GDP = C + I + G + (X – M).

The above equation provides one way to conceptualize economic activity for a country. It makes the relationship between Consumption (C), Investment (I), Government spending (G), and the difference between exports and imports (X-M). Simple in form. Impossibly complex in function.

For decades, the U.S. economy advanced on a set of shared assumptions: cheap goods from abroad, stable institutions at home, and a government that could run persistent deficits without anyone raising too many concerns. Then came the new administration — and with it, a growing sense that none of those assumptions are sustainable anymore.

And as we have experienced over the past three months, they’re not thinking surgically — they’re going straight for the shock paddles. Each part of the economic system is being jolted: not because it’s entirely failed, but because they fear that without intervention, it soon might. Secretary of the Treasury Bessent recently called this moment one of “strategic uncertainty” — a phrase that captures the strange tension of bold action under fragile confidence.

What’s striking isn’t just the presence of significant change — it’s the simultaneity of it. Each element of the GDP equation is being pulled into the reform agenda.

A quick aside. We will spare you all any political opinions we may have, as they are meaningless when it comes to investing. Instead, we want to discuss the various puzzle pieces that we see in our attempt to see the larger picture. We should note that this discussion will not result in a change to our investment directions. Our investment process continues to be built on time-tested empirical studies that measure investor behavior and risk tolerance within the global investment ecosystem. Attempting to develop an economic forecast when there is so much uncertainty is unproductive and, in this case, manic.

Upon the changing landscape, two questions come to mind: 1) Why the urgency around government spending, and 2) Why the need to forcefully restructure trade? It appears that those two questions are at the root of many of the policies being enacted.

The answers to those questions may substantiate the need for such drastic adjustments. The answer to the first question revolves around a material change in deficit spending over the past decade. As the Deutsche Bank chart below shows, the U.S. has been running an extremely large deficit, even as the economy continues to chug along at a steady pace. The possibility is that the country may enter a precarious situation, which has led other countries to experience economic shocks as they approach a debt-to-GDP ratio of 150%. Is the U.S. comparable to those other countries that hit that turbulence? No, but do we want to test it?

The answer to the second question appears to be the growing concern amongst both political parties that the U.S. needs to reduce its dependence on China. The new administration has added color to this discussion, believing that the era of the globe having a single global power is over, and we are back to a multipolar global environment. With the fall of the USSR, the world saw the U.S. fill the vacuum. Over the past two decades, China has grown to a size comparable to that of the U.S. in terms of economic strength and global reach. Right or wrong, the new administration sees a need to adjust decades-long policies to a new reality.

As stated earlier, the path being chosen touches and tests every component of the equation. Although the U.S. consumer is in strong shape, consumption is entering uncertain territory. For years, Americans have benefited from a global trade system that prioritized cost efficiency, even if it meant geopolitical dependency. It led to two decades of pricing disinflation. That changed somewhat under the prior administration as concerns about global warming led some to shift from the focus on faster, better, and cheaper to faster, better, cheaper, and less harmful. The new administration wants to refocus attention on faster, better, cheaper, and more strategic solutions. With the drive for new tariffs and supply chain reshuffling now on the table, it isn’t easy to imagine an environment where goods pricing does not need to adjust to a higher norm. That may serve strategic goals, but it also tests the limits of consumer tolerance in a system that has long relied on abundance at low cost.

Investment plans are also undergoing significant realignment. New policies and trade negotiations are driving new investments into the U.S. for sectors such as semiconductors, artificial intelligence infrastructure, and domestic energy production — areas viewed as essential not just for growth, but also for sovereignty. This is likely to have a positive impact, although there is uncertainty surrounding the timeframe. For example, we recently read “Apple in China” by Patrick McGee, which highlights the impact that corporate investment can have on a country. He highlights that Apple’s move to China for manufacturing at the turn of the century resulted in Apple training over 28 million Chinese in leading-edge manufacturing practices. Interestingly, he draws an analogy to the Marshall Plan following World War II, which helped rebuild Europe. Using that as a measuring stick, Apple’s investment in China was equivalent to the size of two Marshall Plans focused entirely on one country.

