Quarterly Review & Market Outlook – 2nd Quarter 2025
A pessimist complains about the noise when opportunity knocks.
– Oscar Wilde
When the Fed lowered rates last Fall, nobody knew how far they could push before inflation perked up again, but that was a tomorrow problem. The first few meetings were low-hanging fruit. Four cuts later, policy was closer to neutral. The labor market steadied with no inflation worries.
The next few cuts were always going to be a harder call because of course rates should be higher than before with the US investing heavily in artificial intelligence (AI) and electrification. New investment is ultimately disinflationary but requires resources today—steel, workers, etc. Tight monetary policy essentially slowed down apartment construction to make room for datacenters.
The Fed’s job got harder on April 2 when President Trump injected tail risk into the veins of the global economy. Investors were expecting tariffs, but nothing so big and immediate as what he announced. Global trade stopped. Bond markets cracked. President Trump said he would not back down without negotiations, but the Treasury market did not give him that kind of time. Something had to give, and the bond market won. President Trump reversed the unworkable parts before real damage was done.
That was just the first week of the quarter. Whew. It feels like ancient history now, but the shock and awe announcement and subsequent retreat gave investors information about how President Trump would respond to market feedback. Whether tariffs are good or bad is beside the point. If the rules are workable, people and businesses will adapt.
The economy otherwise looks solid. The labor market is slower but steady. Corporate profits grew faster than expected in the first quarter. AI adoption is accelerating. Rate-sensitive areas like housing are consumer spending are showing cracks and would likely be responsive to lower rates. Whether more cuts are warranted depends on whether tariffs alone can offset new demand from the One Big Beautiful Bill (OBBB) passed by Congress in early July. This is still very much TBD with President Trump threatening new tariffs amid ongoing trade negotiations. Meanwhile, the Fed is under extraordinary pressure from him to lower rates regardless.
This is a different economy than the one we grew up with. The old one flirted with recession, the new one with inflation. Past governments delivered underinvestment and underemployment. This one is pressing the accelerator into full employment and using tariffs as the brake pedal. Growth then was scarce. Now even long-stagnant economies like Europe and Japan are showing signs of life.
More action in more places is welcome news for a balanced portfolio. Diversification was harder in a growth-starved, low-rate world. It is vital today. We can invest in the new world and still protect against these ever-evolving risks. We can achieve our goals without relying on one sector, or country, or the whims of politicians. We need only the courage and humility to embrace uncertainty not as a flaw, but a feature that we can use to our advantage.
Market Review
Performance during the second quarter mirrored the news. Markets sold off about 10% in the days following the tariff press conference and mostly recovered after the reversal. Even at the lows, the S&P 500 never traded at a valuation much below the 10-year median. By the end of April, the S&P 500 was down less than 1%. Like nothing happened.
Positive earnings in May and June fueled a stronger rally, boosted by a more dovish Fed. After a rocky first quarter, the tech-heavy Nasdaq Index resumed leadership, rising 17%. The S&P 500 finished the quarter up 11%. Major international markets were up a similar amount, with half of the return from currency adjustments.
Fixed income performed well, especially among more credit-sensitive sectors. The combination of tighter credit spreads and a steeper yield curve suggests investors are not worried about a recession. Tax exempt municipal bonds largely sat out the rally. Potential tax code changes caused investors to take a wait and see approach. The OBBB left municipals mostly untouched. New issuance has kept long-term municipal yields at unusually attractive levels.
Market Outlook
We like having core exposure to Technology yet also believe the benefits of AI are expanding beyond the “Magnificent 7” that currently dominate the indexes—Microsoft, Apple, etc. They are amazing companies, and amazingly profitable. They are also investing world-moving amounts of cash into AI development with an uncertain payoff.
While technology fundamentals should remain strong, the benefits are spreading as AI productivity tools grow more capable and the cost falls. Software firms are among the biggest AI users as well as one of the clearest beneficiaries. A similar story echoes across nearly all knowledge-intensive sectors with a high labor cost-to-sales ratio—media, finance, and wide range of professional services.
For better or worse, the US is still the primary way to invest in AI. According to a recent Anthropic study, 45% of the US market cap comes from sectors with the highest AI usage, compared to 29% in Japan and 10% in Europe. There are still good reasons to look for opportunities elsewhere. We just need to stay clear-eyed about what that means.
In fact, optimism about “elsewhere” is justifiable. Japan is several years into successful reforms of corporate incentives and monetary policy. Over the last three years, a currency-hedged Japan index outperformed the S&P 500. Europe is in a deeper, heavily-regulated hole, yet has perked up this year on signs they may have at least stopped digging.
A lot has also changed within Fixed Income. The bad news first. Long-term government bonds were valuable when investors raced to the safety of government bonds during market stress, but that is not happening today. Above-target inflation and procyclical fiscal policy make owning longer bonds a less attractive proposition.
The good news is we have alternatives. Safety was expensive when rates were pinned at zero. Today, we are paid to stay safe. We do not need to reach for riskier credit or long duration unless they make sense on their own. With our expanding Private Credit toolkit and other non-traditional strategies, we can build a solid foundation that protects against inflation and recession.
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Diversification is vital. It also requires purpose. We need to be disciplined about where we invest and what we are hoping to achieve. Every line item matters. Uncertainty is high, even unusually so. Yet we cannot recall a time when there were more tools at our disposal. We do not need to swing for the fences. We only need to set reasonable goals and stick to the plan.
The news changes quickly, so consider this a point-in-time snapshot of our always-evolving views. We look forward to any questions or comments you may have.
Written by the Waverly Investment Team
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| Clay McDaniel, CFA®
Partner, Chief Investment Officer |
John B. Cox, CFA® CAIA
Partner, Chief Economist |
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