The Supreme Court Is More Diversified than the S&P

History 101

Soundbite: Of course, every day the world makes history, but the past few months have been distinctly historic. Mark Carney’s Davos declaration that Canada and other “middle countries” must forge new networks in response to the bipolar world of the U.S. and China could be the start of the new world order. Friday’s Supreme Court decision could also mark a historic reclamation of the Legislative Branch’s power. The conservative Justices splintered across non-ideological lines that could influence coming cases of historic import involving presidential authority. It was a victory for the rule of law. Those expecting bearish stock behavior after tariffs were overturned must consider the bullish undertones for foreign capital that left due to concerns over unchecked presidential power.

The markets will enjoy five months of stable tariff policy, but that is too short a runway to confidently make decisions on employment or capital outlays. Understandably, there is concern about an adverse bond market reaction, but even a 40% reduction in tariff revenue from last year represents only a $50 billion shortfall compared to a $1.8 trillion budget deficit, so on the margin, it is far from cataclysmic. We would only expect another extended leg down if the 10-year yield rises toward 4.30%, but so far there has been zero movement in yields. 

We have discussed the need for more uniform tariffs as a necessary step. Because the administration is contemplating the maximum 15% of Section 122 tariffs, we will operate under a uniform global tax rather than 2025’s uneven patchwork of tariffs. Even with exception clauses, it represents a stable framework, allowing companies to plan strategically. If permanent, this is a positive occurrence that would eventually lower risk premia in the markets. Unfortunately, Section 122 tariffs have a shelf life of five months, requiring Congressional approval (what a concept) for extension. With two-thirds of voters against tariffs, it is unlikely Congress grants such approval. That should force the administration to turn to Section 301 or Section 232 to levy tariffs in July. Applying those tariffs requires declarations of unfair trade practices or threats to national security. If that unfolds, it lands us back to square one with country-specific, whimsical tariff declarations, denying the Fed and corporations the visibility they need to make long-term strategic decisions.

On a larger scale, the Supreme Court’s decision could have deeper implications moving forward. The split among conservatives was based on the “major questions doctrine” where Congress must explicitly give the president authority to unilaterally exercise executive power. The conservatives who voted in favor of President Trump’s tariff policy did so because they believe any presidential decision involving foreign affairs does not require Congress to grant clear statutory authority.

Equity markets ignored the tariff news Friday, assuming the administration would direct the Treasury to implement another method to substitute for the now invalidated IEEPA levies. Section 122 tariffs are estimated to generate roughly two-thirds of the revenue (assuming they continue all year) compared to 2025 levels. Last year’s tariff haul improved the $1.8 trillion budget deficit by only 7%, while Section 122 would represent a 4% reduction. The $50 billion shortfall is insignificant relative to the massive Federal Deficit, so we do not expect bonds to react dramatically.

Anecdotally, the topic of reimbursing tariffs imposed on foreign exporters could put our government in a bind, given the argument that exporters shouldered the entirety of the tariffs. A recent NY Fed survey, corroborated independently by a German economic institute, showed only 10 percent of the tariffs were absorbed by foreign companies, with the brunt taken by U.S. firms (and passthroughs to consumers gradually rising). Major exporters such as Toyota and Alcoa have sued the government, so it will be interesting to see whether Washington backtracks on the president’s and Fed Governor Stephen Miran’s insistence that exporters shoulder the entire tariff burden. 

Blue’s Clues

Soundbite: Blue Owl Capital, the private lender, restricted redemptions in one of its retail funds, evoking yet more concern about private credit. Stocks of Nondepository Financial Institutions such as Apollo, KKR, Blackstone, and Ares were hit hard, along with Blue Owl. We have been discussing the deteriorating foundations in private equity and credit, with these companies propping up defaulting portfolio companies by repeatedly abusing exceptional earnings adjustments, creating even more leverage through Payment-in-Kind extensions, and shrinking original collateral pools to bring in new secured lending.

The fact that private credit investments are causing retail investors to lose money while they are already suffering from Crypto investments could mean further dampening of consumer spending and deeper distrust of Wall Street. However, the real story lies underneath. Blue Owl, whose loan portfolio is 70% software, was able to sell $1.4 billion loans at 99.7 cents on the dollar. This is quite a vote of confidence. Despite this seemingly positive news, the excessively pessimistic stock reaction coincides with news that Google searches for “Bitcoin going to zero” have spiked to record levels. We could be witnessing a short-term contrarian buy signal, despite it being negative for consumer confidence.

Blue Owl allowed investors access to purchase private credit instruments previously restricted to the wealthy. The private credit industry’s recent problems do raise the thought that market participants are whistling past the graveyard. We share the anxiety that private credit has yet to encounter an extended period of economic stress. When default rates begin to accelerate to a level that causes corporate borrowing rates to rise, then a liquidity crisis will naturally follow. At that point, private credit instruments will encounter swift and dramatic discounts, causing widespread losses that will cascade into commercial bank write-downs.

