Jessica Schmitt (00:04)
Welcome to Understanding Edge, where we explore the trends, challenges, and opportunities shaping the fixed income markets. I'm your host, Jessica Schmidt, director of Investment Communications, and today we're diving into the nuances of market volatility, tariffs, inflation, and their impact on consumers and investors. Joining us for this insightful conversation is Douglas Gimpel, senior portfolio specialist here at Diamond Hill, and the author of our monthly fixed income market commentaries that help break down these complex dynamics. Together. We're going to explore the shifting landscape of 2025 and discuss how investors can adapt their strategies to better manage risk and seize opportunities. Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights. So sit back, grab that cup of coffee or tea, and let's get started. Thank you for tuning in, and I hope you enjoy this conversation with Douglas.
Hey, Doug. Welcome back to the podcast.
Douglas Gimple (00:06)
Thanks, Jess as always for having me. It's always fun being here.
Jessica Schmitt (00:10)
Well, great. We're going to get a good update today on fixed income markets and what's going on in the macro environment, but to kick us off, can you walk us through some of the key factors that contributed to the market volatility that we saw in April, and maybe even more importantly now that it's the 20th of May, how things are looking today?
Douglas Gimple (00:33)
Yeah, yeah. Where to start really by now, we all know the impact of Liberation Day when President Trump announced tariffs across the board for anyone and everyone that is doing business with the United States, the resulting day-to-day fluctuations in the equity markets, the fixed income markets were reminiscent of the worst days of Covid and the financial crisis, but by the end of the month, we had a bit more clarity on the implementation of tariffs and the markets had kind of stabilized. Note that a bit more clarity is a relative term as we went from the most aggressive form of tariffs since the Smoot Hawley days in 1930 to a blanket sort of amnesty. As negotiations began, the s and p 500 was down more than 11% through the first week of April before rallying to finish the month near even rebounding with the announcement of the 90 day postponement of reciprocal tariffs.
But remember that the blanket 10% tariffs remain in place. The fixed income markets went on a rollercoaster ride in April with the two year pushing the yield pushing as high as nearly 4% during the month before ending at 3.6%. The 10 year treasury was pretty much unchanged during the month, starting at 4.21%, reaching as high as 4.5%, as well as low as 4% and finishing at 4.16%. So not a huge change there Spreads in the risk sectors of the fixed income market pushed out significantly before pulling back and stabilizing as the markets steadied into the end of the month as we've been talking about. So after spending much of 2024 in the early part of 2025, rallying spread sectors, experienced some what I would consider overdue widening in the early days of April before calming down and settling in at a slightly higher level than they were when they began the month.
And just as the markets had adjusted to this new reality of what appeared to be ever-changing tariffs, their potential impact on inflation and the labor market, Moody's finally joined s and p and Fitch and downgrading the US government debt to essentially AA Plus. As listeners will recall, s and p was the first reigning agency to move on US debt back in, it was August 5th, 2011 while Fitch downgraded on August 1st, 2023, Moody's is a bit late to the party as you can see, and their action simply served as a not so gentle reminder of the US' known deficit issues. As we've become acclimated to the knee-jerk reactions in the market, thanks to the April experience, it shouldn't come as a surprise that the treasury market sold off in the initial opening period after the announcement, but finish that trading day slightly lower in yield across the curve.
Jessica Schmitt (03:40)
Okay. Well, let's talk about some of those macroeconomic factors. With inflation being obviously one of the key ones, it's cooled off, but still certainly above the fed's long-term target. How do you see the Federal Reserve balancing this dual mandate of trying to control inflation and keep it low and reach that target while also supporting employment in the labor market?
Douglas Gimple (04:05)
This is a really challenging question, and the Fed has so far, I think been proven correct in its approach to managing the future path of interest rates. Patients and data dependency have been the keywords associated with the Fed recently, and despite the ongoing assault from the executive branch pushing the Fed to lower rates, Powell's most recent press conference focused on the surprise that was felt not just by the Fed, but also by the overall markets at how aggressive the initial tariff levels were. If we remove the angst and uncertainty tied to tariffs and we just examine the mandate of the Federal Reserve, we can see that there's a very challenging path ahead based on the current labor market and the status of inflation. I've heard it discussed a couple of different ways, kind of analogies. There's a fork in the road with inflation on one side and the labor market on the other, or you can think of a soccer goalie facing a penalty shot and having to decide which direction to jump based on the nuanced movements from the kicker.
