Markets bounced back faster than expected this quarter, thanks to Trump’s tariff U-turn, lower-than-expected inflation, and de-escalation in the Middle East.
Download PDF VersionLast quarter's report was published the day after President Trump unveiled his reciprocal tariffs on "Liberation Day", which sparked turmoil in the markets and left the US stock markets down 20% from their February highs.
Luckily for all concerned, President Trump quickly did an about-turn and suspended the reciprocal tariffs, replacing them with a baseline 10% tariff, initially on everyone except Mexico, Canada, China and some specific industries. Cue a market recovery that reversed the losses.
In theory, a new deadline looms as the 90-day suspension of reciprocal tariffs ends on 9 July. However, the market seems to believe that the 10% base tariff will be rolled over in most cases. But there may still be spats over specific items or with individual trading partners (e.g. the EU).
In effect, this is what we described as the positive scenario in our last two quarterly reports: the tariff threat would force America's trading partners to the negotiating table and not escalate into a full-blown trade war. While tariffs are economically damaging, if contained to a fairly limited scale they are unlikely to derail the global economy.
The key point to remember is that the underlying environment remains positive, with economies continuing to recover from the inflation and interest rate shock of 2022.
Notwithstanding the fears about a possible short-term upsurge in inflation due to tariffs, in overall terms inflation and interest rates are still falling around the world. By slowing growth, tariffs could even be helpful by bearing down further on underlying inflation and cooling labour markets and wage growth.
Towards the end of the quarter, the market recovery was turbocharged by the swift end to the conflict over Iran's nuclear facilities. This removed a tail risk of a drawn-out conflict leading to a jump in the oil price. Furthermore, recent inflation data has indicated that Donald Trump's tariffs have so far had a limited effect on inflation, which has made rate cuts more likely.
This explains the positive mood on the stock markets since the tariff suspensions. It is not so much that the markets are ignoring the adverse effects of tariffs on global growth, which have been pointed out by the IMF and others, but that the underlying economic backdrop is benign and now appears unlikely to be derailed.
There is uncertainty about what will happen when the 90-day pause on reciprocal tariffs ends on 9 July. The direction of travel is clearly now towards further deals, but higher tariffs could still be imposed on individual countries. The two biggest trading partners in the firing line at present appear to be Japan and the EU.
The next few months will also be pivotal for the debate about whether US inflation will continue to fall, or stagflation - weak growth with stubborn inflation - will set in. The Federal Reserve (Fed) has indicated that rate cuts are off the table until it has seen a few more months of inflation data. US interest rates could therefore fall more sharply, or more slowly, than currently expected. We will also find out whether the economic slowdown in the US is temporary or something more serious.
Finally, will the AI boom continue, with capital spending and stock prices continuing to rise stratospherically, or could it lose steam due to a reassessment of the business prospects of one of the main players, or the effectiveness of the technology itself, as occurred briefly after the release of DeepSeek?
Weaker and stronger data have been alternating on the US economy, which is probably consistent with an economy that is growing sluggishly but is not near a recession. The tax cuts in the One Big Beautiful Bill Act should help to boost growth at the margin.
Gross domestic product (GDP) fell by 2.0% in Q1 2025, but this was distorted by a surge in imports due to stockpiling ahead of the tariff announcements. Growth is expected to rebound in the second quarter. However, the Fed has revised down its
growth forecast for 2025 from 1.7% to a relatively modest 1.4%. This is below-potential growth, which should put downward pressure on underlying inflation.
Job growth has slowed in recent months, though unemployment has so far remained steady between 4.1% and 4.2%. There have been some signs of wobbles in consumer spending, with retail sales falling by 0.9% in May. Against this, consumer confidence has actually picked up a little, albeit from a low level. The manufacturing sector has been contracting mildly for most of the past two years, with the ISM purchasing managers' index remaining stuck just below 50, but is well above recessionary levels.
The best news on the US economy has been the absence of an inflationary impact from tariffs so far. Core consumer price inflation has continued to slow from 3.2% at the turn of the year to 2.8% in May. The Fed's preferred measure of core Personal Consumption Expenditures (PCE) inflation stood at 2.7% in May, only marginally up from April's 2.6%.