However, the degree of liquidity in the financial system showed up in all its glory last week, with institutional players happily buying Blue Owl paper effectively at face value. We will be watching the IGV/SPY Software ETF relative to the S&P 500 index to see whether we are approaching a (temporary) bottom in the software selloff.

Everything Everywhere All at Once

Soundbite: There are regular phases to investment themes that drive sector rotation. Sector leadership changes as the economy moves from a rebound out of recession (deep cyclicals such as materials stocks) to mid-cycle recovery (energy, industrials) to late in the growth cycle (defensives such as consumer staples). However, we are undergoing an unusual leadership congestion: industrials are soaring along with energy, but materials and consumer staples are also leading. We believe this unfamiliar investing environment supports our view that this new phase in our geopolitical evolution demands a shift from simplistic investment approaches to an adaptive process. The markets are truly undergoing a discovery process, and this plays to Pave’s strengths.

The fact that capital is flowing to small caps, which normally signals an early cycle recovery, is confusing when there is parallel outperformance in defensives. This is happening as Pave’s models identify a contradiction in favoring economically sensitive stocks against a backdrop of higher risk scores. Risk normally plummets in our model as we move into an economic recovery. This multidimensional factor adjustment needs to be measured in detail before risk-adjusted portfolios can be constructed. When markets are influenced by various factors, diversification is the answer, but passive indexing is not the solution right now because the indices are top-heavy. The answer lies in deliberately calibrated risk scores that are updated on a timely basis to capture quick changes. Diversification is required. However, the wide array of sectors currently outperforming is certain to change, and it is questionable whether hiding in the indices, given their current sector composition, is the most prudent path.

Saying investors are facing crosscurrents in a highly uncertain environment is a massive understatement. There is no doubt the world is on the doorstep of massive change, aside from the opaque and uneven impact that AI represents. Our models are currently balancing across several dimensions and seeking lower-valuation foreign markets that have good growth prospects. The Pave models are also built to assemble portfolios of U.S. stocks that move in alignment with these more attractive markets. As the economic environment shifts toward adversity or a growth burst, the rankings will shift organically and reposition portfolios.

Sector diversification will drive outperformance, but it must be controlled by a very deliberate and robust process. The depth of nuance required of fiduciaries going forward is unprecedented in the forty years we have been navigating markets, and simplistic diversification will fall short.

What to Look for This Week

(All times E.S.T.)

1. Friday, February 27 at 8:30 a.m. Producers Price Index for January. Key number with PCE coming in on the high side in December. Core PPI was compressed at 2.9% in August through October (there was an October PPI, unlike CPI) and November rose to 3.1% and unexpectedly hit an annual 3.3% inflation rate, above a 2.9% consensus. That represented the biggest increase in core producer prices since July.
2. Friday, February 27 at 8:30 a.m. Canadian Q4 GDP. Q3 rose 2.6%, after a -1.8% annualized GDP for Q2, and the consensus is for zero growth to have occurred last quarter. If it is negative for the second time in three quarters, it is a problem: despite the rupture that has occurred between the U.S. and Canada, their economies tend to track one another in a broad sense. In Q3, imports contracted 8.6% while exports rose 0.7%. Also, investment surged 2.3%, mostly in residential structures (6.7%). Government investment also soared 12.2% while household spending declined 0.4%. Our focus is on exports and government investment.
3. Wednesday, February 25 at 9:00 a.m. Mortgage Bankers Association MBA Purchase Index for February 20. The index made a three-year high in January and then fell back to the lowest levels over the past year. Mortgage rates fell from over 7.00% in January 2025 to 6.10% last week and are currently at 6.01%, so if there is no pickup in the Purchase Index, it is concerning.

FOMC Voters Speaking: Tuesday, February 24 at 10:15 a.m. Fed Governor Christopher Waller speaks, followed by Governor Lisa Cook at 10:30 a.m. Waller dissented at the January FOMC, and has a bias toward easing on his concern over weaker unemployment. Thursday, February 26 at 10:00 a.m. Vice Chair of Supervision Michelle Bowman speaks. Several FOMC nonvoting participants speak this week, and we will see if a common theme arises.

Earnings: A busier week upcoming, with the crown jewel being Wednesday, February 25 after market with NVIDIA (NVDA). Before market on Thursday, February 26, we will look at Toronto-Dominion Bank (TD) and Royal Bank of Canada (RY) to see if they are seeing loan demand fall off due to the tariffs. Canada has been mostly spared thanks to tariff exceptions on areas such as energy, but any slowdown signs would be significant. After market Thursday, Rocket Companies (RKT) reports, and may shed light on the Nonbank Mortgage Servicers market. Software makers Intuit (INTU) and Autodesk (ADSK) also report after market and may comment on AI-disintermediation in software. Earlier in the week, on Tuesday, February 24, Home Depot (HD) will discuss consumer spending before market.

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By Peter Corey

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