action one way or another. We're keeping some powder dry.
On a personal note, switched my coffee choice to Tim’s dark roast this morning and our Sunday old fashioned cocktail (bourbon) has been swapped for a Canadian Club iteration.
What Happens When the Earnings Growth Slows?
Within our multi-asset portfolios, we have a clear tilt towards more equal-weighted U.S. exposure rather than market-cap-weighted. Though this tilt underperformed last year, when we regularly reexamine our rationale, the thesis remains sound. Abandoning the process to chase performance works out occasionally. However, over time, the process is the only aspect of investing that is repeatable. This isn’t the first time we’ve discussed the preference for equal weight, but it is a good time to revisit it.
2025 is off to a promising start for the equal-weight tilt. January saw a broad rotation within the S&P 500. Some of the top-performing sectors were health care, financials and materials. Technology was the only sector that declined, falling -1.1%. Equal weight did quite well, rising 4.6% compared to the cap-weighted index, which rose 4.0%. January 27th, or, as we now call, it ‘DeepSeek Day,’ was a glorious day for diversification. The big question now is whether this marks a pivotal turning point or just a speed bump for the AI-driven market.
The chart above highlights the daily performance gap between the equal-weighted and cap-weighted S&P 500. The DeepSeek moment brought about a number of unusual occurrences. We witnessed back-to-back extremes: one of the largest days of equal-weight outperformance in four years, immediately followed by the worst daily underperformance since 2020. We previously warned about heightened volatility in 2025, and this is volatility in action. It’s a seesaw market, but unfortunately, due to concentration risk, this volatility is directly tied to the world’s most-watched index.
Weird Breadth Happenings
On January 27th, the S&P 500 declined by 1.5%, yet 70% of its index members were up on the day. We dug into the data and found that such a divergence is extremely rare. The table below highlights similar occurrences since 1990, and strikingly, the only comparable periods were in 1999 and 2000. The table is not a harbinger of doom. It’s more due to the fact that this period was the last time the market was so concentrated. It does, however, clearly express the risks of concentration within the market. The market can materially decline, even though the average stock is doing just fine.
What’s also curious is how quickly the market turned on Nvidia, arguably its biggest champion over the past few years. We’re not going to go too ‘deep’ into the AI melt-up; there’s no shortage of reports from the past week discussing the details of AI training. What’s clear is that the stakes are high for the Magnificent 7 thanks to DeepSeek. Looking back, collectively, the Mag 7 added over $6 trillion to the S&P market cap in 2024. The rest of the U.S. stock market gained $8 trillion. The size and scale of this concentrated advance are very rare. In our opinion, how quickly investors reacted to the news from a company out of China that few even knew about is an indication of how fickle sentiment can be when many investors are sitting on sizeable gains.
The Meat and Potatoes: Earnings & Valuations
The valuation gap between the S&P 500 and the equal-weighted index remains glaringly large. At -4.5 points, the S&P 500 cap-weighted index is much more expensive. Yes, it is more heavily tilted towards higher growth tech companies, but we’re of the belief that valuations matter, especially if growth rates slow. High valuations are justified if growth expectations are high and, more importantly, accelerating.
In the earnings growth chart below, we separate out the Mag 7 vs. the rest of the members of the S&P 500. Over the past couple of years, the earnings growth of the Mag 7 was exceptional and helped support those high valuations. But now, the earnings growth rate has started declining over the past year, and looking ahead, earnings expectations are much more pedestrian and not all that different than the rest of the index. The earnings outlook questions why the valuation disconnect is nearly as large as ever.
The fact that the valuation gap remains this large while the earnings growth rates are converging shows that it has more to do with excessive optimism rather than a clear and sustainable growth advantage. Sentiment is erratic; this past week is evidence. There should be concern over the valuations of semiconductor companies considering that a few of these companies such as Nvidia have been trading at such high multiples. If DeepSeek is proof that leading-edge AI development can happen with less capital expenditure on expensive chips, then this may warrant a rethink of the earnings potential of the manufacturers behind AI.
So is this the big AI bubble bursting? Actually, no. The DeepSeek moment could be a big gift to consumers and businesses who don’t have billions to spend on AI. It shows that the cost of implementing a quality AI model doesn’t have to be gargantuan. We read this somewhere, but it seems the most poignant: “This isn’t the end; it’s simply the end of the beginning.”
This divergence in valuations and convergence in earnings underscores why we prefer equal weighting over traditional cap-weighted U.S. exposure. The recent volatility is a glaring reminder of the concentration risks embedded in the S&P 500. When performance is dominated by so few, it amplifies the risk and instability of the market. In contrast, equal-weighted strategies offer a cost-effective way to gain broad participation in the U.S. economy, reduce concentration risk and provide a more balanced exposure.
Another benefit is the tilt towards smaller-cap, domestically oriented companies which could benefit from the U.S.-centric policies coming from the current administration. The year has so far been good for equal weight and one final point to keep in mind is the famous saying, "As January goes, so goes the year."
Market Cycle & Portfolio Positioning
With all the uncertainty around potential policy changes (aka tariffs), we must acknowledge that the economy continues to show signs of improvement. So far in 2025, we have seen an uptick in data and signals pretty much everywhere. The probability of a recession for the U.S. over the next year, based on consensus from economists, has dropped to 20%, the lowest or best reading since early 2022. It’s a bit higher elsewhere, with Canada, the UK and Japan all around 30%. Overall, that's pretty low risk… pending a policy mistake, which is a possibility.
The U.S. economic indicators are responsible for much of the upward move in our market cycle indicators, but it is also a global story. The CitiGroup economic surprise indices are positive across all six of our major buckets, including the U.S., Canada, the Eurozone, China, Japan and emerging markets.
It is this strong global economic backdrop that appears to be making the equity market resilient even with a higher degree of policy uncertainty. Of course, this could change, and we would highlight the concentration in the U.S. remains a risk, highlighted by the DeepSeek hiccup. But it would take a lot to push the global economy into a recession.
At the overall portfolio level, no big moves so far. We remain equal weight in equities, with our bullishness based on the market cycle indicators tempered due to policy risk and concentration. This has us with mild underweight in Canada and the U.S., with mild overweight internationally. If we do experience a market reaction, and if it’s deemed an overreaction, we would be opportunistic and have extra cash to put to work.
On the bond side, we were tempted when U.S. yields moved over 4.75%, but given the dip back to 4.55%, we're less tempted. We’re currently underweight in bonds as we do believe inflation is picking up somewhat. Even with this view, we do believe bond allocations should be a bit more tactical than in years past.
Diversifiers have done well. While the need for volatility management hasn’t surfaced yet, the risk of a market pullback appears elevated. And the real asset (aka gold) has been doing very well.
We remain in the camp of waiting for any market overreaction to act. That is our playbook for an environment with so many moving parts and attention-grabbing headlines.
Final Note
2025 is off to a great start, but with added volatility, which is not too surprising given the concentration in parts of the market and such a noisy policy environment. February is often a bumpier month. Thankfully, it is a shorter one, too. We continue to believe sudden portfolio reactions to this constantly changing environment are not a good strategy; instead, monitor and look for potential market overreactions to create portfolio opportunities.
— Craig Basinger, Derek Benedet and Brett Gustafson
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Sources: Charts are sourced to Bloomberg L. P.
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