iCapital Market Pulse: The Path of Least Resistance is Still Higher, but with More Dispersion

The tug-of-war in the markets that was expected in January (link) has continued into February on the back of a flurry of tariff headlines – boosting both policy and trade uncertainty. Despite the increase in volatility, equities have gotten off to a good start. Indeed, the S&P 500 and Nasdaq 100 are both up by roughly 3% year-to-date (YTD)¹, as they have been supported by solid economic and earnings growth – something we expect to continue throughout the year.

With fundamentals on a solid footing, we believe the path of least resistance is still higher for equities. Investors will continue to face incremental headwinds throughout the year, but they are unlikely to be large enough to change the overall direction for equities.

While we believe equities will continue to trend higher this year, it will be important for investors to be selective, as we could see a greater dispersion in returns across stocks and sectors.

Indeed, given recent events (DeepSeek news and increased trade rhetoric), we think investors should continue to favor the AI theme, Trump 2.0 policy winners and companies with high U.S. domestic revenues and low imported cost-of-goods-sold (COGS) exposure, all of which are outperforming the S&P 500 on a YTD basis.

Strong economic data and earnings continue to support markets

As discussed in our 2025 outlook (link), we felt the economy was on solid underpinnings heading into the new year. Indeed, recent data shows that economic growth has remained solid. This was highlighted by the Institute for Supply Management (ISM) manufacturing PMI returning to an expansion (a reading > 50) for the first time since October 2022, and the new orders subcomponent rising to its highest level in three years.² Given new orders are a leading ISM component, this could point to further upside for manufacturing activity later this year.³

But it is not just the macro data, solid earnings growth has also supported equities YTD. Indeed, S&P 500 earnings have grown by 16.4% year-over-year (YoY), which is notably higher than expectations and the strongest growth reported since Q4 2021.⁴ The breadth of earnings growth is also quite strong as six sectors have reported double-digit growth, including financials, communication services, consumer discretionary, information technology, health care and utilities.⁵ This trend is expected to continue throughout the year as earnings are projected to grow by 8.7% in Q1, 10.2% in Q2, 14.5% in Q3 and 13.3% in Q4 as seen in Exhibit 1.⁶ This would bring full year earnings to $272.10 – (+13%) YoY.⁷

Incremental headwinds are unlikely to change the overall trend for markets

While strong fundamentals would suggest further upside to equity markets, there are incremental headwinds – tariffs and inflation – that markets will have to contend with over the coming months. While this could boost uncertainty, we do not believe these headwinds will change the overall direction of equity markets.

1. Tariffs. In three short weeks we have seen a substantial amount of tariff related rhetoric and headlines. Indeed, we have seen the most news headlines on tariffs going back to August 2019, as seen in Exhibit 2.⁸ Tariffs have also been a common theme this earnings season as 318 companies have mentioned tariffs in company earnings transcripts – the highest level since Q2 2018.⁹

However, while there is much focus on tariffs, we think the impact on the economy and earnings will be somewhat limited. Based on the additional 10% tariff placed on China, this will only shave 6bps off of GDP growth and boost core PCE by 14bps – assuming retaliatory tariffs from China.¹⁰ Similarly, if reciprocal tariffs are implemented, this could increase the effective tariff rate by 2 percentage points (pp), which would only add 20bps to core PCE.¹¹ Markets may be receptive to reciprocal tariffs, as they seem to be an alternative to the universal tariff that President Trump discussed on the campaign trail.¹²

The impact of tariffs on S&P 500 earnings would also be relatively limited. In fact, every 5pp increase in the U.S. tariff rate would only reduce S&P 500 earnings by 1-2%.¹³ If you also include the potential impact from a strong U.S. Dollar (USD), for every 10% increase in the trade weighted USD, this shaves an additional 2% off of S&P 500 earnings per share (EPS).¹⁴ With earnings expected to grow at 13% for 2025, the impact from tariffs may slow earnings growth but not derail it altogether.¹⁵

