Wow, what a wild few weeks! Thank goodness the president has pivoted from simultaneous, punitive tariffs on every one of our trading partners to a more focused effort on China. The world can rally around more sustained tariffs on China as they have been exporting deflation everywhere for years and have been known to be a mercantilist trading partner.
Nonetheless, it looks likely the 10% across-the-board tariffs might stick post-negotiations, and the willingness and ability of both the president and the Chinese to dial back the egregiously high tariff levels that both have just implemented is very much an open question (but so far so good with the “temporary” exemptions for consumer electronics). Even if they are dialed back, the ending levels will more than likely be higher than at the beginning of the year.
Hopefully, the following analysis will turn out to be more of an academic exercise as we finish in a good place with fairer and freer trade in less than 90 days. In the meantime, I also hope this can provide a better understanding of why an unwind of globalization could be a body blow for mega cap multinational corporations relative to the U.S. economy (as discussed in the last strategy note) and more domestically oriented middle market corporations.
The Galactic Mean Reversion is back
I take zero pleasure in reintroducing the concept of the Galactic Mean Reversion, but the best way to explain the current tariff/trade war driven implosion of equity markets is that we are now going through the Galactic Mean Reversion Part II.
This is a term we first coined to describe the equity multiple compression1 and bear market of 2022 that took place while the economy—in terms of both real and nominal gross domestic product (GDP)—and labor market (as measured by unemployment and job openings to unemployed ratios) were red hot to scorching.
The key drivers of the massive pre-2022 outperformance of the S&P 500 relative to nominal GDP, real GDP and real wages (as shown in the following chart) were:
- Secularly declining interest rates, which lowered borrowing costs, permitted higher degrees of leverage and provided the intellectual justification for paying higher and higher prices for financial and real assets.
- Consistently well-above nominal GDP growth rates of money supply (M22) (particularly in the period post-Global Financial Crisis through 2021), which provided the excess liquidity to drive asset class valuations higher and higher.
- Globalization, which (along with lower taxes, greater productivity and lower borrowing costs) helped drive S&P 500 profit margins higher and higher.
Source: S&P 500, M2, real GDP, nominal GDP and corporate profits wages rebased to 1990. Federal Reserve, S&P Dow Jones Indices, U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, Macrobond FS Investments as of March 31, 2025.
Galactic Mean Reversion Part I was caused by rapidly rising interest rates and money supply growth turning into money supply contraction. And we know how that turned out, with the S&P 500’s forward price-to-earnings (P/E) going from 21.2X at the end of 2021 to 15.75X in October 2022.
From 2022 to today: Tariff/trade war implosion of equity markets
The Galactic Mean Reversion Part II is driven by a potential meaningful but hopefully only partial decline in corporate profit margins—particularly of U.S. multinational corporations—which were some of the biggest winners from globalization (international revenue growth and lower costs of goods sold).
Since 1990, the S&P 500 is up over 3,200%. S&P 500 corporate profit margins rose from around 5% to 12.6% most recently in Q4 last year, with about 30% of that gain driven by lower labor costs and more efficient supply chains aka globalization. (The other drivers were lower borrowing costs, lower tax rates and increased efficiency/productivity.)
This has helped drive S&P 500 corporate profit growth of around 950%, which is far in excess of U.S. nominal GDP growth of approximately 500%. (In contrast, U.S. real median wages are up only 20% … over 35 years!)
Who will lose out in this environment?
So, once again, we are where we are in the U.S. political evolution. Every rational market participant is rooting for a positive outcome that addresses the real or perceived wrongs of 31 years of hyper-globalization—from the North American Free Trade Agreement (NAFTA) onward—without equity markets cratering further and tariff implementation leaving a meaningful dent in the U.S. economy and labor market while simultaneously reaccelerating inflation.
However, it is pretty clear the biggest losers from the Galactic Mean Reversion Part II are some of the biggest winners from globalization: U.S. trading partners that replaced much of the historical U.S. manufacturing base and continued with mercantilist/protectionist policies (despite U.S. largesse and generosity), as well as U.S. multinational corporations that benefited not only from lower costs of goods sold, but also sales growth outside of the U.S. Even with the temporary reprieve for consumer electronics, if we end at 10%–20% tariff rate, that will be substantially higher than what was conceivable as recently as April 1 (pre-“Liberation Day”).
Remember, around 40% of S&P 500 sales/revenues come internationally, and in the case of mega cap tech names, the range is more like 40%–60%, so the unwinding of globalization could be fundamentally painful and not a market overreaction.
What it means for U.S. equities
When you look at the decline in U.S. equities since the recent sell-off began, it has not only been caused by multiple compression driven by uncertainty, but also by the real risk that earnings growth is much slower or flat this year, driven by margin compression3 and lower revenue growth.
