It’s a time-honored ritual in global financial markets: in times of trouble, seek out the safest of safe havens until the storm passes. Treasury securities and the US dollar fit that script – at least they have, prior to the current tempest. Amid the wild volatility on a near-daily basis in the stock market since the ill-fated tariff policy announcement in the White House’s Rose Garden on April 2, the US dollar has plummeted while yields on the safest (supposedly) bond instruments have soared. This sharp reversal from the way things usually work has a number of observers wondering about the long-term fate of the dollar.

The Legacy of 1971

The last time there was a discernible transition from one financial era to another was nearly 54 years ago. On August 15, 1971, then-President Nixon removed the gold exchange standard that pegged the US dollar to $35 per ounce of gold, the exchange rate framework set at the Bretton Woods conference in New Hampshire near the end of the Second World War. Gone for good was the relationship between gold and national currencies that had prevailed for most of the time since the advent of the Industrial Revolution.

Nixon’s closing of the gold window – the “Nixon Shock” in the parlance of the day – had many observers convinced that the days of dollar supremacy were over. The early 1970s was a period in which the hitherto uncontested economic leadership of the United States was challenged, particularly by the rapid rise of Japan and West Germany as viable competitors on the world stage. Inflation had started to tick up in the US by the late 1960s, and a recession in 1970 presaged an even deeper downturn in 1973. Eventually, the 1970s would earn its place in economic history as the decade of stagflation, where anemic growth and persistently high inflation conspired to make life miserable for average households trying to make ends meet and for central bankers trying to implement an effective monetary policy.

The dollar did fluctuate wildly over the course of this decade. But it remained the linchpin of foreign trade, the preferred asset for central banks’ stores of foreign exchange reserves, and the most sought-after currency for black market traders on the streets of Buenos Aires, Jakarta and other emerging markets in their earliest stages of growth. The dollar’s role as the world’s reserve currency was solidified as the 1970s gave way to the Global Age, when finance became the world’s most important industry and US financial institutions bestrode the globe with their dealmaking knowhow and endless pipeline of capital markets innovations. The US trade deficit grew over this time, but a ready supply of foreigners willing to hold US dollar-denominated assets to fund the deficits minimized the potential economic pain.

A Quandary for the Fed

By our reckoning, the Global Age ended for all intents and purposes with the global financial crisis of 2008. That crisis hit the US harder than many other countries, and the dollar index hit its lowest point since the Nixon Shock during the crisis. But the dollar soon regained its footing, losing nothing of its importance to the world economy, as the post-2008 environment came to be dominated by the Federal Reserve. The US central bank was arguably the most important economic entity of the 2010s, with its program of quantitative easing alongside ZIRP – zero interest rate policy – shoring up financial markets and (again, arguably) keeping the economy from tipping back into recession. The Fed reprised its role as the sun around which all else revolves during the Covid pandemic, unleashing a flood of bond-buying at the peak of panic during March 2020 that in turn made the world safe for speculators in any imaginable form of asset, wisely or less so, throughout the pandemic period.

Jay Powell’s Fed broke decisively with this pattern in 2022, when the central bank responded to the highest inflation since the 1970s with a resolute policy of monetary tightening that took interest rates from zero to a high (for the Fed funds rate) of 5.5 percent in just two years. The Fed defied the ceaseless expectations of the bond market that it would throw in the towel and pause or cut rates every time something went sideways somewhere in financial markets. Bringing inflation back down to two percent was, and remains, the central bank’s number one priority.

Which brings us to the difficult moment the Fed finds itself in today. Not only are there serious questions about what is going to happen to inflation given the ongoing chaotic quasi-implementation of tariffs by the administration, but there are even more fundamental questions about the ongoing role of the US dollar and, by extension, the traditional safe haven of the Treasury market. Last week, as we noted in our commentary last Friday, the Treasury market appeared close to having another March 2020 moment before the administration blinked and “paused” most of the April 2 tariffs.

Conditions since then have been somewhat more stable for stocks, bonds and currencies, but volatility and the potential for disruption hang over edgy market sentiment. Will the Fed have to intervene again to facilitate liquidity if the Treasury market goes pear-shaped again? What should the Fed’s policy be (if any) vis a vis a possible dollar retreat from its centrality as the world’s reserve currency? These are questions without clear answers. Sadly the Fed’s independence, which should not be an issue for discussion, is also in the mix. While we do not see a worst-case scenario here as a high probability outcome (that would be a nightmare for market sentiment), we can’t ignore it entirely. Strange times, these.