Either way you look at it, there's a decision to make in the coming months and you're not going to have the full set of data to make the right decision. Essentially higher than targeted inflation is traditionally attacked by increasing rates in order to slow things down and bring inflation back in line with targets. The Federal Reserve's aggressive tightening campaign in 2022 is the most recent example of this approach. As we all know, the Fed funds rate was increased 425 basis points in 2022 and an additional a hundred basis points in 2023 to combat the covid induced runaway inflation. Another example would be kind of the late seventies, early eighties battles against rampant inflation by then, chairman Paul Volker. While inflation has cooled more recently, as you said, Jess last month's, data shows it's holding the line at 2.8%, well ahead of the 2% Fed targeted level.
Tariffs do have the potential to ramp up inflation with a vengeance, though the pace and extent of the impact are going to be up for debate for the next several months. We've already heard from Target and Walmart that price increases will be passed through to the consumer as these retail firms operate at pretty tight margins and they can't absorb the entirety of the impact of tariffs with uncertainty clouding the inflation outlook, the Fed remains on the sidelines ready to move if and when it is needed. On the labor market side of the equation, it's a bit of a different story. The labor market continues to show resilience averaging around 153,000 jobs added per month over the last 12 months with the unemployment rate holding this range of 3.9 to 4.2% range well below the historic average of 5.7% from 1948 to 2025. But the dual-edged sword of Doge staffing reductions and potential downsizing in anticipation of the impact of tariffs could lead to higher rates of unemployment in the coming months and a slowdown in the labor market. And historically, we can look to periods like the bursting of the.com bubble to the global financial crisis, to the Covid pandemic to see how the Federal Reserve reacts to increases in the unemployment rate. And while the labor market has held strong in the years since the worst of the Covid pandemic, a potential increase in the unemployment rate could rattle markets and force the Fed to choose between these two very different paths, raising rates in order to battle inflation or lowering rates in order to alleviate any potential strain in the labor markets.
Jessica Schmitt (08:01)
Do you have any information, Doug, from historical situations in which way they've leaned, have we seen this kind of environment before?
Douglas Gimple (08:10)
Well, I mean you could look at the seventies and the eighties and that time period, the stagflation, which is a word that's getting thrown around quite a bit more these days. I think that's a great example of what we could see. And as we all know, the Fed took a very aggressive approach and raised rates, which was incredibly unpopular at the time. Volcker was vilified, received death threats, but looking back now, he's a hero. He is kind of the man when it comes to fighting inflation and to taking the steps that are needed. And the question becomes is Powell, does he have that same type of stamina to do something like that? I think he does, but will he even get the chance to do so? His terms up in 2026, depending upon how things shake out, I would think he's got the ability to do it and the backing, but it remains to be seen. But yeah, I would say kind of that 70 eighties timeframe is something, obviously every situation is different, different nuances, but from a high level of inflation and a high level of unemployment, I think that's where people look the most.
Jessica Schmitt (09:26)
Another thing you had mentioned in your most recent monthly commentary, Doug Powell in his term, and the fact that the current US administration President Trump has made insinuations, or I don't know if you call them threats about removing him. What's the latest there and what's the potential for that?
Douglas Gimple (09:47)
That seems to have died down quite a bit. I mean, and in the commentary, I kind of pointed out that we had a pretty significant move when the president was quoted as saying, I can get rid of him whenever I want, which we know is not the case to, I think it was like maybe 10 days later, he said, oh, I never said I was going to get rid of him. He, he's fine. I don't like what he's doing, but he's got his job
And the market rallied. And so when we look at it legally, and I'm not a lawyer, but from what I've been reading, there are some precedents that are working their way through the courts right now that are tied to government positions and the president's ability to remove those people that could potentially serve as a precedent for attempting to remove Powell. But I don't think it gets that far. I think that the administration has seen how the market reacted to just the implication that Powell could be removed between the market reaction, the reaction from both sides of the aisle and the other members of the Fed. And really the bottom line is getting rid of one person doesn't really change anything. He's one vote and he's the guy that's doing the press conference. He's the guy that's out there, although I would argue that they're all giving speeches and whatnot, but removing one person, even if it's the head of the Fed, doesn't change the fact that they still vote.
