The second quarter was volatile but surprisingly good for markets.
Throughout the first quarter, speculation about and fear of tariffs drove much of the market narrative. Those fears crystallized in early April as the Trump administration unveiled its proposal on “Liberation Day”. Markets sold off as the initial tariff rates were greater than most economists and strategists had forecast.
Economic and market forecasts became increasingly pessimistic through April as companies, economists, and market strategists rushed to assess the impact. As the weeks and months unfolded, fears subsided as it became clearer that the initial rates were a starting position rather than an ending point. As we write this, there is still much to be determined on the tariff front. The outlook remains cloudy, but so far, the economy and corporate America have remained resilient.
The bond market initially sold off as tariffs stoked renewed inflation fears. Interest rates rose initially, before more or less returning to where they had been before “Liberation Day”. The net result was a bond market that posted positive returns for the quarter, with more volatility and positive correlation to equities than is usual in a steep equity market sell-off. In some ways it was similar to moments in 2022, when stocks and bonds fell in tandem.
The inflation fears related to tariffs have kept the Fed holding interest rates steady. This is despite a continued deceleration in inflation and a steady stream of criticism of the policy from the Trump administration. The argument from the administration is that inflation is easing and lower than when they had previously cut the Fed Funds rate. They further argue that the current interest rate regime is restraining economic activity and costing the US government, because it adds to the budget deficit. For all the bluster, they have a point, but whether lowering interest rates is the correct or incorrect policy action is debatable. We have written in the past that this administration is likely to challenge Fed independence. The Fed remains independent, but one wonders how much longer that will remain the case. Chair Powell’s term expires in May of 2026, and the concept of a shadow Fed chair seems to have some currency with the administration.
Fiscal policy should remain expansionary, as Congress passed, and the President signed into law, the One Big Beautiful Bill. The bill extends or makes permanent features of the Tax Cuts and Jobs Act from the previous Trump administration, along with a number of other changes to the tax code. Corporate America and the economy should benefit from more certainty on tax policy while it deals with tariff uncertainty from trade policy. As far as the market is concerned, what it may do to the US government’s deficits and growing debt is an issue for another day.
Turning to the longer-term investment environment, it is hard to see how a government with a growing budget deficit amid mounting debt obligations is not structurally inflationary in the long run. From the government’s perspective, the definition of inflation is squishy and subject to change. An economy with falling interest rates and faster growth would be welcome and help alleviate those issues, but we are not sure that should be the base case assumption. We can see nominal growth being acceptable, but assessing real growth could become increasingly difficult. We can envision a world where inflation metrics keep getting massaged to produce lower headline numbers and used to justify interest rates that are lower, at least for the short end of the US Treasury curve. We can also see a captive Fed operating to keep longer-term rates somewhat lower than they would otherwise be.
The recovery in asset prices has some scratching their heads. In the environment we described, we would rather be an equity asset owner and perhaps a borrower, rather than a lender. In our view, it is possible that the market is getting ahead of that kind of environment.