Government spending is undergoing philosophical triage. The deficit is growing, the national debt is flashing warning lights, and the last of the major credit agencies just downgraded U.S. sovereign debt from AAA. So, while the dollar remains dominant for now, there’s less breathing room than there used to be, especially if pundits are correct about the fear of China’s growing global footprint. Few will question the inefficiency in federal programs, but the current actions are likely to lead to the cutting of muscle, not just fat. With government spending accounting for around a third of the economy (larger for specific sectors), a significant adjustment in spending will likely have ripple effects for some time as public and private institutions adjust to a new environment.

And then there’s trade — the (X–M) term that used to live quietly at the end of the equation but is now center stage. Reshoring and “friend-shoring” have replaced globalization as policy priorities. The U.S.-China relationship has shifted from pragmatic interdependence to strategic decoupling. The “Red Curtain” that seems to be rising now is more complicated than the Iron Curtain ever was: it’s not just ideology, it’s supply chains, pricing power, capital flows, and trust.

As engineers, we understand that every equation comes with error bars for each component, which help to frame the potential variation in calculations. Those have grown over the year, suggesting that we are in a period of greater uncertainty. The economy isn’t falling apart, but it is being reassembled while it continues to operate. Markets, naturally, are struggling to translate intent into likely outcomes. Earnings forecasts for 2025 came down in the early part of the year but have remained surprisingly firm, high single digits for the S&P 500 — but there’s a growing sense that conviction in any direction could be dangerous. Forecasting in an environment where the inputs are still shifting is like trying to steer with a compass during a magnetic storm.

In moments like these, it’s easy to mistake uncertainty for collapse. But there’s another reading, too — one rooted in generational cycles. The Fourth Turning, by Strauss and Howe, describes a recurring pattern of societal reset, in which old institutions falter and new norms are forged under pressure. These periods are messy, but they are also necessary. Reform doesn’t happen in spring. It starts in winter, when the ground is frozen, and the future looks hard.

There’s no guarantee that the current policy direction will succeed. Still, the underlying goals — rebuilding institutional credibility, reshaping critical dependencies, and revitalizing productive capacity — respond to concerns that are broadly acknowledged, even if the strategies provoke debate. This isn’t about choosing optimism or pessimism. It’s about humility. About recognizing that we are mid-transition, and that clarity, like a harvest, doesn’t arrive the moment seeds are planted.

So we stay alert. Strategic uncertainty doesn’t call for bold predictions; it demands humility and vigilance. We ground our approach in signals that have proven their worth through past periods of economic and political unrest, resisting the urge to chase headlines or cling to tidy narratives. We remain skeptical of certainty, and cautious of promises—whether they suggest smooth sailing or inevitable collapse. Because in times like these, it’s not the volatility that breaks portfolios. It’s overconfidence in a single path forward.

• Equity markets have gone up 80% of the time when viewed on a 6-month rolling period. They have experienced 10% or greater declines over a 6-month period approximately 10% of the time.
• Of the worst downturns over the past 60 years, the market has recovered to its past high within 18 months… on average.
• Equity markets reach their low before the worst of the economic downturn.
• Emotional response to market volatility results in investors losing more than 25% of the market’s opportunity.
• The downturns do not necessarily lead to negative annual returns.

We have discussed the instabilities in the markets and the economy. We have been adding to our cash positions since Thanksgiving of 2021 as we looked to mitigate an expected adverse market environment. In the first quarter of this year, some questioned as to why we were not fully invested. Now that the major indices are down 20% to 30%, we are being asked why we are not fully in cash. The answer is we look to be approximately right rather than precisely wrong. To have the confidence to move to an extreme requires much more than a recession. It would likely require a banking crisis.

There is little doubt that the inflation wave we are experiencing and the fight against it will be painful. And the markets will have to reflect it. Which they are. Now.

Investment markets—both equity and fixed income—discount future events. When those anticipated future events are positive, no one questions that discounting. However, when the future becomes darker, the downward adjustments are not easy or graceful. When the market is finding its correct level, the changes are typically abrupt, halting, and clumsy. Of course, dramatic data and big swings between the ups and the downs can make people feel uncertain and out of control. The danger is when feeling like that brings people to act on fear and regret—regret that “I should have sold all of my portfolio in…”

Consider, however, that historical market movements have demonstrated the best time to buy (or sell) is when the opposite action would feel most comforting. Our models, based on pattern-recognition over decades, have been working, so we will continue to follow their unemotional and empirically tested direction.

