With half the year in the rearview mirror, we’ve seen what felt like a full year’s volatility in just six months. The second quarter began with the announcement of a significant increase in tariffs on virtually every U.S. trading partner. Investors were stunned and capital markets sold off quickly. The administration paused the implementation of most of the tariffs for ninety days to allow time for trade negotiations. Following the delayed implementation, markets have broadly recovered and were at or near record highs by the end of the quarter.
During the first quarter, the S&P 500 index of large U.S. companies dropped sharply in the first week following the “Liberation Day” tariff announcements, bottoming on April 7th. However, with the tariffs delayed, investors grew more optimistic and drove the U.S. stock index up to a record close by the end of the quarter. The S&P 500 gained 10.9% in the second quarter and is up 6.2% year-to-date. This was also driven in part by a recovery in expectations for tech stocks which struggled in the first quarter. Smaller company stocks recovered somewhat but are still down 1.8% since January. Smaller companies are more susceptible to supply chain disruptions and have been hit harder by the trade policy uncertainties.
On the other hand, international stocks soared on continued stimulus talk and a steady decline in the U.S. dollar. The MSCI EAFE Index of stocks in developed countries is up 7.8% in local currency terms but an astounding 19.5% when measured in dollars. Bonds have served their traditional role as a shock absorber for volatile markets, with the Bloomberg US Aggregate Bond Index (representing the entire bond market) up 4.0% during the first half of the year.
Alternative investments were broadly positive. High Yield bonds gained 3.6% during the quarter. Commodities rose 4.9% despite a drop in oil prices. Commercial real estate, represented by the Dow Jones US Real Estate Index, rose 3.5% during the quarter.
Economy
During the first quarter, the economy shed 0.5%, due largely to a huge jump in imports ahead of anticipated tariff announcements. Imports are a detractor from Gross Domestic Product because they represent goods added to the economy from outside the U.S. The second quarter is likely to be positive, but again mainly due to the fluctuation of imports and inventory accumulation.
More importantly for the second quarter, the administration’s on-again-off-again implementation of tariffs resulted in a rapid loss of business, investor and consumer confidence. The University of Michigan’s closely watched survey of Consumer Sentiment has dropped from 74 in December to 52.2 in May. Expectations for growth plummeted while inflation expectations soared. Tariff and profit warnings dominated business earnings calls during the quarter as businesses delayed investment and hiring decisions waiting for clarity on trade policy.
The hard data, which shows what people are actually doing with their wallets, have been slower to react, but have generally softened as well. While non-farm payrolls are holding up, Industrial production was up in the first quarter but slid through May. Real Retail Sales have also fallen by about 1.3% since March. Light vehicle sales spiked in March from 15.5 million in January to 17.8 million and have dropped to 15.3 million, likely due to consumers’ front-running expected tariffs.
At the same time the recently passed One Big Beautiful Bill Act (OBBBA) is expected to add somewhat to economic growth in the next few quarters, partially offsetting the impact of tariffs. In addition, the retroactive tax cuts included in the bill should provide some cash for consumers early in 2026. The bill does increase the deficit significantly, but so far, the bond markets have not reacted to the expected increase in bond issuance by the Federal Government.
Meanwhile, the Federal Reserve walks a tightrope. On the one hand, inflation is moderating, coming in at 2.4% in May. On the other hand, inflation is expected to rise to around 3% or more as a result of the impact of higher tariffs. With unemployment at 4.2%, the job market is at or near full employment and does not show outward signs of needing additional stimulus. Markets expect one or two interest rate cuts this year, but the Fed has been clear that such cuts will depend on how the economy reacts to the trade and immigration policies of the Trump administration.
On balance, we remain cautiously optimistic, but with two major caveats. Increased immigration enforcement is only just beginning to impact the labor market. Anecdotal evidence suggests a shortage of workers in agriculture, construction and hospitality is driving up costs in those sectors (higher wages to entice other workers) while some crops aren’t being harvested. Secondly, the net impact of higher tariffs has yet to be felt by consumers. According to JP Morgan, tariff revenue has increased from about $8 billion in January to $27 billion in June, with more to come. $30 billion a month is a significant increase in costs that will largely be borne by consumers.
Economists expect the hardest impact among lower income workers where imported goods and food make up a larger share of spending, but market strategists are unsure just how this will broadly impact consumer behavior and spending.
