***Q1 Client Update***

Following the election of Donald Trump to a second term, I broke with the vast majority of pundits and media when I had high conviction that 2025 would not be a repeat of 2017 where we saw animal spirits unleashed and markets soar. 2017 was all about the largest tax cut in history along with massive deregulation. Combined, that likely added hundreds of billions if not trillions into corporate coffers and individual balance sheets to stimulate an economy that didn’t really need a boost.

Without Congress extending the 2017 tax cuts in 2025, the country would face the largest tax increase in history. I knew that wasn’t going to happen, but I also knew that just an extension of business as usual would not have a stimulative effect on the economy. That would require a whole new round of tax cuts and I knew the will to add trillions more to the debt wasn’t there. Yes, eliminating taxes on tips and overtime was a popular campaign promise. However, even if it passed Congress, which I doubted, it would have little impact on the economy.

Without new sources of stimulus besides deregulation, I thought the economy would be okay but slowly weaken throughout the year as the cracks of subtle weakness had already appeared in Q4 2024. As such, I thought Q1 2025 would be more challenging for the financial markets and that a 10%+ correction lasting 7-9 weeks would be seen by the end of Q2.

With the new administration inaugurated in January, we saw some of the largest overnight changes in political history. Tariffs, deregulation, deportations, DOGE and the border became top priorities for Donald Trump and his minions. Deregulation is probably the least controversial of that group. By the end of Q1, there was little progress on that front although it seemed to be on the way. If the administration succeeds, less regulation will likely help reduce prices and juice the bottom lines of corporations which would stimulate the economy and stock market. With a softer Federal Trade Commission, deregulation should also unleash a wave of mergers and acquisitions, further helping stock prices.

That’s where the good news ends. Economically, mass deportations of those entry level hourly workers would likely create serious dislocations in the labor force, hurting companies who rely on less skilled labor. The new Department of Government Efficiency, DOGE, presents an interesting dilemma. On the one hand, reducing fraud and waste has been welcomed on a bipartisan basis since Ronald Reagan was president. On the other hand, firing tens or hundreds of thousands of government employees would increase the unemployment rate, slow the economy and reduce services in those departments.

The white elephant in the room is protectionist tariffs, the likes of which the U.S. has not seen since Smoot-Hawley in the 1930s. As you know from my writings and videos, I am firmly against tariffs, new and old. I think they are a horrible economic tool when implemented. No country can tariff or protect its way to prosperity. No country wins a trade war. Every country loses, just not to the same degree. And I like economic victories.

Rather than start a global trade war, I would first seek to make individual trade deals with our closest allies. Then I would strong arm the World Trade Organization, WTO, to forbid tariffs for all members. Why should India (picking on them for no reason here) be able to put a 70% tariff on U.S. imported autos? Or Canada having a 100%+ tariff on imported milk from the U.S.? I am sure a number of people would push back that in the case of “national security”, there should be exemptions. That’s something to be negotiated, but it also seems too easy to circumvent.

The longer a global trade war goes on, the more economic damage is done with recession risk rising. Corporations and consumers will eventually adapt and adjust. Global supply chains will eventually come back to home countries and labor will no longer flow to where it’s treated worst. While consumers will initially celebrate buying more goods that are produced at home, that theme will get old sooner than later as prices potentially rise until demand is eventually destroyed.

Elsewhere in Q1, the war in Ukraine became headlines again with President Trump promising to forge peace between Russia and Ukraine. While there would be celebration if and when the war ends, I do not believe it would be much of a market-moving or economic event. Similarly, the war in Gaza continued after a multi-week ceasefire brought some hostages home and temporary aid to the Palestinians. Geopolitics in the Middle East are the most complex anywhere on earth. A long-term solution is highly unlikely.

As I wrote about in Q4 and during Q1, tariffs or not, I fully expected the U.S. economy to weaken in 2025. However, I did not envision a negative quarter of GDP growth in Q1. The Atlanta Fed’s Now Cast had been showing a down 2-3% quarter for several months. I wonder if this period will look something like 2022 where we saw two straight quarters of negative GDP growth without triggering a recession.