So I think that has really died down, again, based on those things that I was talking about, the market reaction, both sides, the Democrats and the Republicans saying, no, we have to honor the independences of the Fed. That's how it's always been. And so I think that's definitely quite a down, but as we've seen, the president can have a bad day and just blame it all on Powell and start throwing out the idea that he wants to fire him again. I don't think that's going to happen. I think the lesson's kind of been learned with the market reaction.
Jessica Schmitt (11:46)
Okay. Let's circle back around to tariffs. Doug, you had mentioned obviously can be an emerging source of additional inflationary pressure. How significant is their current impact at the levels that they're at, which we know have been wildly up and down this year, and how could this potentially derail the Fed's progress on inflation?
Douglas Gimple (12:13)
It's really hard to accurately measure the full impact of tariffs. One, because we're still in the early days, and two, the entire process, as you pointed out, it's been kind of a moving target. Tariffs levied on China got as high as 145% before pulling back to 30%. There's been a trade deal reached with the United Kingdom, and it's going to take a while to see how that impacts the trade relationship. But the 10% tariff that was originally proposed remains in place. So as we know, tariffs can manifest in a couple of different ways. There's the tariffs on goods imported from outside the country that are used directly such as food items, think avocados from Mexico, and then there's the tariff on goods that are used in the production process such as components needed for medical equipment or automobiles. So the Federal Reserve Bank of San Francisco published a report titled The Effects of Tariffs on Inflation and Production Costs on May 19th, which is available on their website, and it's an attempt to quantify the potential impact of tariffs.
The report, I think, does a really nice job in breaking down the variables and their possible impact, but I'm not going to spend a bunch of time quoting their work and running through the details because we'd be here for hours. But their conclusion, which was delivered with quite a few caveats was an estimate that implies that if the tariffs are passed through to finished goods and across the board, tariff of 25% raises prices on goods used in. So again, those medical equipment parts, for example, would be 9.5% and it would be two point half percent for direct to consumer prices. So again, fruit or food coming in from out of the country, the biggest issue that we're facing is the uncertainty surrounding tariffs. There's the front and center issue of how things are going to shake out with China, but there's also the other multitude of countries that the US must now negotiate with in the hopes of coming to some kind of agreement. And remember, they only have 90 days in which to do that, they have to negotiate with a ton of countries in 90 days. So to clearly quantify the overall impact of tariffs with any kind of accuracy is a daunting and most likely impossible task. Since we don't have all the information and everything is so fluid, at the end of the day, any level of tariffs above and beyond where we were prior to liberation day is most likely going to be inflationary. We just don't know the severity or the length of that impact.
Jessica Schmitt (15:00)
Let's talk a little bit about that impact more to the consumers. We obviously all know supply chains were heavily disrupted during the Covid pandemic chasing down toilet paper at any store that you could find it at. And are we starting to see new challenges due to tariffs impacting the supply chains and what kind of shortages or disruptions could we potentially see on store shelves and how that's going to affect the consumer in the months ahead?
Douglas Gimple (15:31)
Yeah, who would've thought that we would all become supply and logistics experts in tracking down toilet paper and disinfectant wipes, which was the go-to, but this is one of the concerns on top of that inflationary impact, how are companies going to handle the increase in prices? We learned, as we were just talking about through covid, but also the grounding and people forget about this, the grounding of the container ship ever given that shut down the Suez Canal for six days. We learned how susceptible the global supply chain is to any kind of disruption. So on the heels of the 145% original retaliatory tariff directed at China and the subsequent Chinese response of 125% tariffs on US goods, we already had seen a drastic reduction in cargo shipments departing from Asia with some estimating of reduction in shipping at roughly 60%. And remember that shipping on a container vessel from one side of the Pacific to the other isn't something that happens quickly. Transit time for shipping via C freight can take anywhere from 30 to 40 days. This means that any disruption, the process can create significant issues for importers as the delays can cascade and create log jams. We all remember seeing the cargo ships parked outside the port of Los Angeles during Covid because they just couldn't get in.