It remains to be seen if an inflationary effect does begin to filter through in the next few months. The Fed has kept the federal funds rate on hold at 4.25% - 4.50% so far this year as it continues to await the impact of tariffs on growth and inflation. The market is still pricing in a reduction of at least 50bp later this year.
After a cumulative fall of over 20% from its record high in December 2024 to the post-Liberation Day low in early April, the Nasdaq index rebounded in the second quarter in response to the suspension of tariffs and reached new record highs at the end of June, leaving the index up 6% year-to-date. It was premature to see the tech sector's troubles earlier this year as heralding the end of the AI story, as it has come roaring back stronger than ever.
The "Magnificent 7" (Mag 7) tech giants also rebounded in the second quarter, with the exception of Apple, which is more directly exposed to the tariff war and is also seen as an AI laggard. However, along with Apple, the share prices of Tesla and Alphabet are also still down year-to-date, with Amazon flat. There has therefore been increasing divergence among the Mag 7. The winners so far this year are Microsoft, Nvidia and Meta, which are seen to have superior AI positioning and/or offerings. Their share prices are up 15-25% so far this year.
There have been some signs of a modest pickup in the eurozone economy this year, and with the slowdown in the US, Europe is no longer lagging as far behind. GDP growth accelerated to 0.6% on the quarter and 1.5% year-on-year in Q1. Manufacturing purchasing managers’ indices (PMIs) have picked up in recent months, although this has been partly offset by a decline in services PMIs. Germany's expansionary fiscal policy is forecast to boost growth in 2026 and 2027.
Where Europe differs most markedly from much of the rest of the world is that inflation is now back on target. After falling steadily over the past year, euro area inflation was 2.0% in June. Inflation is therefore not a constraint on policy and this has allowed the European Central Bank (ECB) to continue cutting its policy rate to 2% by June 2025. This easing of monetary policy should provide a boost to the European economy.
President Trump has threatened to hike tariffs on the EU to 50% if a trade deal is not reached by 9 July. The EU is demanding a similar deal to that offered to the UK and has prepared retaliatory measures if a deal is not reached. The most likely outcome in the short term is that the current 10% baseline tariff is rolled over while talks continue, but an escalation is not impossible.
Ironically, considering the fierce debates for and against Britain leaving the EU, the UK economy is growing at almost exactly the same rate as the eurozone. UK GDP grew by 0.7% quarter-on-quarter in Q1 and 1.3% yoy, practically identical to the eurozone performance. However, in one respect the UK is doing much worse than the EU, which is in relation to the UK's stubbornly high inflation. Consumer Price Index (CPI) inflation was 3.4% in May, with services inflation close to 5% and wage growth at 5.2%. This has forced the Bank of England to move slowly in lowering interest rates. It made one 25bp cut to 4.25% in the second quarter.
The UK economy will gain a small boost, at least in relative terms, from the limited trade deal it has agreed with the US. This gives the UK a preferential tariff rate of 10% on car exports and 25% on steel and aluminium (though the latter could potentially increase after 9 July). Just as importantly, it is now out of the firing line in any future trade spats.
Data on the Chinese economy remains mixed. It continues to grow sluggishly by its standards, at or slightly below 5%. The property market is still one of the main drags on growth and it will be some time yet before the market has fully recovered from the crisis. The Caixin manufacturing PMI rebounded to over 50 in June, following a sharp drop in May at the height of the US/China trade war. Meanwhile, CPI inflation was -0.1% in May and has been around zero for over two years. China has so far held back from a large-scale fiscal stimulus, and its many small policy steps in recent years have only had an incremental impact on growth.
China and the US struck a deal to suspend their spiralling trade war and return to the universal 10% tariff rate. However, added to previous tariff rounds, overall tariff rates stand at around 50% on the US side, and 30% on China's.
China also agreed to restart exports of rare earth minerals. Stocks of these have reached critically low levels in many industries, particularly the auto industry, where they are used in electric vehicles (EV) - cars in particular.
The Fed stayed on hold again in the second quarter of 2025 as it continues to await further information on how big an impact Trump's tariffs are having on inflation, and whether the slowdown in growth persists and spreads more widely.
