Overview of the Second Quarter of 2025
The volatility of market returns in the second quarter of 2025 was closely tied to the unpredictability of tariffs during the quarter. On April 2nd, President Trump announced sweeping tariffs on all countries – a day he referred to as “Liberation Day”. The S&P 500 subsequently declined by more than 10% over the next two days. The White House then postponed the increases for 90 days to allow time for negotiations, and over the course of the rest of the quarter markets rebounded. Eventually, the S&P 500 gained almost 11% in the second quarter.
While markets seem to have taken a more sanguine view of the eventual tariff impact amid the delays and legal challenges as well as a few new trade agreements, significant uncertainty remains. JP Morgan expects that the average effective tariff rate should eventually settle around 15-18%. This would represent a significant increase from the 2024 average rate of 2.5% and will likely have at least some impact on both inflation and economic growth.
Inflation figures – as of May’s data – had not yet shown significant tariff impacts. This is because many of the proposed tariffs have been delayed, and because many retailers stockpiled goods in the first quarter in anticipation of tariffs. However, expectations for future inflation have jumped. The University of Michigan inflation expectation survey indicated consumers expect inflation will reach 5.0% a year from now. Still, this is a different kind of inflation than cyclical inflation, and the imposition of tariffs will not necessarily result in the kind of upward spiraling of prices that can make inflation so dangerous and difficult to stop. The more likely scenario (barring a worsening trade war) is a one-time price jump.
The long-term growth impact of the tariff policy is uncertain since reversing globalization is novel in modern times. However, the short-term impact is likely to be negative for economic growth because tariffs are causing uncertainty and disrupting supply chains. Early signs of an economic slowdown in the US are already being reported. Consumer spending declined in the most recent report, housing starts are down, and the composite Leading Economic Indicators (LEI) contracted 2.7% over the past six months. The GDP number will likely look strong for the second quarter when it is reported, but don’t be fooled – that is mostly due to technical reasons having to do with companies frontloading imports to avoid the expected tariff hikes.
In the “Looking Ahead” section at the end of this commentary we’ll consider how the market is likely to react to these tariff-driven economic impacts. First, we’ll review the results of the second quarter.
Stocks
In the second quarter, US stocks rebounded from first quarter declines, but April started out with wild swings. After President Trump announced his unexpectedly aggressive tariff plan on April 2nd, the Russell 1000 index of large US stocks fell by 11.6% from April 2nd to April 8th. Then, after Trump announced a 90-day pause on the tariffs, the market rallied and the Russell 1000 gained 7.8% in a single day. The rally continued in May and June, and by the end of the quarter, several stock indices hit new all-time highs.
The Russell 1000 index of large US stocks gained 11.1% for the second quarter, after having declined 4.5% in the first quarter. Still, international stocks outperformed US stocks in the quarter and for the year to date. The EAFE index of developed country stocks gained 11.8% in the second quarter, on top of a 6.9% gain in the first quarter.
During the second quarter, large growth stocks like those in the technology sector led returns. Artificial intelligence (AI)-related giants like Microsoft (up 32.7%) and Nvidia (up 45.8%) rebounded strongly from what had been sharp first quarter declines. As further proof of the market’s focus on AI, Apple – a former leader among technology stocks – declined 7.5% this quarter as investors indicated disappointment with the company’s slow progress with AI.
Value stocks like Berkshire Hathaway and Johnson & Johnson, which had solid returns in the first quarter, trailed growth stocks in the second quarter. As of June 30th, growth stock and value stock returns were about even for the year-to-date period.
Bonds
The bond markets also had an up and down quarter. Long term rates initially fell, but then steadily rose after the April 2nd tariff announcements, eventually settling back down as fears cooled. The 10-year Treasury rate ended the quarter at 4.24%, which is about where it started.
Short term rates have started to decline amid anticipation that the Fed will resume rate cutting after taking a pause since the election (see the “Looking Ahead” section below for more on this).
Overall, bond returns were modest as the US Aggregate Bond Index returned 1.2% for the quarter (and 4.0% for the year to date). The best performing bonds have been international bonds – especially those held in local currencies, which have benefited from the declining dollar. For example, the iShares 1-3 Year International Treasury ETF returned 8.8% for the quarter (and 13.6% for the year to date).
Commodities and Currencies
The US Dollar continued to fall this quarter, and the Euro reached its highest exchange rate versus the dollar since 2021. There is no universal consensus as to why the dollar is falling, but it’s likely a combination of asset flows moving from the US to other countries (which involves selling dollars), and investors hedging their dollar risk as the US economy weakens and US interest rates are expected to fall.
Oil prices were volatile this quarter as conflict rocked the Middle East. Still, as the Iran-Israel conflict cooled, oil prices as measured by WTI crude declined from $71 at the start of the quarter to $65 by the end. Gold is in its third year of steady gains now as central banks invest in dollar alternatives, and the second quarter was no exception. Gold gained 6% for the quarter and is now up over 26% for the year.
Looking Ahead
The market expects the Federal Reserve to reduce interest rates in the coming months to counteract the negative economic impact of the tariffs. Fortunately, given the current Fed Funds target rate of 4.5%, there is room to do so. This year, the Federal Reserve is expected to cut at least two more times before year end, to end up around 4%. The market further expects rates to end 2026 closer to 3%. These forecasts are only for short-term rates – it doesn’t necessarily mean long-term rates, like mortgages, will see nearly as much of an impact.
The decline in interest rates will be seen as a positive by the market. If the economy contracts into a recession, on the other hand, that would clearly be a negative. So, in the end, the question may be whether rates can be reduced quickly enough to hold off a serious recession.
Investment cycles are inevitable, and our answer is to hold a long-term diversified portfolio. We hold inflation-protected bonds to protect against inflation risks. We hold foreign stocks and gold to hedge against a recession. We hold foreign stocks and some of our foreign bonds in local currencies to protect against a decline in the US dollar. In the first half of this year, diversified portfolios have been doing a good job of providing strong returns while offsetting the ups and downs of a chaotic year in the markets. We’ll continue to monitor and make adjustments as we see risks in the markets evolve, but we’ll always maintain a widely diversified asset allocation.