Institutional market update 2Q 2025

Following the extreme volatility and sell-off that ensued after Liberation Day, few could have predicted that the second quarter would not only include a major geopolitical escalation involving U.S. military action in Iran but also include one of the greatest equity market recoveries in history with the S&P 500 reaching new all-time highs.

While surveys continue to reflect subdued consumer confidence and lingering recession concerns, the evolving policy framework under the Trump administration, which has emphasized tariffs, now presents a more measured tone. Coupled with robust underlying economic indicators, this suggests an economy that, although slowing, remains on an upward trajectory.

Even as U.S. equity markets have more than rebounded from the tariff-induced turbulence, concerns persist over foreign demand for U.S. assets — particularly Treasurys — following the passage of “One Big Beautiful Bill,” which is expected to add trillions to an already swelling national debt. Meanwhile, the Federal Reserve remains in a holding pattern, despite mounting political pressure, as the inflationary effects of tariffs remain unclear and economic growth softens, though not enough to warrant an interest rate cut, yet.

As we enter the second half of 2025, a key question is whether the durability of the rally can be maintained amid moderating economic growth, stretched debt and equity valuations, potentially persistent inflation risks, and heightened geopolitical uncertainty, all within a more complex policy and macroeconomic landscape.

^{Source: Bloomberg as of June 30, 2025.}

On April 2 the Trump administration unveiled one of the most dramatic overhauls of U.S. trade policy in a century, aimed at jump-starting domestic reindustrialization and narrowing the trade deficit. The sweeping measures, as quantified by JPMorgan, implied an average import tariff of approximately 22 percent, marking the highest rate in over 100 years. Financial markets recoiled: the S&P 500 suffered one of its steepest two-day declines since World War II, the dollar slipped, and Treasury markets swung violently. Fears of an imminent economic downturn took hold as recession probabilities climbed to as high as 60 percent. A few days later, however, the administration announced a 90-day pause—pushing implementation to July 9 (and now August 1) — to allow for negotiations, offering investors a momentary sigh of relief that the worst might be avoided.

^{Source: Bloomberg & Polymarket as of June 30, 2025.}

Tariffs now appear likely to stabilize at levels well above those seen in recent decades, though still below the initial extremes. As this new reality takes hold, both market sentiment and equity performance have shown signs of recovery. Meanwhile, economic data continues to hold up, albeit with a degree of inconsistency that reflects the ongoing crosscurrents like frontloading of purchases and changes in immigration policy.

As we head into the second half of the year, the U.S. economy is projected to grow at a modest pace, although recession risks remain elevated, with economists assigning a 30 percent–40 percent probability. The labor market remains a focal point, as job creation has cooled from its post-pandemic highs. Initial jobless claims are on the rise, and continuing claims indicate people are staying unemployed longer. With both hiring and immigration decelerating, the job market appears broadly balanced, with openings now roughly matching the number of unemployed workers. While the labor market remains stable, we continue to monitor it for signs of an acceleration in layoffs or a rapid slowdown in job growth as we assess the forward growth trajectory. The most recent June payrolls report indicates overall labor market resilience as the unemployment dropped 0.1 percent to 4.1 percent and the U.S. economy added 147,000 jobs.

Equity market U-Turn

On April 8, the S&P 500 fell to its lowest level since April 2024, registering a year-to-date decline of approximately 15 percent, and marking one of the worst starts to a year in history. Investors were gripped by profound fears over the enduring severity of tariffs and the ominous threat of a prolonged trade war.

Concerns centered around:

• Inflation pressures stemming from tariff pass-throughs and potential retaliatory measures.
• Diminishing economic growth due to delayed capital expenditures and reduced consumer spending.

In other words, stagflation.

