NOTEWORTHY

Q1 25 IU

First Quarter, 2025

Click here for a printable version of the Investment Update.

April 5, 2025

We penned the attached first quarter 2025 Investment Update before the Trump Administration’s April 2nd tariff announcement and the strong reactions from trading partners and financial markets. 

In our Global Thematic Equity research, we try to focus beyond the noise of the short-term news cycle, as we pursue long-term investment opportunities brought about by broad secular trends that impact corporate performance and stock valuations across geographies and sectors. 

Occasionally, however, the news of the moment has long-term implications for businesses and investors. We believe this is one of those times. The new tariffs upend the calculus that business leaders have used to make decisions for decades. Therefore, they require careful consideration. 

These tariffs also constitute the largest peace-time tax increase in U.S. history. Yet to be determined is how much of that tax will be borne by consumers versus companies. If unchanged, the tariffs will reduce corporate profitability and raise the risk of a U.S. recession. Retaliatory tariffs likely to be enacted in response by other countries would reduce demand for U.S. exports. $8 trillion in annual sales generated by foreign subsidiaries of U.S.-domiciled multinationals are also now in jeopardy. 

Understandably, these changes have roiled equity markets. The S&P 500 declined 11% in the two trading days after the announcement. The index is now down 14% year-to-date.

In addition to studying significant near-term, first-order impacts, we are focused on understanding longer-term, second- and third-order impacts that may outlast this tariff regime, particularly if the announced tariffs are merely a starting point for negotiation, as some posit. This radical pivot in trade policy is only one of several changes that are recasting the role of the U.S. on the global stage, increasing the importance of our Opportunities Abound Abroad investment theme. 

While these events are deeply unsettling, we believe our time-tested investment process will help us to navigate this policy-induced volatility with a clear-eyed, long-term perspective that will ultimately benefit our clients. 

During this tumultuous period, please reach out to us, or to our wealth advisors and portfolio managers, who remain intensively focused on the opportunities and risks of this moment.

Sincerely,

Signatures

In the first quarter of 2025, financial markets started to reflect several of the risks we noted in our Fourth Quarter 2024 Investment Update. Already grappling with high levels of uncertainty, U.S. companies and consumers started to defer spending and investment. This is an environment for which we have prepared; we will try to navigate it with equal measures of ambition and caution.

 

U.S. financial markets had an unsettling first quarter. After starting out strong, with the S&P 500 reaching an all-time high of 6,144 on February 19, the index dropped 10% through March 13, wiping out more than $5 trillion of U.S. equity market capitalization in just three weeks. Non-U.S. equities, however, rose nicely.

The MSCI All Country World Index excluding the U.S. (ACWI ex U.S.) finished the quarter up 4.6%, driven by double-digit increases in Germany, Hong Kong, Spain and Brazil. The S&P 500 ended at 5,612, down 4.6%, delivering its worst quarterly performance relative to the ACWI ex U.S. in over 15 years.

These results defied widespread expectations at the start of 2025 for continued strong U.S. equity market performance and weakness in the rest of the world.

Q1 25 Exhibit 1

We didn’t share in consensus expectations. In our Fourth Quarter 2024 Investment Update, we stated that, in our view, “U.S. equity market valuations fully reflect both recent good news and expectations of more, increasing the risk of a correction.” We listed seven risks to the S&P 500’s extraordinary run: very high expectations, valuations near record highs, U.S. equity domination, unprecedented market concentration, high bond yields, policy risk and extremely broad and high levels of equity ownership.

Clearly, trade worries weighed on investor sentiment in the latter half of the first quarter. We believe two other factors were also meaningful contributors to U.S. market declines:

A newfound measure of realism about the future profitability of artificial intelligence (AI) and continued cash flow growth for the Magnificent 71

TRADE AND TARIFFS: ONLY PART OF THE STORY

During the first quarter, the Trump Administration imposed the highest U.S. tariffs in almost a century, called them off, put them back and threatened more to come, driving the Trade Policy Uncertainty Index to a record high.

Q1 25 Exhibit 2

High tariffs are likely to depress trade and raise consumer prices, if left in place. Uncertainty about tariffs and other policies has already had negative effects. Many businesses are delaying capital investments and hiring until they have more clarity on policy decisions that could affect their return on investments. Wealthy U.S. households have also cut spending due to concerns about an equity market decline. As a result, many Wall Street economists lowered their forecasts for U.S. GDP growth in 2025.

