Institutional market update 1Q 2025
By: Kelly Kowalski CFA and Kevin Schultz
This article will ...
Outline the challenge of fighting inflation against a backdrop of trade wars and recession fears.
Describe the two pivotal themes for the U.S. economy for the remainder of 2025.
Underscore the importance of keeping a long-term perspective and staying diversified.
As highlighted in our previous edition, 2024 exceeded consensus expectations: risk assets outperformed, consumers proved resilient, and the labor market remained robust. Entering 2025, the expectation was moderation, attributed to several factors, including elevated valuations, persistent inflation, diminishing fiscal stimulus, and policy uncertainty. However, underperformance of U.S. equities and a historic sell-off in early April was not in the cards.
The timing, severity, and impact of the policies introduced by the incoming Trump administration remained unclear heading into the year. The imposition of tariffs, federal labor cuts, and declining net immigration posed potential threats to economic expansion. Conversely, deregulation and tax cuts had the potential to stimulate economic activity and bolster growth.
So, what has actually happened? Two of the three less growth-friendly forces mentioned above, tariffs and federal labor cuts, have dominated headlines. This shift has greatly weighed on sentiment, as reflected in market reactions in the first quarter:
U.S. equities, as proxied by the S&P 500, whipsawed to the downside, plummeting by 10 percent from their mid-February peak to their mid-March trough and underperforming international equities.
Credit spreads, a measure of risk or stress in corporate debt markets, started to widen from their historical lows
Treasury yields experienced first quarter peak to trough declines of approximately 47 basis points on the 2-year and about 64 basis points on the 10-year as investors flocked to “safe haven” assets amid growth concerns.
Futures implied Federal Reserve interest rate cuts for 2025 peaked at three 25-basis-point reductions, up from as low as one, as investors began to price in the possibility of more rapid easing to spur the economy.
Gold continued to surge almost 20 percent through the end of the first quarter, reaching new all-time highs as a traditional hedge against economic uncertainty.
As the page turned to the second quarter, investors’ “worst case” tariff scenario emerged on April 2 or “Liberation Day”. As of April 4, the S&P sold off almost 10 percent and fell approximately 17.5 percent from its February high. Additionally, Treasury yields continued their descent, and futures implied interest rate reductions for 2025 reached a year-to-date peak of four 25 basis point cuts, clearly demonstrating deepening recessionary fears stemming from a potential retaliatory spiral. As individuals and institutions grapple with the administration’s continuous policy revisions, unpredictable foreign responses, and conflicting data, markets understandably continue to exhibit considerable volatility. If the rest of the year looks anything like the first quarter and first few days of April, it will be a bumpy ride.
Soft data paints dire picture
At their core, markets reflect expectations of future events, incorporating beliefs, sentiment, and risk appetites in real time. The sentiment that pervaded markets in the first quarter is consistent with “soft data,” or survey-based economic data, that points to a pessimistic outlook. On the other hand, hard data — more quantifiable and objective — paints a less dire picture, for now.
What are we observing in the realm of soft or survey data? Let’s first focus on one of the fundamental pillars of our economy—the consumer. As mentioned, part of last year's outperformance can be credited to a resilient consumer base. Unfortunately, the University of Michigan's measure indicates that consumer sentiment continues to plunge to levels rarely seen in history. This significant decline is largely due to concerns about rising prices and slower growth linked to tariffs and general policy uncertainty. In fact, another example of weak soft data comes from exactly that—U.S. economic policy uncertainty. An index reflecting this, as measured by Baker, Bloom, & Davis, shows that economic policy uncertainty has reached levels higher than during historical events like the sovereign debt crisis and the global financial crisis, rivaled only by the COVID-19 pandemic.
Finally, the main event of the past couple years — inflation. Also measured by the University of Michigan, median inflation expectations have seen a sharp increase. Over a one-year horizon, expectations have surged to 5 percent, up from 2.8 percent at the beginning of the year. Five-to-ten-year expectations have climbed to levels not seen in over two decades at 4.1 percent, compared to 3.0 percent at the start of the year. Putting it all together, the soft data seems to point towards a scenario of slow economic growth coupled with high inflation — better known as, stagflation.