The thrills and spills of the new world order (such as it is or may be) continued this week with some of the wildest swings in equity markets since 2008. As much as those gyrations in the Dow and the S&P 500 dominated the financial news shows, though, the real action was taking place in the bond market. It was there, in what is often called the plumbing of the global financial system, that a sudden spike in Treasury yields midweek led to the temporary “pause” on the novel and ill-considered tariff program announced last week.

Vigilantes, Of a Sort

A few weeks ago, we made reference in this space to the “bond vigilantes” of a few decades ago – the likes of Salomon Brothers economist Henry Kaufman and his ilk, who bet against bonds (sending yields higher) in reaction to what they considered irresponsible fiscal chicanery coming out of Washington. What we saw this week in the bond market was a bit of vigilante-ism, giving a thumbs-down to the budding trade war, but also something potentially even more concerning.

Because Treasury securities are highly liquid, they are relatively easy to dispose of in the market when you need to raise cash quickly. This week, a number of institutional investors needed to do just that. Plummeting stock prices hastened margin calls, leading financial players highly exposed to short-term market disruptions to unload Treasuries. The spike in yields, shown in the chart above, caused a break in the normally stable fabric between spot yields and Treasury futures for commensurate maturities. Hedge funds are a major player in arcane strategies that aim to profit from the relative value movements between spot and futures prices. When those movements go wonky, as they did earlier this week, bad things happen. The mechanics are complex, but the net outcome is that more Treasuries get sold, and then yields keep going up, and then more needs to get sold in what can turn into a very nasty doom loop.

Shades of 2020

The last time things got this bad in the Treasury market was in March 2020, at the height of the Covid panic. The S&P 500 had fallen by 34 percent from its recent high on March 23 of that year, when the Fed stepped in with a fire hose of liquidity to stabilize markets. But the Fed wasn’t there because of the equity market plunge. It was there because the Treasury market was about to blow up, and the consequences of that would be far, far worse than any damage stock prices could cause. It worked – both stocks and bonds stabilized after the Fed’s intervention, and the “everything rally” in risk assets began.

This time around, though, the root cause of the market disruption was not an exogenous event like a health pandemic. It was a policy decision that had the potential to severely damage the global trading system – a decision of human construction that could be reversed as easily as it was put in place. The “pause” announced Wednesday wasn’t great – it did not include China (and the problem with that is a story in and of itself), it is only for 90 days, and it still leaves us with a much higher average rate of tariffs than we had at the beginning of the year. But it was enough, for the moment at least, to reduce tension in the bond market to a manageable level.

A Lesson About Short-Term Market Moves

You have heard us say over and over again that short-term movements in the market are unknowable. In times of unusually high volatility, like now, the big intraday swings can be either up or down. When the S&P 500 racked up more than twelve percent in losses in the four trading days after the April 2 tariff announcement, the limbic brain was urging sell, sell, sell! But then came the backtrack on April 9, and whoosh – up goes the index by 9.5 percent in less than four hours of trading. The point is – things are going to happen, and we aren’t going to know what those things are until they happen, and they are going to move prices both up and down, often instantaneously. Trying to outguess any of this is a futile exercise. Stay disciplined. As for us we will, to paraphrase Metallica, sleep with one eye open…on the bond market.

So here we are. The Wall Street Journal – not a publication known for any kind of a liberal bias – calls it the “dumbest trade war in history.” And that’s saying something, because there have been some epically dumb trade wars in the past. Take the infamous Smoot-Hawley Tariff Act, signed on June 17, 1930, just eight months after the Crash of ’29, which was supposed to help US manufacturing “bounce back” by creating a wall of protection around domestic industries but instead added more fuel to the conflagration that became the Great Depression. If the tariffs announced on April 2 all go into effect as stated, the average rate this time around will actually be higher than those of Smoot-Hawley.

