Cornerstone 2nd Quarter 2025 Commentary

The benefits of a tariff are visible. Union workers can see they are ‘protected’. The harm which a tariff does is invisible. It’s spread widely. There are people that don’t have jobs because of tariffs but they don’t know it – Milton Friedman

It was on May 19th, 1828, that President John Quincy Adams, signed into law the tariff bill that gave the United States its highest tariffs, measured by percent of value. Tariffs have always played a significant role in U.S. history. Starting in 1789 with a tariff to finance the Federal Government, they were the main source of revenue for over a century until Federal Income tax was introduced in 1913, following a constitutional change to enable it. At times they have been nearly 95 percent of federal revenues. – Adam Smith Institute

Of course, the primary news of the second quarter of 2025 was the Liberation Day tariffs.  While not the only significant news event of the quarter, tariffs dominated headlines throughout the period.  In our view, tariffs largely overshadowed other significant economic news including two Federal Reserve Open Market Committee meetings, the U.S. bombing of Iran, and the NATO Summit. While Elon Musk’s departure from DOGE and the White House was also newsworthy, it, too, soon vanished amid the onslaught of tariff related news.  Finally, the emergence and progression of the One Big Beautiful Bill moved in and out of headlines throughout the quarter, but it would, no doubt, have received much greater attention and scrutiny were it not for the fixation on tariffs.

One might say that the tsunami of tariff related information was far and away the most important issue affecting markets not only in the U.S. but around the world as well.  Perhaps the only other economic data point capable of giving tariffs a run for their money is AI.  News related to artificial intelligence continues to dramatically impact the market, and with King Nvidia eclipsing $4 trillion in market cap following the end of the quarter, some might say that it is the more important of the two issues.  Regardless, with the elevated focus on these two significant issues, investors and markets seem to be largely ignoring other historically significant data points.

Another key factor affecting stock and bond prices during the second quarter was the falling dollar.  The dollar has declined significantly during the first half of 2025, leading to strong outperformance by international equities and bonds when measured in dollar terms.  This is the first such period of significant outperformance since 2018 – a surprising fact which has led to a sharp shift in asset flows into international equities and fixed income. 

Inflation data was mixed during the quarter, and the Fed, concerned about the impact of tariffs on prices, chose to remain on hold throughout the quarter.  Comments from its most recent meeting had a more hawkish feel, and, consequently, expectations for near term interest rate cuts have remained low.

As noted in our first quarter summary, economists and market participants alike had been expecting tariffs, but as more information became available, the market grew more and more concerned about what was to come. It was those fears leading up to Liberation Day on
April 2 which led to the precipitous decline from the highs of February to the anxious days of late March.  Those fears were realized in April as the market plummeted around the Liberation Day announcement.  All U.S. markets were hit hard in April, but then as the Trump administration began to alter, postpone, and eliminate various tariffs, equity markets experienced a dramatic V-shaped recovery which continued through the end of the quarter.

Positive first quarter earnings results, relatively benign inflation data, and a resilient consumer provided additional support for the rally, and after falling approximately 20% peak-to-trough in April, most markets recovered by the end of the quarter. Investor sentiment shifted from extremely fearful and bearish as the quarter opened to euphoria and FOMO as the quarter ended.  Frankly, an inattentive investor could have missed the entire debacle if, like Rip Van Winkle, one fell asleep in early February and woke in late June to markets once again approaching all-time highs. 

With the notable exceptions of REITs and the dollar, the second quarter of 2025 was an incredibly strong quarter.  Following significant declines early in the quarter, virtually all asset classes rallied.  The Dow and S&P both reversed their losses and not only gained ground throughout the quarter but ended the first half of 2025 in positive territory – a stunning feat given the speed with which it was accomplished.  Much like the rebound from the dark days of Covid, the market embraced the TACO (Trump Always Chickens Out) narrative with gusto and seemed determined to focus on a positive outcome following its early quarter tantrum.  The Russell 2000 rallied strongly during the quarter as well, but despite strong returns it was unable to get back into the green on a year-to-date basis, and it is still well below its highs attained last year following the election.  This is somewhat disconcerting and is suggestive of more late-cycle behavior.  REITs hampered by interest rates continue to struggle as well. 

Bonds performed quite well during the quarter.  While the Fed did not lower rates during the quarter, inflationary news remained relatively benign and tariff-driven fears remained largely unrealized during the quarter.  The Bloomberg Aggregate Bond Index ended the quarter up a solid 4%, and if nothing changes it could easily eclipse 6% by year end. 

International equities and bonds were, somewhat surprisingly, the best performing assets in dollar terms.  The dollar weakened significantly during the quarter.  The dollar declined over 7% during the period and is down slightly more than 10% on a year-to-date basis.  This fact led to dramatic outperformance by international and emerging markets equities in the portfolios of U.S. investors.  The MSCI EAFE was up nearly 12% during the quarter and is up almost 20% on a year-to-date basis.  Not bad for the tech “light” index.  Emerging markets also rallied nearly 12% during the quarter and ended the first six months of the year up over 15%.  Finally, unlike domestic markets, international small cap rallied, up nearly 17% for the quarter and nearly 21% for the year.  The currency impact helped the performance of foreign bonds as well, and the Bloomberg Global Aggregate Bond Index was up over 7% in dollar terms during the first half of 2025. 

As previously noted, the two significant themes impacting results during the quarter were tariffs and AI.  The signing of the One Big Beautiful Bill into law following the end of the quarter is also significant, but its ratification has had little real effect on markets.  The narrative surrounding the probability of recession has also shifted.  The market seems determined to ignore the possible negative impact of tariffs as well as cautionary data that may be found around the margins of the economy.  Concerns about growing credit card delinquencies, failing loans, and negative leading economic indicators have largely been ignored.  Solid employment, AI enthusiasm, and positive earnings growth seem to be enough to propel the market higher.  Further, the acceleration of imports into the first quarter and the postponement of many of the liberation day tariffs is likely to result in a short-term boost to second quarter GDP.  This fact makes it unlikely that a recession declaration is right around the corner. 

We remain hopeful that the market can hang onto its gains through the remainder of the year.  However, short-term investor optimism has reached levels which often indicate negative volatility is right around the corner.  The latter part of the summer and early fall are often challenging times in the market.  Volume falls as traders go on vacation, exacerbating news-based volatility, and this market is primed for a sharp short-term reversal.  Current news on tariffs remains relatively positive, and it is difficult to foresee what the triggering event for a negative reversal might be.  Nonetheless, we would caution our readers that the current rally is likely to be tested.  Diversification along with systematic rebalancing remains, in our view, the best protection for long-term investors.

The graph below from last quarter’s commentary serves as a reminder of why international diversification remains important even in a market which has recently been dominated by AI-driven themes. 

It is true that international markets have a much lower exposure to technology in general and AI more specifically, but they are significantly cheaper, and the renewed focus on military and infrastructure spending in Europe specifically is providing at least a short-term boost to share prices.  At this point, we do not plan to significantly increase our exposure to non-U.S. equities.  However, given the impact of currency effects and attractive valuations, we plan to allow our international allocations to drift higher throughout the third quarter.   We expect the Fed to remain on hold throughout the quarter, and, consequently, U.S. short-term interest rates are likely to remain higher than those in many other developed markets.  Should the U.S. broker more deals as President Trump implies, the dollar may stabilize a bit in the short term, but currency moves are notoriously difficult to predict.