Asset Allocation Bi-Weekly – The Economy That Won't Die (6/16/25)

The economy and the stock market have been resilient in the face of soft looking economic data, a troubling bond market, and warnings by economists that a recession is drawing ever closer. Confluence Associate Market Strategist and certified business economist Thomas Wash joins Phil Adler to discuss why, so far, this is an economy that won't die.

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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).

Phil Adler: 00:04

Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report for 06/16/2025. I'm Phil Adler. The economy and the stock market have been resilient in the face of soft looking economic data, a troubling bond market, and warnings by economists that a recession is drawing ever closer. Confluence Associate Market Strategist and certified business economist Thomas Wash joins us today to discuss why so far this is an economy that won't die. Thomas, how would you describe the stock market's message so far amid all this recession gloom talk?

Thomas Wash: 00:43

Thank you for having me. You know, it it might feel a bit counterintuitive, but right now, the stock market seems pretty confident despite all the talk of a looming recession. It's almost like investors are betting that the current administration will step in and shield stocks from any major hits caused by this ongoing trade war. Think back to when those high tariffs were first proposed. There was a lot of worry that they'd act like outright embargoes, especially for countries involved in Indo Pacific trade.

Thomas Wash: 01:11

But since then, major economies have made some progress and negotiations, which have largely eased those concerns. It looks like these new trade deals could actually end up being a net positive for markets in the long run. What's more, the economic data we're seeing is backing up this confidence. Even though people might be feeling little gloomy, that weak sentiment hasn't translated into less household spending. And the labor market?

Thomas Wash: 01:35

It still appears to be tight with companies holding off on layoffs even as many of them are feeling the pinch of higher tariffs.

Phil Adler: 01:43

Well, it's true that many investors who sold stocks because of recession fears missed out on some pretty nice gains at the June. Are investors often better off ignoring economists' predictions?

Thomas Wash: 01:57

You know, the recent rally might lead us to assume that the worst is over. However, downturns are inherently unpredictable. It's not that economists are wrong because they don't know what they're talking about. Instead, when people get a heads up about a possible recession, they often take steps that actually soften the blow. Think about it.

Thomas Wash: 02:17

You know, a big part of the recession risk we faced was probably reduced because companies proactively stocked up on inventory before those tariffs kicked in. That gave them reserves to lean on while trade deals were being worked out. Now that said, if we completely ignore all recession warnings, we're basically increasing the chances of one actually happening. It's kind of like ignoring the expiration date on a carton of milk. You know, sure, sometimes you drink it past the date and it's totally fine.

Thomas Wash: 02:45

Feels like you got lucky, right? But that doesn't mean you should just stop checking those dates altogether. The longer you ignore them, the higher the chance you'll end up with spoiled milk, and ignoring recession calls are no different.

Phil Adler: 02:57

Thomas, we mentioned at the top soft looking economic data that seem to suggest troubles ahead. But you suggest that often headlines we pay a lot of attention to don't present the whole picture, and gross domestic product is an example. What have we missed by fixating on the latest headline number?

Thomas Wash: 03:17

Well, first, you're right. We've seen some soft looking economic data making headlines, which can definitely suggest some trouble ahead. Take that recent dip in consumer confidence, for instance. It was a pretty sharp drop, mostly because folks were worried about rising tariffs would jack up prices. Now a lot of analysts saw that as a big red flag, thinking consumers will pull back on spending as they anticipated higher import costs.

Thomas Wash: 03:40

We think that the drop in confidence was probably a signal of discomfort with a sudden shift in US trade policy rather than a permanent change in how consumers behave. In fact, if you look at the latest GDP report, it suggests that spending is already bouncing back. Though we are seeing consumers shift away from, you know, nonessential items as they get ready for the potential inflationary pressures, Still, it's worth noting that ongoing uncertainties in the job markets are still making people feel at least somewhat uneasy even with all this, progress that we've seen.

Phil Adler: 04:12

So as investors, we need to be aware that a weak looking number might not be a sign of fundamental economic weakness, but might only be a temporary distortion. What in your opinion may have caused a temporary distortion in the latest GDP report?

Thomas Wash: 04:29

Looking at the GDP breakdown, much of the recent decline was clearly driven by a surge in trade activity linked to chair front running. Outside of the pandemic period, the first quarter of the year saw the largest drag from imports in US history. However, this influx of imports also means firms now have ample inventory, reducing the need for near term restocking, which helps explain the sharp rebound in net trade seen in the latest trade data. Additionally, in q one, government spending contracted due to cuts from the Elon Musk led dose task force, though this factor is unlikely to persist for the rest of the year.

Phil Adler: 05:07

What are the areas of economic strength that underpin the GDP report?

Thomas Wash: 05:14

As previously noted, the household consumption remained a net positive for the economy with spending on services holding steady despite ongoing tariff uncertainty. However, the most substantial growth driver was investment spending, which not only bolstered economic expansion, but also played a pivotal role in preventing a more severe downturn. Now, much of this investment appears concentrated in technology driven sectors, with notable increases in equipment spending and construction activity, particularly in power infrastructure and related projects. We believe this surge is likely tied to AI related capacity building, a hypothesis supported by NVIDIA's outsized earnings growth during the same period.

