Shareholder Resources

Equity Market Reset

With equity markets priced for perfection in early 2025, it didn’t take much to send stocks lower in March. The S&P 500 Index briefly entered correction territory, defined as a 10% drop from its most recent high. Many of the high-flying technology stocks that led the market’s performance over the past two years—referred to as the Magnificent 7—saw even more dramatic declines, with some falling by 20% or more.

At the heart of the equity market’s volatility was a reevaluation of earnings growth expectations, particularly in the technology sector, where AI-driven capital spending has drawn increased scrutiny. The unveiling of China’s DeepSeek AI application in January raised questions about the return on investment from the massive capital expenditures by U.S. tech giants. The market’s reassessment of these investments, combined with broader economic uncertainties, contributed to a more cautious tone in equity markets. Investors have responded by positioning defensively, favoring sectors like Healthcare and Utilities and seeking opportunities in international markets, which have outperformed. European equities, for example, have been buoyed by Germany’s fiscal package and a broader shift in the region toward more accommodative fiscal policies.

While market volatility has increased, the correction in equity prices was, in many ways, a healthy development. The repricing of some of the market’s most expensive stocks has created opportunities for investors with a long-term perspective, particularly in areas of the market that remain attractively valued relative to historical norms.

Economic Data Sends Mixed Signals

Adding to the uncertainty was shifting economic data. Consumer sentiment weakened as inflation concerns resurfaced, driven by the ongoing debate over tariffs and trade policy. The Atlanta Fed’s GDPNow model forecasted a -1.8% contraction in U.S. GDP for the first quarter, signaling potential economic weakness ahead. Consumer spending, which has been a key pillar of economic resilience, slowed notably, raising concerns about whether the affluent-driven consumption that sustained growth in 2024 would continue to provide support.

Early signs of labor market softening, particularly in government and leisure sectors, added to the uncertainty. The full impact of government spending cuts has yet to be realized, but it is widely expected that employment in the public sector will continue to decline. While the broader labor market remains healthy, these emerging cracks warrant attention.

Inflation data for March came in slightly below expectations, with a decline in core services and falling energy prices helping ease pressure on consumers. Shelter prices, a significant driver of inflation in 2024, also continued their decline. Still, inflation remains stubbornly above the Fed’s target of 2%. In its updated summary of economic projections (SEP), the Fed confirmed its more cautious stance, revising its inflation forecast higher while maintaining its 2025 growth outlook at a subdued level.

Shifting Sentiment and Policy Uncertainty

Following the 2024 election, small business and consumer sentiment surged on the promise of lower regulations, pro-U.S. trade policies, and tax cuts. However, optimism has steadily receded back toward pre-election levels as uncertainty over the impact of the administration’s policies has crept into sentiment surveys. In an early March interview, President Trump warned of a “period of transition” and indicated a willingness to accept an economic slowdown or recession as a side effect of the administration’s policies.

At the same time, the GDPNow forecast and other recent economic data may be skewed by companies attempting to get ahead of potential trade disruptions. The manufacturing sector, for example, has shown better-than-expected numbers, but this may be temporary-driven by businesses stockpiling inventory in anticipation of tariffs rather than a sign of sustained growth.

Practicing Caution

The Federal Open Market Committee (FOMC) held rates steady at its March meeting, as expected. Chairman Powell’s comments reinforced a patient approach: “We do not need to be in a hurry to adjust our policy stance.” This aligns with market expectations for only gradual rate cuts in the coming quarters. While lower inflation prints provide some reassurance, ongoing policy uncertainty-particularly regarding tariffs and fiscal policy -makes it difficult to predict the Fed’s next moves with confidence.

Treasury yields remained volatile throughout the quarter, with the 10-year Treasury yield rising to 4.8% to start the quarter before its bumpy ride down to 4.2% as markets adjusted to shifting expectations around Fed policy. The credit market has remained relatively complacent, but tight credit spreads leave little cushion for volatility. Historically, when spreads do widen, the move tends to be sudden and significant.

Tariffs, Trade Policy, and Market Implications

The Trump administration’s evolving stance on tariffs has created additional headwinds for the economy and markets. While tariffs generate an immediate price increase, we don’t view them as a long-term structural driver of inflation, but more akin to a tax. The more concerning impact, in our view, is the drag on economic growth. Businesses and consumers alike are adjusting to the uncertainty surrounding trade policy, which has led to hesitancy in investment and spending.

The Federal Reserve is closely watching the labor market for signs of strain stemming from trade disruptions, but at this stage, we do not expect the Fed to adjust its policy stance in response to what is likely a temporary price shock. The broader concern is that persistent policy uncertainty could dampen corporate confidence and lead to further market volatility.

Looking Ahead

As we close the first quarter of 2025, we recognize that uncertainty remains a dominant theme. Inflation is cooling but remains a concern, the labor market is showing early signs of strain, and corporate earnings expectations are being recalibrated. Meanwhile, policy uncertainty – particularly around tariffs – continues to weigh on sentiment.

Markets remain highly reactive to economic data, often over-interpreting individual reports rather than considering the broader trend. This dynamic has led to increased volatility, making it challenging to rely on any single data point or policy headline as a definitive guide for market direction.

While we remain cautious about near-term volatility, our investment philosophy remains unchanged. We continue to focus on high-quality companies that can weather periods of uncertainty. Valuations still favor sections of the market outside of the Magnificent 7, and we continue to emphasize quality in our positioning.

Despite these challenges, we remain confident in the resilience of the U.S. economy. Periods of market volatility often create the best opportunities for disciplined, long-term investors. We will continue to navigate these markets with a focus on quality, valuation discipline, and risk management.

We appreciate your continued trust and partnership.

This piece was authored by Patrick Ryan, CFA®, Chief Investment Strategist, Head of Multi-Asset Solutions, and Portfolio Manager for Madison Investments. He also serves as a member of the Investment Risk Oversight Committee and is a Madison Investments Foundation board member.