Hard data appears less draconian, for now
What story is the hard data telling? Let's look at what truly drives consumers’ ability to spend — jobs. As it stands, unemployment remains relatively low at 4.2 percent. Moreover, despite marginally lower-than-expected changes in nonfarm payrolls for January and February, March greatly surprised to the upside, and job creation has remained a consistent characteristic of the economy. Also, while survey data suggests an anticipated re-acceleration of inflation in both the short and long term, hard data suggests inflation continues its downward trajectory. February's CPI surpassed expectations at 2.8 percent for the headline measure and 3.1 percent for the core measure.
While soft data has been driving market performance so far, the question remains: when and how will this begin to influence hard data? The timing is uncertain, but the mechanism seems clearer. Firstly, labor market cracks are likely to deepen as the Department of Government Efficiency (DOGE) continues their crusade for federal labor cuts in a bid to reduce wasteful government spending. In terms of inflation, anticipated price increases and higher input costs due to tariffs should pervade into CPI data, with risks to the upside should retaliatory measures from other nations spiral.
The consumer, which drives approximately two thirds of GDP, has been resilient over the past few years, supported by higher income households. The wealth effect (i.e. people spending more money because they feel wealthier) has been a factor, and there is a significant risk that the pronounced sell-off in equity markets could result in a more restrained upper-income consumer.
New administration seeks disruptive realignment
Through DOGE and tariffs, the administration is trying to pursue smaller government, reduced deficit spending, reduced imports, and increased domestic manufacturing.
DOGE aims to reduce government spending via cutting the federal labor force and other spending. The core issue is the rapid pace of government expenditure and escalating debt. To put this in perspective, the US national debt is approximately $36.7 trillion, with annual deficits occurring every year since the early 2000s. This continuous debt increase has resulted in interest expenses on the debt surpassing both defense and Medicare spending.
Part of the proposed solution involves reducing the federal labor force by an estimated 10-20 percent of the 2.4 million civilian federal workforces, representing approximately 1.5 percent of total nonfarm payrolls. While these measures pose short-term risks to growth and employment, they could lead to long-term benefits from reallocating resources and reducing government spending and deficits.
Tariffs are intended to serve three primary purposes: incentivizing domestic production, equalizing the trade environment among international counterparts, and generating revenue to improve the U.S. fiscal position. Tariffs also threaten to slow growth, increase prices domestically, and place upward pressure on inflation.
While these aims seem logical, the “chainsaw” and extreme approach is driving significant uncertainty and unease, threatening recession over the short-to-medium term. According to Bloomberg, the administration’s initial proposal equates to an average tariff rate of 22 percent on U.S. imports, the highest in over 100 years of data, and 2.2 percent of U.S. GDP. According to the IMF, U.S. GDP could fall 2 percent through 2026 due to tariffs and trade policy uncertainty.
“Lagnificent 7” and the credit dilemma
The Magnificent 7 — Microsoft, Amazon, Meta, Apple, Alphabet, Nvidia, and Tesla — have been the darlings of the stock market over the past couple of years, but they have disappointed investors to start 2025. According to the UBS Magnificent 7 Index, this group, which achieved impressive total return performances of 76 percent in 2023 and 48 percent in 2024, has seen a dismal -15 percent total return in the first quarter and a further -12 percent in the days following “Liberation Day.” Heading into 2025, the S&P 500 was highly concentrated in the Magnificent 7, making up nearly 35 percent of the total market capitalization. Consequently, the overall S&P 500 has shared in the underperformance of these major players.
While year-to-date volatility might seem alarming, especially considering we are only a quarter of the way through the year, it is important to remind investors that drawdowns are a normal part of market activity. It is precisely this volatility that explains higher positive expected returns over time. To put the recent drawdown into perspective, since 1998, the average maximum intra-year drawdown has been -16 percent. Moreover, a -10 percent drawdown or greater has occurred roughly 60 percent of the time during this period, with many drawdowns being significantly larger. Thus, while the current market decline may be unsettling, it is far from unprecedented.
In the first quarter, corporate credit spreads widened slightly from historically tight levels due to softening growth sentiment and elevated valuations. Investment Grade spreads widened 14 basis points during the quarter, while High Yield spreads widened 60 basis points. Then, through April 4, spreads continued their climb with Investment Grade spreads widening an additional 15 basis points and High Yield spreads widening an additional 80 basis points. These movements brought spread levels in each market to a place not seen since late 2024 and late 2023, respectively. Does this shift imply that credit markets are cheap? Not exactly. Investment Grade and High Yield spreads still trail their long-term averages of approximately 147 basis points and 511 basis points, respectively.
