The second quarter of 2025 began with dramatic policy developments in DC and panicked reactions in financial markets. The ultimate impact of Trump administration trade policy remains unclear as we begin the second half of the year. Despite the trade turmoil, Trump threats to politicize the Federal Reserve and moments of heightened geopolitical tension, the economy has proven remarkably resilient. Financial markets saw considerable volatility with large drawdowns in equities and the U.S. dollar and a significant spike in U.S. Treasury yields after Liberation Day. After the trade rhetoric cooled a little in mid-April, major domestic equity indices steadily recovered, and Treasury yields retreated somewhat. As the third quarter begins, the economy remains in expansion, domestic large cap equities are near all-time highs, and we have a fiscally expansive new budget law in place. We still lack substantial clarity on tariffs beyond the fact they will remain materially higher than those prevailing at the end of 2024. While the economy and financial markets are stable for now, we see the potential for a bumpy road ahead in the second half of 2025.

2Q25 Economic Review

Trends in the second quarter pointed to a slowing but surprisingly resilient economy. Manufacturing, as measured by ISM’s Manufacturing PMI survey was in contraction for the entire quarter as businesses braced for the potential impact of tariffs. The ISM Services PMI showed that sector in expansion for most of the quarter although it briefly dipped into contraction in May. The labor market was stable with relatively weak hiring, but no material rise in layoffs. Private employment gains were notably weak. Personal income held steady before weakening sharply in May on both a nominal and real basis. Retail sales were stable as the high income households spent freely. While core inflation as measured by CPI came in at or below expectations in the second quarter, we still view inflation as sticky at levels above the Fed’s 2.0% target. Finally, we note that headline GDP for 1Q25 was reported at -0.5%. However, that reading was massively influenced by an exaggerated growth in imports as U.S. businesses and consumers raced to purchase imported goods and raw materials prior to the imposition of tariffs. An unusual drop in federal government expenditures, particularly defense spending also had a negative impact on the headline number. Our preferred core GDP metric, which excludes international trade and direct government spending, registered a solidly positive 1.9% for the first quarter. Notably, however, this marks the first time in nine quarters the core GDP growth number fell below 2.5%.

2Q25 Financial Markets Review

Fear? Greed? U.S. financial markets ran the gamut in the second quarter. Between the end of the first quarter and the height of the Liberation Day panic on April 8^th, the S&P 500 and NASDAQ 100 fell 11.2% and 11.3%, respectively. The April 8^th nadir from those indices previous highs on February 19^th was 18.7% and 22.8%, respectively. Yet after the panic peaked, the S&P 500 rose 24.9% over the balance of 2Q and the NASDAQ 100 advanced 32.9% over the same period. Trailing twelve month returns for the S&P and NASDAQ as of 6/30/25 were 15.1% and 16.1%, respectively. The Magnificent 7 leads the way for trailing one year returns at 24.2%. The strong equity returns so far in 2025 are nearly exclusively due to expanded valuations. Earnings estimates for the S&P 500 for 2025 and 2026 are each down nearly 4% from where they stood in January. Meanwhile the 12 and 24-month forward P/Es on the index have both increased 0.8 turns to 22.3x and 19.9x, respectively.

Major domestic bond indices have also posted positive returns for the second quarter, year-to-date and over the trailing twelve months. As has been the case for much of the past several years, the Bloomberg High Yield Corporate Bond Index led the way in 2Q with a 3.5% return, followed by the Bloomberg Aggregate Index at 1.2% and the Bloomberg U.S. Treasury Index 0.9%. Treasury yields across the curve spiked after Liberation Day, especially at the long end, but ended the quarter much nearer year-to-date lows than year-to-date highs. Similarly, both high-yield and investment grade corporate bond spreads surged higher during the risk-off period in the financial markets in April but ended the quarter nearer trough than peak levels.

Finally in financial markets, the U.S. dollar fell 6.6% in the second quarter and is down 9.1% year-to-date. The dollar was widely perceived as overvalued coming into 2025 but demand for the currency had been buoyed by strong demand for U.S. assets and positive interest rate differentials between the U.S. and many foreign markets. Part of the dollar decline can likely be traced to a loss of confidence at the margin in U.S. economic exceptionalism spurred by America First trade and security policies. Part is also do the dollar’s high valuation coming into 2025. The expectation that the Fed will cut rates in response to a slowing economy and easing inflation, thereby narrowing interest rate differentials, also played a part in the dollar’s weakness. Trump and Treasury Secretary Bessent welcome a weaker dollar as it helps narrow the trade deficit and boosts the earnings of domestic companies that derive a substantial portion of their revenue and earnings outside of the U.S. Despite the ongoing uncertainty, the dollar has rallied modestly early in the third quarter. While further dollar weakness is likely over time, we have little fear that the dollar will lose its reserve currency status or centrality in international trade over the foreseeable future.

