Stocks Rise for the Quarter Despite Ongoing Trade Tensions

Volatility in the equity markets remained high during the second quarter, with stocks selling off as investors reacted to hawkish trade policy announcements in early April. The reciprocal tariff rates announced on so-called “Liberation Day,” April 2, were significantly higher than investors expected. The tariffs unveiled in April and subsequent ratcheting up of levies on goods from China translated to levies for goods imported into the U.S. running at an average of 25 percent, up from 2.5 percent prior to the announcement. The revenue generated from the new tariff rates was estimated to account for more than 2.5 percent of U.S. gross domestic product (GDP), and investors quickly became rationally concerned that this significant headwind could push the U.S. economy toward a mild recession in the following months. Between April 2 and April 8, the S&P 500 fell more than 12 percent, while high-yield credit spreads (the difference between yields on high-yield bonds and investment-grade bonds) expanded by 100 basis points. The spread between the two types of bonds is generally viewed as a loose proxy for macroeconomic risk. After hitting a closing peak on February 19, the S&P 500 declined 18.8 percent through April 8, marking the decline as the 28th correction (a decline of 10 percent or more from the latest peak) since 1960.

These unusual moves in safe-haven assets likely prompted the Trump administration to “press pause” on its reciprocal tariff policies.

On April 9, the Trump administration announced that there would be a 90-day pause on implementing the reciprocal tariffs and that during the interim negotiation period a baseline 10 percent tariff would remain. This abrupt change in policy was likely not driven just by faltering equity markets but probably more so by the bond market. Typically, in periods of economic or policy uncertainty investors flock to the perceived safety of assets like the U.S. dollar and U.S. Treasurys. Early in the equity sell-off, Treasurys rallied as investors moved toward this safe haven but then quickly reversed course with yields on the 10-year Treasury rising from 4 percent to 4.5 percent in just a week (bond yields and returns are inversely related). Additionally, the turmoil in the equity market did little to reverse the weakening 2025 trend of the U.S. dollar. In fact, dollar weakness accelerated during the equity sell-off in early April, pushing the currency down 10.7 percent for the year as of June 30. This weakness helped boost dollar-denominated returns for international equities.

These unusual moves in safe-haven assets likely prompted the Trump administration to “press pause” on its reciprocal tariff policies. While levies are currently higher than they were at the beginning of the year, they are about half of what they would be if the rates announced on April 2 were in effect. As such, the risk of a recession has been reduced. Markets responded to the change in trade posture with a fierce rally that pushed the S&P 500 to fresh all-time highs. For the second quarter, the S&P 500 was up a remarkable 10.94 percent, pushing the index into positive territory for the year, now a gain of 6.2 percent for the first six months of 2025.

On the international equity side, the MSCI EAFE and MSCI Emerging Markets indices each posted better than 12 percent returns for the quarter. The move higher helped to expand the international sector’s year-to-date lead over U.S. equities. Through the first six months of the year, the MSCI EAFE continued to lead across our nine asset class portfolios, up 19.45 percent, with the Emerging Markets index up 15.27 percent. As we noted earlier, a weak U.S. dollar is the story behind the strong performance of international equities. On a local currency basis, the EAFE is up 7.83 percent for the year, while EM is up 10.79 percent. Both still outpace the S&P 500 but at a more muted level.

The prospect of a slowing economy stemming from uncertain trade policy continues to weigh on sentiment toward commodities.

Despite elevated volatility in the bond market, the Bloomberg Aggregate Bond Index rose1.28 percent for the quarter and is now up 4.05 percent for the year. This resilience is bolstered by today’s favorable rate environment, which offers investors a return cushion against continued volatility in interest rates. Consider the following scenario analysis of a 10-year Treasury bond over the next year with a starting yield of 4.28 percent as of June 30. A 100-basis-point rise in interest rates from that level would translate to a 2.65 percent decline in total return during the next 12 months. However, if interest rates declined by 100 basis points, the same bond would produce 11.61 percent in total return over the course of 12 months. Despite continued concern over rising debt levels and the potential inflationary impacts of tariffs, today’s real rate environment skews positive for fixed income investors who have reasonable time horizons. At current yields, bonds can help hedge downside risk in equities while generating attractive levels of income.

