Tariffs Take the Spotlight, but the Real Market Risk Lies Elsewhere

By: Garret Melson, Portfolio Manager Natixis IM Solutions

Tariffs, tariffs, tariffs! Not even one quarter into 2025, and tariffs are already proving to be the word of the year.While tariff risks and the administration’s admission of potential short-term pain are getting plenty of attention, tariffs are more of a sideshow than a real market driver.

Since the market peak on February 19th, a basket of tariff-exposed companies has only underperformed the S&P 500 by just 0.5% and has actually outperformed the Nasdaq by 3.7%. On Monday’s slide, those same tariff-exposed names outperformed both the Nasdaq and S&P 500—not what one would expect if tariffs were the market’s primary concern.

Instead, the market’s focus appears to be shifting from tariffs themselves to their broader economic effects. While tariff risks and policy uncertainty are part of the narrative, the real issue isn’t trade tensions, but rather the underlying trend of economic cooling that has been underway for months.

The True Market Pain: Unwinding Crowded Trades

Tariffs have weighed on investor sentiment, but the greatest equity pain has come from unwinding crowded trades in high-beta and momentum assets:

• Long U.S. equities
• Long U.S. Tech/AI
• Long Bitcoin (BTC)

The worst-performing assets are those that outperformed over the past year, drawing in assets and inflating valuations. The real risk now is that this unwinding morphs into a broader and deeper correction as a growth scare takes hold—which now appears to be happening.

Markets entered 2025 too optimistic on growth and too pessimistic on inflation. Now, they are confronted with clear signs of cooling in both areas. While it’s premature to call a recession, downside risks are growing.

The Economic Pillars Are Weakening

The key drivers of U.S. economic growth in recent years are all showing signs of fatigue:

• Real incomes are slowing as labor markets soften, suggesting weaker consumer spending.
• Government spending is set to cool, especially as defense spending levels become unsustainable.
• State and local budgets are tightening, after years of strong contributions to growth.
• The housing market remains frozen, with affordability issues sidelining demand.

All of this is happening at a time when recession expectations had nearly vanished, and the Federal Reserve remains more concerned about inflation than employment.

The Fed’s Dilemma: Policy Uncertainty and Market Overreaction

While policy uncertainty on trade and fiscal matters is a headwind, the bigger issue is its impact on monetary policy: it keeps the Fed sidelined as growth cools.

The market reacts far faster than the Fed, meaning there is a window for markets to overreact before the Fed finally pivots. With neither Chair Powell nor President Trump showing much concern about slowing employment, it’s likely that growth will slow further before policy intervention kicks in.

A Silver Lining: A Potential Entry Point for Investors

Despite short-term risks, it’s not all doom and gloom. Any correction through the seasonally weak Q1 and early Q2 period may offer an attractive entry point for second-half gains.

As uncertainty fades, the Fed shifts to defending labor markets, and growth stabilizes, markets could see a rebound, even if at a more modest pace.