Institute Alert

• Equity prices started the week on a high note as the countertrend rally is holding with limited news over the weekend and Monday.
• We believe the combined weight of universal, reciprocal, retaliatory, and sector-specific tariffs ultimately will decide between recession and no recession but that the final tariff menu remains unsettled.

• We see this as an opportunity for long-term investors to add exposure to high-quality U.S. Large Cap and Mid Cap stocks, and the Communication Services, Energy, Financials, and Information Technology sectors.
• Investors should remain cautious on lower-quality areas like U.S. Small Caps and Emerging Market Equities.

There are weeks when nothing happens and then there was last week, when a decade happened. Let us hope this shortened trading week is better. Mercifully, equity prices started the week on a high note as the counterrally uptrend is holding with limited new news over the weekend and Monday (April 14).

The S&P 500 Index closed up 5.5% last week, its best week since November 2023 with continued momentum Monday. The index is still down more than 10% from the February 19 highs with the low watermark remaining April 8’s close when the index was 18.9% below the peak. The S&P 500 Index experienced similar drawdowns (14% to 20%) in 2010, 2011, 2015-16, and 2018 when markets began to price in impending recessions that never materialized. We believe the combined weight of universal, reciprocal, retaliatory, and sector-specific tariffs ultimately will decide between recession and no recession.

U.S. Large Cap and Mid Cap equities have begun to balance valuations at new price levels, with 80% of companies within the indexes now trading below their five-year average valuations (based on the ratio of price to earnings). Critical to this, in our view, will be the aggregate markdown of the “E” of earnings as companies begin to suspend or lower 2025 earnings guidance on more uncertainty and anticipated tariff friction in the system. Small-cap equities continue to underperform their large-cap peers. Russell 2000 small-cap stocks set a new relative low compared to Russell 1000 large-cap stocks last week with the gap between the two at the widest level since 1979. The number of non-earners in the Russell 2000 is approaching all-time highs.

Households also are paying attention. The University of Michigan Consumer Sentiment Index fell 6.2 points to 50.8 last week for the month of April, the second-weakest reading ever. The rapid decline in consumer sentiment at all income quintiles is historic, matched only by the COVID pandemic in 2020, when the economy shut down almost overnight. Also, one-year inflation expectations in the survey rose 1.7% to 6.7% and 5-to 10-year inflation expectations rose 0.3% to 4.4%.

The 10-year U.S. Treasury yield increased half a percentage point on the week, the single-largest weekly increase since 2001, and widened the gap over short-term rates. Volatility in rate markets has consumed even more attention than equity volatility. The Treasury market is pressured but has not been disorderly or dysfunctional as rates backed up. Sources of this historic rate volatility have consumed much oxygen on Wall Street. Concerns that foreign central banks may be net sellers look to be somewhat overdone at this point. This is important as foreign investors own 33% (roughly $8.5 trillion) of U.S. Treasuries, 27% (roughly $4.4 trillion) of U.S. corporate bonds, and 18% (about $16.5 trillion) of U.S. equities.

On the tariff development front, after an initial April 11 announcement of reciprocal tariff exemptions for imported electronics, including smart phones, computer monitors, semiconductors, and electronic parts, the Trump administration appeared to reverse course — or at a minimum clarify — on Sunday. Commerce Secretary Howard Lutnick, and later President Trump, indicated the exemption is only temporary and will be covered under sectoral tariffs still to come on imported semiconductors and pharmaceuticals. Even a temporary exemption was enough to push equity prices higher on Monday, but if not permanently exempted, electronics may prove a difficult sticking point for the willingness of Asian countries (ex-China) to negotiate since these products are a big part of their net exports.

We should expect volatility to remain high, but last week proved the power of markets to push the administration not to break the financial system. Hence, we should have a floor for equities and a ceiling for rates. It’s likely we will need to price out some of the anticipated Federal Reserve cuts, as it’s not about monetary policy at this stage and rate cuts won’t ultimately solve the tariff problem, in our view.

Tariff policy as proposed has two key shortcomings. First, tariffs can generate specific “income” — but only through the form of a tax, ultimately paid by consumers (higher prices), businesses (lower margins), investors (lower growth), or countries (lower demand). Second, fiscal and current accounts (the balance of trade and income flows between the U.S. and the rest of the world) are linked. The proposed policy aims to reduce trade deficits. However, assuming success that trade deficits are reduced, it’s not obvious the rest of the world will continue to fund U.S. fiscal deficits, ultimately leading to higher term and risk premia, a weaker U.S. dollar, and reduced international demand for U.S. assets.

So, what is a viable solution to this vexing problem? If we want to focus on a number, think not about trade deficits, but rather about our total exports. If that number is large and growing (which it is, by the way) then our manufacturing base is likely in a good place. It signals the U.S. is efficiently producing globally competitive goods.

For investors who have cash and are considering investment, even amid uncertainty, we would stick with quality. Our favorable rating on Commodities may help hedge against potential inflation effects.

Our equity guidance prioritizes quality, while our fixed-income guidance emphasizes selectivity. International economies depend more on trade than does the U.S. economy, so we favor U.S. equities. Among the U.S. markets, we favor U.S. Large Cap and Mid Cap Equities and select sectors (Information Technology, Communication Services, Financials, and Energy). We also favor investment-grade fixed income and would focus on corporate bonds and essential-service municipal securities. In our view, the middle range (3 to 7 years) offers the best value at this time, in our view.

For investors who have a long-term focus and want to remain cautious here, some buffer can make sense. Money market rates are a lot higher than they were the last time major uncertainty landed on financial markets, at the beginning of the COVID lockdowns. So, for now, we believe rates above 3% may be one solution. If prices settle as we expect, legging back into financial markets, especially if underweight to strategic targets, remains a priority as markets finally settle.  

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT). The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.

Cash alternatives typically offer lower rates of return than longer-term equity or fixed-income securities and provide a level of liquidity and price stability generally not available to these investments. Some examples of cash alternatives include: Bank certificates of deposit; bank money market accounts; bankers’ acceptances, federal agency short-term securities, money market mutual funds, Treasury bills, ultra-short bond mutual funds or exchange-traded funds and variable rate demand notes. Each type of cash alternatives has advantages and disadvantages which should be discussed with your financial advisor before investing.

Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. Communication services companies are vulnerable to their products and services becoming outdated because of technological advancement and the innovation of competitors. Companies in the communication services sector may also be affected by rapid technology changes; pricing competition, large equipment upgrades, substantial capital requirements and government regulation and approval of products and services. In addition, companies within the industry may invest heavily in research and development which is not guaranteed to lead to successful implementation of the proposed product. The Energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources, and risks that arise from extreme weather conditions. Investing in the Financial services companies will subject an investment to adverse economic or regulatory occurrences affecting the sector. Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks, especially smaller, less-seasoned companies, tend to be more volatile than the overall market.

Russell 1000^® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 90% of the total market capitalization of the Russell 3000 Index.

Russell 2000^® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

Russell 3000^® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

University of Michigan Consumer Sentiment Index is published monthly by the University of Michigan. Each month at least 500 telephone interviews are conducted throughout the U.S. The Index of Consumer Sentiment is developed from these interviews.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

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