Phil Adler: 05:56

So as long as spending holds up, we may avoid a recession, and spending on AI is a category we should watch closely.

Thomas Wash: 06:05

You know, in in short, yes. Both consumption and investment spending are critical for supporting economic stability, especially when other sectors face heightened volatility. As core components of GDP, they offer a clear gauge of The US economy's underlying strengths. What's especially noteworthy is the resilience of AI driven investment spending, which seems largely unaffected by shifts in trade policy. This suggests a structural rather than cyclical driver of growth, one that can sustain momentum even amid global trade uncertainties.

Phil Adler: 06:37

Now the Trump budget bill would ban AI regulation by the states. Is this something investors should pay a lot of attention to as the bill works its way through congress?

Thomas Wash: 06:48

More specifically, the legislation would establish a federal moratorium on new state level regulation that could hinder further AI investment. You know, this would be very good for tech companies looking to expand without having to worry about regulations disrupting their project. However, this particular provision deserves close attention as it would essentially prevent states from addressing the local impacts of AI infrastructure development. We're already seeing early pushback on the issue. During the Biden administration, he faced community complaints about data centers generating noise pollution and failing to deliver on promised employment benefits.

Phil Adler: 07:25

Another closely watched economic report we all pay attention to, Thomas, is the monthly labor report. And the latest one showed the economy added more jobs than anticipated in the month of May, and the unemployment rate remained steady at 4.2. What might we miss by focusing on these headline numbers?

Thomas Wash: 07:44

Well, at first glance, the headline numbers appear more positive than negative. Based on our methodology, maintaining a stable economy typically requires monthly job growth of around 120,000, which makes May's figure of 137,000 respectable, though not outstanding. However, one concerning trend is the persistent downward revision in reaching jobs data. For instance, the past two months saw a combined downward revision of 95,000 jobs, and there are some signs that the recent jobs report could also face downward revisions. As a result, we still believe that the outlook of the labor market may still be more bleak than the headline numbers may suggest.

Phil Adler: 08:24

We also mentioned a troubling bond market. The yield on the ten year treasury note is up sharply from the April as the bond market seems to focus on the likely expansion of US debt. The stock market has appeared to shrug its shoulders at this. Why?

Thomas Wash: 08:40

I wouldn't say markets are shrugging off the tariffs as treasury rates have largely remained consistent with preannouncement levels. Earlier rate declines were driven by recession fears, but we've seen a rebound as those concerns ease. That said, the growing supply of debt is a longer term issue, likely to weigh more heavily on highly leveraged firms with weak earnings. As for the stock market, the current rally has been concentrated in large cap and profitable companies. The reason, as we noted, is that size is increasingly seen as relative safe haven.

Thomas Wash: 09:12

Larger firms not only generate steady earnings, but also have more capacity to pay dividends, making them more resilient in uncertain times.

Phil Adler: 09:21

Confluence Investment Management, Thomas, is on record as anticipating a recessionary environment occurring sometime during the next three years. And to be prudent, Confluence has, in the latest quarter, reduced exposure to risk across all its portfolios. But anticipating a recessionary environment and planning for it is not quite the same thing as actually calling for a recession. Are we possibly overweighting the risk of rising inflation and unemployment in this new environment of tariffs?

Thomas Wash: 09:54

Phil, that is an excellent question. One that has generated significant discussion amongst committee members. Our decision to reduce exposure was driven primarily by heightened uncertainty, not just elevated recession risk at the time. As we've mentioned before, the original tariffs were so high that in some cases they could be considered outright embargoes. The murky macroeconomic outlook suggested we were overexposed to sharp swings in the market at the time, which prompted us to adopt a more conservative stance.

Thomas Wash: 10:23

Now with greater clarity on trade policy, we may consider adjusting our position accordingly.

Phil Adler: 10:30

What are key events coming up on the calendar that may tip the scales for the markets one way or another?

Thomas Wash: 10:37

You know, I believe that the tax bill will be a significant catalyst for markets as it should deliver additional economic stimulus, potentially extending the current expansion. Meanwhile, the next two months will serve as a critical test for the full impact of tariffs on the economy, which could manifest in higher inflation or rising unemployment. These factors will ultimately shape the trajectory of monetary policy. And lastly, the July 9 update on whether tariff escalates further could prove pivotal in determining market direction.

Phil Adler: 11:07

Broadly speaking, what investments appear most appealing in this environment?

Thomas Wash: 11:13

Well, in this current environment, we've seen that large cap stocks with strong quality attributes may offer the most compelling opportunities. Focusing on companies with robust earnings, low debt burden, and minimal foreign supply chain exposure could serve as an effective screening framework. From a long term perspective, the technology sector appears particularly promising as the federal government seems committed to ensuring US leadership in the AI race. This strategic focus could create significant tailwinds for the sector.

Phil Adler: 11:43

Thank you, Thomas. The title of this week's Confluence asset allocation report is the economy that won't die, and you can find a link to the written report on the web page, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Phil Adler: 12:08

Our audio engineer is Dane Stole. I'm Phil Adler.