Market Commentary Q2 2025 – Resiliency Through the Noise

The first half of the year demonstrated the remarkable resilience of the stock market, once again. Despite a myriad of reasons to be cautious, the rapid selloff in equities was short-lived, with the S&P 500 rallying back to all-time highs by the end of the second quarter.

This most recent correction was erased in just 89 trading days, a record for the fastest 15%+ selloff and subsequent recovery to a new all-time high. The stock market appears to be more willing to shrug off bad news, including geopolitical concerns that have historically led to more prolonged market corrections. This may be a reflection of growing investor complacency, and/or the apparent resiliency of current stock market leadership, less reliant on materials/goods, more focused on technology/services businesses.

Regarding this most recent selloff, we believe two key developments likely restored investor optimism from the depths of the April decline. First, a de-escalation in tariff rhetoric eased fears of a worst-case, prolonged trade war. Second, the major “hyperscalers” reiterated capital expenditure outlooks during Q1 earnings calls, reinforcing the structural demand story around Artificial Intelligence (A.I.) and cloud infrastructure, key drivers of corporate earnings growth and investor sentiment.

The economic backdrop appears to be a mixed bag, with lingering uncertainty related to trade policy. Soft data, such as consumer sentiment and CEO confidence, hit extremely low levels in April. So low that some degree of economic slowdown seemed inevitable. Nevertheless, hard data, supported by resilient consumer spending and corporate profits, has held up relatively well thus far. Sectors with the most direct exposure to tariffs, such as manufacturing, transportation, and retail, appear to be the most negatively affected. Overall, Real GDP is projected to grow nearly 3% in the second quarter, with a lot of noise related to net imports.  

The employment market, in our view one of the better leading indicators for the economy, is in a precarious position. While non-farm payroll reports exceeded expectations in April and May, and the unemployment rate remains relatively low, the ratio of job openings to unemployed has been steadily declining. Longer term, there remains a real possibility that the unemployment rate could rise, through A.I.-related job losses or otherwise, while the stock market continues to hum along, on the merits of increased operational efficiencies.

This may further support the growing sense that the pulse of the main street economy increasingly diverges from that of the stock market, a dynamic that has become more pronounced in recent years and which may be amplified by recent tariff uncertainty.

Interest rates have also mirrored the volatility of investor sentiment this year. Longer-term rates are well off their highs of early May, but the yield curve continues to steepen as investors balance the likelihood of near-term interest rate cuts, forecasted economic growth, and growing concerns around our country’s long-term fiscal trajectory.

Potential concerns around inflation have limited the Fed’s willingness to cut rates in the near-term, despite “encouragement” from the Trump administration and the potential opportunity to send a lifeboat to the beleaguered housing market. Longer-term, risks towards stagflation are rising, especially if fiscal stimulus measures fail to produce sufficient growth.

One of the more prominent trend changes in the first half of the year was the rapid selloff in the U.S. Dollar Index, which plunged nearly 11%, it’s worst first-half decline since 1973. A combination of long-term fiscal and trade policy concerns may be likely to blame. A similar trend also occurred during the start of Trump’s first term, which ended up being short-lived. While we are mindful of the long-term concerns around the greenback, we also don’t see a viable alternative for what remains the backbone of global trade and foreign currency reserves.   

Nonetheless, dollar weakness has contributed to relative strength for international stocks during the first half. While we welcome broader global participation in the stock market rally, international gains thus far have been largely driven by currency translation and improved valuations. Fiscal stimulus and other growth initiatives offer some optimism for future earnings, with growth thus far skewed heavily towards U.S.-based companies.

U.S. earnings have meaningfully outperformed global peers in recent years, but that growth has become increasingly concentrated. The divergence in profitability for large and small companies is likely driving the historically wide valuation spreads for U.S. stocks. At the end of June, the market-cap weighted S&P 500 traded for 22x earnings, while the equal-weighted S&P 500 traded at 17x earnings. Small and mid-cap stocks, whose earnings remain below 2022 highs, traded for 15x and 16x earnings, respectively.

We believe there are two ways to look at this. On the one hand, the largest companies are generating a disproportionate amount of earnings growth, and the durability of that growth is deserving of a valuation premium. On the other, the valuation bar is much lower for the rest of the market, and margin improvements, including those tied to A.I., could eventually benefit other businesses. In aggregate, we believe earnings breadth will improve over time, potentially leading the average stock to outperform the broader index in the years ahead.

Despite all the macroeconomic noise, corporate earnings have held up reasonably well. While estimates have been revised lower for 2025 and 2026, expectations still call for over 9% growth for both years. With Q1 results benefiting from a pull-forward in demand, we believe the bar is higher for Q2 and Q3 earnings. Investor sentiment may drive short-term volatility, but corporate earnings remain the most important underpinning of long-term market strength, in our view.

As this year has demonstrated, making predictions for the stock market based on the economy is incredibly difficult, other than it generally pays to error on the side of optimism long-term. Fortunately, our equity investment process does not rely on short-term macro forecasting.

Given today’s below-average equity risk premium for large-cap stocks, valuation hurdles have become more challenging as we underwrite both new and existing investments. This has recently led us to finding more value “down market,” where growth and profitability assumptions appear more reasonable. We continue to maintain a strong bias toward quality, focusing on businesses we believe are positioned to generate above-average returns on capital over the long term.

Authored by: Jack Holmes, Chief Investment Officer

DISCLOSURES: Thought Leadership Disclosures