But from an economic perspective, the Journal is right – these are even dumber, because they aren’t actually “reciprocal” tariffs as advertised by the administration. Cambodia, a poor country, has factories where workers make less than a dollar an hour to stitch together running shoes for export to the US, but Cambodia doesn’t buy a bunch of expensive Nvidia GPU semiconductors from us in return, so according to the blinkered trade logic of this administration, Cambodia deserves a whopping tariff rate of 45 percent because of this bilateral trade deficit. This completely unnecessary trade war is bad for Cambodia, bad for the US and bad for the rest of the world (though we assume the penguins on Heard and McDonald Islands, off the coast of Antarctica, are largely indifferent to the 10 percent tariffs now slapped on them).

When Fear Takes Over

This ill-conceived trade war has put financial markets back into a mode of fear, which means it is time for us to trot out the chart we always come back to in times like these.

Yep, it’s the long-term price performance history of the US stock market since 1929, showing all the good times and bad times along the way. We highlight the five most prominent bear markets – two during the years of the Great Depression, one in the tumultuous decade of the 1970s, and the two bursting asset bubbles of the 21^st century’s first decade. We then list the nine other bear markets – defined as a peak to trough reversal of more than 20 percent – that happened throughout this 96 year span of time.

There are really two main reasons why we think this chart is important for our clients in navigating through times of fear. The first is to show that, even when it has looked like the world was coming apart at the seams, sooner or later things always recovered. How soon? Well, in the case of the Covid-19 pandemic, the S&P 500 fell by 33.9 percent from its high point of February 19, 2020, to the low mark of March 23. It took only five months, though, to regain that high point, which it did on August 18 of the same year.

By contrast, the S&P 500 did not recoup its record high close of 31.86 on September 16, 1929, until 25 years later, on September 22, 1954. That was a quarter-century of depression, war and the early years of postwar reconstruction. Everything else falls somewhere in between those two endpoints. For example, it took about four years after the 2008 global financial crisis for the S&P 500 to regain all the ground it lost during that event.

Getting Back In Is Harder Than Getting Out

The second reason why we think this long-term chart is helpful is because it shows you what happens after the market hits its low point for the cycle – namely, that it starts to go back up, and in a manner typically characterized by large bursts of intraday gains. Here’s the key: being in the market when those post-trough gains happen is incredibly important for preserving your capital over the long term. The problem, of course, is that you never know in advance when that worst day will happen. Fear will keep you tentative and afraid of another shoe dropping – which, to be perfectly honest – often happens. False dawns are a regular feature of these bear cycles. The math is brutal: by the time you decide that things are bad enough to sell out, the market is presumably already down quite a bit from its last high point. But even that decision is easier than figuring out when it’s time to get back in. In the long run, you lose.

Nobody knows how this, the dumbest trade war in history, is going to play out. Much is going to depend on how other countries react. China, for example, has already made a first retaliatory move by matching the 34 percent tariffs on it announced Wednesday with the same level on all products it imports from the US. French president Macron has called for a cessation of investment into the US by his fellow Europeans. The idea that other countries are simply going to bend the knee in appeasement seems unlikely. More likely, we are probably in the early stages of a structural global realignment. There will be opportunities here as well as risks, and we will be looking to take advantage of those wherever possible.

In the meantime, though, we believe that the most prudent action we can take is to remain disciplined and avoid the temptation to give into fear. We will not be shy in communicating with you our views and specific courses of action we are taking as we assimilate more data from the shifting tectonic plates taking place in the global economy. Our commitment to discipline, with an eye always on the specific long-term growth objectives, risk tolerance and income needs of each one of you, will guide these actions.

As the current corporate earnings season winds down, the last companies to report are giving us a preview of what to expect when the Q1 numbers start coming out next month; notably, that consumers are increasingly unhappy with the current state of things and even less happy with what they imagine the state of things will be later on this year. The less happy the consumer is, the less likely she will be to shell out $100 for a pair of yoga pants, a message delivered loud and clear by upscale athleisure wear maker Lululemon in the company’s Q4 earnings report yesterday.

Sour Lemons

Lululemon joins a bevy of consumer-facing companies that have been guiding future sales and earnings lower amid the never-ending uncertainty around tariffs and prices. Nike, one of its main rivals in the athletic wear segment, saw its share price hit a five-year low last week as the company forecast an unexpectedly large drop in revenue, citing tariffs and the potential for a global trade war as distinctly unhelpful to efforts to increase sales. FedEx, widely seen as a proxy for consumer activity (those goods have to get to your house somehow), also flagged consumer caution and general macro uncertainty in its most recent earnings release. Macy’s, Kohl’s and other brick-and-mortar department stores are closing hundreds of locations while others, including of late Party City and fabric & crafts emporium Joann’s have called it quits for good.

