A fork in the road: Why Washington has Wall Street nervous

Summary

• Until recently, investors were more focused on strong corporate earnings than the potentially negative market impacts of President Trump’s economic agenda.
• But increased tariffs have stoked market volatility and uncertainty about the Fed’s next move.
• Consumer confidence has fallen, triggering concerns about economic growth.
• Businesses are signaling uncertainty about trade and immigration but remain cautiously optimistic on 2025 earnings based on solid economic fundamentals and expectations for deregulation. 

It’s been a bumpy ride for investors so far in 2025.

Volatility has picked up as investor confidence has waned, according to Niladri “Neel” Mukherjee, chief investment officer of TIAA Wealth Management. Another big shift: Last year’s laggards have become this year’s winners. Stocks from the United Kingdom, Germany and other developed nations are outperforming stocks from the U.S. Also unlike last year, Large Cap Value is outperforming Large Cap Growth.

Writing in the March issue of the CIO Perspectives newsletter, Mukherjee notes that most asset classes remain expensive relative to their price history—a dynamic explored in TIAA Wealth Management’s 2025 Outlook. As of late February, the S&P 500’s average forward 12 months (FTM) price-to-earnings ratio (P/E)—forward P/Es measure how much investors are paying for a company’s next 12 months of earnings—was 22x versus a 10-year average of 18x and a long-term average of 16x (Figure 1).

“We’re at an interesting juncture,” Mukherjee writes. “Equity and credit markets are not discounting the potentially negative impacts of key components of President Trump’s agenda. Rather, markets are focused on current fundamentals, which remain sound, with an optimistic eye toward what deregulation and tax-cut extensions might mean for corporate earnings and consumer spending.”

There are signs, however, that investors are getting more worried about those potentially negative impacts. As Mukherjee wrote in another client note, new 25% tariffs on Canadian and Mexican imports “represent an unwelcome escalation that, unless rapidly defused, may lead to a damaging tit-for-tat, with ramifications that could be far-reaching for both the U.S. and global economies.”

If fundamentals stay solid, higher valuations can be supported, according to Mukherjee. However, risks have increased due to tariffs, China’s DeepSeek artificial intelligence (AI), and indications the Federal Reserve (Fed) could pause its interest rate cutting cycle while it assesses the impact of trade and immigration policies. 

As the environment continues to evolve, Mukherjee and his team are monitoring key issues:

1. Investors don’t know what to expect from Washington. President Trump’s policy sequencing and the severity of related impacts are critical to our investment outlook in 2025 and 2026. President Trump began his second term with a flurry of executive actions, many of which caught the world off guard. For instance, the threat and imposition of tariffs came quicker than many investors expected.

The global trade landscape remains in a state of flux. Though tariffs on Mexico and Canada have been delayed, the U.S. did increase tariffs on Chinese imports in mid-February, and tariffs on China and several European nations could go higher. This would be consistent with the administration’s “America First” trade policy, designed to reduce the trade deficit in goods, bolster national security, protect key technologies and bring home supply chains.

Ongoing punitive and retaliatory tariffs and tariff threats should support the U.S. dollar (USD). But they’re also likely to create more frequent bouts of market volatility and feed uncertainty about the Fed’s next actions. 

2. Inflation expectations are rising. Two-year and five-year breakeven inflation rates—a metric predicting future inflation in coming years—have risen in 2025. Consumer expectations for inflation are up too, likely due to tariffs. The University of Michigan Index of Consumer Sentiment for one-year inflation expectations rose to 4.3% in February, up from 3.3% in the prior month.

Five- to 10-year inflation expectations jumped to 3.5%—the highest since 1995. These expectations are likely to influence the Fed's decision-making process.

3. The Fed should remain in a “wait and watch” mode for now. Given its dual mandate of maintaining stable prices and maximum employment, the sooner-than-anticipated news around tariffs has put the Fed in a tough position. Tariffs can create downside risk to economic growth and upside risk to inflation.

Uncertainty surrounding tax cuts and government spending further complicates things for the Fed. Whatever the Fed decides to do next may be the toughest choice any Fed has faced in decades. That said, Chairman Jerome Powell’s Fed has shown an asymmetrical dovish bias.

Powell has been more accepting of higher inflation and less accepting of weaker growth. If we see more signs of labor market weakness in the near term—even if inflation stays in the 2.5% range—the Fed will likely tilt toward lowering interest rates, according to Mukherjee. 

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4. Corporate earnings remain solid. Mukherjee notes Q4 2024 earnings are better than expected, with 12% YoY growth for large cap equities. While businesses are signaling uncertainty about the path forward for trade and immigration, they have been buoyed by expectations for deregulation and have expressed cautious optimism about the outlook for revenue and earnings growth this year.

Another takeaway from earnings season: Any negative impact of DeepSeek on the investment plans of U.S. hyperscalers (large data centers providing cloud computing and data management services) appears minimal. Investments are expected to total $290 billion in 2025, up 35% YoY, according to Bank of America Global Research. It’s an indication capital expenditures related to the development and adoption of AI remain robust.

Looking ahead, Mukherjee believes the tension between healthy fundamentals and rising risks will likely keep investors cautiously optimistic but already high valuations may struggle to climb higher. “This,” he writes, “could translate to broader gains than in 2024, when mega cap tech stocks dominated the stock market. In this environment, the benefits of diversification across and within asset classes have become more evident.”

We’re here to help.

For more perspective on recent market volatility, read Tariffs Souring Sentiment  on Wall Street and Main Street. For more insights on the market and economy, and to discuss the implications for your investment portfolio and financial plan, please schedule a meeting with a TIAA advisor.