Stock market rally driven by 'unwarranted optimism' as tariff risk looms over $9 trillion rebound

After a massive drawdown in the initial reaction to President Trump’s April 2 tariff announcement, major stock indexes have roared back, with the S&P 500 (^GSPC) adding $9 trillion in market value in just over a month.

But after six straight days of gains that have brought the S&P 500 within 3% of a new all-time high, some on Wall Street are cautioning the market rally may have extended too far, even if the probability of recession has declined in recent days.

“Equity markets have reacted with unwarranted optimism, overlooking the persistent economic drag posed by elevated tariffs,” EY chief economist Gregory Daco wrote in a research note on Tuesday.

The latest tariff delay, a 90-day pause on duties between the US and China, moved the estimated effective tariff rate from around 25% down to 14%, according to Daco. As we noted in the Yahoo Finance Chart of the Week, this better-than-expected tariff outcome helped drive the latest boost in stocks.

But now, with markets back at levels not seen since late February, Daco fears investors may be ignoring the fact that the effective US tariff rate remains at its highest level since 1939. And while the economic story has improved, forecasts aren’t calling for accelerating growth either. Daco projects that US economic growth will approach “stall speed” by the fourth quarter, with GDP rising just 0.6% from the year prior in the final three months of 2025.

Read more: What Trump’s tariffs mean for the economy and your wallet

Daco expects tariffs to eventually result in higher prices and weigh on household demand. He sees real consumer spending growing 2.2% in 2025 and that rate slowing further to 1.1% in 2026. In 2024, real consumer spending advanced 2.8%.

“While the near-term outlook is more constructive, risks remain tilted to the downside,” Daco said.

Still, it appears that investors are hoping the effective tariff rate will come down further, limiting impact to the economy. In a research note sent to clients on May 16, Deutsche Bank US equity strategist Parag Thatte noted that discretionary investors have moved back to an overweight position in stocks, which reflects no slowing in earnings growth or GDP on the horizon.

“An increase in tariff rates of this magnitude will weigh on growth, but discretionary investors are likely factoring in additional rollbacks and exemptions once the impacts start to manifest,” Thatte wrote.

On Monday, JPMorgan Chase (JPM) CEO Jamie Dimon warned that he sees an “extraordinary amount of complacency” in markets after investors clawed back their “Liberation Day” losses. Dimon added that the risks of “stagflation,” where economic growth slows and inflation reaccelerates, remain.

“I do think there is some complacency [in markets],” Charles Schwab chief investment strategist Liz Ann Sonders told Yahoo Finance when asked about Dimon’s comments.

Sonders pointed out that at the bottom of the market drawdown, investor sentiment had hit historically low levels. Since then, market sentiment has made a U-turn as a large tech rally has led the rebound.

“We may be at that point where the setup, from a sentiment perspective, suggests that the market could have some downside if we get a negative catalyst,” Sonders said. “And that’s really the best way to think about this market. It’s hard to judge it based on what policy announcements are going to be and when they’re going to come. That’s a fool’s errand.”

Sonders believes a turn in economic data could be the key negative catalyst, should one emerge at all. Consumer sentiment and other surveys have tumbled in the wake of the tariffs, with both businesses and consumers bracing for higher prices. But that hasn’t played out in data that measures actual economic activity thus far.

Read more: What is consumer confidence, and why does it matter?

In April, a reading of wholesale inflation showed “core” producer prices, which exclude the volatile food and energy categories, decreased 0.4% over the prior month. This followed a separate Bureau of Labor Statistics report that showed consumer prices fell to their lowest level in more than four years during April.

Sonders noted that those surveys were taken early in April and don’t reflect a consistent period in which tariffs have been in place.

“If we were to start to see indications of a pickup in inflation, that could be a negative catalyst that would put, maybe, the Fed further on the back of their heels,” Sonders said.

She added that while there hasn’t been any clear sign that the cooling in the labor market is accelerating, that also remains a key risk to the economic narrative that warrants watching.

Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.

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