When the markets entered 2025, they were riding a wave of euphoria, a veritable sugar high born from the 2024 election results. The new administration, with its tagline of being the “Most Business-Friendly” in history, sparked a significant rally. We, however, remained upbeat but professionally skeptical, primarily because of the lack of clarity regarding two critical and potentially disruptive issues: the administration’s Tariff doctrine and the proposed Department of Government Efficiency (DOGE) cuts. Our caution was ultimately validated when the “April Liberation Day” tariff announcements took Wall Street completely by surprise, serving as a stark reminder of the complexities ahead.
Navigating the New Doctrine of Tariffs & Trade
While it is a prudent exercise for any administration to periodically review its trade agreements, it remains to be seen if addressing all of them simultaneously yields more favorable deals or, in fact, worse ones. Some of the administration’s calculations for reciprocal tariff rates have been a headscratcher for us, as they seem to imply that even small countries should purchase U.S. goods in quantities nearly equal to our own. The United States is a wealthy nation, so of course, it will always have different trade dynamics with countries that have lower GDPs per capita. We believe the strategic goal should be to strive for freer markets, with tariffs at or near zero on both sides, to promote robust competition and provide greater access for our companies to new global consumers.
The economic landscape has fundamentally shifted. Today, with service-based companies (primarily software) representing a staggering 40% of the S&P 500‘s market capitalization, and with our economy being a net importer (we import approximately $4 trillion vs. exporting $3 trillion annually), we have departed from our historical doctrine. For decades, America conquered new markets through the commercial and cultural victories of brands like Coca-Cola, McDonald’s, and Nike. Now, as President Trump puts it, the strategy is to “sell access” to our domestic markets in the form of tariffs.
The market had been expecting tariffs in the range of 10%, which made the “Liberation Day” announcement a significant shock. Following the self-imposed August 1st deadline, the market now anticipates an average tariff rate of 14%, excluding those already levied on China. Anything more than this would be detrimental to consumers, who are already showing signs of financial strain. It remains a critical question as to how much of these tariff-related costs will ultimately be passed on to them at the checkout counter.
After the significant market slump in April, this administration has shown that it is more sensitive to market stability than was previously known. They have extended deadlines and now make major tariff announcements (such as the 30% tariff on the EU and Mexico on July 12th) on Saturdays, a tactic seemingly designed to allow markets time to digest the news over a weekend. Even the recent escalation in the Middle East began and concluded before Sunday futures trading opened. President Trump was quick to tweet about the spike in oil prices when the Straits of Hormuz were at risk of closing following the U.S. strike on Iran’s nuclear sites, a move that forced traders to cover their positions and calmed nerves. This indicated he could ease market fears with strategic oil inventory releases and signaled a willingness to punish Iran if it tried to block the vital strait. While parts of the investor community remain skeptical, we remain optimistic, given what has been dubbed the “TACO Trade” — the theory that the administration is ultimately responsive and takes direct feedback from the markets to avoid major downturns.
The “Big, Beautiful Bill” and the AI-Fueled CapEx Boom
While the DOGE cuts and tariffs were initially seen as significant drags on consumers and consumption, their perceived impact has been recalibrated. The mandate for DOGE has been reduced to saving billions rather than the trillions previously implied. This, combined with benefits aimed at lower-end consumers within the “Big, Beautiful Bill” and other government spending, is expected to significantly boost capital expenditure (CapEx).
We do not agree that all onshoring will be a net benefit for the USA, particularly for low-margin items like clothing and shoes, which even China is now outsourcing. We are, however, focused on the immense strategic value of this policy shift. The onshoring of semiconductors, computer chips, robotics, automobiles, batteries, and other high-end precision manufacturing would not only bring more high-quality jobs to American shores but, more critically, would increase the security and resilience of our nation’s supply chain in any adverse global scenario.
A technological arms race is currently underway between the “Hyperscalers” to quench the seemingly unquenchable thirst for the unlimited computing power needed by Artificial Intelligence (AI). Current demand has beaten sober estimates from just two years ago by an order of 100 times. With the advent of agentic AI, robotics, and self-driving cars, the race to build this capacity is one of the defining economic stories of our time.
This trend was already in motion, but it has been supercharged by what the administration calls “tariff sterilization” via the “Big, Beautiful Bill.” This legislation is designed to directly offset the impact of tariffs by encouraging a domestic investment boom through several powerful provisions:
- Factory & Data Center Investment: If you build a factory or data center in America, you can write off 100% of the cost on day one, directly incentivizing a domestic building boom.
- Capital Goods Orders: A permanent 100% day-one write-off for capital goods orders directly benefits industrial titans like John Deere and Caterpillar and their customers.
- Domestic R&D: R&D expensing is now a 100% write-off if it is conducted in America, providing a significant boon for the medtech, pharmaceutical, and biotechnology sectors.
- Utility Incentives: Utilities can now write off corporate interest against Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), a more favorable calculation than the previous 30% of Earnings Before Interest and Taxes (EBIT) limit. While cuts to renewable energy subsidies of around $500 billion will offset this somewhat, the overall package remains a clear net positive for the markets.
The enthusiasm for AI is palpable, as corporations are now using it to write almost 50% of their code. They are training AI to be more “agentic” — capable of navigating different websites and taking control to perform required tasks. This is driving a level of unprecedented productivity growth not seen since the advent of the personal computer. The evolution of AI, fueled by massive private CapEx and explicitly encouraged by government policy, is a transformative event more akin to the development of the national railway system in the 19th century.
