Over the last several years, particularly since Russia’s invasion of Ukraine, Strategas has increasingly considered the impacts of De-Globalization – which we view as the breakdown and ultimate revocation of long-held geopolitical, societal, and economic operating conventions – as anchor tenets of portfolio construction.  If President Trump’s re-election accelerated this trend toward multi-polarism, we do not believe it’s unfair to characterize his Administration’s rollout of its tariff program, earlier this month, as untethering the norms of global trade and capital flows from convention.  Without extrapolating too far, this should lead to the ultimate re-stacking of corporate fundamental building blocks, specifically how companies extract profit from their economic ecosystem.  To be clear, U.S. corporate operators are adept at adapting to change and maximizing profit at scale but in periods of dislocation, the process is rarely smooth.  As we noted at Strategas’ 18^th Macro Conference last week – prior to Trump’s announcement – if the executive summary can “hold,” i.e., isn’t recanted via Tweet in days or weeks, but establishes a framework – whether it agrees with one’s politics or economic theology – corporations will swing into action.  So far, it has held; the market has not.  The longer-term implications will come with time and detail, but in the near-term (and from a market perspective) we are inclined to focus on facts and first principals.  As a starting point we are drawn to three historical analogues as a commentary on profit sensitivity in periods of uncertainty, namely:

1. President Kennedy’s 1962 negotiation with U.S. Steel (the other “X”) as a marker for executive power in economic statesmanship (with Emerging Market economies, e.g., Vietnam, now playing the part of U.S. Steel).
2. The Global Financial Crisis as a guidepost for the negative coefficients of speed and degree with which financial leverage leaves the system.
3. The Covid pandemic, wherein the global economy was mandated to a near-subsistence crawl, providing a barometer of “need” vs. “want” in an environment where the potential for retaliation and a period of supply chain dislocation is likely.

Strategas chief economist, Don Rissmiller, makes the following observation, “blunt tariffs are a level shift up in prices, if they last. With U.S. monetary policy still restrictive (this is a key factor), demand should slow.  Consumers will likely balk at the higher prices (sentiment is already weakening substantially.  If consumers resist price increases, the tariffs will hit profits.”  

What would this look like?  By our count there have been nine recession-related corporate profit resets since the end of World War II.  The most severe in profit terms was the Global Financial Crisis (2007-09) where economic deleveraging saw profits fall approx. -80% in the aggregate.  The least severe was 1968-69 at -20%.  On average, the peak-to-trough earnings decline during recession is -30%; the median is -25%.  If Recession is your base case, we would use -25 to -30% as your earnings adjustment.  The sector-specific impact will be higher or lower as negotiations ensue and details of the new trade order are codified.  A ~25-30% hit to earnings would center the confidence zone for S&P EPS around $180.  Recession is not Strategas’ base case.  Don Rissmiller and Strategas’ economics team place 45% odds on U.S. economic contraction in the next twelve months.  It may seem counterintuitive, but economic data may improve in the near-term if businesses and individuals accelerate purchases ahead of impending tariffs. Vehicle sales in March showed this (17.8 million SAAR). We would resist the temptation for investors to read too much into 2Q data – good or bad – for signs of a trend.  The safety net is likely eroding; the U.S. economy probably only has a couple of months to find positive offsets before a U.S. recession takes hold.

The Covid pandemic was also not the result of a financial “event.”  The impact on the economy is informative.  In the six-months from Feb’20 the Street’s time-weighted estimate of S&P 500 EPS was revised lower by roughly -20%, in-line with the revision profile that typifies the 12-months leading into Recession.  Said another way, the outlook for earnings fell twice as fast as it would typically in the run-up to Recession.  Investors are likely wise to consider the potential for similarity between the post-tariff economic reaction function and that of Covid given their non-financial catalysts, i.e., no financial “event.”  The Street’s time-weighted estimate of S&P 500 EPS (our preferred measure to the “NTM estimate” and our barometer for the “Upside Surprise”) is currently ~$284; a Covid-like revision would reduce this estimate to ~$227.  

The other factor to consider in looking for a fundamental floor in share prices is the earnings multiples, specifically the P/E ratio.  Historical recession-related multiple contraction (for our 9 episodes sample) is approximately -25%, or -5 to -6 multiple points in current terms.  Two things are important to remember, however: first, the market has seen a good bit of this contraction already.  The P/E for the S&P 500 is down about -4 points as of this writing.  Second, trough multiples rarely line-up with trough earnings.  Prices have historically bottomed 4-6 months before earnings on both a discrete quarter or trailing four-quarter basis.  In fact, in today’s terms, the historical coincident multiple to trough earnings would be ~22x as the market began to discount a recovery in profits.

Regardless of the economic tail, we expect downward estimate revision to accelerate.  We revised our estimates lower in late-March.  Strategas’ time-weighted estimate for S&P 500 EPS is ~$270, which would represent a modest increase from 2024.  This may need to come lower but this is how we see it in the wake of the President’s announcement.  Our probability-adjusted fair value for the S&P 500, incorporating a full work through of Covid demand contraction, GFC de-levering and ’62 price mechanics is ~4,600.  This does not mean the market need fall to this level to find it’s footing but it expresses an intrinsic value concept that should provide some relief to worry. 

Looking ahead, we would watch for continued detail to drip out on the Administration’s tariff program as global trading partners – country and company – engage on negotiation.  We would anticipate the Administration to also shift its policy focus toward taxes in an attempt to “secure some wins” for the U.S. economy.  This urgency has likely shifted the timing on the tax bill forward into earlier Summer.  Republicans will be chiefly focused on lowering marginal income tax rates, the corporate tax rate, and the capital gains tax rate to sterilize the impact of the tariffs.  Strategas’ policy ace, Dan Clifton and our team in Washington, are not convinced that Congress is “there” yet.  The environment in DC feels similar early-Covid when it was clear the U.S. was about to shut down its economy and policymakers did not understand the scope of the issue.  As they figure it out, investors are wise to remain focused on the credit market for signs the situation is getting uncontrollably worse. 

Nicholas Bohnsack