^{Source: Bloomberg as of June 30, 2025. All indices are measured in Local Currency. Magnificent 7 = UBS Magnificent 7 Index; NASDAQ = NASDAQ Index; S&P 500 = S&P 500 Index; Japanese Equities = Nikkei 225 Index; European Equities = Stoxx 600 Index; US Small Cap Equities = Russell 2000 Index; US High Yield Bonds = Bloomberg US Corporate High Yield Total Return Index; Leveraged Loans = Bloomberg US Leveraged Loan Index; Gold = Gold Spot Price; Oil = Oil Spot Price; US Dollar = U.S. Dollar Index; Emerging Market Equities = MSCI Emerging Markets Index; Emerging Market Bonds = Bloomberg Emerging Markets Aggregate Bond Index; US Investment Grade Bonds = Bloomberg U.S. Corporate Investment Grade Index; Treasury Bonds = Bloomberg US Treasury Total Return Index; Chinese Equities = Hang Seng Index; UK Equities = FTSE 100 Index.}

Yet, as the year has unfolded, these initial worst-case-scenario fears gradually subsided. The S&P 500 has since surged, boasting a nearly 5 percent price increase as of the end of June, recovering almost 24 percent from its April low. The second quarter rally marks one of the greatest equity market recoveries in history. But what exactly catalyzed this dramatic shift in expectations and market sentiment?

Contrary to initial fears, tariff levels are expected to stabilize at rates much lower than those proposed on Liberation Day. According to most recent JPMorgan estimates, tariffs fluctuated from about 2.3 percent at the end of 2024 to a peak of 26.2 percent, before dropping back to around 15 percent. While some argue that a double-digit rate is burdensome and unprecedented since the 1940s, the reduction from peak levels has been viewed positively, and the administration continues to negotiate bilaterally with various countries. Nevertheless, with the passage of “One Big Beautiful Bill,” some fear that the administration may be emboldened to take a more hawkish approach to tariffs moving forward.

Additionally, inflationary pressures from tariffs have not yet materialized as headline and core CPI have decreased to 2.4 percent and 2.8 percent, respectively. This broadly results from various factors: tariff measures were adjusted with walk-backs and exceptions; AI has increased production efficiency; high S&P 500 profit margins allow companies to absorb higher costs; import frontloading and accumulation of inventories; global supply chains remain diverse; and the Federal Reserve has maintained higher interest rates to control inflation.

^{Source: Bloomberg as of June 30, 2025.}

A closer look at the CPI reveals that the U.S. services sector — accounting for roughly 60 percent of the index — has recently been the primary source of inflation. However, this segment has seen steady disinflation over the year, with its contribution falling from 2.62 percent in January to 2.15 percent, helped by declining rent growth.

On the goods side, pass-through pricing effects are clearly visible, though their overall impact on inflation remains modest, given goods account for only about 40 percent of the CPI. As a result, their contribution has risen only slightly—from -0.019 percent to 0.068 percent. Tariffs affect goods more directly and immediately due to tighter profit margins and a strong dependency on imported raw materials. In contrast, services experience more lagged and diffuse effects, with input costs like machinery unfolding over time, and most inflationary pressure emerging through wages and expectations.

^{Source: Bloomberg as of June 30, 2025.}

Finally, consumption and spending appear steady, with further catalysts likely via fiscal stimulus. Earnings season in the first quarter was strong as S&P 500 earnings per share surprised positively by 7.6 percent, compared to an average of 5.9 percent over the past four quarters, and broadly AI-related capital expenditures were reaffirmed. Second quarter earnings per share are expected to grow approximately 5 percent, led by the communications services and technology sectors. Moreover, “One Big Beautiful Bill,” despite potential debt and deficit concerns, promises immediate market stimulus through tax cuts, credits, capex expensing, R&D incentives, and regulatory rollbacks.

Balancing stimulus with a heavier debt load

“One Big Beautiful Bill,” a centerpiece of investor attention alongside tariffs, has been signed into law. This sweeping legislation not only makes the 2017 Trump tax cuts permanent, but also introduces additional relief measures, including federal tax exemptions on portions of tips and overtime pay, and full expensing for new factories and equipment. While these measures are partially offset by reductions in Medicaid, food assistance programs, and clean energy subsidies, the broader fiscal burden is expected to remain significant.