Outlook for the remainder of 2025

While the chances of a recession in the U.S. have risen over the past six months, we still believe the odds moderately favor continued economic growth over the remainder of 2025. The Atlanta Fed GDPNow forecast predicts 2.4% growth for 2Q25 and the Blue Chip consensus calls for 2.0% growth. If the impact of front-loading imports in 1Q is ignored, that would get us to something near 2.0% GDP growth for the first half. Tepid employment and personal income growth, coupled with ongoing tariff and trade uncertainty are likely to lead to slower growth in the second half. However, the combination of front-loaded fiscal stimulus in the recently enacted budget and positive forward momentum makes it likely the economy remains above stall speed for the rest of 2025. An inability to hammer out trade deals and enactment of recent enhanced tariff threats could derail this view, but we believe Trump’s desire for good deals rather than perfect deals means the worst outcome will be avoided.

Our two main concerns about the economy are where the impact of tariffs will fall and whether productivity growth will outweigh weak labor force growth. We estimate the ultimate blended tariff rate will land a little below the midpoint between the current 13.3% and the early April peak of nearly 28%, so somewhere in the high teens range. That represents a several hundred billion dollar tax or headwind to the economy. The big question is who absorbs this pain. Early indicators show that exporters are bearing little of the burden. In the likely case that this continues, the burden will fall on some combination of domestic importer, manufacturer, distributor and retailer margins or the spending capacity of the U.S. consumer. Where this burden falls will determine whether high inflation readings or falling corporate margins are a bigger issue over the remainder of the year. Neither would be welcome, but a hit to corporate margins would probably weigh more heavily on equity markets.

The labor force issue is a longer-term concern, although a continuation of the recent pause in productivity growth could hurt GDP in the second half. GDP growth for a nation over the long-term equals labor force growth plus productivity growth. The U.S. labor force peaked in April at 171.1 million and has since fallen to 170.4 million. This is due both to weak growth in the native labor force and the virtual cessation of immigration across the southern border over the past several months. The persistence of these developments would appear to condemn us to weak labor force growth at best and a declining labor force at worst. Either immigration reform which allows the inward flow of migrants to resume or an improvement in the U.S. fertility rate back above replacement level would be required to boost labor force growth. A third option would be a higher labor force participation rate. A return to the 1Q00 all time high level of prime age (25-54 years) labor force participation could bring around 1.4 million back into the labor force. Absent a development that boosts labor force growth, productivity growth becomes the only game in town. Productivity growth since 2000 has averaged in the 1.5%-2.0% per annum range. Perhaps the continued rise of artificial intelligence can further boost productivity and thereby GDP growth.

We expect financial markets to remain volatile over the remainder of 2025. While equity markets have demonstrated remarkable resilience in the face of uncertainty year-to-date, we think increased confidence on what we view as optimistic earnings expectations through 2026 will be required in order to move equities materially higher. As noted above, the tariff headwind has to be absorbed through some combination of lower corporate margins and constrained consumer spending. While the recently passed budget contains some consumer stimulus, we question the willingness and ability of consumers to pay substantially higher prices for goods. This is especially true for those households in the bottom half of the income spectrum. These households account for a minority but still substantial portion of total consumer spending. The budget also contains sweeteners for corporations and the promise of a lighter regulatory burden is still in the offing. Additionally, those companies generating material portions of their revenue and earnings internationally will receive a margin boost due to the weaker U.S. dollar. It is difficult to parse where the tariff burden ultimately falls but our gut says corporations will bear more than half.

Our primary concern for fixed income markets is the possibility of upward pressure on interest rates at the long end of the curve driven by the continued profligacy of the federal government. Congressional Budget Office projections show deficits of 6% or more of GDP persisting well into the future and interest payments on the federal debt taking up an ever-expanding portion of government spending. U.S. Treasury rates at the long end of the curve are currently above Liberation Day panic levels and near where they stood just prior to the Global Financial Crisis when U.S. potential GDP growth was higher and federal debt to GDP levels where only about half what they are now. The wake-up call for our thick-headed, reelection obsessed representatives in DC may be well in the future but it seems certain to come.

With these challenges in mind, we remain focused on choosing reasonably valued, high-quality, and all-weather investments for our Byline Wealth Management clients.

Kurt Funderburg
Chief Investment Officer