As American companies look to refresh their inventories, they're going to be fewer and fewer goods arriving at the various ports of entry as Chinese exporters are dealing with those inflated costs to their goods. If we're faced once again with covid like shortages, the knock on effect could result in layoffs in key transportation industries like trucking, logistics and retail and ports are not designed for on, again, off again shifts in volume. They're designed for stable flows, and the timing for the tariffs really couldn't be worse as March and April are the months when suppliers begin to increase inventory for the second half of the year to fill orders for holidays and back to school shopping because of, again, that timing of getting things from one place to the other with the uncertainty surrounding the timing and final level of tariffs. Import is reliant on global trader are kind of frozen, and this could begin to manifest itself on store shelves and retail centers.
And I think where you're really going to see it are these small businesses, the Walmarts and the Targets, the Amazons, they can kind of weather through it somewhat, but it's these smaller companies that are reliant upon product built, made manufactured in China that they'd have to double the price that they're charging consumers. And so that's going to be a really telling sign to see how small businesses are holding up, but even, excuse me, even the most recently announced shift in the tariff stance between the United States and China, it may not be enough to present to prevent the disruption to the economy, though it could reduce the impact on Mother's Day. It was Mother's Day weekend. The toxin Geneva resulted in significant reduction to the initial tariff levels with the reciprocal tariff on China dropping to 20%. Though the 20% tariff imposed on China over its role in the fentanyl, trade remains in place.
So total tariffs levied against China now stand at 30% reciprocal tariffs levied by China on the US dropped from 125% on US goods down to 10%, and these levels will last for 90 days while negotiations between the two countries continue. But that's where the concern really comes into play. Will the market euphoria that we all felt in the wake of those reductions, is that going to hold now that we've been given this kind of 90 day reprieve? More importantly, what happens at that 90 day point if nothing has been agreed upon? Are we going to go back to 145 and 125% tariffs so that uncertainty remaining as this trade war could heat up once again is concerning, but there is this glimmer of hope that maybe the worst damage to the global economy has been prevented by kind of this stopgap measure.
Jessica Schmitt (20:06)
Well, certainly the outlook remains cloudy. What advice would you give Doug to investors to help them mitigate risks and even take advantage of opportunities in the current market environment?
Douglas Gimple (20:24)
That's one of the most challenging aspects tied to any disruption in the financial markets, not just what we went through in April, whether it was the regional bank crisis or global financial crisis, any crisis you can think of, experienced investors know that there's always something that's going to disrupt the markets, and it's usually the thing that you least expect. Tariffs are no different. We had an idea that they were coming, but no one expected the levels at which they would be issued the breadth and depth of them or the response from the rest of the global economy. From a broader standpoint, investors must adhere to this to a long-term time horizon and recognize that there are going to be periods of volatility and some of them are going to be quite painful, but in periods of market turmoil, I think rebalancing an asset allocation can be beneficial to your long-term goals and no matter what is happening in the markets and unwavering commitment to a philosophy and a process is key to that long-term success.
For the team here at Diamond Hill, that means focusing on individual securities, identifying potential risks and making sure that you're getting paid for that risk if you choose to invest. A long running comment that I really like, and I think it encompasses not only fixed income, but the overall financial markets as well, is that there are no bad bonds, there are just bad bond prices, and I didn't coin that. I've heard that many, many times, but I really like it. I think it sends a great message because yes, there are degrees of risk when investing in fixed income securities, but if you can invest in a bond at a price that rewards you for taking that risk, it can be a solid investment. A deep and thorough understanding of the underlying loans and structures is key to finding opportunities during periods like we're experiencing or like we did experience of market disruption. But the key takeaway for investors is don't focus on the day-to-day noise. Stay true to your investment philosophy and process, and hopefully in the long run you'll be rewarded.
Jessica Schmitt (22:36)
Okay, always good advice. Doug, that's all I have for you today. Thank you again so much for your insights and for joining us. It's always a pleasure to have you.
Douglas Gimple (22:47)
It is always a pleasure being here. I look forward to it every month.
Jessica Schmitt (22:51)
Great. Well, thanks again to our listeners as well. Doug and I will return in June for another podcast update as we close out the second quarter. In the meantime, you can visit our website@www.diamondhill.com to download Doug's full monthly commentary and access our other fixed income insights. Until next time, take care