Consumer sentiment surveys validate this recent stream of dour reports. The University of Michigan Consumer Sentiment index was revised lower in its final version today, the third monthly decline in a row and the lowest since July 2022, roughly the time when inflation hit a high of nine percent. Of perhaps greater concern is the rise in long-run inflation expectations, which jumped to 4.1 percent in the revised report. Meanwhile, the Conference Board’s Consumer Confidence index, released earlier this week, touched its lowest level in 12 years for the expectations category. Say what you will about how well-informed the average American consumer is, but he or she appears to have a clear understanding about the relationship between tariffs and consumer prices.

Parsing the 4/2 Tea Leaves

At this point, all that chronically confused investors are hoping for next week is some clarity. April 2 is supposed to be the day when all the tariff pieces fall into place; the reality is likely to be far different. Tariffs on automotive vehicles and component parts appear to be the category on which analysts can most confidently hang their hats – 2.5 percent initially then increasing to 25 percent, supposedly with no exceptions (but there is almost never an instance where “no exceptions” apply, so…). Mexico, the EU and Japan top the list of countries most affected by this measure, each with more than $40 billion in completed vehicle exports to the US annually, and another $50-odd billion in components from Mexico alone. But then there are the broad-based reciprocal tariffs, which will vary by country and product type, and probably a separate tariff regime for lumber and pharmaceutical products, and maybe copper, and possibly some kind of a break for China if something good happens with the TikTok situation, whatever that means. So yes, the “fog of war” continues to apply to the trade war.

We expect the growth environment is going to be challenged for some time to come. There are still pockets of relative attractiveness among certain defensive sectors in the market, and prudent diversification among appropriate asset class exposures remains, in our opinion, a better strategy than a knee-jerk retreat into cash. But there is no doubt that these are trying times, for investors, consumers and businesses alike – and they could be so much less trying with just a little more thoughtfulness and discretion from our government policymakers.

At Wednesday afternoon’s press conference following the two-day conclave of the Federal Open Market Committee (FOMC), Fed chair Powell repeatedly invoked two words. Those words were: uncertainty, and transitory. Uncertainty, as it pertains to the inability to make informed decisions about anything when variables like tariff policy change on a near-daily basis. Transitory, as in the likely trajectory of higher inflation resulting from those tariffs. If we could try to distill this all into one statement it might look something like this: We still don’t understand the actual timing or magnitude of the proposed tariffs well enough to make detailed forecasts about their impact – but in principle, the inflationary impact of any such tariffs should be a one-off, short-term phenomenon that will increase prices in the near term but not have long-lasting effects thereafter.

2021 Flashbacks

Powell’s specific use of the word “transitory” awakened the collective muscle memory of the assembled journalists who, like survivors of a bad acid trip, experienced a sudden flashback to 2021. That was the year inflation kicked in from the twin stimulants of pandemic-era fiscal stimulus on the demand side and manufacturing and logistics bottlenecks on the supply side. At the end of 2020 the Consumer Price Index stood at 1.3 percent (year-on-year growth); one year later it was at 7.2 percent on its way to a peak of 9.0 percent by June 2022. Throughout most of 2021 the Fed insisted that higher inflation would be a transitory shock, a brief response to those one-off demand-side and supply-side factors. It was no such thing, of course. Four years later, inflation remains stubbornly above the Fed’s two percent target. Even if the additional inflation created by higher tariffs is transitory – according to the FOMC’s own economic projections released on Wednesday – that two percent target is unlikely to be reached before 2027.

The Uncertainty Is the Problem

The stock market’s hot take from the Wednesday afternoon press conference leaned dovish, meaning more attention paid to “transitory” and less to “uncertainty.” But, as is often the case when investors sleep on it and then reconsider, sentiment in the days since seems to have pivoted back to uncertainty. Observers of corporate earnings reports are hearing the word come up more and more on the quarterly analyst calls. FedEx, a bellwether proxy for general economic sentiment, noted a “very challenging” macro environment and lowered its forward revenue and earnings guidance on – you guessed it – uncertainty during its management call after the market close on Thursday (FedEx stock is down more than 10 percent since this morning’s opening bell as we write this).

