2nd Quarter 2025 Market Commentary
The Markets in the First Half of 2025
The market has decided to ignore or discount the noise from Washington, so for the first part of this discussion, we will do that too and just talk about market performance. And that performance was not too terrible.
Figure 1: YTD performance of S&P 500, MSCI EAFE, MSCI Emerging Markets, & Bloomberg Barclays Aggregate Bond Indicies (from Kwanti)
The graph above shows that the S&P 500 (in green) dipped significantly in the first quarter and reached its nadir right around April 15th. Since then, it has come back steadily, closing up 6.2% at the end of the second quarter. A 6.2% gain over 6 months is not too bad if you ignore the gyrations necessary to get there. But look at the blue line. That’s the MSCI EAFE index which tracks developed markets in Europe, Asia, and North America other than the USA. Yes, this index dipped slightly in April, but it then came roaring back to be up 19.45% for the whole quarter. The MSCI emerging markets index (heavily influenced by China and India) also did very well, closing up 15.27% for the quarter.
The theme here is while the USA is doing OK, the rest of the world has done better. This is remarkable simply because it has not been true for a very long time. 2017 was the last full year where both EAFE and emerging markets did better than the S&P 500. Most investors have a portfolio which is diversified internationally, and this is the first year in a while where that paid off.
Will this pattern continue? Can the S&P 500 go up further for the rest of the year? Will international markets continue to outpace US markets?
I don’t know the answer to these questions, but now it’s time to look at economic numbers and valuations as well as glance at Washington to try to gain insights.
Economics from the First Half of 2025
Let’s look at the US first. The US economy definitely slowed down in the first quarter with Gross Domestic Product (GDP), a measure of economic growth, turning negative for the quarter with a figure of -0.5. This means the economy contracted slightly. But when you examine the details, there was a lot of front-running of purchases before the tariffs were supposed to kick in. The trade deficit soared, which was all goods purchases. Since the trade deficit subtracts from GDP, that was why GDP was slightly negative. It’s very likely that the second quarter will show a modest GDP increase. So, the economy has slowed but is still expanding.
Jobs are a very important part of the economic picture. While jobs are not as plentiful as they have been, the recent job numbers are still showing an expanding economy. The unemployment rate actually dropped to 4.1% in the most recent reading.
Inflation has been moderating but is still not where the Fed wants it. Core PCE which is the Federal Reserve Bank’s favorite measure on inflation is still running at an annual rate of 2.7% as of the May reading according to the Bureau of Economic Analysis. This is above the Fed’s 2% target and while the Fed did think inflation was coming down pre-tariffs, they also are concerned about the impact of tariffs on inflation.
The Future
The US stock market is near an all-time high. But it is also very expensive and since stock prices are supposed to reflect some kind of fundamental valuation based on future earnings, the question is what will directly impact future earnings. Here is a quick list:
- Financial Stimulus – This could be fiscal stimulus from government spending or tax relief or monetary stimulus from lower interest rates.
- Larger workforce or higher productivity – The economy can only expand as fast as either the workforce expands or productivity increases.
- Economic Expansion – If more people are employed and earn higher wages, then they can spend more. This could be demand in the US if domestic or outside of the US for global demand for US products.
The problem is that there are longer-term storm clouds with all these factors. Let’s discuss them further.
Economic Stimulus
President Trump has just signed the OBBB, his signature tax and spending bill. One of the major things this bill does is to extend the existing lower tax rates that were established in 2017 with the Tax Cuts and Job Act. Many of the provisions in the TCJA had been set to expire at the end of this year. Extending the 2017 tax cuts is fiscally neutral but if the tax cuts had been allowed to expire, that would have been a fiscal pullback. Avoiding higher taxes may be accommodating for the economy, but it is not new stimulus.
There are some additional tax breaks in the new bill which include no tax on tips, additional deductions for some seniors, larger SALT deduction, and a slightly increased child tax credit. The bill also has some additional tax breaks for businesses which purchase equipment or make R&D investments. Although many of the provisions of the bill kick in this year, stimulus is likely to be relatively short-lived in early 2026 when tax refunds will be higher.
Meanwhile President Trump has been cutting federal spending. The stimulus from the tax provisions on the bill are likely to exceed the cut in federal spending, but the end result will be much lower stimulus than from the original TCJA.
The picture for monetary stimulus is also murky. The Federal Reserve has been trying to figure out if it can cut interest rates and has so far held off because of inflation worries. The Fed is not actually supposed to stimulate the economy unless the unemployment rate rises. While that is possible, it certainly has not happened yet and with the labor force shrinking, it may not happen. Meanwhile tariffs might finally cause the inflation that the Fed is worried about within the next couple of months. It’s possible there may be a single drop of 0.25% in the Federal Funds rate towards the end of the year, but it seems unlikely there will be significant stimulus from the Fed. Meanwhile, longer-term rates might rise because of the worries about the US borrowing too much money. These rates are set by the market and demand for US debt. Since the US needs to issue a lot of debt to finance the government, rates pressure will be up and not down.
Economic Stimulus is not likely to be a huge factor in a rising stock market.
Workforce and Productivity
The US workforce is shrinking. There are not enough babies being born in the US to replace the workers retiring. Immigration had kept the workforce growing, but that spigot has now been closed, and immigrants have started to leave the US. This reduces the workforce and keeps unemployment low, even if jobs were not being created. But presently, the US is still creating new jobs, so this puts even more downward pressure on unemployment.
We might not need that many new workers if we can increase productivity. AI might just do that, at least if the promise of AI is fulfilled. I would think AI will increase productivity; the question is how much? The economy can only grow without creating inflation if either the workforce increases or productivity increases. If that happens, then company earnings increase, and the stock market can rise.
Economic Expansion
Economic expansion is what might happen if we have stimulus and an increase in workforce or productivity. But wages need to rise enough over inflation to stimulate higher purchases. If it’s not increased consumer spending, then businesses need to spend to fulfil the expected increase in orders because of international demand. Tariffs will probably reduce international demand as other countries look outside the US for trade. It is possible that President Trump will be able to sign trade deals to increase exports, but ultimately, I think he simply wants to reduce imports and reshore manufacturing. The overall level of US trade could be reduced, which is the opposite of economic expansion. While the US economy has shown remarkable resilience, I think it’s hard to foresee significant near-term economic expansion.
The Stock Market
What does all this mean going forward? The most likely is that the economy sputters along with lowish unemployment and higher inflation. This does not bode well for the US stock market overall. It may simply be choppy with corrections followed by rallies, but it’s hard to see the S&P 500 have gains in the next few years at the same level as the last few.
Foreign markets on the other hand could continue to rally. European countries are stimulating their economies and foreign stock markets sell for much lower valuations than US markets. The war in Ukraine combined with the US pulling back from NATO means European countries are spending much more on defense. Countries such as Tawain, Japan, and The Philippines might do the same. This stimulus combined with lower valuations could mean the rally in foreign markets can continue. It certainly means you should have a diversified portfolio to make sure your investments include these markets.
Staying invested is important, even when it’s hard to see how the stock market can increase. This is because we can’t always predict what can happen. Maybe AI will have such a stimulating effect in the US that it continues to drive the S&P 500 forward? Maybe the war in Ukraine ends and Putin is deposed which acts as a big stimulus in Europe? Maybe pressure from businesses on the Republicans about workforce challenges causes them to increase immigration? Things happen which we can’t predict and that’s why staying invested is the key to long-term success. Just make sure you lower risk by having a diversified portfolio and using bonds and some smart alternative investments to mitigate risk.
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