We firmly believe that market bottoms and tops are processes and should not be viewed as discreet points in time.

“True security lies in the unrestrained embrace of insecurity—in the recognition that we never really stand on solid ground, and never can.”

“Uncertainty is where things happen.”

Over the past two long-drawn-out years, we have discussed the idea that market participants swing between uncertainty and complacency. We have also observed that most investors believe asset prices will be protected by central banks, a phenomenon pundits call the “Fed put.” Investors have had good reason to become complacent and believe in the Fed put because the past two decades have trained them to look to the Fed whenever asset prices drop materially. However, that was during an environment of low inflation, or even deflation, when the Fed had the luxury of acting without igniting an inflationary fire.

The Federal Reserve Bank of the U.S., or the Fed, the dominant central bank in the world, has two mandates: (1) maintain a stable value of the U.S. dollar by fighting off inflationary pressures, and (2) maximum employment. As we have presented over the past few months, the Fed had 40 years of deflationary forces—the Non-Inflationary Consistently Expansionary (NICE) period—that allowed it to dampen economic volatility and reinvigorate a bullish spirit through lower interest rates. And as the next recessionary threat came along, the Fed continued to lower rates because it worked so well the previous time. Investors have been trained like Pavlov’s dogs to gobble up more speculative (riskier) assets when the Fed rings the lower rate bell, and with asset pricing being higher than at almost any time since World War II, the dogs have gotten fat.

The sustained lower rates have reduced investors’ sensitivity to “here and now” cash flows, pushing them into higher risk, more speculative investments. What happens if the next bell to be rung is for higher rates?

We now sit at zero interest rates. Even more importantly, we are experiencing high inflation that could be argued is structural in nature rather than transitory. As uncertainty continues to build with war in Ukraine and an ongoing pandemic, many prognosticators look at the playbook of the last 40 years and assume the Fed will continue down that same path of low rates to protect asset pricing and reinforce speculation, pushing inflation control to a much lower priority.

That assumption seems excessively complacent from our perspective and suggests an anchor bias that could present issues into the future. The anchoring of one’s economic view to only the last 40 years omits the stagflation of the 1970’s and it’s impacts on discretionary spending, economic growth, and the rising uncertainty that plagued the investment markets. We sit with conditions that are far different than those over the past four decades. An underinvestment in energy production along with rising tensions between economic and military parties is a clear deviation from the inclusionary tailwinds experienced since the early 1980’s.

To shake off that anchor bias, we recommend Nassim Taleb’s book Antifragile, written in 2012. Antifragile, very haphazardly summarized, posits that most systems exhibit swings or variations due to system stress, and it argues that such stress, although uncomfortable, can help build long-term resilience and strength into the system. Some will see the “swings” as flaws, or system bugs, and will look to limit the system’s negative feedback. When the Fed moves to dampen economic volatility via lower interest rates, it is doing just that. And we are concerned that such efforts could lead to increased economic instability (which would also surprise many) once rates start trending higher.

Reducing the natural variation that stresses a system prevents adaptation and protects inherent flaws, creating fragility under the appearance of everyday steadiness. The ultimate result is a more chaotic eventual path when larger stresses that can’t be “managed” present themselves. The changing attitude to forest fire prevention presents a wonderful analogy. Today we ignite small, localized fires as a means of controlling undergrowth. The small fires remove latent fuel so that accidental fires have less fuel and are therefore easier to control. Several decades ago, however, the idea was only to prevent all fire, which meant larger, more fierce fires when they did come, which were uncontrollable and devastating to the environment.

In his book, Taleb argues that when large, uncontrollable events occur, there are not only some actors within the system that can withstand the turmoil, there are some that benefit from the periods of increasing fragility. He calls them the antifragile. More on this is a second…

As mentioned above, we contend that the last 20 years of Fed increasing actions to thwart the natural volatility within the economy and the markets have led to a perception of lower uncertainty built into the valuation process of risk assets. It worked because they had the inflation headroom to adjust rates lower. A whole generation of investors have been trained to see lower rates as a solution to market turmoil. We are increasingly concerned that the NICE period is behind us, and the Fed will be forced to focus on inflation fighting.