It is important to note, as Powell himself did on Wednesday, that the uncertainty is not due to any organic changes in the underlying economy. Yes, consumer spending would probably be slowing somewhat anyway, from the fast pace of recent years but, generally speaking, the US economy started the year in strong shape and is still, based on most current variables, healthy. No, the uncertainty is the product of human hands, and those same hands could choose to take away the uncertainty tomorrow, if they were to so choose (we are of course under no illusion that they will). If you take away the tariffs, you take away the uncertainty and also the resulting threat of higher inflation, transitory or otherwise. In which case Powell could spend his next press conference on other more salutary topics, without the need to invoke on repeat loop those two words.

The economic uncertainty we talked about in last week’s commentary has led to a turn for the worse in financial markets this week, and for one asset class, in particular. Small cap US stocks last set a record high in late November last year, as unbridled optimism among small businesses in the immediate post-election environment led to a burst of outperformance against their large cap counterparts.

But the optimism quickly dissipated in the waning days of 2024, and never recovered. As of Thursday’s close, the S&P Small Cap 600 index was down -19.2 percent from the November 25 high, just shy of the technical bear market threshold of minus 20 percent (the index is up slightly this morning as US equities once again attempt a bounce). By comparison, the S&P 500 index of large-cap stocks was down a bit over ten percent yesterday from its last record high of February 19. In Wall Street parlance, a ten percent drop constitutes a technical correction (again, equity markets are up as we write this on Friday morning, but whether the bounce is sustainable through the end of the day is anybody’s guess).

Negative Vibes All Around

The Trump administration is getting a cold blast of the negative vibes that weighed heavily on the Democrats during last year’s election. An influential consumer sentiment index published by the University of Michigan came out twenty minutes ago and showed confidence levels plummeting over the course of the last month. The preliminary March number for the Michigan sentiment indicator was 57.9, well below the 74.0 figure registered at the end of last year, below economists’ March consensus forecast of 64.0, and in fact the lowest reading since November 2022. Consumers increasingly expect inflation to increase, with the year-ahead expectation now at 4.9 percent, up from 4.3 percent last month (and well above the actual current Consumer Price Index figure of 2.8 percent).

The relatively poor performance of small cap stocks in this environment is perhaps unsurprising. Small businesses, as a rule, do not have the same arsenal of defenses against the negative effects of increased tariffs that larger companies do. Nor do they have the same clout in obtaining carve-outs from the government as, say, the major auto manufacturers showed last week when they got a reprieve from the 25 percent tariffs threatened against Mexico and Canada. In past market cycles, a pronounced downturn in small cap stocks has been seen as a harbinger of growth concerns. Indeed, a JPMorgan Chase economic report published this week opined a 40 percent chance of a US recession sometime this year, consistent with recent downgrades of the economic outlook by other major financial firms including Citi and Goldman, Sachs.

Large Cap Signals Less Clear

The growth concerns pushing small caps towards a bear market are not yet evident in a meaningful way among large caps. Much of the downward direction in the S&P 500 thus far can be attributed less to general growth concerns and more to the specific performance of the so-called Mag Seven – the AI-themed megacap tech stocks that have been responsible for much of the upside over the past two years and which collectively make up more than 30 percent of the S&P 500’s total market cap. The S&P 500 equal weight index, which evens out the influence of the market cap heavyweights, is only down 3.3 percent year-to-date, so not yet close to correction territory.

As with everything else in this upside-down environment, it all comes back to the need for clarity, for getting rid of the frenetic on-off approach to major economic policy questions, and for de-escalating the trade war. That would likely go a long way towards improving those morose sentiment vibes among consumers and businesses. This week’s inflation numbers showed that, left to their own devices (i.e., without the implied or actual threat of those ill-advised tariffs), consumer prices should continue to trend towards the Fed’s two percent target. That won’t happen, though, if the environment is such that nobody can make rational decisions around spending, saving or investing.