Even with continued weakness of the U.S. dollar alongside rising tensions in the Middle East, commodities finished down 3.08 percent during the second quarter, with the other real asset class in our portfolio, real estate, also down 1.87 percent. The prospect of a slowing economy stemming from uncertain trade policy continues to weigh on sentiment toward commodities. Additionally, members of the Federal Open Markets Committee have suggested they will take a patient approach in evaluating how tariffs affect inflation before potentially resuming additional rate cuts. Real estate is particularly sensitive to changes in interest rates, and with the Federal Reserve on hold for the time being, underperformance continued in the second quarter.

After a difficult first quarter, the second quarter rewarded investor patience as diversified portfolios notched gains. Our diversified 60/40 portfolio was up more than 5 percent on a gross-of-fees basis. Year to date, the benefits of diversification continue to be strong, with fixed income hedging downside risk to equities and international equities providing a welcome lift to overall portfolio performance. Earlier we discussed the 18.8 percent drawdown in U.S. Large Caps as being the 28th correction of 10 percent or more since 1960. For investors with a diversified 60/40 portfolio, the drawdown experienced was much less severe, with the mix of assets limiting the drawdown to just 8.9 percent through April 8—less than half the total sell-off amount in the S&P 500. Looking forward, we believe diversification will continue to be a valuable tool to navigate a variety of elevated risks, including potential upward pressures on inflation that could weigh on both fixed income and equities. Should inflation rise, an allocation to real assets such as commodities should serve as a hedge. Indeed, commodities are one of the few asset classes that have historically delivered strong returns when both bonds and stocks come under pressure from unexpected inflation. This diversification benefit was demonstrated most recently in 2022.

Factor review

Looking at the equity landscape from a factor perspective is another way to identify the drivers of market performance. A factor is simply a characteristic that’s common to a basket of stocks. As an example, a group of companies that have low valuations compared to their sector peers is a classic example of the value factor. Another could be stocks that are generating market-leading performance over recent quarters, which is known as price momentum.

During the second quarter, the market continued to favor quality and momentum-based factors, with the economically sensitive value factor reversing the strong relative performance demonstrated in the first quarter and weakness in the second quarter likely the result of the downside surprise of hawkish trade policy announcements. As a consequence of value’s underperformance in the second quarter, market breadth deteriorated, with technology stocks once again returning to their leadership position—as reflected by the S&P 500 technology sector up a remarkable 23.71 percent.

As such, having diversified portfolios with exposures to asset classes that should respond well to various drivers of economic and market broadening is a sensible way to navigate today’s environment.

Weakness in the value factor performance tends to correlate with weaker performance from U.S. Small- and Mid-Cap stocks. That was the case once again during the second quarter. While both asset classes had solid returns on basis, U.S. Small-Cap performance of 4.9 percent and Mid-Cap performance of 6.71 percent trailed the 11.53 percent return of the MSCI ACWI Index in the second quarter.

Simply put, with the exception of strong performance from international equities, the second quarter saw a return to the narrow leadership trends that have dominated global equity markets for the last two and a half years. We suspect the elevated interest rate environment and muted near-term prospect of additional rate cuts by the Federal Reserve is the main driver of the continued bifurcation that exists in the economy and in the financial markets. The simple question going forward is this: How long can it continue? We remain steadfast in our belief that it’s a question of when, not if, the economy broadens. As such, having diversified portfolios with exposures to asset classes that should respond well to various drivers of economic and market broadening is a sensible way to navigate today’s environment. Put simply, the market should broaden if economic growth broadens. The likely path to this type of expansion is rate cuts, which could come in response to a temporary slowing of the economy or continued easing of inflation pressures.

