Q1 2025 Market Update: Tariffs Raise Uncertainty

In the wake of the pandemic, the federal government embarked on a massive spending spree. That sparked inflation and resulted in a $1.8 trillion federal budget deficit in fiscal year 2024, up more than 8 percent from the previous year and the third-highest on record. This is an unsustainable path, which prompted the new administration to attempt to rein in spending by cutting agencies, reducing employment and eliminating waste where appropriate. It appears there are few alternatives to bring some fiscal sanity back to the federal government.

Tariffs and trade wars have added another layer of uncertainty to this equation. As a result, the capital markets have become more volatile as investors attempt to ascertain the impact on corporate profits, consumer spending and economic growth. Already, several of the major stock market indices have fallen markedly from their recent highs and economic growth in the first quarter is expected to decline.

While daunting and unsettling, perhaps some short-term pain will lead to better longer-term growth, lower inflation and a healthier fiscal environment.

Time will tell.

Signs of strength and stress in the economy

While several sectors of the economy are holding up reasonably well, other areas are showing some stress. First, the services part of the economy continues to expand at a modest pace. Fourteen industries, including finance and insurance, reported growth, while three sectors contracted. New orders growth accelerated, while backlogs expanded by the most since July 2023. Furthermore, the employment component rose for the third consecutive month, while prices paid reached their highest level in two years.

The biggest concern remains the uncertainty around business activity due to the risk of tariffs and other potential government actions. After almost two years of contraction, the manufacturing sector is showing signs of life. The headline index stands at 50.3, indicating a slight expansion. The employment and new orders sub-indexes have remained volatile, while prices paid have increased, signaling some inflationary pressures.

Finally, the employment picture looks solid, with 151,000 new jobs created last month, and the unemployment rate is up slightly to 4.1 percent, still a historically low rate. Hiring was led by health care, transportation and financial services. Still, the labor market appears to be softening, with more people permanently out of work, fewer workers on federal government payrolls and a jump in those working part-time for economic reasons.

On the other hand, several pockets of the economy are showing signs of stress and weighing on growth. The most glaring part remains the housing market. The combination of elevated home prices, limited inventory in certain regions and mortgage rates over 7 percent have left many people priced out of buying a home. In fact, the new buyer home affordability index is hovering near an all-time low.

While household finances have improved, many consumers are struggling to pay their bills, as noted by higher delinquency rates in credit cards, mortgages and auto loans. Furthermore, retail sales rose less than forecast last month and the prior month was revised down to mark the biggest drop since July 2021. Although there’s no sign of a severe pullback, consumers have become somewhat cautious in their spending habits, which could lead to weaker economic growth in the months ahead.

Volatility returns as uncertainty rises

In this environment, volatility returned to the domestic equity markets, while bonds performed relatively well. The technology-heavy S&P 500 Index fell 4.3 percent for the quarter, while mid and small-cap stocks declined 6.1 percent and 8.9 percent, respectively. Foreign stocks outpaced domestic stocks as the MSCI All-World Index declined 1.7 percent. The Aggregate Bond Index returned 2.8 percent while corporate bonds returned 2.3 percent for the quarter.

Our outlook

Looking ahead, the economy and capital markets are likely to remain volatile from the effects of lower government spending, new global tariffs and weaker spending by consumers and corporations. Should conditions weaken further, the Federal Reserve is poised to lower short-term interest rates to counteract these pressures.

We still expect corporate earnings to grow modestly and inflation to trend slightly lower through the rest of the year. For now, we still expect modest returns in stocks with value and international likely to outpace growth stocks. While bond returns should benefit from slightly lower inflation and weaker economic conditions, producing modest returns.