Another way of looking at it is that equity multiples have dropped by only 15.3% from recent highs if you assume around 10.6% earnings growth this year, and only 5.3% if you assume no earnings growth this year. In contrast, from the end of 2021 through the October low of 2022, multiples compressed by 26%. So, yes, stocks are cheaper now than on January 1, but probably not cheap enough (19.6X 2025 earnings) to aggressively increase your equity exposure.
Thus, you need to be careful when considering legging into equities here. We have had some degree of multiple compression, but certainly not enough yet to consider stocks truly cheap for this new environment, and what we have seen so far is still less than we had in 2022.
That being said, there are certainly powerful “right tails” developing in markets now: A more aggressive rollback of the manmade problem of extremely high tariffs, the potential for substantial short covering by hedge funds and the high probability that if the Treasury market ceases to function, the Fed will be forced to step in (although things will probably have to get worse in order for that to happen).
It might take a while to undo the market damage from tariffs
Hopefully, we will soon resolve new trading regimes with most of our trade partners and strategic allies in a way that is a win for everyone. However, don’t count on this showing up in equity prices overnight since a tremendous amount of technical damage has been done and investor confidence has been badly shaken. These dislocations tend to take months and quarters to resolve as opposed to several weeks. Additionally, the growing gulf between the U.S. and China has probably now become an untraversable chasm. At this point, I won’t delve into the potential for the current trade war to increase the probability of China invading Taiwan, cause, hey, there are sufficient clear and present dangers to worry about for the time being.
Mega caps are likely to suffer
The pain of this period will mainly be felt by mega cap multinational corporations and their listed securities primarily due to their meaningful dependence on foreign revenue (typically around 40% of the S&P 500’s revenue comes from outside of the U.S.) and in many cases, non-U.S. sourced inputs/cost of goods sold (here’s looking at you Apple). Additionally, there are other pain points for external growth (see NVDA’s recent write-off).
In contrast, U.S. middle market private corporate entities generate 84% of their revenue from U.S. sales and entered this year at 10.5X enterprise value/EBITDA, which is well below where valuations were at the end of 2021 (around 17% cheaper) and much cheaper than the 17.5X EV/EBITDA at which the Russell 2000 entered the year.
Additionally, without further fiscal stimulus tacked on top of the Tax Cuts and Jobs Act extension, the recent confusion could cause lower economic growth, modestly higher inflation and sustained higher interest rates for longer, with recession risk meaningfully higher than it would have been otherwise—but this is far from catastrophic for the U.S. economy.
But the consumer is still strong
As a reminder, I have relisted some of the U.S. consumer and banking system metrics we wrote about in Q2 of last year to push back against some misguided commentary from pundits that the U.S. economy came into this period in a weakened state.
Au contraire, mes amis.
I have focused particularly on the consumer because a weaker consumer has been the narrative put forward by bearish commentators (it is hard to pick on business fixed investment excluding the tariff threat—given the fundamentals we discussed in earlier strategy notes).
The reality is generally that the consumer and banking system are in vastly better shape than prior to the Global Financial Crisis. Additionally, the consumer and banking data is materially better than at the end of 2022 (other than the rundown of excess savings of course, but it is called “excess” for a reason).
U.S. consumer and banking system metrics
| Q4 2007 | Q4 2022 | Q4 2024 | |
| U.S. consumer debt to GDP | 102.5% | 76.6% | 71.7% |
| U.S. consumer debt to DPI | 137.3% | 102.4% | 94.8% |
| Mortgage debt to DPI | 100.4% | 65% | 60.9% |
| Aggregate home mortgage LTV | 46.1% | 29.2% | 27.7% |
| U.S. consumer debt service ratio | 13.3% | 9.9% | 9.8% |
| U.S. banking tier I capital | 8.25% | 12.3% | 13.7% |
| U.S. banking system total reserves | $43.5B | $3,107B | $3,240B |
Yes, the lower income deciles of the consumer came into this trade war in slightly worse shape than in 2022–2024—mainly due to the decline or evaporation of excess savings—and the labor market is clearly weaker. However, relative to the past 30 years, the aggregate consumer came into this period in a strong position.
Additionally, (and maybe surprising to some, considering all of the headlines around regulatory relief for banks post-election and the Fed’s aggressive up until recently quantitative tightening4 program), both tier I capital5 and total reserves have increased from the end of 2022 as well, and total reserves have increased further this year.
Protecting capital when markets get ugly: Allocating to alternatives
We hope your past allocations to alternative strategies are helping to cushion the pain of recent equity declines. Everyone that took our advice and rotated out of U.S. listed small caps into middle market private equity probably has a big smile on their face and can demonstrate the value they add to their clients.
As we have always said, protecting capital when markets get ugly is one of the primary benefits of alternative investments, and if you can have a few strategies other than bonds that have generated positive returns so far this year, even better.
It will be interesting to look at the score card at the end of 2025, but I really like the chances of evergreen middle market private equity, clean vintage private credit and commercial real estate lending to post strong positive numbers in 2025 in a similar zip code to 2022. And I also like the chances for liquid multi-strategy funds to comfortably outperform equities—just like in 2022!
Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.