What to watch in the third quarter

Trade and fiscal negotiations will continue to be focus points in the third quarter. While trade policy uncertainty has waned since April 2, major negotiations are still ongoing. Deals that have been announced have resulted in significantly higher tariff levels compared to where they were at the beginning of 2025. As more trade deals are finalized, it’s reasonable to expect that the effective tariff rate will rise significantly from this year’s starting level of 2.5 percent. Because of baseline tariffs already enacted, current levies are effectively in the mid-teens, which most investors expect to contribute to a near-term slowing of economic activity and potentially upward pressure on inflation in the third quarter.

While tariff rates have risen dramatically this year, the impact on inflation has been muted so far. From February through May, the Core Consumer Price Index (CPI) has risen an average of just 0.15 percent per month, equating to a roughly 1.8 percent annualized run rate. However, as companies work through the massive inventory investment they made in the first quarter, replenishing supplies with imports subjected to higher tariffs might put upward pressure on consumer prices in the second half of the year. This concern is keeping monetary policymakers in wait-and-see mode. The good news is that, heading into the third quarter’s tariff-impacted CPI releases, the run rate on core inflation shows progress toward the Federal Reserve’s 2 percent inflation target. If tariffs do not end up putting significant upward pressure on inflation in the coming months, investors will likely expect the Fed to begin cutting rates again as early as September. Coincidentally, that would be precisely one year after the Fed kicked off this easing cycle with an outsized 50-basis-point cut.

The reaction of the bond market to the potential rising deficits will be critical for the path of equities in the coming quarters.

On July 4, the Trump administration signed the massive tax and border security legislation commonly referred to as the “One Big Beautiful Bill.” The fiscal stimulus on the individual side of the statute is somewhat muted for this year, as the law primarily renews the individual rates that have been in place since 2018. Some incremental stimulus will kick in at the start of 2026 in the form of tax relief for tips, overtime, and higher deductibility of state and local taxes, along with an enhanced standard deduction for senior citizens. The more impactful part of the law is on the business side with the restoration of immediate expensing of capital expenditures. As businesses respond to this tax incentive, it has the potential to push the effective tax rate on corporations from the statutory 21 percent to the mid-teens depending on the company's level of business investment activity. It’s worth noting that according to the nonpartisan Congressional Budget Office, the law is not expected to rein in already high federal deficits, which are expected to finish 2025 at 6.2 percent of GDP, a level that is in excess of current nominal GDP growth.

The reaction of the bond market to the potential rising deficits will be critical for the path of equities in the coming quarters. If rates rise in response to potential risks caused by rising deficits, it could spell trouble for equities. Sharply higher interest rates have been a frequent driver of equity corrections throughout history. As you can see in the table below, since 1960, higher interest rates have been a common thread in 18 of the 28 observed S&P 500 corrections of 10 percent or more. Throw in the other risks detailed above, and a picture emerges of an economy facing heightened and typically conflicting risks of the potential for rising inflation and slowing growth. This combination is often referred to as “stagflation” and was last prevalent in the 1970s and early 1980s. While it is impossible to know for certain how the coming months will play out, we believe diversification that includes a combination of asset classes, including bonds and real assets, offers investors a potential hedge against rate, economic and inflation risks.

Spotlight – International Developed Equity

One of the more surprising stories of 2025 has been the performance of international developed equities. As of quarter-end, this asset class has returned just under 20 percent on a year-to-date basis for U.S.-based investors. If the excess relative performance versus the S&P 500 holds, this year would see be the largest outperformance by international developed stocks since 1993. Helping to drive this performance has been the more than 10 percent fall for the U.S. dollar. What makes the downward move in the U.S. dollar particularly noteworthy is that investor consensus heading into the trade war was that tariffs would drive the dollar higher. For U.S.-based investors, the performance of international securities is driven by both the performance of the underlying international security as well as the foreign currency. Both performance drivers are supporting strong returns so far in 2025.

As discussed in the first-quarter commentary, the Trump administration is attempting to change how the U.S. engages with the world in trade and defense. The administration is primarily using tariffs in its pursuit of its goal of reducing the large trade deficits with its international counterparts. While the U.S. has historically and will likely continue to run large trade deficits with counterparties, those deficits are counterbalanced with a large financial account surplus. This means that as U.S. consumers purchase goods and services from overseas, those dollars that are sent abroad tend to find their way back into U.S. financial assets by foreign investors. Over time, this has led to foreign investors owning $26 trillion more of U.S. assets than U.S. citizens own of foreign assets.