2. Inflation. There seems to be a sense of déjà vu as inflation has gotten off to another strong start in 2025 – seen with the latest CPI report and University of Michigan inflation expectations. While inflation readings ultimately cooled from the strong January readings in 2023 and 2024, the latest readings suggest progress on inflation has stalled. During Chair Powell’s semi-annual testimony to Congress, he noted this and stated the importance of “wanting to keep policy restrictive for now.”¹⁶ With the Fed likely on a prolonged pause, markets are only pricing in one rate cut for 2025.¹⁷ Given this, the upcoming March FOMC meeting will be an important event for markets as we will receive an updated summary of economic projections (SEP) and dot plot – providing a timely insight for how the Fed sees policy evolving for the rest of the year.

As yields approach the highs set in January (4.80% on the 10-year U.S. Treasury)¹⁸, yields are likely more reflective of current expectations for one rate cut this year and that is well aligned with the Fed’s current stance. As stated in our outlook, we expected that the 10-year U.S. Treasury (UST) yield would likely be rangebound in 2025.¹⁹ Therefore, with the 10-year UST yield near the high-end of the range, any disappointment from inflation data or economic data could result in lower yields and ultimately support equity markets.

The path of least resistance is still higher, but with more dispersion within equities

While these incremental headwinds may persist, solid fundamentals should support equity markets. But if trade rhetoric continues to increase over the coming months, there are a few ways we would navigate this environment.

1. Understand the full extent of the downside if tariffs are implemented as threatened.
2. Step in to buy if/when the downside has been sufficiently discounted.
3. Allow for the possibility of a positive deal/settlement and resolution.

So while the full extent of the downside may not be fully recognized just yet – more tariff announcements could come – even when incorporating the impact from the tariffs that have been implemented, the S&P 500 could still see double digit earnings growth in 2025. Coupled with the potential for positive announcements, like we saw with Mexico and Canada, this should also be supportive of equity markets.

However, the news flow and policy rhetoric could create an environment where we have a higher dispersion of returns within equity markets. We see this with some of our top investment ideas for 2025 which have outperformed the S&P 500 YTD. Indeed, AI software is up 18.2%, AI power is up 7%, financials are up 6% and onshoring beneficiaries and companies with high domestic sales are both up 4%.²⁰ Conversely, companies that are more exposed to tariff threats and inflation have lagged this year. Notably, companies that face tariff risks are down 1%, consumer tariff risk stocks are down 2.1% and companies that don’t have strong pricing power are flat on the year.²¹

Given this backdrop, we think it will be important for investors to be selective in 2025, and to favor secular trends such as AI (specifically in Software and Power), likely policy winners under a second Trump administration (onshoring beneficiaries and financials), and companies that have high domestic revenues and are somewhat isolated from any tariff threats (health care and real estate).

With the potential for higher volatility – the VIX is averaging 16.7 so far this year vs. 15.5 last year²² – investors should also be focused on their Alternatives allocations. We believe Alternatives should benefit from a higher volatility environment as they historically deliver lower volatility and better risk-adjusted returns. In addition, Alternatives, specifically private equity, venture capital and event driven hedge funds, should also benefit from a better capital market and exit environment. M&A and IPO activity is expected to rise throughout the year as indicated by our capital market activity barometer.²³

Higher dispersion within equity markets should also be supportive of hedge funds. Because they can go both long and short specific stocks, hedge fund opportunities typically increase in periods of high dispersion and low correlation, as seen in Exhibit 4. Increasing stock dispersion places an emphasis on security selection, which should enable funds to generate alpha relative to publicly traded indices. With secular trends seemingly set to continue and policy out of Washington D.C. uncertain, this should create distinct winners and losers, therefore correlations within the S&P 500 may remain low.

While we maintain our overall pro-risk view on equities, we acknowledge the importance of being selective in this environment and would use volatility and pullbacks to prioritize our top investment ideas, especially if they are under allocated in portfolios.