Investment Overview: 1st Quarter 2025

The economy

U.S. economic growth exceeded expectations for most of 2024 led by resilient consumer spending. For the full year, economic growth of the world’s largest economy was 2.8%, down slightly from the 2.9% reported for 2023. Fourth quarter GDP decelerated to a 2.4% growth rate, and most economists predict a continued slowdown to be reported for the first quarter of 2025, as a spike in uncertainty primarily regarding tariff policy is likely to have an impact on many sectors of the economy. Given the heightened uncertainties, the S&P 500 experienced its biggest quarterly loss since 2022, dropping nearly 5% in the first quarter. 

A healthy labor market is undoubtably key to continued strong consumer spending, which accounts for the majority of U.S. GDP. The unemployment rate currently stands at 4.1%, which is slightly higher than a year ago but still low by historical standards. The economy has added approximately 168,000 jobs per month on average over the past 12 months, with February’s gain of 151,000 slightly below average. Weekly unemployment claims remain benign for now but are edging higher while the number of long-term unemployed persons has increased, potentially signaling a tighter labor market ahead. 

While inflation has significantly moderated from prior peak levels over the past 12 months, evidence of “stickier” inflation data remains. February saw headline Consumer Price Index (CPI) inflation rise 2.8% annually, which came in slightly below expectations. This figure was 3.2% a year ago and around 6% two years ago. The Fed’s preferred measure of tracking inflation, called the core Personal Consumption Expenditures (PCE) price index, also rose at an annual rate of 2.8% in its most recent reading, which was higher than the previous month and slightly above expectations. Taken as a whole, inflation data is closer to targeted levels but remains elevated and worries of higher inflation persist.

Against the backdrop of a reasonably strong labor market and stubborn inflation, consumer confidence plunged to a four-year low in March according to the Conference Board. The primary reason for the drop included fears of a recession and higher inflation due to tariffs. The future expectations component of the survey showed its lowest reading in 12 years. The expectations index fell to a level well below the threshold that usually signals a recession. An interesting aspect of the survey showed that some consumers plan to accelerate purchasing some bigger ticket items due to their expectation of higher prices stemming from potential tariffs.

The manufacturing side of the economy has seen some green shoots recently, as the widely watched ISM Manufacturing Index has been hovering near expansionary readings over the past quarter, after residing in contractionary territory for most of the past two years. March’s ISM reading came in at 49.0, below February’s number of 50.3. The report noted that many manufacturers are dealing with high levels of confusion and supply chain issues regarding tariff policies. New orders contracted for the second straight month. Any reversal of these trends would be a welcome development for the U.S. economy. 

Across the globe, geopolitical tensions remain high, posing an elevated risk profile. These conflicts may adversely affect trade, consumer behavior, and impact commodity prices. Further, with the prospects of increased tariffs, international trade and supply chains will likely be significantly impacted. One silver lining for foreign economies has been the prospects of increasing spending on defense, as the U.S. has warned not to take its military protection for granted. For now, most major global economies continue to wrestle with slow growth, and several central banks are easing monetary policy. China appears willing to implement large stimulus programs to reignite growth, but uncertainties are still prevalent for the world’s second largest economy.  

With the seemingly increasing prospects of lower growth and persistent inflation, the U.S. economy appears to be losing some of its luster. While positive but below-trend growth for the U.S. economy is still the base case, many forecasters believe the possibility of a recession is increasing. International economies may benefit on a relative basis, and the case for asset diversification appears to be improving.

Fixed income

Interest rates declined during the first quarter on all but the shortest-maturity bonds, despite the Fed standing pat on its Fed Funds target rate and indicating it was in no hurry to cut rates. The decline in rates was largely due to fears of an economic slowdown and a flight to safety among investors.

The 10-year Treasury Bond finished the quarter with a yield of 4.21%, down from 4.57% at year end. The 2-year Treasury Bond also saw its yield move lower, ending the quarter at 3.89%, down from 4.24%. With rates moving lower across the curve, the bond market maintained its positive slope, meaning investors receive a higher yield for longer-term bonds.

As bond prices move inversely to interest rates, bond market performance was positive for the quarter. The Bloomberg U.S. Aggregate Index was up nearly 3% for the quarter. Most bond indices were higher as well, but corporate bonds fared slightly worse as credit spreads widened marginally amid the aforementioned economic uncertainties. 

The Federal Reserve Open Market Committee (FOMC) met twice during the quarter, and as expected each meeting ended with no changes to the Fed Funds target range, which remains at 4.25% to 4.50%. This “wait and see” approach appears prudent at this time as chair Jerome Powell mentioned they “do not need to be in a hurry to adjust policy and are well positioned to await greater clarity.” The FOMC did announce it will slow the pace of its quantitative tightening program, which may marginally lower longer-term bonds.

