The S&P 500 entered correction territory in March, at one point declining -10% from its February all-time high. For historical context, the average intra-year decline since 1980 is -14%. With stock valuations already elevated by historical standards, increased policy uncertainty and concerns about potentially slower AI investment contributed to the selloff.
Among the many policy changes taking place and under consideration by the new administration, tariffs and government spending have had an outsized impact on stocks. While economic/trade negotiations have been ongoing, investors have struggled to assess what the final tariff picture will look like. Close attention will be applied to the effect of tariffs on corporate earnings and inflation as the year progresses. Cuts in government spending are also top of mind in markets. Federal deficits (as a % of GDP) have reached unprecedented levels in the past three years, only comparable to periods of very high unemployment and World War II. Economic theory says large deficits stimulate the economy and are inflationary. A substantial reduction in the federal deficit could lead to a short-term economic slowdown, potentially prompting the Federal Reserve to cut interest rates. Fed Chairman Jerome Powell indicated the Fed will attempt to focus interest rate/monetary policy on non-tariff inflation sources due to their inability to impact tariff policy and the “transitory” nature of tariff inflation.
The “AI trade” provided a strong tailwind to the U.S. stock market in 2023 and 2024, causing the S&P 500 and related index funds to become heavily weighted towards AI-related stocks. By the end of 2024, the combined technology and communication services sectors accounted for 42% of the S&P 500, with NVIDIA alone representing 7%. AI stocks struggled in the first quarter, contributing to the S&P 500’s -4.3% decline. The S&P 500 Equal Weight Index, which weighs all 500 companies equally, declined -0.6%, reflecting better performance in the broader market. The first quarter also saw high dispersion, meaning individual stocks diverged more than usual as investors evaluated policy impacts on companies. In a market characterized by high concentration in tech/AI and high dispersion due to policy changes, maintaining diversification is crucial. Whether through passive or active strategies, overexposure to a narrow set of factors such as AI or tariffs presents significant risk to investors. We continue to carefully evaluate how potential policy changes might affect portfolios.
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