It revised down its 2025 growth forecast from 1.7% to 1.4% at the June meeting and simultaneously revised up its inflation forecast from 2.7% to 3.0%. The "dot plot" also showed an increasing number of Federal Open Market Committee (FOMC) members expecting just one or even no rate cuts this year. However, the president has upped the pressure on Chair Powell to cut interest rates. Several FOMC members have broken ranks and suggested that rates should be cut as soon as July, but Powell has indicated that he sees September as the earliest date.
The Fed has stated that it is attentive to risk on both sides of its mandate - i.e. both the risk of higher unemployment and the risk of higher inflation - but seems to be leaning towards giving priority to worries about higher inflation in the short term.
Would it cut interest rates if growth slows further but inflation remains above target?
Most observers believe that if push came to shove, it would. For one thing, the Fed might not be able to withstand the political pressure to ease policy. The market has increased its expectations of rate cuts in recent weeks and is now pricing in at least two more interest rate cuts, with a chance of a third, by the end of the year.
The ECB carried on with its steady rate cuts, reducing the discount rate by a further 50 bp to 2%. However, it signalled after the latest cut that it is approaching the end of its rate-cutting cycle. Rates are now likely to be left on hold for at least several months.
The Bank of England trimmed interest rates by 25bp and remains constrained by relatively high consumer price inflation of 3.5% and rapid wage growth of over 5%, even though the economy is clearly sluggish. But these constraints are expected to ease eventually and allow the Bank of England to cut rates further in the course of the year and into 2026.
In spite of inflation remaining high in Japan at 3.5% in May, the Bank of Japan (BoJ) left its policy rate unchanged at 0.5% in the second quarter. It argues that inflation has been pushed up by temporary factors, underlying inflation is still below its 2% target and inflation expectations are not yet anchored at 2%.
It also does not want to do anything to disrupt the economy while uncertainty about trade and tariffs is high.
The BoJ announced it would slow the rate at which it tapers its quantitative easing purchases of Japanese bonds, whose yields have risen steadily this year.
With many equity markets hitting record highs, is now the time to go all in on equities, or turn more cautious?
As we have already discussed, the current economic backdrop is benign: moderate growth, inflation still falling on trend and interest rate cuts by central banks. While there are obviously risks to all of these from several different directions, it would take a severely negative scenario to completely derail the favourable backdrop.
So far this year many European, Asian and emerging markets have outperformed the US, though this pattern was reversed in June, when the US market stormed back. The fall in the dollar has also detracted from US stock market returns for non-US investors (and boosted returns for US investors investing overseas). A weaker dollar is economically beneficial for emerging markets and therefore tends to be helpful for the performance of these equity markets.
Bonds saw modest gains in the quarter, with corporate and high yield bonds again outperforming owing to the “Goldilocks” economic environment. Although inflation data has so far mostly been better than expected, there are lingering fears about the impact of tariffs on inflation. We will get a more definitive picture of what the effect is in the third quarter. If it is smaller than feared, bonds could put in a longer bout of outperformance. Bonds would also benefit if the US economic slowdown becomes more serious. Some analysts have raised concerns about rising US government debt and deficits and suggested this could push up Treasury yields, but these are probably long-term concerns.
After breaking through $3,000 for the first time in March, gold reached a high of over $3,400 before easing back slightly (see our article "Good as gold" from 7 March 2025). Gold's rally is the mirror image of the numerous geopolitical and economic risks and uncertainties that are out there. Gold is also supported by strong fundamental demand as central banks continue to build up their holdings. Gold is effectively a form of "disaster insurance" to hedge risks that other asset classes do not, in particular inflation, geopolitical and systemic risk.
Given the uncertainties at present, we recommend holding a well-diversified portfolio with equities and bonds the core of the portfolio. They are generally good hedges for each other and could both benefit if the economic backdrop remains favourable. An exposure to cash to lower overall risk also makes sense and some exposure to gold as "disaster insurance" is also worth considering.
At the time of publishing this quarterly report, some of the trade, macroeconomic and geopolitical clouds that have been hanging over the markets this year seem to have dissipated.
There is, of course, no shortage of risks just over the horizon with the potential to upset the apple cart. Nonetheless, the economic backdrop is benign and we are cautiously optimistic that it will remain so on balance. This is still a positive backdrop for financial assets.
It is important to maintain a well-diversified portfolio that is resilient to the uncertainties that lie ahead, and, with our help, constant dialogue with your investment manager is the key to understanding your own risk/reward asset allocation.
CEO