It’s Friday morning. Do you know where your tariffs are? Of course you don’t, because nobody really knows what is going on with all the pinballing decrees on which tariffs apply to which countries, with exceptions and deferrals and audibles called at the line of scrimmage and then reversed for whatever combination of reasons or no reason at all. It has been a strange week. In the midst of all the weirdness markets have been doing what markets normally do when nobody has a clue about anything – selling out of risk assets, especially those with pricier valuations, and buying safety. As this week got underway, the yield on the 10-year Treasury note, at 4.15 percent, was 0.65 percent lower than where it was just six weeks ago – a massive move in percentage change terms for what is supposed to be the world’s safest asset. As the week wore on, though, investors seemed to find safer waters in shorter maturities, with the 2-year note falling below four percent while the 10-year ticked up a tad.

Here Come the Growth Concerns

Markets don’t like uncertainty, and neither do businesspeople who have to make decisions about how many widgets to produce based on data like input costs (raw materials, labor etc.) and demand trends. It’s hard to make these kinds of decisions when you don’t know whether something you need to import is going to be 25 percent more expensive next month on account of some new tariff, or whether wages are going to be pushed up as more immigration cuts take place, or whether your customary buyers will decide they’re tapped out and need to put aside discretionary spending choices in order to buy $10 cartons of eggs. The not knowing is worse than dealing with the actual fact of a tariff policy that is announced, implemented and unchanged. At least you can make plans around a known fact, even if that fact is a negative for your sales.

These kinds of concerns are starting to show up in economists’ growth forecasts for 2025. We have already seen a couple notable downward moves recently in high-profile consumer and business sentiment surveys. Then, on Monday of this week, the Atlanta Fed tossed a stunner into the daily economics chat with its latest GDPNow estimate, projecting that real GDP growth for the first quarter will be negative – yes, negative – 2.8 percent (by the end of the week that number had crept up to minus 2.4 percent, but still). Worries about growth pushed aside last week’s chatter about inflation – even if those draconian tariffs don’t happen and inflation remains in check, the slowdown in business activity could lead to a recession sooner rather than later.

Now, the Atlanta Fed number should be taken in stride. Because it is absorbing a constant stream of data in real time, the GDPNow figure is quite volatile and at times – like now – will be far away from the consensus forecasts of economists. The Blue Chip consensus, one such forecasting data point, currently has Q1 GDP coming in at a midpoint around positive 2.4 percent. We expect that when all is said and done, real growth for the first quarter will still be positive, but somewhere below two percent. Evidence of a growth slowdown is accumulating, including the most recent jobs report from the BLS this morning showing nonfarm payroll gains of 151,000, below economists’ forecasts of 160,000, while the unemployment rate also ticked up slightly from 4.0 to 4.1 percent. There was a chance the numbers could have been much worse than that, though, so we’ll take what we can get.

Still Time to Reverse

So where do things go from here? It’s anybody’s guess what the next policy move – or for that matter the next tweet, which seems to be where it all happens – is going to be. If anybody cared to listen to us, though, we would say that getting rid of uncertainty is job number one. Look, if you announce a tariff, and then the car companies call you up and say that the tariff would be devastating for your industry, and then you hear the same thing from farmers and from food manufacturers and everyone else – well, maybe it just means that these tariffs are a bad idea with very little upside and should be shelved entirely rather than the current silliness of a new delay or carve-out or “review” every day. Markets, businesses and consumers would all be most appreciative. Growth would likely be slower this year than last anyway, regardless of government policies, based simply on the normal course of things in the economic cycle. But hastening the decline, especially with the attendant lingering specter of higher inflation, is the opposite of good policy.

Inflation is back at the top of the list of economic concerns felt by everyone from the voting members of the Federal Open Market Committee, to portfolio managers trying to figure out target maturities for their bond allocations, and to families dreading the next trip to the grocery store. A couple weeks ago, those concerns heated up with the publication of the January Consumer Price Index (CPI) report, a function of the Bureau of Labor Statistics, which showed inflation coming in hotter than expected.

This morning, though, we got a second take on the subject with the Personal Income and Outlays report issued by the Bureau of Economic Analysis. This report contains the Personal Consumption Expenditures (PCE) index, which happens to be the inflation indicator most closely studied by the Fed in its monetary policy deliberations. Happily for all of us worried about inflation’s recent stickiness, the PCE numbers for January were right in line with expectations. Significantly, the year-on-year gain in core PCE, which excludes the volatile categories of food and energy, fell to 2.6 percent from 2.9 percent last month.