Nonetheless, tariff uncertainty doesn’t seem to fully explain the drop in U.S. equities in the first quarter. Many international equity markets that appear to be vulnerable to the new tariff policy performed remarkably well. Some highly cyclical sectors, such as energy, also rose.

 

AI REALITY BITES THE MAG 7

The Mag 7 fell by just over 16% in the quarter and are well off their all-time highs. Since they collectively represented more than one-third of the S&P 500 when the year began, they dragged the index down, after powering it higher for the past five years.

Q1 25 Exhibit 3

We suspect that the Mag 7 declined in the first quarter because of growing skepticism that AI will become profitable near term. Most of the Mag 7 are quasi-monopolies. It is hard to see how investing hundreds of billions of dollars in new infrastructure will make these companies more profitable than they already are. Furthermore, history shows that major shifts to new technologies have tended to disrupt the existing market hierarchy, not reinforce it.

Concerns about Mag 7 valuations may have also taken a toll. At year-end 2024, the Mag 7 were selling at extremely high valuations: about 44 times earnings on average, including 124 times earnings for Tesla. In recent years, many analysts have justified Mag 7 valuations by citing their low capital-spending burdens. But now, the Mag 7 are spending heavily on server farms and other assets in response to the AI opportunity. As a result, the Mag 7 have higher capital expenditures relative to sales than any other sector, except utilities.

Q1 25 Exhibit 4

As usual, some enthusiasts claim, “this time is different.” Unlike the market favorites during the tech bubble of the late 1990s, they say, the Mag 7 companies that are investing heavily in AI are profitable and cash-flow positive. We think that story is dubious at best. We suspect that the Mag 7’s AI businesses would be revealed as deeply unprofitable if we could separate them from the cash-cow, quasi-monopoly businesses that support them. Privately held pure-play AI companies are valued at extraordinarily high multiples of minimal sales and are incurring huge losses.

Q1 25 Exhibit 5

FOREIGN CAPITAL FLOWS MATTER (BOTH IN AND OUT)

Repatriation of foreign funds was another driver of the market drop in the first quarter. For many years, three concurrent factors made U.S. equities very alluring to non-U.S. investors: relatively strong U.S. economic growth, strong equity market outperformance and U.S. dollar appreciation. Much of the S&P 500’s 150% rise since January 2019 was due to unprecedented buying from outside the U.S. In aggregate, non-U.S. investors increased their holdings of U.S. equities by almost $10 trillion over five years, while the value of non-U.S. holdings by U.S. equity investors “only” increased by about $2 trillion.

The situation changed in the first quarter. Some non-U.S. investors withdrew from U.S. markets, due at least in part to the sharp rise in political tensions between the U.S. and its long-time allies. For example, the Danish teachers’ pension fund, AkademikerPension, with roughly $20 billion of assets under management, said it would sell its remaining Telsa shares, mainly in response to Elon Musk’s interference in European politics. The U.K. government is pressuring pension funds to commit 10% of their assets to British equities, up from roughly 4% today. Canada is similarly exerting pressure on institutions to bring assets “home”.

If the first quarter is a harbinger of things to come, outflows could weigh heavily on U.S. equities. There are also non-political reasons to expect U.S. and non-U.S. investors to diversify equity holdings into other geographies.

THEMATIC UPDATE – OPPORTUNITIES ABOUND ABROAD

Over the last 15 years, U.S. nominal GDP grew 94%, well above the 10.5% average for the Group of 7 nations2 excluding the U.S. Over the same period, the S&P 500 rose 427%, while the MSCI ACWI ex U.S. rose only 34%. The U.S. dollar also appreciated sharply versus its trade-weighted index.

There were many reasons for U.S. economic and financial market outperformance in this period. Europe was beset by integration issues and the Sovereign Debt Crisis of 2012-2013. The U.K. vote in 2016 to leave the European Union inflicted further damage. Japan was struggling with the challenge of an aging population, sustained deflation, competition from China, and a weakening yen. Meanwhile, rapid earnings growth from the U.S. tech sector contributed to outsized profits for U.S. companies.

A more prosaic explanation for faster economic growth in the U.S. gets less attention: greater U.S. fiscal stimulus. The U.S. government has spent lavishly and cut taxes to support economic growth over the past 10 years, while other nations ran much smaller deficits relative to their economies’ sizes.

This situation isn’t likely to last. Until 2022, extremely low interest rates allowed the U.S. to accumulate increasingly higher levels of debt without interest expense spiraling out of control. However, the higher interest rates of the last few years have caused interest expense to soar. Today, interest expense is a greater share of total expenditures in the U.S. than it is in Italy, a country long associated with fiscal profligacy.

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