Q2 2025 Market & Economic Outlook

 

Current Economic Views

The U.S. economy entered 2025 with momentum after posting a respectable real GDP of 2.8% for 2024. So far in 2025, there has been a noticeable difference between survey-based “soft data” and quantitative “hard data.” This divergence is partially due to the Trump administration’s trade and tax policies. While all new administrations have transition periods, 2025 has been very volatile so far.

 

In early March, lawmakers agreed to a fiscal year 2025 spending blueprint, but 2026 remains unsettled. The Trump administration has promoted pro-growth policies such as lower taxes and less regulation. However, the future of the partially expiring Tax Cuts and Jobs Act is still unknown.

 

Trade angst ramped up during the quarter as the administration announced numerous tariffs on adversaries and allies for many imported goods. The tariffs were also often delayed and changed. Given the uncertainty, the Federal Reserve held rates steady at the March meeting. Chairman Jerome Powell referenced the “uncertain” environment 16 times during his March press conference. For comparison, he referenced it once in September.

 

The job market remains strong, with unemployment low at 4.2%. For the first quarter of 2025, job growth averaged about 152,000 per month, similar to the 2024 pace of 153,000 per month.

 

Businesses front-loaded imports to get ahead of potential tariffs and boost their inventories. Industrial production and manufacturing remained relatively flat compared to 2023 and 2024.

 

Overseas, there were notable pro-growth policy announcements. In Europe, led by Germany, spending is expected to increase on infrastructure and defense. China recently announced another stimulus package, nearly 5% of the country’s GDP, to boost consumer and business spending.

Looking ahead

Coming into 2025, we took a “to be determined” outlook on the economy, given potential changes in government policy. While growth may slow as consumers and businesses adjust to the new trade policies, we expect growth to continue with risks to the downside.

 

Bloomberg’s consensus estimate recently increased its near-term recession probability to 30%, and others are even higher. The current projections are worth watching, however the frequent policy changes make the situation very fluid.

 

The labor market remains a bright spot. The unemployment rate is still low, and there are more job openings than job seekers.

 

Consumers are nervous that prices could increase further. The Fed has taken a position that tariffs could boost prices in the near term and also slow growth in the long term.

 

The months ahead will likely remain cloudy, but the second half of the year could bring some clarity. At some point, businesses will get clarity and be able to respond and set plans accordingly. We expect lawmakers to extend the TCJA in some fashion, which would remove one layer of uncertainty. Trade is trickier since the outlook and potential outcomes change frequently.

 

The Fed does have room to lower rates if growth slows and/or unemployment rises.

Current Investment Views: Equities

 

Equities were lower in the first quarter of 2025; with the S&P 500 down 4.6%, the Russell 2000 down 9.8%, and the Nasdaq Composite down 10.4%. March also happened to be the worst month for the S&P 500 and Nasdaq since December 2022. Interestingly the equal-weight S&P 500’s total return for the quarter dipped roughly 1%, highlighting that the losses were not equally distributed.

 

The big technology industry notably lagged for the quarter with the Magnificent 7 falling into bear territory, tumbling about 16% for the quarter and 21% from the December peak. Semiconductors also had a rough quarter with the SOX (a semiconductor index) down for a third straight quarter, at 14%.

 

Consumer discretionary (down 14%), technology (down 12.8%), and communication services (down 6.4%) underperformed. Energy (up 9.3%), health care (up 6.1%), consumer staples (up 4.6%), and utilities (up 4.1%) outperformed.

 

Equities started the quarter strong, with the S&P 500 hitting its record high on February 19. Unfortunately, this momentum was fleeting as the S&P 500 and Nasdaq fell into correction territory later in the quarter.

 

Several developments during the quarter called into question the market’s bullish narrative, but the predominant driver revolved around tariff uncertainty and President Trump’s sequences of policy announcements. Additionally, cracks began to form in soft economic data. Finally, questions surrounding the durability of Generative Artificial Intelligence investment began to emerge, which dented the industry’s growth theme and contributed heavily to the selloff in the second half of the quarter.

Looking ahead

The Federal Reserve will continue to loom large as more hawkish language from the central bank emerges. Chair Jerome Powell acknowledged the high degree of uncertainty from the trade policies but stressed that the central bank is not in a rush to adjust rates. Powell stated that recession odds have increased and reiterated that the Fed’s emphasis is on hard or quantitative data.

 

Wall Street’s 2025 earnings per share estimates for the S&P 500 are coming down. Our forecast calls for lower sales growth and a slight margin contraction. We have recently revised our margin projections lower because tariffs will weigh on input costs. Also, we think the S&P 500’s year-end fair value is roughly 5,700, compared to about 6,000 a few months ago.

 

Tariff uncertainty and volatility will continue to influence market performance. It is unknown if trade policies will escalate. Overall, tariffs will increase concerns about economic growth, consumer sentiment, and inflation.

 

Another issue we are watching is government spending. Less government spending may cascade down to businesses potentially laying off employees or earning less. Immigration policies can be challenging. There will likely be a smaller pool to draw from in many industries, which could cause wage inflation. If labor becomes too scarce, we could see companies spend more on automation.