Similar But Different

Any macroeconomic data point, whether trying to measure growth in output, changes in the labor market or changes in consumer prices, is imperfect; it applies a formula to measure some subset of all the possible data available. The CPI and the PCE both measure consumer prices, but the methodology is different. The Bureau of Labor Statistics, the organization responsible for the CPI, has a helpful little guide to tell us that there are four basic differences in approach that lead to the variations we observe between the two indexes: (i) the formula used (notably, the PCE reflects consumer substitution among detailed items as relative prices change), (ii) the relative weights applied to different categories of goods and services; (iii) the scope effect (the PCE includes the change in prices, not just of items consumed by households but also by institutions serving households such as employer coverage of health care costs); and (iv) other effects, a sort of grab bag of residual differences such as seasonal adjustment methodologies. One of the outcomes of the “scope effect” difference is that the PCE encompasses a wider range of products and services covered – i.e., its “market basket” is bigger than that of the CPI. This is perhaps one of the key reasons why the Fed is more inclined to use the PCE as its go-to inflation metric when deliberating changes to monetary policy.

Still Stuck Above Two

Investors were relieved to see the PCE in line with expectations; a hotter reading probably would have knocked out whatever good feelings remained after a tough week that has pushed both the S&P 500 and the Nasdaq Composite into negative territory for the year to date. As we write this on Friday morning, US stocks are trading flat to slightly down. The main concern, of course, is that with both inflation measures still stuck above the Fed’s two percent target rate, the next few months may not be as benign. In the eternal will-they-won’t-they guessing game about tariffs, the latest word is that the 25 percent hit to products from Canada and Mexico is still on track for March 4, which leaves March 3 (next Monday) as the last day for one of those famous last minute rabbits out of the hat to kick the can down the road.

More concerning than the pinballing policy decrees, though, is growing evidence that inflationary expectations among households and businesses are taking root more firmly than they did three years ago when the indexes were at their high points. Back then, sentiment surveys showed that most people expected inflation to be transitory and back to normal within two to three years. Those expectations are changing now, given both the stickiness in prices over the past half year and the specter of tariffs hanging over the near future. We can only hope that some policymakers are paying attention. There is no sugarcoating the potential detrimental effect of excessive tariffs, on consumer prices and on growth.

This Sunday, the good citizens of Germany will go to the polls to vote for the country’s next government. The composition of that government will likely not be known for some time, since no party is on track to win an outright majority. But it will almost certainly not be led by Olaf Scholz, the current chancellor who set this whole snap election thing in motion last November by dismissing one of his own partners from the fragile coalition of the Social Democrats (Scholz’s party), Greens and Free Democrats. More likely will be a yet-to-be-identified coalition led by the Christian Democrats (CDU) and its leader, Friedrich Merz.

Growth Engine No More

This new government will inherit a bevy of economic, political and social problems plaguing a country that was once a byword for “Europe’s growth engine.” That growth has not been in evidence now for some time, with GDP more or less stagnant for more than two years, domestic infrastructure needs not being met (thanks in part to an unduly restrictive constitutional “debt brake” capping Germany’s structural deficit at 0.35 percent of GDP), and a business model largely dependent on high quality exports in a world of worsening conditions for global trade and a key trading partner, China, with its own major problems.

But hey, if nothing else, the new incoming chancellor can at least enjoy (for now) the performance of German equities, which have been on a bender so far this year.

A Zeitwende for Bargain Hunters?

The German word “Zeitwende” signifies a major change of some kind that alters the present course of events. Chancellor Scholz used the phrase back in 2022 to describe a major overhaul of Germany’s foreign policy and defense strategy in response to Russia’s invasion of Ukraine that year. The country is due for another Zeitwende this year – specifically, a bold political decision to scrap that outmoded debt brake that has kept policymakers from carrying out much-needed investment in infrastructure and social spending. There has been talk of this happening among political analysts observing the electoral vibe ahead of this weekend’s elections, and some of that talk may be fueling investors’ optimism that a new set of policies could boost economic fortunes – and lift those outperforming shares on the DAX index even further.