The Federal Reserve’s Dilemma
We began the year with a very positive overtone, with markets expecting 100 basis points in cuts from the Federal Reserve to start in the second half. As we now enter that second half, the probability of such significant rate cuts has diminished, if not been eliminated entirely. The primary reason for this shift has been the prospect of higher-than-expected tariffs. The tariffs that were modeled at closer to 5% at the beginning of the year are now suddenly between 10% and 30%.
Retailers have been anxious, restocking their inventories in huge sizes and thereby causing a numerical contraction of GDP in the first quarter as they attempted to front-run the tariffs. As we enter July, the core CPI is holding at 2.54%.
These tariffs will inevitably show up in consumers’ shopping carts, as companies cannot absorb a 30% hit to their profits; there will be price shocks. While this is predicted to be a one-time event, companies have already been gradually declining promotions and raising prices. This trend should continue for the next several quarters as they seek to avoid a significant decline in sales volume. This situation fully warrants the Federal Reserve and Chairman Powell’s stated position to keep rates stable, as monetary policy must be forward-looking. If their models project an inflation increase by the end of the year, they should not, by any means, cut 100 basis points.
The Fed’s dual mandate is price stability and full employment. The long-run unemployment rate is estimated at 6.1%, and we are currently at 4.2%. This is as close to full employment as it gets, especially when considering reduced legal immigration. This dynamic decreases the labor supply and weakens the arguments in favor of rate cuts, as the onshoring capex boom and AI-related spending will likely keep the labor market tight. Consequently, we expect there to be no significant rate cuts for the remainder of the year, barring a sudden and severe economic downturn.
Risks to the Thesis
The administration has, in our view, handled the tariff situation poorly, especially with allies who depend on the United States for their security. As Treasury Secretary Scott Bessent rightly stated at the beginning of the year, China needs to be reined in, as it attempts to manufacture its way out of its current economic glut. This is a direct threat to private manufacturing worldwide, as Chinese producers, backed by government subsidies and cheap loans, are positioned to sell goods at a loss simply to gain global market share. The administration should have coordinated with all G-7 countries and the European Union to put unified tariffs on China to safeguard national interests. Instead, singling out allies with tariffs that are often in excess of what those countries charge the U.S. is demoralizing and counterproductive.
Take, for instance, Japan, which charges very little — less than 5% on most non-agricultural items and 0% on machinery — and has been met with 25% tariffs by the administration, effective August 1st. This weakens the resolve of allied nations and doesn’t bode well for long-term trade relationships and dependence on the USA. While this may bring in a large amount of tariff revenue, it is, in effect, a tax on consumers who will have to pay more for the same products, which will inevitably drive down future consumption growth. It also weakens the case for U.S. companies and startups to expand globally.
The overall economy could weaken as federal cuts are set to begin on September 1st. Paired with the downsizing of federal employees, private companies like Microsoft and Amazon are already laying off more staff as they use AI to increase productivity. This is a bearish short-term signal for the economy.
The lowering of consumption due to the “Tariff Tax,” which should show up in prices as the 90-day pause used by retailers to load up on inventory runs out, will decrease GDP growth. GDP growth is now expected to be close to 1.4% by the end of the year, revised down from the 1.9% previously expected.
A final, significant risk is retaliation. The situation with Canada was a key example. While Canada is heavily dependent on the USA for its exports, its leadership knew precisely where to hit to cause maximum political pain: by threatening tariffs on U.S. services (specifically, software). This is our economy’s crown jewel, comprising 60% of the S&P 500’s value. The tariffs were quickly rescinded, but the move signaled to all other nations where to aim to make the administration fragile. This is a significant risk in the second half of the year. The EU, Canada, and Mexico, unhappy with proposed 30% tariffs, could team up with Korea and Japan (facing 25% tariffs) to retaliate in unison against our services— Microsoft, Netflix, Google, etc. —where we enjoy 80% gross margins and which form a massive part of our market indexes.
Last year’s 1.8% GDP growth was attributed to 1% productivity growth and 0.8% increased labor participation. This year, due to lower immigration, AI-driven productivity increases could be eclipsed by lower labor growth, potentially resulting in a lower-than-average GDP growth rate.
Conclusion
In summary, we are positive about the prospects for the second half of the year but remain exceptionally cautious regarding the risks that the market is not currently pricing in. The worries over tariffs and other policy matters have been delayed and not fully resolved by the current administration.
We have great faith that our portfolio companies and the businesses we analyze are resilient. They will be able to navigate the given circumstances and deliver strong results as they squeeze their suppliers, strategically remove promotions, and pass on costs while diligently protecting their margins.
To reflect this outlook, we have strategically positioned our portfolio. In equities, we are underweighting Consumer Staples and Consumer Discretionary stocks due to our forecast of a slowing consumer. Conversely, we are overweighting Industrials and Small-Cap companies, which are poised to benefit from the onshoring movement and a favorable deregulatory environment for American manufacturing. We maintain an equal-weight position in Technology; while we foresee significant margin expansion driven by AI productivity, the sector faces a nuanced outlook, as these companies remain in the crosshairs of trade wars, and their massive capital expenditures may be a drag on near-term earnings.
This cautious but opportunistic stance extends to our fixed-income strategy. To account for a stable Federal Reserve policy and persistent inflation uncertainty, we are overweight medium-duration and short-duration floating-rate bonds, while underweighting U.S. Treasurys and other long-duration bonds.