Overseas conditions remain favorable, particularly in Europe as governments shift to more hawkish defense policies and begin the process of building up their militaries. China is still bogged down by its real estate sector and lackluster growth, but as in the U.S., innovation in technology (especially Artificial Intelligence) has created some enthusiasm among investors. Depressed valuations and the decline in the dollar this year further boosted gains to U.S. investors from international stocks, providing a significant (and somewhat unexpected) diversification benefit as U.S. shares sagged.
Outlook
As we noted above, we remain cautiously optimistic. Investors have learned not to react to every midnight post on social media, so many of the Trump administration’s worst or most bizarre announcements are now taken with something of a wait and see attitude. That said, if tariffs, deportations or other policies impact corporate profits or consumer spending, markets will not react well.
The Federal Reserve remains on hold until the impact of these significant policy changes becomes clearer in the data. While increased tariffs are expected to push inflation higher, necessitating higher interest rates, this could be offset by a deterioration in consumer spending or hiring, resulting in a need for lower interest rates. Though much ink has been spilled about the potential for higher interest rates from the OBBBA, we remain unconvinced that investors will significantly punish increased government borrowing. After all, several developed countries are in as bad or worse shape than the U.S. without seeing higher interest rates or bond market revolts. For now at least, the worsening federal deficit is viewed by investors as mildly helpful to the economy on balance, even as economists argue that the higher cost of federal borrowing crowds out other investment opportunities and generally slows the economy in the long run.
Higher tariffs could put upward pressure on inflation while slowing economic growth, but clarity on trade and economic policy would likely balance out the negative impact of the higher tariffs, at least to an extent.
S&P 500 valuations have recovered with stock prices, with the index trading at roughly 22 times future earnings, approaching valuations last seen in 2020 and 1998. With the passage of the OBBBA and (so-far) delayed impact of tariffs and deportations, investors have settled into an optimistic frame of mind about the direction of the economy and markets. As we said at the beginning of the year, volatility is to be expected.
On the interest rate front, the Federal Reserve has halted its shift to lower interest rates as inflation has leveled off above its 2% target. The 10-year Treasury dropped as low as 4.01% during April amid the Tariff tantrum and has fluctuated around 4.3% – 4.5% for most of the quarter. Rates could fall again if equity investors flee to safer havens. We do not expect rates to rise much higher than 5%. If rates remain where they are, the higher yields on bonds offer attractive investment opportunities.
Internationally, the European economy has surged on increased government spending while the Euro has gained as European interest rates and economic prospects rise. The impact of U.S. economic policies is a major question mark. Trade negotiations are moving slowly despite threats of higher tariffs from the Trump administration.
Thus, the outlook is broadly mixed, with risks in both directions. As the 90-day pause for most tariffs expires, it remains to be seen what the ultimate policy will be. It does seem that President Trump likes the increased revenue they are providing, which helps to offset the cost of his other policy agenda items. JP Morgan described the likely economic trajectory as cooling (while tariffs and uncertainty drag on the economy), with a brief spell of warming early next year caused by tax refunds, followed by further cooling as the sugar high of the refunds gives way to higher taxes (tariffs) and a cooling labor market.
Our Portfolios
Our stock exposure is currently broad-based and weighted towards large U.S. companies, but our international exposure has been a clear positive so far this year. Though we have reduced our exposure to smaller companies, there is still some under the hood in our core market funds so the underperformance there has continued to be a bit of a drag on returns. Smaller and medium-sized companies offer better valuations than larger companies but can also be more sensitive to economic volatility. Small company stocks have also been battered by the slowing economy and trade uncertainty, as they tend to have less financial flexibility to adapt to changing conditions and are more susceptible to supply chain disruptions caused by the volatile trade policy.
We are well positioned for economic expansion, but if a recession does occur, we would expect our large company stock (and value bias) to hold up somewhat better than the broad stock market. Our international exposure remains balanced between (currency) hedged and unhedged investments and should continue to benefit from more attractive valuations than comparable U.S. equities.
As we noted, the Federal Reserve’s current pause (with a bias towards lowering interest rates) should benefit our bond holdings and expected returns on our bond portfolios going forward will be more attractive than they were three years ago. More importantly, if a recession occurs, interest rates will likely settle back down, resulting in good returns on bonds.
This year, we expect continued volatility as investors grapple with multiple potential risks and shocks. The possibility of a recession seems to have eased for now as investors remain cautiously optimistic about the direction of trade and economic policy.
As always, we are here for you and are ready to provide the guidance and planning you expect from us. If you have any questions about your investments or your financial plan, we would love the opportunity to discuss them with you.
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