Q2 2025 Market Update: Mixed Signals Persist, but Pockets of Strength

Throughout the first six months of the year, both the economy and capital markets continued facing headwinds and mixed signals relative to growth, inflation and global stability. On the one hand, the latest data show inflation cooling to a more normal range and closer to the Federal Reserve’s mandate of 2 percent; yet, economic growth in the first quarter was slightly negative. However, the latest estimates for growth in the second quarter show a rebound to around 3 percent annualized.

Furthermore, the uncertainty surrounding the escalating global conflicts, along with erratic tariff policies by the new administration, has left investors somewhat exhausted. Trying to figure out whether the latest trends are a mirage or enduring feels like a fool’s errand at this point. Even through this economic uncertainty and volatile market conditions, it appears there is modest underlying economic strength. The unemployment rate remains relatively low, inflation is going down, and consumer spending appears remarkably resilient. Perhaps, over time, these positives will outweigh the nagging list of negatives.

Signs of a Cautious Consumer and Business Pullback

From an economic perspective, there are signs that a modest slowdown is occurring as both consumers and businesses appear a bit cautious in this relatively uncertain environment. To begin with, both factory orders and manufacturing activity remain neutral. The Manufacturing index recently fell below 50, a level that separates expansion and contraction. The data showed the steepest contraction in new orders and the highest prices-paid since late 2022, indicating a more pronounced impact on demand and inflation due to higher duties on imports.

There are additional signs, such as weaker May auto sales, that consumers are becoming more discerning in their spending habits. The larger services sector, which comprises about 70 percent of our economy, also slipped into contraction territory for the first time in nearly a year on an abrupt pullback in demand. Eight service industries reported a contraction, including retail, construction and transportation, while ten reported growth.

Rising Costs and Housing Weakness Add Pressure

Further complicating the picture, service providers experienced higher costs as the prices-paid component jumped to the highest level since November 2022. Consequently, consumers have become more discerning in their spending habits, as noted by the weak retail sales data in recent months. In May, retail sales fell by 0.9 percent, the most this year. Seven of thirteen categories posted declines, suggesting consumer finances are stretched.

Finally, the housing market continues to struggle with high mortgage rates and low inventory in certain areas. The latest data release showed a 9.8 percent decline in new housing starts and a 2 percent decline in new housing permits. The industry is facing weak demand, elevated inventories and softening homebuilder sentiment.

Labor Market and Incomes Offer a Bright Spot

Although some economic data suggests a modest slowdown, pockets of strength remain, which should help offset the negatives and provide a foundation for better growth in the future. First, the nation’s job market remains solid, with an unemployment rate of around 4.2 percent, which is still quite low by historical standards. The recent employment report showed 139,000 new jobs created in the latest month, along with a slight increase in average hourly earnings. Further, job openings have increased slightly to over seven million, indicating a demand for qualified workers. While initial jobless claims are rising modestly, as some companies scale back their workforces amid tariff uncertainty and slowing consumer demand, they are still quite low relative to historical measures. Consumer income and spending are other positive areas of the economy. Incomes were up 0.8 percent in the latest month, well above expectations. Consumer spending habits are generally positive, but there are signs that consumers are pulling back a bit due to some economic uncertainty.

Markets Rebound as Uncertainty Lingers

In this still somewhat uncertain and volatile environment, domestic stocks bounced back from their lackluster performance in the first quarter, while international stocks continued to lead. The S&P 500 Index returned 10.9 percent for the quarter, while mid- and small-cap stocks posted a 6.7 percent and 4.9 percent return, respectively. Foreign stocks soundly outpaced domestic stocks as the MSCI All-World Index returned 11.6 percent. The Aggregate Bond Index returned 1.2 percent while corporate bonds returned 1.7 percent for the quarter.

Our Outlook

Looking ahead, the combination of a softening economy, confusion around tariff policies and rising global tensions will likely keep investors on edge and the capital markets a bit volatile. The Federal Reserve is monitoring these developments and is prepared to lower interest rates further if necessary. However, they are concerned that lowering interest rates too much will reignite inflation and lead to a further slowdown in the economy.

While still positive, corporate earnings growth is expected to moderate in the coming quarters. For now, we still expect modest returns in stocks with value and international likely outpacing growth stocks. Meanwhile, bond returns should benefit from slightly lower inflation and weaker economic conditions, producing modest returns.