On one hand, the bill is stimulative, meaning it supports economic growth through tax cuts, tax credits, and business incentives. On the other hand, the bill is expected to add about $3.3 trillion to an already ballooning national debt. To put recent trends into perspective, it took the United States two centuries to rack up its first $12 trillion of debt; we've added another $12 trillion in just the past four years through relentless deficit spending. Reflecting these pressures, Moody's stripped the U.S. of its last AAA credit rating this quarter, citing bipartisan inaction on revenue increases and spending restraint.

^{Source: Bloomberg & usdebtclock.org as of June 30, 2025.}

The situation brings to mind the poignant fiscal policy controversies during Liz Truss’ brief 45-day tenure as Prime Minister of the United Kingdom in late 2022. Truss introduced a fiscal package with substantial tax cuts, but the market response was overwhelmingly negative. The UK already faced high inflation and elevated debt levels, and the uncosted nature of the announcement exacerbated the market's concerns. The result was a sharp decline in the British pound, soaring government bond yields, stressed pensions, and significant political fallout. It raises the question of whether, down the line, the U.S. might encounter a similar "bond tantrum" due to analogous policy decisions.

Why does U.S. government debt exceeding 120 percent of GDP matter?

• Rising Interest Costs: Interest payments now exceed $1 trillion annually—more than the entire defense budget

• Crowding Out Private Investment: Heavy Treasury issuance can push up yields, making borrowing more expensive for businesses and consumers. We’ve already seen bouts of market volatility tied to weaker auctions and expansionary fiscal plans

• Reduced Crisis Flexibility: In the COVID-19 downturn, ample fiscal firepower enabled historic relief packages. With deficits and debt so elevated today, future emergencies—whether recessions, pandemics, or natural disasters—will meet a far more constrained federal balance sheet

Taken together, the new bill’s growth boost comes with a steep trade-off: powerful short-term stimulus at the cost of mounting long-term risks.

All roads lead to the Fed

Movements in interest rates this year have largely reflected two things:

• A slowing growth backdrop.
• The expectation that the Federal Reserve will eventually resume its easing cycle.

The Treasury curve has steepened year-to-date with the 2-year Treasury yield dropping 52 basis points and the 10-year Treasury yield dropping 34 basis points.

^{Source: Bloomberg as of June 30, 2025.}

Although market pricing reflects an expectation that the Fed will cut short-term rates approximately 50 bps this year beginning in September, it is no guarantee that it’s the trajectory they will follow as the market has repeatedly misjudged future Fed moves.

At present, the Federal Reserve is “on hold,” unlikely to cut interest rates this month, citing concerns over the potential long-term inflationary effects of tariffs, which have yet to appear in backward-looking figures, along with the short-term inflationary effects of fiscal stimulus from the “One Big Beautiful Bill,” and a still resilient labor market.

President Trump has expressed disagreement with Federal Reserve Chair Jerome Powell’s firm stance, calling him “too late” and publicly suggesting that a replacement might be announced before the end of Powell’s term in May 2026. Markets have largely coalesced around the idea that Powell’s successor will adopt a more dovish approach, leading to a continued decline in the U.S. dollar and benefiting stocks as expectations for interest rate cuts have been moved forward.

As we look out over the second half of the year, we continue to pay close attention to the evolving economic backdrop, which will inform the Fed’s decisions and market trajectory. Based on the “hard data,” companies and consumers have thus far weathered the storm, though their attitudes and sentiment might not reflect as much. Equity and corporate bond valuations remain historically elevated, but that may be justified given the demonstrated resilience of the economy, sustained margin strength, market concentration in high-performing companies with above-average earnings and revenue growth, and the expanding potential for exponential innovation as AI adoption accelerates.

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