AOR Update: As good as it gets?

One thing that was not expected coming into the year was non-US markets pulling ahead of the United States, with the MSCI EAFE Index outpacing the S&P 500 by 5.9% in the first two months of 2025. Much of this performance gap emerged in February, as policy uncertainty led to mounting fears that US economic growth will slow. However, we believe this dynamic may reverse in the coming quarters, as US exceptionalism re-asserts itself.

Core to this view is the premise that policy uncertainty in the United States should ebb in the coming months, giving way to the more investor-friendly elements of the new administration’s agenda such as deregulation and tax cuts. While policy headlines have come at a fast and furious pace over the past several weeks, cutting through the noise shows that the underlying fundamentals are often less dire than the headlines suggest. For example, about 77,000 federal workers have accepted the Department of Government Efficiency (DOGE) buyout so far, which keeps them on the payroll for the next six months. Importantly, this is roughly one-third the number of workers in the United States that file for unemployment benefits for the first time in any given week. Put differently, the scale of government workforce reductions so far appears digestible and represents more of a modest economic headwind than a shift in trajectory.

That said, one development worth monitoring is the jump in initial jobless claims during the last week of February. A rise in newly fired workers tends to foreshadow a slowdown in consumption and ultimately can lead to a recession, which is why it’s a top variable in the ClearBridge Recession Risk Dashboard. However, this dataset can be volatile in any single week, which is why we (and many others) evaluate it on a four-week moving average basis. 

Importantly, last week’s jump does not appear to be a sign of more widespread DOGE-related layoffs, as initial claims actually fell in total across the three areas most likely to be impacted by cutbacks in government spending: the District of Columbia, Virginia and Maryland. While the catalyst for the recent move higher remains unknown, the jobless claims indicator remains firmly in expansion territory, suggesting that fretting over labor market weakness is premature. 

The confidence crisis from policy uncertainty has recently begun to impact business sentiment as well as consumer and investor sentiment. The ISM manufacturing survey slipped slightly in February amid a number of comments within the report citing tariffs. However, the internals of the report were less supportive, with the New Orders sub-component that the dashboard focuses on falling from 55.1 to 48.6, bringing the measure back into yellow territory this month. Additionally, the 10-year less 3-month portion of the Yield Curve re-inverted late in February, bringing the signal back to red.

Both of these indicators had improved in recent months, and their steps backward are a good reminder that economic conditions do not move in a straight line. There are no other changes to the dashboard this month, and the overall signal remains solidly in green territory. The aggregate picture suggests that while some warning signs may be re-emerging, overall recession risks remain muted for now.

Whether the current confidence shock metastasizes into something worse will only be known with the benefit of hindsight. Decreased confidence and choppy markets reflect the increased possibility of unfavorable outcomes emerging, a risk bolstered by the emergence of a budding economic soft patch. While historically this has been concerning, the signal value from consumer surveys has been diluted in the post-pandemic world as weak sentiment has not translated to weak spending over the past several years. Put differently, today you need to watch what consumers do, not just what they say. 

The consumer has been on solid footing, supported by a strong labor market and healthy individual balance sheets. Furthermore, extreme weather has likely distorted the true pace of US economic momentum with the country experiencing its coldest January since 1988.  As more clarity emerges in the coming months, and importantly as positive policy dynamics such as the extension of tax cuts come into view, confidence is likely to be bolstered and economic growth expectations should improve. Should this materialize, the current period of digestion would give way to the resumption of this bull market. As such, the current bout of volatility may represent a buying opportunity for long-term investors.