Current Investment Views: Fixed Income

 

Yields across the curve declined meaningfully during the first quarter. The 10-Year U.S. Treasury Yield dropped 36 basis points, ending at 4.21%, and the 2-Year U.S. Treasury Yield fell by 36 basis points to 3.88%. Although volatility remained high, there was a clear downward trend in yields throughout the quarter. Reasons for the fall in yields included:

 

• Estimates for first-quarter growth show a slowing U.S. economy. Some estimates indicate a contracting or stagnant economy, although much of this is related to the significant increase in imports before tariffs took effect.
• The Trump administration’s policies, particularly tariffs and spending cuts, generated significant uncertainty. Consumer and business sentiment plunged, increasing concerns of a severe slowdown, although quantitative economic data remains decent.

 

Credit spreads (the excess yield investors demand for holding a corporate bond rather than a similar U.S. Treasury) leaked slightly wider off growth concerns but remain well below long-term averages. This signals that the market believes the economy and businesses will continue to perform reasonably well. Spreads will likely widen significantly if the quantitative economic data starts to sour because investors tend to flock to "risk-free" U.S. treasuries during economic hardship periods.

 

Overall, the fixed-income market responded to the new administration’s policies and deteriorating soft/survey data with concerns about economic growth.

 

The fed-funds futures (a data point used to project future policy changes by the central bank) priced in roughly 100 basis points in cuts to the Fed’s benchmark rate by the end of the year. The benchmark rate changes frequently, but the market thinks the Fed cares more about slowing economic growth as the primary reason for rate reductions.

Looking ahead

In the Fed’s latest economic projections, the median real GDP growth estimate for 2025 decreased to 1.7% from 2.1%. The Fed also lowered median forecasts for 2026 and 2027.

 

The central bank’s median core PCE inflation projection for the end of the year increased to 2.8% from 2.5%, mainly reflecting the effects of tariffs. However, inflation estimates in later years were unchanged, reflecting the slowdown in demand and one-time price increases that tariffs could cause.

 

The median unemployment rate projection for 2025’s year-end was revised to 4.4% from 4.3% to reflect slowing growth and federal job cuts.

 

The median projection for two quarter-point rate cuts in 2025 was unchanged, as were future forecasts. Due to the current economic uncertainty, Fed members likely found it difficult to change this projection.

 

Monetary policy appears well-positioned despite the murky outlook. Inflation is stil above target and tariffs may complicate further progress. On the other hand, the economy is showing signs of slowing. The national debt, legal challenges to executive orders, and a razor-thin Republican majority in Congress create unknowns. The Fed will wait for more data and certainty as it aims for an economic soft landing.

 

The landscape can shift quickly, especially as more policy changes occur and consumers and businesses feel the effects.

Asset Spotlight: Europe

 

After more than a decade of relatively sluggish economic growth in Europe, recent news from the continent has market participants more willing to invest there.

 

Parts of Europe recently agreed to policies that could spur growth. They include:

 

• European Union state members are expected to increase defense spending by $84 billion by 2027. European defense spending made up 1.8% of the area’s GDP in 2024, which may rise to 2.4% by 2027¹. Military spending may reach 3% of GDP by the decade’s end².
• Europe’s central banks have cut interest rates more aggressively than the Federal Reserve. Also, many European GDP projections have recently been revised upward, while the opposite happens domestically.
• Germany, Europe’s largest economy, recently approved a spending package equivalent to $1.9 trillion for defense and infrastructure. This represents a seismic shift for the country.

 

The Stoxx Europe 600 has outpaced the S&P 500 by roughly 10% in the first quarter, its largest quarterly lead in years.

 

From a tactical perspective (meaning over a shorter time horizon, typically 12-24 months), European equity valuations look more interesting now than in past years. Market sentiment is driving this tactical shift, but what’s happening in Europe also represents a change in the strategic asset allocation landscape (a full market cycle, typically seven to 10 years). Basically, we think the changes in Europe mark a shift in fiscal policy that will likely positively change economic prospects there for years to come. So, while the tactical opportunity has been playing out, we are also looking at this with a long-term perspective.

Looking ahead

Recent consensus earnings growth for the next 12 months for non-U.S. companies is around 4%, led by the Eurozone, where estimates are over 9%. For context, the S&P 500’s recent earnings estimates are roughly 9%, driven by the fast-growing big tech firms. However, the Trump administration’s tariffs might curb capital spending within the technology sector.

 

Since the election, the S&P 500’s gains have been eliminated and then some. Concerns are increasing about economic growth in the U.S. Money flows to where it is treated best, and European stocks may benefit.

 

From a strategic perspective, we still think U.S. equities have stronger growth prospects than the rest of the world’s markets, including Europe. However, the discord at home makes the situation very fluid.

 

The U.S. is still a reserve currency, has a diverse economy, is the leader of innovation, and has among the greatest militaries (if not the greatest). Europe still has long-term issues, such as an aging population, a lack of mass innovation capabilities, and strict regulations. Also, Europe is funding some of these new initiatives with deficit spending, which can cause issues down the road. Some European countries recently trimmed various employee benefits, which should help negate the defense and infrastructure costs.

 

¹ Goldman Sachs, www.goldmansachs.com/insights/articles/how-much-will-rising-defense-spending-boost-europes-economy

² Oxford Economics: https://www.oxfordeconomics.com/resource/defence-spending-could-still-pose-a-fiscal-challenge/