The second quarter of 2025 was marked by continued volatility in U.S. financial markets, shaped by intensifying geopolitical tensions, persistent inflationary pressures, and growing signs of economic deceleration. Despite this, equity markets staged a strong rally in May and June with the S&P 500 and Nasdaq both closing at record highs amid a thaw in trade rhetoric, a quick end to the Israel-Iran war and better-than-feared corporate earnings. Market leadership reverted to large-cap growth companies, primarily in the technology sector as AI-related enthusiasm reaccelerated. For the quarter, the S&P 500 rose 10.9%, Nasdaq posted an astonishing 17.9% gain, and the Dow Jones Industrial Average ended up a relatively paltry 5.5%. Although there was significant intra-quarter volatility, the yield on the 10-year bond ended roughly flat at 4.23%, up 2 bps for the quarter. Notably, the dollar fell sharply, with a key measure of its value relative to other major currencies falling 7.1%.
Market internals, which during April’s selloff revealed a continued rotation away from the large-cap technology stocks that had driven the market in recent years, reversed during the quarter. The Information Technology and Communication Services sectors, which declined precipitously in April, came roaring back, posting quarterly gains of 23.7% and 18.5%, respectively. Typically defensive sectors such as Health Care, Real Estate and Consumer Staples, which proved resilient during April’s selloff, lagged by significant margins as markets rebounded. The Quality and Momentum style factors were the top performers during the quarter, with the latter posting strong returns during the market rebound as mis-positioned investors clamored for outperforming companies, particularly in large cap technology and AI-related stocks. Given the quarter’s dynamics, Value and Small Cap were unsurprisingly the worst performing factors.
Q2 brought a mixed set of macroeconomic signals. The labor market continued to show signs of softening. The unemployment rate edged up to 4.2% in June, and both job openings and wage growth moderated further. June's JOLTS job openings data confirmed a multi-month downtrend in job openings, and layoff announcements across technology, logistics, and government sectors picked up steam. Consumer sentiment deteriorated steadily through the quarter, with the University of Michigan's sentiment index hitting a 16-month low in June as inflation expectations ticked higher.
Inflation remained the central challenge. While headline CPI readings moderated slightly, core inflation proved stubborn. The year-over-year core CPI rate stood at 3.4% in June, with services inflation, particularly shelter and insurance, remaining elevated. These persistent price pressures kept the Federal Reserve in a holding pattern. Despite market expectations for rate cuts earlier in the year, Fed Chairman Jerome Powell reaffirmed at the June FOMC press conference that policymakers remained data-dependent and wary of easing prematurely. Markets are still pricing in two 25 bp rate cuts before the end of the year, likely beginning in September, but concern about tariff-induced inflation may keep the Fed on hold until later in the year.
The high level of uncertainty surrounding U.S. trade policy, stubbornly high inflation and market interest rates has led companies and consumers to pullback or postpone investment and spending plans and continues to crimp economic growth. The final Bureau of Economic Analysis estimate for Q1-2025 GDP growth was revised down -0.5%, the first negative reading since 2022, though this was skewed to the downside by a surge in imports ahead of anticipated tariff increases. Consensus forecasts now point to 1.5% GDP growth for 2025.
Our base case economic outlook for the remainder of 2025 has shifted toward a more cautious stance. While a recession is not our central scenario, we acknowledge that downside risks continue to accumulate as effects of tight monetary policy, elevated real interest rates, and restrictive trade policy filter through the economy.
International markets continued their strong year-to-date performance, with the broad ACWI ex-US index gaining 11.5% in the second quarter. Performance was driven by monetary easing across Europe, Latin America, and parts of Asia, along with targeted fiscal support in China and Germany. Despite being on the receiving end of U.S. tariffs, these regions benefited from stronger domestic demand, lower inflation, and currency appreciation relative to the U.S. dollar.
High-quality fixed income appears increasingly attractive as current yields, historically strong indicators of forward returns, remain close to 15-year highs, thus offering strong income potential and downside protection should economic growth continue to slow. As additional Federal Reserve rate cuts come into focus, bond investors also stand to benefit from capital appreciation and higher income than money market funds currently provide. We remain selective within our portfolio’s fixed income allocation, focusing on higher quality, more liquid, and resilient investments. U.S. Government-guaranteed mortgage securities (Agency MBS) are particularly attractive, as their spreads over Treasuries remain near historical highs, making them a liquid alternative to corporate credit. Credit markets offer select opportunities but also heightened risk as credit spreads have collapsed near all-time lows. Careful sector and asset selection, and a value-driven investment approach are essential in these markets. The weaker dollar and country and region-specific growth drivers have made International fixed income markets increasingly attractive and we are actively seeking opportunities outside the U.S. Historically, global diversification has offered superior volatility-adjusted returns to single country portfolios. As always, fixed income portfolio duration should align with client cash flow needs, with a neutral benchmark anchoring.
Looking ahead to the second half of the year, earnings growth is expected to accelerate which is supportive, but historically high valuations and muted volatility readings leave financial asset prices vulnerable to shocks. Key risks include further escalation in trade tensions, potential supply chain disruptions due to tariff enforcement, and the possibility of disappointing earnings results should consumer spending weaken materially. These effects may be somewhat offset by the recently signed tax and spending bill, which provides modest stimulus through tax incentives for corporate investment, higher defense spending and effective tax breaks for the wealthiest consumers.
We remain cautious but constructive in our asset allocation. Within equities, we maintain a modest overweight to high-quality U.S. large caps while continuing to increase international exposure, particularly in Europe and Latin America, where valuations are more attractive and policy conditions are turning supportive. We have trimmed exposures to the more speculative corners of the market but remain overweight cyclical sectors relative to defensives. We continue to favor companies with pricing power, strong balance sheets, and durable earnings models. Gold remains a favored diversifier, particularly amid elevated geopolitical and inflation uncertainty, and we maintain an overweight position in relevant portfolios.
In this environment, we believe that discipline, diversification, and a quality bias across asset classes are key. While the market continues to wrestle with an evolving macroeconomic and policy landscape, attractive opportunities remain for patient, risk-aware investors with a long-term horizon.
Author:
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Bruce Schoenfeld Principal Investment Analyst First American Trust |
Bruce is the Principal Investment Analyst responsible for investment research coverage of various asset classes and equity industry sectors. Bruce has more than 27 years of experience as an equity analyst and portfolio manager. He joined First American from 3P Associates, LLC, an investment and strategic management consulting firm he founded. He previously served as Director of Research at BlueStar Global Investors and as an analyst and portfolio manager focused on emerging markets for Delaware Investments, Artha Capital and Caisse de depot et placement du Quebec, Canada’s second largest pension fund.
Co-Authors: |
Jason Nerio SVP, Director of Investment Research & Strategy First American Trust |
Jason Nerio is the Director of Investment Research and Strategy at First American Trust. Mr. Nerio has more than 28 years of investment research experience. He is responsible for formulating investment strategy and serves as a leading member of the investment committee which monitors and manages the firm’s allocation strategies for over $2 billion in client assets.
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Scott Dudgeon, CFA Director, Equity Research First American Trust |
Scott Dudgeon is the Director of Equity Research at First American Trust. Mr. Dudgeon is a Chartered Financial Analyst® (CFA®) Charterholder and has more than 29 years of investment research experience. He also serves as a leading member of the investment committee and has a proven track record for outperforming the markets for our clients. He has been with The First American Family of Companies for 20+ years.
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