…if you’re fighting for something you believe in – even if it means alienating some people along the way – things usually work out for the best in the end.
– Donald Trump
Financial markets staged a powerful recovery during the second quarter, one that drove U.S. equity indices to all-time highs at quarter’s end. Perceived progress in trade negotiations and ongoing economic strength, absent definitive evidence that tariffs are pushing inflation back up, gave investors more confidence to bid up equities, especially those in the U.S. Information Technology and Communications sectors.
Recall how the quarter began: under the shadow of Trump’s aggressive trade policy pronouncements. Within a few weeks, however, it became increasingly clear that Trump’s Liberation Day tariff rates, as shocking as they were, merely reflected his signature negotiating style; adopting an extreme initial position intended to bring our trading partners to the table for talks.
While talks are still ongoing, and the outcomes still uncertain, investors are optimistic that reasonable agreements can be reached. In the meantime, the U.S. economy continues to perform well, consumer confidence rebounded as inflation continues to improve, and companies, despite decrying trade related uncertainty, continue to largely operate with a business-as-usual mentality.
This is perhaps best reflected in the outlooks companies issued when reporting first quarter’s earnings in April and May; while we can’t speak for every company, the vast majority of the companies we own for clients downplayed the potential impact of tariffs and/or retaliatory tariffs on their business prospects, citing already implemented initiatives to diversify their supply chains out of China, including many that adopted a localized supplier base for their local customers. For this reason, we are generally more constructive on equities going into the second half of the year than we were just three months ago.
The Global Economy
Although the deleterious effects of U.S. trade policy may not be evident in the U.S. economic data yet, they are clearly starting to affect the global economy, as evidenced by dramatic declines in exports to the U.S. To wit, in April, U.S. imports declined 20% compared to March’s pre-tariff levels.
Certainly, a large portion of the decline is attributable to the timing of Trump’s tariff announcements, which artificially inflated March’s import data and then depressed April’s data, but some of it is also attributable to the weaker U.S. dollar vis a vis foreign currencies (a weaker dollar makes foreign countries’ exports to the U.S. more expensive and U.S. exports to foreign countries less expensive). Because the rest of the world largely exports products to the U.S. (whereas the U.S. primarily exports services to the rest of the world), U.S. trade restrictions are an additional stress for the global manufacturing sector, which has struggled to shake off its post-Covid hangover.
In Europe, for example, exports to the U.S. declined 10% in April compared to March, creating additional idleness among factories and jeopardizing the economic rebound that began during the first quarter. In response to industrial weakness, and probably in anticipation of further weakness, in June the European Central Bank once again lowered its benchmark rate to help offset the downward pressure the continent is experiencing from U.S. trade policy.
In the U.S., any psychological stress inflicted on businesses or consumers in April appears to be receding, while the underlying fundamental data remains quite good. Though companies added fewer employees on average during the second quarter than they did during the first quarter, companies are increasingly constrained by the number of new entrants coming into the labor pool. As such, fewer job additions at this point don’t suggest the labor market is deteriorating. The number of job postings still exceeds the number of unemployed, the number of hires roughly match the number of total separations, and separations themselves when they do occur are still primarily voluntary (quits versus layoffs), all while the unemployment rate hovers in the low 4% range.
On balance, the labor market continues to provide the solid foundation consumers rely on to spend. Inflation-adjusted consumption is growing 3% annually, supported by inflation-adjusted, after-tax disposable income that is also growing 3% annually. Household balance sheets continue to improve overall, and net worth as a percentage of disposable income was only higher than it currently is immediately after Covid when the U.S. government literally paid people simply because they existed.
Corporate profits continue to rise but are doing so at a slower pace because taxes have expanded over the past few years. After buckling under tariff-related uncertainties, small independent business confidence has rebounded as more companies believe that, based on the current political environment, now is a good time to expand, make capital outlays, and hire more people.
Our generally upbeat assessment of the economy extends even to inflation, where the latest data suggest that tariffs are not having the inflationary impact economists had expected. It’s a welcome development for the Federal Reserve, which is nervous that tariffs will simultaneously fuel inflation and suppress economic activity, a no-win situation given their dual mandate (stable prices and full employment). The positive developments on inflation notwithstanding, the Fed kept its benchmark rate unchanged in June, as expected, but, based on their internal models, lowered their projections for economic growth and raised their projections for unemployment and inflation for the rest of the year. Investors took their adjustments in stride, largely because the adjustments were minor, and because company management teams remain quite positive on their company’s prospects for the remainder of the year.
