Escalating Tensions

Markets reacted swiftly to President Trump's social media post that suggested he is considering a "massive increase" in the tariff rate on Chinese imports — a seeming counterattack against China’s rare earth export controls and the recent fees China is imposing on U.S. cargo ships docking at its ports. President Trump has characterized China's actions as “hostile,” and he is walking back plans to meet with President Xi at the APEC conference in South Korea in two weeks’ time. 

Although the market has been conditioned to interpret the president’s social media posts to be worse than their actual bite, escalating trade tensions have historically driven increases in market volatility, and we can see this distinctly in Friday's trading, as volatility increased nearly 30% during today’s session. For context, however, today's spike in the VIX — commonly known as the “fear and greed” index — to 20.95 pales in comparison to the early April tariff-tantrum level of 50.  

There is no progress to report on resolving the U.S. government shutdown, which entered day 10 this Friday — indeed, as of the time of this writing, the administration had reportedly commenced layoffs of federal employees on Friday afternoon.

Although there was discussion on changing the Senate filibuster rules to eliminate the need for the 60-vote threshold and effectively bring the majority vote to a close, Senate Majority Leader Thune expressed opposition. There were also negotiations reportedly taking place to find some middle ground on a possible constrained extension of the Affordable Care Act subsidies. However, there is nothing material to report on this front, and House Speaker Mike Johnson has confirmed that the House won’t be coming back until the Senate passes the continuing resolution. At the same time, the Senate has effectively vacated Washington D.C., putting enormous pressure on an important date — October 15 — which is when U.S. military members expect to receive their paychecks.

So far, markets have looked through the government shutdown, likely anticipating up to this point that passage of the continuing resolution is a question of “when” and not “if.” 

The minutes of the September Fed meeting were released this week. While the Fed did ease policy in September, lowering the fed funds rate by 25 basis points to 4.00% to 4.25%, the minutes reveal that a few participants indicated they would have supported keeping rates unchanged: Many participants expressed concerns about the trends in inflation, as well as the risk that inflation expectations could become unanchored if inflation were to resurge as a result of tariffs. It is clear that FOMC members' concerns about labor market conditions were increasing and that this risk took precedence over the upside risks to inflation. In terms of the forward view, the Fed remains data-dependent and is not on a preset path, with future policy heavily influenced by the evolving economic conditions as revealed by the official data.

Although some might have found this element of the discussion to be esoteric, the minutes also signaled vigilance around liquidity conditions as the Fed’s balance sheet continues to shrink. Since reaching a peak of nearly $9 trillion in 2022 from a pre-COVID low of $3.8 trillion, the Fed has significantly reduced its holdings of U.S. government debt to roughly $6.5 trillion and is on pace to bring this level down even more in 2026. A shrinking Fed balance sheet has a direct impact on bank reserves, which are anticipated to fall to roughly $2.8 trillion in Q1 2026, and this reduction in liquidity will require continued oversight to make sure it does not negatively impact money markets. Because the Fed has proved itself adept at managing similar transitions in the past, we don’t anticipate any problems going forward — but this risk was noted in the minutes as an area of focus.

As we sit at the beginning of the Q3 earnings season for the S&P 500, it is worth noting that fundamentals remain not only strong, but improving. Earnings expectations have continued to drift upward during the quarter, with estimates ticking higher over the past several months. At the start of Q3, Wall Street consensus was for roughly 7.3% growth in earnings year-over-year. Today, the forecast has risen to 8%, supported by solid revenue growth of nearly 6%.

Of course, much of the strength emanates from the largest stocks: The MAG7 (Amazon, Apple, Microsoft, Alphabet, Meta, NVIDIA and Tesla) have a collective earnings growth forecast of 9.5%, according to FactSet. Beyond Q3, earnings growth is expected to top 11% for these growth stocks versus 7% for the rest of the S&P 500.