Put simply, efforts to reduce the trade deficit may put downward pressure on foreign ownership of U.S. assets, reversing long-standing trends and further pressuring the U.S. dollar.

This recycling of capital back into the U.S. has put upward pressure on the dollar for a considerable time period. Over the years, the capital flow has pushed the U.S. dollar into overvalued territory when measured through metrics such as purchasing power parity against other major currencies like the euro, yen, and pound. The current administration has acknowledged this currency valuation headwind as a contributing factor to growing trade deficits.

Put simply, efforts to reduce the trade deficit may put downward pressure on foreign ownership of U.S. assets, reversing long-standing trends and further pressuring the U.S. dollar. Continued pressure on the dollar, if this trend were to continue, would act as a tailwind to performance of international developed stocks in the future for U.S.-based investors. This has happened before, most recently in the period from 2001 to 2007. During that stretch, a similarly overvalued U.S. dollar fell roughly 30 percent, which helped to increase the competitiveness of U.S. exports and magnify international equity returns for U.S.-based investors. International developed equities on a dollar-denominated basis returned more than 75.5 percent versus 30.5 percent in local currency. Importantly, despite the depreciation of the U.S. dollar, the greenback continued to be the reserve currency of the world.

Lastly, NATO allies have increased their stated commitment toward defense spending while also seeking to satisfy increasing economic populism trends that are putting upward pressure on government spending. As an example, Germany has pledged to spend 500 billion euros (11.9 percent of German GDP) on domestic infrastructure and defense. The move comes after years of fiscal restraint in response to significant gains by fringe political factions. In addition to the announced fiscal stimulus, the European Central Bank continues to ease monetary policy with a largely uninterrupted string of rate cuts totaling 200 basis points so far. While collectively this is less significant than the supersized stimulus that followed the pandemic, it is a tailwind in the near term to international developed growth. Despite these tailwinds, international equities continue to trade at steeper discounts to their U.S. counterparts than the typical 15-20 percent seen historically. Specifically, the most recent measurement shows international equities trading at an estimated 35 percent discount to U.S. stocks.

Final Word

After a volatile second quarter, trade policy uncertainty has lessened but has not disappeared. While the tariff impact to GDP has moved from around 2.5 percent of GDP to around 1.5 percent as the effective tariff levels have dropped from the mid-twenties to the mid-teens, this is still an incremental headwind on consumers that’s occurring as the labor market continues to slow. Offsetting some of this headwind is the near-term stimulative impact of the recently signed fiscal legislation in Washington along with continued deregulatory efforts. Finally, the path forward of monetary policy will be dependent on the inflationary impact of tariffs in the coming months along with the changes in the labor market. Investors are expecting rate cuts to resume in September, with continued easing into 2026. Continued resilience in the labor market, albeit in a slowing trend, will make the inflation reports in the third quarter the major focus of investors. If tariffs cause inflation to reaccelerate and the labor market holds steady, investor expectations of the timing of Fed easing will likely get pushed out and could put upward pressure on rates in the near term.

We continue to stress the importance of diversification and time horizon as the strongest defense against continued volatility and today’s elevated uncertainty. As we saw during the first six months of this year, diversification can help hedge downside risk in equities while simultaneously enhancing returns. We acknowledge that the attractiveness of this approach the last few years has tested investors’ patience as U.S. Large-Cap stocks have dominated returns. However, looking forward, the expensive relative valuations and heightened concentration risk of U.S. Large Caps underscore the merits of diversifying into asset classes with different risk profiles. As is the case with international equities this year, asset-class leadership can change abruptly and surprise investors. Only time will tell if this change in leadership will have staying power beyond a few quarters, but history suggests that change in asset-class leadership over the long term is a more likely outcome than continued domination of just one asset class.

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