Data pointed to economic weakness in 2024. However, the threat of tariffs along with the on again, off again plan has done more damage to the psyche of consumers and corporations alike. Economic data from Q1 pointed to a loss of confidence and future concerns rather than actual behavioral changes which is fascinating. Consumers became worried and surveys plummeted, but actual spending habits did not change, at least not yet. Corporations were able to hide behind tariffs and will continue to do so when earnings and forward guidance isn’t strong. Additionally, companies are also suspending future guidance because tariffs supposedly remove visibility. I think it’s mostly nonsense and another way to hide from weakening earnings.

The Federal Open Market Committee (FOMC) is late, yet again. Recall, I strongly criticized Jay Powell & Company five years ago for not reigning in the tsunami of money they were flooding in the system in 2020. They were more than a year late in raising rates. And after a quick cutting cycle last year, the Fed should have reduced rates by ¼% in March. Instead, they hid behind an enemy that doesn’t exist anymore, inflation. As Q1 ended, the Fed was 1/2 -3/4% behind the curve and they will be in catch up mode, once again, in Q2 and Q3. To the Fed’s credit, they continued to sell assets from their still bloated balance sheet although at a slower pace. I have previously implored them to reduce their balance sheet to at least $4 trillion, the size pre-COVID.

The financial markets had a good half quarter in Q1. All was well though mid-February, even with the threat of tariffs, until Wal-Mart warned of a strapped consumer, something you rarely hear from Wal-Mart. That’s when the growth scare became our operating thesis and stocks fell 9%. Nike and FedEx followed suit later in the quarter, which helped Q1 end solidly in the red for the major stock market indices.

With a struggling stock market, bonds provided some ballast as the textbooks teach us. That theory lost much credibility in 2022 when stocks declined by 20-30% and bonds fell 50% more than their worst year prior to that. However, bonds did their job and finished in the black by 2%. Gold was already rallying when Wal-Mart warned and that scare put the gold bulls into overdrive, soaring straight to the end of the quarter. On the flip side, energy prices remained in their trading range after falling sharply in 2024.

The ultimate risk asset, Bitcoin and other cryptocurrencies, fell more than 10% in Q1, further solidifying my position that these highfliers are not a hedge against inflation, weakening growth nor Fiat (paper) currencies. Rather, they are a levered instrument to seek outsized gains during periods of strong “risk on” assets. That’s their strength. Believing that the crypto space provides ballast against stock market declines is about as accurate as gold providing a hedge against inflation. It does not.

At this point in the report, I usually write about my barbell strategy for investing. If you picture a barbell from the gym, there is a long, thin bar with big weights on both ends. Think of those weights as our conservative strategies and aggressive ones, the exact proportions do not matter yet. In theory, your money would have higher weights to conservative and aggressive strategies, especially if you are in or very close to retirement, and lower allocations to the middle of the road strategies.

This barbell approach has also worked very well with monies being transferred in from 401K and 403b plans as those pre-packaged plans rely heavily on bonds for the more conservative approach and do not account for interest rates rising. Additionally, their aggressive choices do not usually reward the risk taken. If you would like to learn more about the barbell approach, we can set up a meeting, call, or Zoom.

Q2 should be more sanguine for tariffs. Markets expect a slew of positive news on a country by country basis, leading up to a one on one trade war with just China. Should Donald Trump revert back to the $660 billion plan which represents about 2% of GDP, I would expect another period of crankiness in the markets, but not nearly to the level we have already seen. If you want to watch one non-market indicator to help you determine where the country stands with tariffs, just watch which person from the administration gets paraded out in the media. In short, Scott Bessent is very bullish for the markets. Peter Navarro is bearish for the markets. It’s that simple. At some point I do expect Navarro to be shown the door, especially if there is another tariff-led plunge later in Q2. Finally on this topic, I do believe we will wake up one day to negative tariff news. And the stock market rallies. That will mean the markets have fully priced in tariffs and have moved on to another issue.

Assuming the worst is behind us with tariffs, I expect the extension of 2017 tax cuts and deregulation to be major topics in Q2. Both would be bullish for the markets if and when they happen. The latter will definitely take place, but in what form? As I have said many times, Extending tax cuts in not stimulative to the markets nor economy. It’s status quo. Not extending them would result in the single largest tax increase in history. 2017’s market and economic boom were because hundreds of billions, if not trillions of dollars, would be in consumers’ and companies’ pockets. In 2025, the only way to juice the markets and economy would be band new tax cuts and other programs, like accelerating write offs for domestic capital expenditures. Deregulation could be the big stimulative card and corporate deals could skyrocket.