Equities
With the exception of Health Care and Energy stocks (which we discuss momentarily), U.S. equities performed well during the second quarter. A temporary détente in trade friction allowed investors to resume their focus on fundamental company results and their outlooks, which were not as pessimistic as many feared. Where there is optimism, it’s strongest in companies associated with the A.I. theme, and as such, investors returned to their favored stocks; large, AI-driven structural growth stories such as Nvidia (NVDA), Microsoft (MSFT), and Meta (META). The AI theme was evident not just within the sector performance discrepancies, but within the largest technology companies themselves. Apple (APPL), one of the Magnificent Seven stocks during the last two years, declined nearly 8% during the quarter after disclosing relatively disappointing progress on its own AI initiative, Apple Intelligence.
The tech-focused optimism, though significant, is not meritless. The IT and Communications sectors are two of four (Health Care and Utilities being the other two) that delivered better than expected first quarter earnings results, are the only two sectors that expect to deliver second quarter earnings results (to be reported in July and August) at least 5% above last year’s second quarter (both expect second quarter earnings to grow at least 15% year over year), and are two of three sectors (Health Care being the third) that expect to deliver double digit earnings growth in 2025. In a slowing growth scenario, companies with structural growth tailwinds become even more attractive, and right now, investors are concentrating on technology.
On the flip side, Health Care and Energy are facing stiff structural headwinds. Within Health Care, pharmaceutical companies’ decades old practice of recording the lion’s share of their profits in their foreign subsidiaries (often located in Ireland, where corporate tax rates are among the lowest in the world) has caught Trump’s ire and is likely to become the target of concerted efforts to tax or tariff drug imports. The implications for that industry’s profits are significant. For the energy sector, Trump’s desire to expand energy production is negative for energy prices, and a potential threat to that industry’s profits and cash flow.
Against this growth and profitability backdrop, where earnings expectations are either roughly flat or down and prices are up, valuation multiples have only returned to their beginning of the year levels by some measures (Price / Equity ratio), and are roughly inline with where they have been over the last few years by other measures (Inflation-adjusted Free Cash Flow Yield). If our generally constructive view of the U.S. economy proves correct, equities, despite their strong second quarter performance, could continue to march higher, especially as additional progress is made with trade negotiations.
Fixed Income
Yields on U.S. Treasuries declined across “the belly” of the curve during the quarter, which could mistakenly be interpreted as bond investors’ growing expectations for a recession. On the contrary, in our view, the decline is a function of lower inflation expectations, partially offset by modestly higher expectations for economic growth, as evidenced by higher inflation-adjusted yields on Treasury Inflation-Protected Securities (TIPs) and the narrower spread between TIPs and their U.S. Treasury counterparts. Corporate bonds also appear to be pricing in a lower risk of recession, based on their spreads to their U.S. Treasury counterparts; after spiking in response to Liberation Day tariff rates, corporate bond spreads have since returned to their prior, historically low levels.
Commodities
In the commodities complex, gold continued to perform well, while oil, natural gas and gasoline all struggled with expectations that the global surplus of oil will expand during the back half of the year. Although the Federal Reserve tends to focus on inflation measures that exclude energy prices, for the average consumer, lower gasoline and natural gas prices are a welcome development that should support ongoing consumer confidence and sustainable inflation-adjusted income growth, all else equal.
Conclusion
Whether you love him or hate him, no one can reasonably deny that Trump is fighting for something he believes in, or that, in the process, he risks alienating many of our closest trading partners and strategic allies with his tariff policies, or a number of Republicans in Congress with his “One Big Beautiful Bill” (a topic that we’ll take up in a future Review if it passes). The question is whether it will be worth it in the end. We think it will.
Our optimism stems in the near term primarily from the innovative, creative, and adaptable nature of American businesses, and in the medium-term, in the deregulatory push Trump initiated in January. Though his deregulatory efforts are scarcely discussed any more, in our view, they represent the biggest potential tailwind for the U.S. economy over the next two to three years because they have been so detrimental to small business confidence.
Regulations take time to unwind, but the process has started and we expect that next year, the U.S. economy will benefit from a revitalized small business community, invigorated by 1) lower regulatory burdens and taxes, 2) a more balanced labor market, 3) slightly more favorable borrowing costs, 4) stable inflation, and 5) a more level playing field domestically and abroad when compared to foreign competition. If we are correct, the unpredictability and often distasteful nature of Trump’s personality, and the surprises and challenges that accompany them, will eventually produce a higher rate of structural growth for the U.S. economy. As such, we are hopeful that things will work out in the end.
