Market volatility rises when uncertainty rises, and the first quarter of 2025 saw uncertainty soar across a range of important fundamental variables. Whether it was the impact of an evolving trade policy on both the economy and inflation, uncertainty over immigration and its impact on the labor market, the implementation of government layoffs or greater geopolitical uncertainty emerging from shifting long-standing relationships, investors had their work cut out for them. 

As we look ahead to the second quarter, our focus remains on the fundamental trends that drive markets, aiming to assess material changes such as tariffs that could alter the long-term outlook for stocks or bonds. In periods of high uncertainty, this is more difficult and can justify taking a more conservative tactical stance. But we stand by a core tenant that tolerating shorter-term periods of uncertainty and volatility rather than making large changes to investment portfolios in response to short-term data helps avoid the risk of locking in losses by being out of the market for the inevitable rebound in returns. 

The economic outlook has deteriorated

The U.S. economy entered 2025 with strong domestic demand, a robust jobs market and rising productivity amid a massive investment boom in artificial intelligence. Consumption and investment appear to have remained solid through the first quarter of 2025.  A surge of imports, however, might result in a negative reading for gross domestic product (GDP), a measure of economic growth.  That’s because the accounting for GDP factors in net exports, which likely will be significantly negative due to a jump in imports to get ahead of tariffs along with a surge of imported gold. The core domestic economy, however, appeared solid heading into the jump in policy uncertainty. 

The veil of uncertainty over trade policy and inflation weighed on both consumer and business confidence. However, the sharp drop in confidence so far has not been entirely aligned with changes in spending, employment or capital expenditures. How consumers feel and what they do often is different. Consumer confidence has been falling, but so far consumers in aggregate have kept spending as there is often a lag between sentiment and action. The longer market volatility persists, however, the greater the risk that spending declines. 

While consumer finances overall remain solid, there are early signs of stress as loan and credit card delinquencies continue to rise. Tariffs likely weigh further on consumer confidence and finances as the lower- and middle-income segments of the population are more sensitive to higher prices. While the upper income tier—a significant contributor to aggregate consumption—has been healthy, delinquencies are rising even among the wealthy, albeit modestly from a very low base. And insofar as stronger stock markets had helped fuel spending in the wealthier segments of the population, so too could large drawdowns in markets weigh on the upper-income population’s propensity to spend. 

Meanwhile, businesses came into the year optimistic that they would be able to benefit from lower taxes, less regulation and a generally more business-friendly environment. But policy uncertainty has clouded optimism and business sentiment measures have fallen to levels that have been associated with sharp economic slowdowns. Despite these concerns, businesses have seen strong sales year-to-date while unemployment has remained contained. The outlook for the second quarter, however, is cloudier, with some companies guiding down earnings.  

In our view, a scenario where economic growth is weak and inflation rises (also known as stagflation because the economy remains stagnant while inflation persists) is increasingly likely. We do not, however, expect a return to the stagflation seen in the 1970s and early 1980s with double-digit inflation and high unemployment. We believe the risk that economic growth softens further is more likely than it rebounding sharply in the near-term. We also expect inflation to remain elevated versus the Fed’s 2% target, especially if the recently announced tariffs are fully implemented and met by a strong foreign response. In the event large tariffs are sustained, the effect will depend on their magnitude, and economists differ on the impact and its duration, but investors should expect a significant impact on growth, inflation and market returns. 

• Bottom line: It is too early to declare a recession is inevitable, but the odds have risen substantially.  At a minimum, a period of slower growth and higher inflation is likely if tariffs persist and bump up prices, resulting in weaker consumer and business confidence triggering lower spending and investment. 

The U.S. Federal Reserve (Fed) is likely to be supportive

Slower growth and elevated inflation create something of a conundrum for the Fed, which has a dual mandate to contain both inflation and unemployment. While slower growth would advocate for interest-rate cuts, and higher inflation would advocate stable or possibly even higher interest rates, we expect the Fed to remain on hold over its next few interest-rate policy meetings. Given that the Fed is facing the same uncertainties as the financial markets and seeking the same clarity on longer-term trends, we expect it would prefer to wait until there is greater clarity on global trade policy before taking action. 

That said, the Fed does see current interest rates as restrictive. Various committee members have recently indicated they see risks to economic growth. Several members, however, have focused on the risk of higher inflation. The Fed wants to ensure that one-time tariff price hikes do not evolve into ongoing inflationary problems. As such, the Fed likely remains on hold without clear data pointing to a significant rise in unemployment. Ultimately, the Fed could be faced with a choice between inflation and jobs. We expect it will lean toward supporting jobs outside of clear signs of inflation sustainably and significantly rising.

• Bottom line: Expect the Fed to lower rates to support the economy should the unemployment rate rise significantly, even if inflation is about its target level, as higher unemployment would work to dampen any inflationary pulse given less consumer demand. 

Stay invested in stocks, favoring U.S. large-caps

The S&P 500^® Index fell from its record-setting highs in the first quarter to end the period down around 10%. After the tariff announcement on April 2, stock markets plunged further as markets struggled with the growing uncertainty of the large change in trade policy designed to reorder global trade. The key questions are the degree of retaliation by trading partners, and the extent negotiated compromises can be reached. We expect some compromises will ultimately be found, but tariffs will remain higher than previously. Market volatility and drawdowns triggered tend to end once there is greater certainty and markets can price in the impact of the key issue, which in this case is tariffs and their impact on the U.S. and global economies. Once the veil of uncertainty starts to lift, markets can reset and start to recover. 

Support for the market also should come from the correction providing more reasonable valuations in stocks, driven in part by companies having already lowered expectations for earnings. However, sustained strength in equities will be dependent on earnings growth, which historically drives markets over the long term. Earnings have been solid, but are likely to be revised down, especially as roughly 40% of the S&P 500’s earnings are from outside the U.S. While there may be bumps, the longer-term outlook for earnings remains strong. Additionally, domestic economic policy could ultimately remain positive for stocks, particularly a more supportive domestic tax policy and evidence of the benefits of deregulation. 

We believe large-cap stocks are better positioned to navigate the current environment as they are typically global companies with very strong cash flow and both high profit margins and cash balances, which could be used to help (temporarily) offset the effect of higher tariffs. Mid-cap and small-cap stocks, in contrast, are not as likely to perform as well in an environment of slowing growth as they tend to be more cyclical. 

We have maintained our small overweight to equities broadly, favoring U.S. large-cap stocks while being roughly neutral in small-cap stocks. But our modest overweight in equities is in line with our strategic preference for equities over fixed income. Should we see a significant further correction in stocks without a corresponding deterioration in the long-term outlook for the U.S. economy, we would be inclined to add tactical exposure. 

Recently, international stocks have broadly outperformed U.S. equities, particularly European equities. We have been positioned underweight international stocks and expect to maintain this position as we anticipate the U.S. economy can remain more dynamic than Europe’s in the years ahead. Also, Europe is much more exposed to global trade than the U.S. However, should that outlook shift because of policy choices in the U.S. or Europe, we may look to reduce our relative underweight to Europe. 

• Bottom line: We expect volatility to remain high if policy uncertainty persists but expect the market to find a bottom in the coming months.