Changing AI Leadership, Trade War 2.0 and Market Volatility

Monthly Market Summary

• The S&P 500 Index returned +2.7% in January, marginally outperforming the Russell 2000 Index’s +2.5% return. Seven of the eleven S&P 500 sectors outperformed the index, as AI-related news led to a sell-off in Technology stocks.
• Corporate investment-grade bonds produced a +0.6% total return as Treasury yields edged lower but underperformed corporate high-yield’s +1.4% total return as corporate credit spreads tightened further.
• International stock returns were mixed. The MSCI EAFE developed market stock index returned +4.8% and outperformed the S&P 500 due to strength in Europe, while the MSCI Emerging Market Index returned +2.2%.

Changes in Market Leadership

One month into the new year and markets have continued to rally; however, renewed geopolitical uncertainties could pose challenges to solid market gains. Indeed, after a strong showing in 2024, stocks traded higher to start 2025, but the factors driving the rally took on a different character in the past month than we have seen over the past year. For example, the segment of stocks that powered the recent market gains, Large Cap Value stocks, had lagged over the past year but outperformed Large Cap Growth by more than 2.5% in January.

At the same time, the Dow Jones Industrial Average climbed back toward its all-time high in early December after closing last year on a weaker note. Meanwhile, growth stocks, as measured by the Nasdaq 100 and the Technology sector in general, which led markets higher for most of 2024, underperformed the broader index for the month.

This shift was largely driven by AI-related developments in China, which raised concerns about U.S. dominance in the sector and broader market trends. What this means is that while tech stocks powered last year’s gains, other sectors may take the lead in 2025, especially if geopolitical risks remain contained. This kind of shift in leadership is not uncommon following strong market years, as investors look to rebalance portfolios and identify opportunities in areas that were previously overlooked.

Are Tech Stocks Out of Steam?

So then, is tech as a driving force of the current rally down for the count this year? It might be too soon to tell. Indeed, January saw a major shake-up in artificial intelligence (AI), with ripple effects across U.S. markets. That’s because Chinese startup DeepSeek introduced an AI model that claims to be able to compete with top U.S. platforms like ChatGPT but at a fraction of the cost. The model was allegedly developed using less advanced and cheaper chips, challenging the assumption that leading AI models require heavy investment in high-performance computing. If this approach catches on, it could significantly alter the industry and affect U.S. leadership in AI.

That’s why markets reacted quickly, and the impact was significant, leading to a selloff in U.S. tech stocks, especially those that had seen strong gains on AI growth expectations. That’s because the prospect of lower-cost AI development raised concerns about the demand for high-end chips. So then companies like Nvidia, a key supplier of advanced AI hardware, saw its market capitalization fall by nearly $600 billion, which was one of the most significant single-day losses for a U.S. company.

At the same time, the selling pressure extended to Microsoft, Alphabet, and Meta, as investors reassessed what appears to be rich valuations in the AI space. And this market response likely reflects broader worries that progress in the AI space may not be as capital-intensive in the future as once believed, which could challenge the dominance of companies that have benefited from high investment requirements in AI-related infrastructure.

Even so, what’s notable here is that although the initial market decline was concentrated in a handful of companies, their heavy weighting in the S&P 500 dragged the broader index lower. Nevertheless, investor sentiment is rarely one-sided, and after the initial selloff, markets stabilized coming into February as some investors viewed the pullback as a buying opportunity, particularly in areas of the market that may benefit from AI-driven cost efficiencies. Still, given AI’s significant role in market performance, markets will be keen to keep a close eye on developments in the sector while rebalancing to other market opportunities.

Trade War 2.0 Developments

Changes in trade policy also added another layer of market uncertainty after a solid start to the year. That’s because, on February 1, 2025, President Trump announced new tariffs as part of what some are dubbing “Trade War 2.0”: 25% on imports from Mexico and Canada (with a 10% levy on Canadian energy products) and 10% on Chinese imports. The move is positioned as an effort to address trade imbalances and immigration concerns and prompted immediate responses from major trading partners. Even so, Canada and Mexico secured temporary delays while committing additional resources to combat organized crime and drug trafficking.

But, China responded swiftly, imposed tariffs on U.S. coal, liquefied natural gas, crude oil, and agricultural machinery while launching an antitrust probe into Alphabet. The reaction in financial markets was immediate, with major indices dropping over 1% and the U.S. dollar reaching a 20-year high against the Canadian dollar. Markets have since recovered modestly since the initial selloff, but the surge in the dollar could have additional implications for U.S. multinational companies, as a stronger currency can weigh on exports by making American goods and services more expensive overseas.

These developments reinforce the risks of an escalating trade war, which could lead to higher inflation, supply chain disruptions, and slower economic growth in affected regions. And while markets have endured trade-related tensions in the past, the unpredictability of policy responses are likely to keep investors on edge, especially as incoming data suggests that economic growth is moderating.

Looking Ahead

So, what does this mean for your portfolio? Well, over the next few months, investors will be watching trade policy developments, AI innovation, and Federal Reserve decisions for signals on market direction. While the broadening of market leadership suggests a more balanced rally, geopolitical and macroeconomic risks remain a central headwind to any potential market rally.

Here’s the big takeaway: This complicated environment makes it especially important for investors to avoid reacting too strongly to short-term headlines.

Indeed, it’s essential to remember that markets don’t move in a straight line, and with AI disruptions and trade tensions shaping 2025, staying committed to your long-term plan will be key. Because the question isn’t just how these forces play out, it’s how you position yourself in response.

Therefore, taking a proactive approach to portfolio positioning, especially rebalancing your investments rather than being swayed by short-term volatility, will be critical to navigating market volatility.

Either way, how political and economic events unfold will shape the market’s trajectory. But for now, the best strategy is to focus on your disciplined investment strategy, ignore the noise, and ensure your financial plan is positioned to give you clarity, confidence, and peace of mind as you move through another period of economic and market uncertainty.