We are not the only ones discussing this conundrum and what it means for the economy and asset prices. Incremental investors are more and more on the lookout for antifragile assets while distancing themselves from fragile assets. By fragile asset we mean those that have their value arriving in the distant future rather than ones that generate (and protect) value in the here and now. Some recent phenomena suggest a move away from fragility. For one thing, growth stocks have come under increasing pressure. Also, blockchain instruments have been halved since the beginning of the year. And innovation stocks are down 60% to 80% over the past year.

One issue with defining anything as fragile or antifragile is that the definition will be dependent on the system one is looking at and the factors that drive it. What was once antifragile may turn out to be fragile under a different context. During the financial crisis, U.S. long-term sovereign debt was a safe haven. Can that be true in a rising rate environment? The jury is still out.

What we at Auour do know is that cash, the basis for valuing almost all assets, is likely to be antifragile if we see pricing of all assets needing to adjust to an inflation-fighting Fed. Our strategies currently hold roughly 25% cash as we continue to crave antifragility.

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What changed?

The market has been on an upswing that has lasted longer than any time period in history without a 5% correction. 422 days when the average is typically about 200 days. The actual reason for the swift move over the past week is hard to pin down. However, quick adjustment in interest rates (from ~2.5% to 2.8%) combined with readings of a pick up in inflation (though still at very modest levels) were part of the equation. These generated a fear that the Federal Reserve Bank would need to accelerate the pace of rate increases, potentially increasing the chances of an economic slowdown.

Should we do something?

On Monday, January 29^th, Auour’s short-term signals became cautious as the rapid increase in the markets combined with the increase in interest rates caused us to believe the likelihood of a near-term soft spot had increased. We removed all leverage from our most aggressive equity product and increased cash to approximately 10% in all equity products. We also dramatically cut the equity weight in our balanced strategies with Global Balanced moving to 45% equity from 60% and our Multi-Asset Income strategy moving to 25% equity from 40%. Our Global Fixed Income also mitigated some risk by reducing exposure to the higher risk corporate and emerging markets as well as raising some tactical cash.

What caused the rapid deterioration over the past few days?

As we are only one participant in a market driven by tens of millions people, it is impossible to directly lay blame. Let us also remind ourselves that as of this writing, the S&P 500 has only retracted to levels last seen only two months ago. However, certain factors are reminding us of the speed (not the severity) of the very quick correction that occurred in 1987 caused by the broad adoption of portfolio insurance. In the 1980’s, large pensions were told that they could insure against market corrections through the use of derivative instruments. It became a self-fulfilling event which instigated a “run for the exits”, not driven by underlying company fundamentals.

Over the past year, it has become commonplace to see inexperienced investors bet against a rise in market volatility. This caused complacency to build and as we know, the market does what is most inconvenient for the majority of participants. The rapid rise in interest rates, the start of a market downturn, and the fear of government instability resulted in a rise in volatility. The rise in volatility created a panic among those betting against it and resulted in them covering their increasing losses. The absorption of that change in direction has resulted in a massive movement in the derivative markets, pushing markets down. Another case of a “run for the exits” that has little to do with underlying valuation or company fundamentals.

What do we do now?

Again, as only one participant in a field of millions, no one can accurately predict the short-term gyrations of the market. The volatility seen even within the last hour of writing this makes it difficult to gauge the value of short-term actions. Days like yesterday will take over emotions and blind you to logic. In 1987, the market dropped over 22% in one day yet if one looked at just the yearly numbers, the market was up over 5% for the entire year. Swings in markets driven by derivatives can produce wild daily and weekly rides but the fundamentals of the underlying markets are what dictate the long term.

We continue to evaluate the data and the global markets’ reactions to it. At this point, we do not see this as a systemic issue that could drive a deep and enduring downturn. Fundamentals around the world are very good. Interest movements to date are normal and well within our thinking of where they should be moving to. Events like the last week can and should raise fears. Yet, we take some comfort that our signals moved us into a more conservative allocation with tactical cash protection before this drop. Time and data will drive our decisions, not emotions.