Where that talk is not being heard with much conviction, though, is among the candidates themselves. Merz, the CDU leader, has been tepid in replying to questions about whether his government would be ready to ditch the brake. At this point, Merz has no clear idea of what his coalition is even going to look like, let alone what kind of policies would come out of what promises to be a protracted set of negotiations and concessions. According to the latest polls, the CDU is on track to win around 30 percent of the vote. In second place, alarmingly, is the far-right Alternative for Germany (AfD) party, currently polling around 20 percent. Scholz’s beleaguered SPD is in third place with around 15 percent, closely followed by the Greens in fourth. For the time being, at least, both the CDU and the SPD have declared themselves unwilling to form a national government that would include the AfD. We will see what the reality looks like after the results come in on Sunday.

Even if the new government does manage to shake off its customary lethargy and enact some vigorous new policies, it will still be operating in the growing shadow of a wholly different set of conditions for global trade and, for that matter, global security. Western Europe has been a key member of the world order that lasted for eighty years since the end of the Second World War. That order is unraveling, and the continent’s future in whatever takes its place is uncertain. The times are going to call for bold thinking and decisive action by the new government in Berlin, traditionally the center of European policymaking. And that will have to come sooner rather than later, if both the trust and support of the German people and the current optimism of German equity investors are to be in any way validated.

Every election cycle has its own peculiar trope at the center of the narrative, the very tangible thing that brings swirling abstract narratives into recognizably defined three-dimensional space. For the 2024 campaign, that thing was the price of eggs. The complexities of global supply chains, the arcane accounting practices for billions of dollars of government expenditure, the extreme distortions of consumer demand trends during and after the Covid pandemic – all the many variables involved in the highest levels of inflation experienced since the 1970s boiled down to one simple formulation: Have you seen the price of eggs lately? Yes they had, and they were not happy about it, and they made their point on November 5.

The Chickens and the Eggs

Given the prominent place afforded last year to that one food category as a proxy for the entire inflation story, it is perhaps an unfortunate coincidence that eggs are back in the news recently for reasons unrelated to the inflationary forces at play for much of the past three years. The spread of avian flu has caused havoc among the chicken farms from which our Grade-A cartons begin their long journey to our kitchen tables. The price of eggs today is roughly double what it was a year ago, and soared by 15 percent in the month of January alone. The flu has necessitated the slaughter of millions of chickens, drastically reducing supply, and the magnitude of the resulting price increases for eggs accounted for fully two-thirds of the total increase in food prices last month, according to the latest Consumer Price Index report issued by the Bureau of Labor Statistics this past week.

But it’s not just about eggs. The Fed doesn’t pay as much attention to the volatile categories of food and energy products as it does to so-called core inflation, the more stable baskets of goods and services like apparel, medical care and shelter. The problem is, these categories are proving to be stubborn as well.

Gimme Shelter

Non-food and energy services, in particular, have not come down at the rate the Fed was expecting to see a year ago. For the last twelve months, prices for shelter (rent and owner’s equivalent) have increased 4.4 percent while transportation services, of which airline travel is a major component, have gone up 8.0 percent. That has kept the core CPI number (the gray dotted line in the above chart) stuck at or around 3.3 percent since the middle of last summer. The Fed went ahead with its first rate cut in September regardless, thinking that the numbers would continue to decline, but here we are in February and 3.3 percent is still the number for core inflation.

And That’s Without New Tariffs

The seeming intractability of inflation alone would strongly suggest a continued pause by the Fed, with no rate cuts likely for the foreseeable future. But that, of course, doesn’t take into account whatever tariffs are eventually going to make their way into law. As we noted in our commentary last week, the only consistent aspect of the new administration’s tariff policy so far is its inconsistency, with policymakers saying one thing one day, watching how markets react, and saying something else the next day (or the next hour). The word in vogue this week has been “reciprocal tariffs,” which sounds like a sort of tit-for-tat policy aimed at matching the tariffs other countries set on products we currently import. Or is it? Does it include things like the 20 percent VAT applied to many European exports? How about structural barriers on products from places like Japan and India? And when? The latest indications point to April (maybe) as the likely start date (unless something else comes up in the meantime, and notwithstanding carve-outs and exemptions and all the rest of the baroque ornaments of this administration’s approach to tariffs).

All this remains to be seen, and markets have yet to exhibit any overriding concerns. Meanwhile, interest rates are likely to remain where they are, and vegan baking recipes that call for egg substitutes are likely to grow in popularity.