Q2 should also see volatility abate as the quarter moves on. I would be surprised if the stock market goes straight back to new highs. Rather, after the initial strong bounce in April, there should be backing and filling, lots of ups and downs before the market is ready for a more sustained rally. In other words, buying weakness should begin to be rewarded again. 80% of our research suggests a 20%+ rally over the coming 9-12 months leading to fresh, all-time highs.

And let’s not forget what I discussed three months ago. Year three in bull markets often see heightened volatility, a 10%+ decline and more modest returns which were in my forecast by July 4th. My studies suggested that 17% downside was the worst case. Unless the jobs market weakens significantly, the markets should be okay on balance for a while.

The bond market should benefit from slower and weaker growth as the Fed finally comes to their senses and cuts rates again. That should also keep gold as an in demand asset class for investors, not to mention global central banks like China’s who have been rumored to have bought massive amounts the past year. Some may wonder why central banks buy billions in gold. From my seat there are only two reasons, economic or military war. I think both apply to China as we already know they have curtailed their purchase of U.S. Treasuries and have supposedly sold in the secondary market to prevent the U.S. from using sanctions on their money like we did with Russia.

China is in a terrible, losing and weak position. I believe the country looks similar to Japan in the early 1990s after their initial real estate bubble imploded. Both countries have government imposed negative birth rates. Both countries severely restrict immigration. Both countries have upside down demographics. And both countries have massive amounts of vacant real estate without demand. Japan lost three decades before righting their economy. China may end up with a similar scenario.

Finally, please remember some of the opportunities at hand. We will do our best to harvest tax losses in taxable accounts. If you have IRAs, you should strongly consider ROTH conversions with the goal of having as much as possible in ROTHs during retirement. ROTHs are the single best account structure ever invented and far too few people take advantage of them. And I equally love ROTH 401Ks for your employer sponsored plan, especially for folks under the age of 50.

I know a number of CPAs who simply do not understand the power of the ROTH and instead focus on the one consequence, that being the income taxes owed the following April. The CPAs are wrong. Lastly, updating your retirement projections is an invaluable tool, especially during periods of market weakness. Remember, we account for 10% declines, 20% declines and multi-year bear markets in our projections. Stock market declines reinforce our projection process. It is those projections that matter most over the long-term, not the day to day market volatility which causes discomfort to so many investors.

Please continue to share your feedback, positive and negative. Investing is a marathon not a sprint and the long-term future continues to look very, very bright. We look forward to sharing that with you over the coming years. And I am always interested in meeting, whether it is to create or update retirement projections on your financial situation, review the strategies in your portfolio, run social security analysis’ on when and how to file for the best benefit, discuss your estate or even smaller transactional-type issues like securing a mortgage or weighing insurance. Again, here is the link to my calendar to schedule a meeting in the office, call, Zoom meeting. https://schedulewithpaul.as.me/

Thank you for the privilege of serving as your investment adviser!

Sincerely,

Heritage Capital, LLC

Paul Schatz AIF®
President

According to SEC and state regulations Heritage Capital, LLC will deliver Form ADV Part 2 to all clients within 60 days of its annual amendment filing date. Here is the link to our disclosure documents including our privacy policy as well as our ADV Part 2A & 2B. Additionally, we may engage unaffiliated investment advisers as sub advisers to assist us with management of client assets. Our services under the investment advisory contract do include financial planning. https://investfortomorrow.com/disclosures/

Past performance may not be indicative of future results. The above individual account performance information reflects the reinvestment of dividends, and is net of applicable transaction fees, Heritage Capital’s investment management fee (if debited directly from the account), and any other related account expenses. Account information has been compiled solely by Heritage Capital, has not been independently verified, and does not reflect the impact of taxes on non-qualified accounts. In preparing this report, Heritage Capital has relied upon information provided by the account custodian. Please refer to formal tax documents received from the account custodian for cost basis and tax reporting purposes. Please remember to contact Heritage Capital, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you want to impose, add, or modify any reasonable restrictions to our investment advisory services or to add a Trusted Contact to your accounts. Please Note: Unless you advise, in writing, to the contrary, we will assume that there are no restrictions on our services, other than to manage the account in accordance with your designated investment objective. Please Also Note: Please compare this statement with account statements received from the account custodian. The account custodian does not verify the accuracy of the advisory fee calculation. A copy of our current written disclosure statement discussing our advisory services and fees continues to remain available upon request.