The Federal Reserve predicament
Over the past few years, inflation has dominated the focus of both the economy and the Federal Reserve. Now, with growth and recession fears looming larger due to the policies emanating from the White House, has the focus officially shifted?
Recent headlines have begun to emphasize the growing threats of recession, trade conflicts, and prevailing uncertainty. In fact, JPMorgan is the first bank to predict an outright recession in 2025 as part of their forecast. Even Chair Powell has acknowledged that the economic impact of new tariffs is likely to be significantly larger than expected, leading to higher inflation and slower growth.
To make matters more complicated, inflation remains far from the Federal Reserve's 2 percent target, and as measured by core CPI, has failed to fall below 3 percent. This persistent inflation, coupled with emerging growth concerns, presents the Federal Reserve with a significant monetary policy challenge. Should they continue prioritizing price control, or should their focus shift to supporting economic growth?
Looking ahead
As we navigate through the rest of 2025, various factors such as policy, tariffs, geopolitics, inflation, and the economic growth outlook remain in flux. Thus, we expect ongoing volatility and uncertainty to undoubtedly persist.
As for markets, we identified two primary risks heading into 2025: the Magnificent 7 concentration and high valuations. Year to date, as equity markets declined, the Magnificent 7 concentration decreased from around 35 percent of the total S&P 500 market capitalization to approximately 30 percent. Additionally, S&P 500 forward 12-month P/E multiples have compressed by roughly 16.5 percent, from over 22.5x to roughly 19x. Earnings per share growth estimates for 2025 have only slightly declined from around 11 percent at the beginning of the year to just below 10 percent. But it seems only a matter of time until negative sentiment and tariff impacts start to seep into consumption and, consequently, company-level earnings
The narrative of strained sentiment, punitive trade policy, and pervasive uncertainty underscores the tenuous nature of both the U.S. and global economies.
We remain focused on several themes, but two pivotal themes for the rest of 2025 are:
Trade policy changes: These include the reactions from foreign nations, domestic and international consumers, domestic and international companies, and central banks
Sentiment's impact on the real economy: Monitoring the timing and breadth of sentiment effects on the real economy, such as labor, consumption, and investment
While investors should expect persistent volatility and a headline-driven market, they should also remember the importance of a long-term perspective and diversification to help weather this volatility.
We look forward to discussing developments in the economy and markets with you this summer.
Disclosures
Market Indices have been provided for informational purposes only; they are unmanaged and reflect no fees or expenses. Individuals cannot invest directly in an index.
Description
The UBS Magnificent 7 Indextracks a group of 7 of the largest mega cap tech stocks listed in the US. The stocks mirror their respective S&P 500 weight reweighted pro-rata.
The NASDAQ Composite Indexis a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market.
The S&P 500 Indexis widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80 percent coverage of available market capitalization.
The Nikkei-225 Stock Averageis a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949, where the average price was ¥176.21 with a divisor of 225.
The STOXX Europe 600 Indexis derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 17 countries of the European region.
The Russell 2000 Indexis comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8 percent of the Russell 3000 total market capitalization. The real-time value is calculated with a base value of 135.00 as of December 31, 1986. The end-of-day value is calculated with a base value of 100.00 as of December 29, 1978.
The Bloomberg US Corporate High Yield Bond Indexmeasures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded
The Bloomberg US Leveraged Loan Indexmeasures the performance of USD denominated, high-yield, floating-rate,institutional leveraged loan market. The US Loan Index was created in 2024, with history backfilled to January 1, 2019.
Gold Spot Priceis quoted as dollars per Troy Ounce.
The MSCI EM (Emerging Markets) Indexis a free-float weighted equity index that captures large and mid-cap representation across Emerging Markets (EM) countries. The index covers approximately 85 percent of the free float-adjusted market capitalization in each country.
The Bloomberg USAgg Indexis a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
The Bloomberg US Treasury Indexmeasures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.
The CSI 300 Indexis a free-float weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges. Index has a base level of 1000 on 12/31/2004. * Due to our agreement with CSI, shares in the index is restricted, please visit SSIS<go> for more information and access. This ticker holds prices fed from Shenzhen Stock Exchange.
Oil Spot Priceis quoted as dollars per barrel for export quality Brent crude oil.
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