The Art of the Deal, Tariff Edition

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on the volatile markets, the economy, the Fed, tariffs and Trump’s deal making, and opportunities in fixed income. We finished with a random round of questions and personal reflection.

Market Performance: Total Return

Let’s start with markets. April was an absolute rollercoaster for markets. How did stocks and bonds finish?

The S&P 500 Index was down only slightly—less than a percent, which is staggering if you’d ask somebody at the beginning of April. For the year, equities are mostly down. Oddly enough, the Russell 1000 Growth Index was positive, up almost 2%. Fixed income also started off extremely volatile and experienced a rough start in April, but we had a recovery in the second half of the month to finish about flat. Year-to-date, the equity indices are down roughly 5%; the bond indices are up 2 to 3%, depending on risk levels.

On the whole, it’s been a risk-off year in essence because of tariff uncertainty. The tariff bomb was detonated, April 2, touted as “Liberation Day” when President Trump announced higher-than-expected tariffs. A week later, he issued a 90-day pause, so the markets started to recover as the president deescalated. The S&P 500 was up about 10% on the day the pause was announced. The market is attempting to underwrite what’s happening based on signaling and rhetoric, which is a difficult task.

Still the Lag 7

How did the Mag 7—or Lag 7, as it’s been called this year—do in April?

As for the Mag 7 for the year, the stocks are down anywhere from 6 to 30%. That said, the fundamentals are holding up. For example, Meta, Microsoft, and Amazon all beat on Q1 expectations for earnings.

10-year Treasury Yields Remain Range Bound

April was a risk-off market, but yields rose at the long end of the U.S. Treasury curve. Does the 10-year still benefit from the flight to safety? That was the big question in April.

Last month, we had the 10-year dip just below 3.9% and then jump to 4.5%. So, what happened? Two days prior to Trump announcing a 90-pause on most of the new tariffs, you had risk-off in equities. In a typical situation when you had equity sell-off that much, the 10-year should rally. But the Treasury market ended up going in the opposite direction. I think President Trump is very rate focused since he’s been in real estate developer most of his life. So, when the Treasury market cracked, that to me was a signal this could get bad quickly, and Trump hit the pause button. And to answer your question directly, in generic risk-off situations, I think flight to safety benefits the 10-year. But in extreme situations like in April, I think you had global central banks taking action on our Treasury markets because it was essentially an economic war against them. I do think what happened is a short-term and unique situation.

Implied Fed Funds Rate and Number of Hikes/ Cuts

In light of this week’s FOMC meeting, has the calculus of rate cuts changed with tariffs?

On the margin. Going into the meeting this week, expectations were that three cuts were still in play for 2025. What has changed is the anticipated June cut has been pushed to July, with additional cuts in September and October. Still three expected cuts. But as we’ve seen, that can change on a dime. Since there’s so much uncertainty and the Fed is data dependent, I think the central bank will wait for more information before cutting again.

Economic Dashboard

Is the impact of the trade war showing up in the hard and soft data yet?

GDP was down 30 basis points in the first quarter, which by some measures is halfway to a recession. Blue-chip consensus for the second quarter is for GDP to come in just under 1%, so we’ll see what happens. Inflation moved slightly lower. The job market remains solid. I think the real move since the trade wars began has been the Consumer Confidence Index, which has fallen dramatically from 109.5 to 86. When you have that volatility and uncertainty, then you have business executives saying, “I don’t know how the rest of the year is going to look, which means the best way to de-risk on a business side is to eliminate costs, cut jobs, etc." And, of course, that negatively affects consumers as they face the potential for higher prices and layoffs.

Sharpest Decline in Earnings Outlook Since 2020

How have the tariffs affected the outlook of companies?

We’re experiencing the sharpest decline in earnings outlook since the pandemic, which obviously was also a very uncertain time.

Impact of Tariffs on Real Economy Stocks Was Swift and Pronounced

What about impacts on the stock market?

Again, uncertainty and volatility are the key words. The market is trying to dissect the signaling and rhetoric, and the thought of a negotiation between certain countries is leading to a rally because they’re hoping to get to certainty.

Texas Manufacturing Outlook Survey

When do you think businesses and consumers will start to see the effects of the tariffs?

My best guess is Q3, but I don’t think it’s necessarily going to be a big spike or a cliff. I think it’s a climb into stress. Each day we get closer to the supposed end to the 90-day tariff pause without key deals leads to stress. Certainly, companies are feeling the pressure. The Dallas Fed’s Texas Manufacturing Survey’s New Orders Index when from around 10 several months ago to -20 in April. I think businesses are waiting with bated breath to see how this all plays out.

U.S. Treasury Holdings in Japan and China

Japan’s finance minister said that the country’s more than $1 trillion in U.S. Treasury holdings could be a card in the trade talks. Could the bond market be collateral damage in the trade war?