At its March meeting, the Fed updated its economic projections, which included a modest shift towards a more stagflationary environment. GDP growth expectations were revised lower to 1.7% from 2.1% for 2025, while inflation expectations were revised modestly higher for the year. No changes were made to the dot plot, where two rate cuts are still projected by year-end 2025, followed by another two cuts in 2026. As always, these potential moves will be data dependent, and a higher than usual level of uncertainty exists.

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).

Equities

Coming on the heels of two of its best calendar years in history, U.S. equity markets retreated during the first quarter amid a spike in political and economic uncertainty. Both the S&P 500 and the Nasdaq Composite saw their biggest quarterly drop since 2022. The S&P 500 Index dropped 4.3% for the quarter, while the growth-oriented Nasdaq Composite slid into correction territory by falling just over 10% for the quarter.

The start of 2025 has carried plenty of drama. The S&P 500 hit an all-time high in February before the impact of the seemingly ever-shifting tariff policies impacted stock markets. Earnings estimates for U.S. stocks have been revised down, and profit taking after the sharp rally of the past two years pushed large cap stocks lower.

The comparatively surprising bright spot for stocks were international returns. After a difficult fourth quarter which saw worries about the impact of a tariff war on foreign economies, international stock indices rallied in the first quarter with developed foreign markets up 7% and emerging market indices up 3%. Investors in foreign markets see signs that new spending plans in countries could provide a boost for growth overseas.

The biggest shift in U.S. markets was a rotation away from the “Magnificent Seven” stocks into more of a value and defensive tilt. January saw the first jolt to mega-cap tech stocks and their peripherals, as questions began to arise about the amount of spending on AI versus its benefits. A broader market selloff continued for most cyclical areas of the markets as the on-again off-again nature of tariff negotiations and threats escalated, calling into question the earnings predictability scores of many companies. The beneficiaries of this uncertainty included many non-cyclical companies with lower but seemingly steadier growth profiles.

Although the pullback in the market somewhat lowered valuations, we remain concerned with elevated price-to-earnings multiples as well as the heavily concentrated nature of large-cap U.S. stocks. The S&P 500 now trades at roughly 21 times its expected earnings over the next 12 months, above its 10-year average of 18.5 times. Likewise, the top 10 positions in the S&P 500 now account for about one-third of the overall index, which is down from recent readings but still shows well above average concentration.

Versus an expensive and concentrated large-cap market, we continue to find the valuation of smaller-cap stocks compelling. In fact, small-cap, mid-cap, and international stocks all trade at meaningful discounts to the mega-cap-dominated S&P 500. Any tangible evidence of improving earnings growth relative to their large-cap counterparts will likely improve performance from the areas of the market that have been relative laggards over the past few years.

Moving further into 2025, uncertainty over fiscal and monetary policies will remain center stage. While hopes for favorable tax policies and regulatory reform remain, recent proposals from the current administration suggesting extensive tariffs have ignited fears of slower growth and rising inflation. Ultimately, the impact these policies have on corporate earnings will likely determine the direction of the markets.

Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).

Sector returns

First-quarter sector returns saw a significant rotation away from last year’s winners into some of the recent lagging sectors. Driving much of the change were factors including economic uncertainty, lower interest rates, and speculation on impending tariffs and their potential effects on specific industries.

While the market pulled back modestly for the quarter, the majority of sectors showed gains. Energy led the way with a 10% gain, while traditionally defensive areas of the market including Consumer Staples and Health Care were also ahead of the broad market. Rate-sensitive areas of the market, including Utilities and Real Estate, also performed positively for the quarter, benefiting from lower rates.

The best performing sectors from the massive rally of the past two calendar years saw pullbacks, as some of the enthusiasm over the artificial intelligence trade waned. Information Technology saw a double-digit decline for the quarter, as many of the mega-cap technology leaders pulled back due to high valuations and concerns over how durable growth rates may ultimately be.

Consumer Discretionary was the worst performer of the quarter, as its two largest constituents (Amazon and Tesla) faced a bumpy road and pulled back from lofty levels. Further, many companies in the sector face among the greatest uncertainties from both a tariff perspective as well as an outsized headwind in the event of any slowdown in overall consumer spending.

As we continue to move into 2025, hopes of broader stock market participation abound. Valuations may normalize and defensive areas of the market may catch a bid given the uncommonly elevated level of uncertainty.

The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).