The S&P 500 Index finished the second quarter of 2025 +11%, capping a furious +25% rally off the April 8th low. As we discussed in our second quarter Outlook, we believed the tariff policy laid out on Liberation Day was a self-inflicted policy mistake by the US Administration. However, we also noted, “a mere modification in the administration’s policies could quickly lead to a turnaround for an otherwise healthy global economy”. Thankfully, these modifications materialized in the form of extensions, deals and ongoing negotiations. The volatility underscores the importance of not timing the market, which we believe is a relatively futile and potentially dangerous exercise for long-term investors. Historically, the S&P 500 has experienced an average intra-year decline of ~14%, yet annual returns were positive in 35 of the 45 years. Warren Buffet once said, “the stock market is a device for transferring money from the impatient to the patient.” Patience was yet again rewarded during this bout of volatility.
We are not through the storm just yet. While effective tariff rates may be lower than originally projected, they are six times higher than they were to start the year. We believe this can ultimately have a negative impact on trade, growth, labor and inflation. Additionally, the longer negotiations last, and the more the terms change, the harder it is for businesses and consumers to move forward with investment and consumption decisions. This has not yet been evidenced in US GDP growth, which was +2% year-over-year in the first quarter and is set to be strong again in the second quarter, as per initial estimates. Nor has it had the anticipated impact of helping push inflation higher, with Core PCE just 2.7% in May versus a year ago. Many economists believe the disconnect is a result of massive inventory accumulation in advance of “Liberation Day,” which allowed many businesses to maintain pricing and production schedules without suffering meaningful margin contraction. These stockpiles of mainly components and parts have dwindled since March but remain above historical levels. Ultimately, the $30b per month currently generated by tariffs is paid by either companies (in the form of higher costs and lower profits) or consumers (higher prices). Investors have been left wondering which it will be and will be focused on getting answers to this question in the second quarter earnings season which kicked off last week.
US Large Cap Equities, as measured by the S&P 500 Index, now stand +6% for the year 2025 with the tail risks posed by the original trade plan having significantly lessened. Future corporate earnings estimates have been revised lower but remain remarkably resilient overall. 2025 S&P 500 earnings are now expected to grow 9% this year (to $265/share), while 2026 earnings are expected to grow 14% (to $300) and 2027 earnings are expected to grow another 12% (to $337).. These lofty earnings growth assumptions can support current elevated valuations (12-month forward Price-to-Earnings ratio is 22x as compared to the long-term average of 17x), but only so long as these growth levels are achieved. We have moved back to Neutral weight (from a slight Underweight) in our asset allocation models. US Mid Cap Equities (S&P 400 Index) and US Small Cap Equities (S&P 600 Index) returned +7% and +5% respectively in the second quarter of 2025, failing yet again to keep pace with their larger counterparts. Small businesses have faced the same uncertainty from a policy and trade standpoint, but traditionally have less pricing power with their end consumers and supply chains. Additionally, small businesses continue to be more negatively impacted by higher interest rates than their larger counterparts. But at 15-16x forward earnings, we believe these asset classes provide compelling opportunities for long-term investors. We remain Neutral weight to US Mid and Small Cap Equities in our asset allocation models.
Non-US Equity markets have provided investors with positive diversification benefits after years of trailing their domestic counterparts. Non-US Developed Equities, as measured by the MSCI EAFE Index, have returned +19% this year and Non-US Emerging Market Equities, as measured by the MSCI EM Index, +15%. Global inflation data has been better than expected, allowing central banks, including the ECB, to lower interest rates. Corporate earnings continue to improve on the back of encouraging economic data and stronger local currencies relative to the dollar. Companies have continued to pay out these earnings in the form of investor friendly dividends. Despite these positive returns and developments, valuations remain attractive on an absolute and relative basis. We remain Neutral weight Non-US Developed Equities in our asset allocation models. However, we are cognizant of the risks that changes in tariffs and trade policy pose, particularly in select countries that are highly dependent on global trade. As a result, we have moved to Neutral weight Non-US Emerging Market Equities in our models.
The Federal Reserve has kept short-term interest rates steady at 4.25-4.5% this year. Markets now expect just two interest rate cuts in 2025, reversing the more aggressive path that was priced in amidst recent market volatility. We believe the Fed will stay in wait-and-see mode, watching unemployment and the effects of tariffs on the economy. Some of the spotlight has shifted away from the Fed of late as constantly changing expectations around growth, inflation, and US Fiscal policy have impacted long-term interest rates. The 10 year Treasury has ebbed and flowed this year between 4% and 5%, ultimately finishing the second quarter at 4.2%. We continued to take advantage of the opportunity presented by this volatility, purchasing high quality bonds at attractive yields to lock in income in client portfolios. Our investment team has focused on generating consistent cash flow from the fixed income portion of client portfolios, whether through coupon income or consistent maturities. This cash flow is not only useful to manage client liquidity needs, but also helps protect against the risk of rising interest rates as the cash can get reinvested at higher market rates. We have been keeping maturities shorter with new cash in portfolios, but we remain Overweight to high quality Investment Grade credits. Non-Investment Grade Bonds, as measured by the Barclays High Yield Index, returned +4.6% in the first half of 2025 after a +8% return in 2024. Credit spreads over Treasuries – the premium charged by investors to hold Non-Investment Grade bonds – have narrowed considerably and are well below their long-term averages. We have been gradually reducing our allocations to these bonds even though the income is attractive on an absolute basis, because we do not believe investors are being adequately compensated for taking excessive credit risk. We are now slightly Underweight to Strategic Bonds.
As disciplined investors, our clients know how important it is to stay focused on long-term objectives and not get too discouraged (or elated) by violent short-term swings in global financial markets. The market movement we experienced last quarter was a good example of the importance of this core principle. Clients like their advisors to be forecasters, and we take time and care to form our opinions around asset classes that we feel are under or over-valued. But we are financial planners first and foremost, and our investment philosophy for our client families will continue to be driven by the time tested principles of investing: diversification, tax efficiency, cost mitigation, rebalancing, and patience.