I think it came into play during the Treasury selloff in early April as Japan’s a significant counterparty. I would also expect, given that leverage in the negotiations, Japan is probably going to be early to the table to get a deal done.

Tariffs Played Major Role in Canadian Elections

It looks like the Trump administration has struck its first deal after the 90-day pause with the UK. Why is this particular deal important?

Let me try to sum up what I think this deal means. Signaling is an important part of business negotiations, which is why I believe “Liberation Day” was meant to be a signal to negotiate. Two, as negotiations begin, I think governments are trying to get a sense of the purpose of the tariffs. On the one hand, are tariffs a revenue-generator mechanism? U.S. Commerce Secretary Howard Lutnick has stated the tariffs are a smart way to raise government revenue without raising income tax. So, if that's the role of tariffs, that actually is incentivizing tariffs to be a high number because we're going to use it as revenue to help reduce the deficit and income taxes. Or are the tariffs designed to establish free and fair trade? Given that scenario, tariffs could go to zero if both companies agree to go that route. This incentivizes low tariffs. I think tariffs where they sit today during the pause—10% for most countries and significantly higher for China—splits the difference between revenue generation and free-and-fair trade. Details haven’t emerged yet, but the U.K. deal will be very important for the markets to digest. Britain is a close ally, has a relatively balanced trade relationship with the U.S, and the 10% still remained, so the deal that’s struck will be an important signal for other countries as to a potential ending point.

I think the grand plan is to get to a trade deal with China. That's the whale. The administration appears to be making deals first with the easiest trading partners such as the U.K., and I believe the EU and Japan are probably next, followed by countries like India, Brazil, Vietnam, Canada, Mexico, etc. By the time you get to China, they will essentially be surrounded by our allies with trade deals in hand. Getting the developed nations on the same page is an important leverage point as you confront the trade rival. It will be interesting to see how they execute.

Fixed Income Yields and Year-to-Date Returns

With all we’ve talked about, what opportunities do you see in fixed  income today?

I do feel with the economy weakening, duration has more of a chance to be a tailwind than a headwind at this point. And it feels to me that the 10-year at 4.25% or 4.50% is probably the higher end of that range. I’m not calling for a low 3% 10-year, but I think you could have some total return in there. And I’m also not saying that flowing-rate loans don’t have a role right now because you’re still clipping with the Fed potentially delaying a rate cut. You’re still clipping 8 to 9% with floating-rate loans.

Do you think it makes sense to add more when it comes to investment-grade credit or loans?

Again, clipping 9% or so on floating-rate loans is attractive. But if you firmly believe we’re going into recession, that’s a different ball game. That makes investment-grade attractive, and U.S. Treasuries come into play there. But if you think we’re getting to meaningful trade deals, then you’re going to want loans to the extent that you do not believe there’s recession.

With that, let’s close with a personal reflection.

This weekend, I am going to my son’s college graduation at the University of Wisconsin. He is then headed to New York City for a job he lined up, which, as a proud dad, I think was a result of his hard work as an undergrad. But many of his classmates haven’t secured a job yet and are beginning to settle for paths they did not want. What I find interesting is young people put so much work in high school gearing up for college. But once they get into a university, I see many kids gear down. They are content to go to classes, get their degree and worry about finding opportunities later. My words of wisdom for college students would be to stay in high gear. Not only will it most likely provide more opportunity, I think it’s more enjoyable, and ultimately more fulfilling.

Definitions

The 10-year Treasury note is a debt obligation issued by the U.S. government with a maturity of 10 years upon initial issuance. It pays interest at a fixed rate every six months and pays the face value to the holder at maturity.

The 10-year Treasury yield is the interest rate the U.S. government pays to borrow money for a decade.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level.

Basis points, otherwise known as bps, are a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form.

A bond is a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time. The entity repays individuals with interest in addition to the original face value of the bond.

The Consumer Confidence Index (CCI) is a monthly report that measures how optimistic consumers are about the economy, labor market, and their finances.

Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk. The shorter a fund’s duration, the less sensitive it is to interest-rate risk.

Fed funds futures is a tool used by traders and institutions to hedge or bet on changes in the federal funds rate, which is key to U.S. monetary policy. The federal funds rate is the target interest rate set by the Fed at which commercial banks borrow and lend their extra reserves to one another overnight.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System that determines the direction of monetary policy and is responsible for raising or lower interest rates.

Fixed income refers to assets and securities that pay a set level of income to investors, typically in the form of fixed interest or dividends.

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. The nominal GDP growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Real GDP is GDP adjusted for inflation.

High-yield bonds are debt securities, also known as junk bonds, that are issued by corporations.

Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return.

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.

Yield is the income returned on an investment, such as the interest received from holding a security.

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Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund’s performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

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