The S&P 500 Index returned 11.0% in the second quarter of 2025, fully recovering from its -21.3% peak-to-trough sell-off after bottoming on April 7, and finished the mid-year at an all-time high. Investors were relieved in April when President Trump revealed his more pragmatic side, quickly deferring the tariffs he had announced on April 2. Investors have since grown more accustomed to his negotiating strategy of taking extreme positions before walking them back.
While the US stock market recovered to all-time highs, the US dollar had its worst half-year performance since 1973, suggesting stock market enthusiasm may stem more from anticipation of easier monetary policy than from faster economic growth. US stocks underperformed most other world markets in dollar terms. The yield of the 10-year US Treasury bond traded down about one-third of a percentage point from the beginning of the year.
OBBBA and Tariffs
The most significant provision in the One Big Beautiful Bill Act (OBBBA) is the extension of the tax cuts implemented as part of the Tax Cuts & Jobs Act (TCJA) during Trump’s first term. Having the tax cuts expire would have been contractionary; extending them is not stimulative—it just maintains the status quo. Nevertheless, the act extends deficits by $3.4 trillion over ten years compared to the Congressional Budget Office’s (CBO’s) prior estimates, which anticipated the cuts’ expiration. The CBO projected deficits would run around $2 trillion per year (around 5.2%-6.5% of GDP) prior to the passage of the OBBBA and prior to the implementation of tariffs, compared with a $1.8 trillion deficit (6.4% of GDP) incurred in 2024. OBBBA and tariffs are likely to increase the national debt by an estimated $1.3 trillion over ten years, according to one estimate.[1]
Some provisions of the act, such as immediate depreciation for tax accounting, will provide additional stimulus and are mostly being adopted this year or next, while other provisions, particularly cuts to Medicaid spending, will be incrementally contractionary, and are mostly being implemented after 2026.
Since tariffs are taxes, Trump’s current round of tariffs may prove to be contractionary, but they could raise $2 trillion to $3 trillion in revenue for the government over ten years,[2] considerably offsetting the extension of the tax cuts. Dramatic restructuring of the federal government’s tax revenue generation from income taxes to tariffs will create both winners and losers, and is fraught with risks. The courts might still overturn many of the new tariffs, since the law Trump is invoking to justify them, the International Emergency Economic Powers Act (IEEPA), only allows the president to impose tariffs unilaterally if there is a national emergency.
It has been estimated that there are eighty times as many workers in US industries that use steel as there are workers in US steel manufacturing.[3] As such, one study estimated that the 25% tariffs imposed by Trump in 2018 increased the number of steel workers by one thousand, but the higher costs put industries that use steel and aluminum at a competitive disadvantage, reducing the number of workers in these downstream industries by 75,000.[4] Even if the tariffs currently being imposed on manufactured goods provide some relief to domestic manufacturers of those goods, the study does not bode well for cost competitiveness or employment overall. End demand will suffer as prices rise.
While it is important to secure strategic supply lines for our military, there probably are ways to do that without handicapping our commercial interests. The Trump administration has announced 50% tariffs on steel, aluminum, and copper at present, but tariff rates and conditions are prone to change. A recent determination clarified that the 50% tariff on copper would not apply to ore or refined metal—only to value-added copper goods.
Manufacturing makes up about 10% of US GDP, and imported goods account for roughly 11% of GDP. While import tariffs will affect sectors like building construction and automobile manufacturing—which in turn influence other areas of the economy—the overall economic outlook remains solid, bolstered by stimulative measures in the OBBBA and an ongoing surge in corporate spending driven by artificial intelligence. Though new tariffs may slow growth and contribute to recessions in some trading partner countries, they are unlikely to be severe enough to cause a recession in the US on their own.
Federal Reserve Independence
With interest expense consuming 13% of the federal budget, Trump has been rattling the Federal Reserve to keep rates low. For once, something Trump has done has precedent. During and after World War II, the US was saddled with gross federal debt exceeding GDP. The Fed sought to support the war effort by helping to keep the debt service manageable. It bought much of the Treasury’s debt issuance, thereby increasing the money supply, and inflation spiked. When the Korean War brought more military expenditures that needed to be financed, the Fed rebelled, eventually coming to terms in what became the US Treasury-Federal Reserve Accord of 1951, asserting the Fed’s independence and effectively ending the Fed’s backstopping of the federal budget. Even with this accord in place, Presidents Lyndon Johnson and Richard Nixon pressured—even bullied—their respective Fed chairmen into cutting rates, each time resulting in bouts of inflation.
Despite this history, Trump has not hidden his desire for lower rates nor his disdain for Fed Chairman Jerome Powell, whose second term as chairman expires in May 2026 anyway. Trump will most certainly nominate someone intent on cutting rates to replace Powell. A cynic might say that candidates for the job are competing to be the most vociferous advocate of lower rates and the most outspoken critic of current Fed policies. Jawboning undermines the Fed’s independence and the credibility of whomever succeeds Powell. If the Fed succumbs to the administration’s wishes, it will mean fighting inflation is taking a back seat to underwriting budgetary profligacy. Federal Reserve independence is central to maintaining confidence in Treasury debt and the dollar.
Regardless of who is approved by the Senate and ultimately appointed Fed chair, the Federal Open Market Committee (FOMC) is comprised of twelve voting members. To implement a more aggressive monetary policy, the new chairperson would need at least six other members to vote with them. That may or may not happen. In any event, the economic outlook may look very different next year.
Short-Term Rates Are Coming Down for Now…
The median expectation of the Fed’s FOMC members is that the long-term neutral fed funds rate is 3%, which compares to the current rate of 4.3%, suggesting short-term rates are higher than they need to be. Rate cuts should be stimulative both to the markets and the economy, but they also risk stoking inflation. The Fed is becoming more comfortable balancing the risk of higher inflation with the risk that rates are too high, curbing growth. The Fed might already have resumed cutting rates except for the uncertainty surrounding what tariffs may do to inflation. Tariffs don’t just affect the prices of imported goods—domestic providers raise their prices to match prevailing rates.
The optics of lowering rates into rising inflation numbers wouldn’t be great, particularly when the core Personal Consumption Expenditure (PCE) price index, which recently ticked up to 2.8%, is already above the Fed’s 2% target. The FOMC needs to be further mindful not to encourage speculative behavior in the stock market. But the committee is likely to resume cutting rates, perhaps just not as fast as Trump would like it to. In their most recent survey, a majority of FOMC members saw at least two rate cuts by the end of this year and another one or two cuts in 2026.
Longer-Term Rates: Different Kettle of Fish
Interest rates had been in secular decline for forty years prior to the pandemic, but a number of factors have changed. The steady outsourcing of manufacturing to countries with lower manufacturing costs provided a steady source of disinflation, contributing to lower rates. The current emphasis on bringing manufacturing back to the US—de-globalization—is inflationary at the margin because it costs more to manufacture goods in the US, to say nothing of tariffs. Wars, countries rebuilding their militaries, engaging in reconstruction, and rebuilding energy infrastructure can also be costly, and therefore inflationary. To the extent that government spending is inefficient, productivity slows, contributing to inflation. Large government deficits increasing the supply of debt outstanding should drive interest rates up. America’s aging population spending down their savings and depleting the social security trust fund, while not inflationary, may still reduce demand for Treasuries.
Interest rates were particularly low across the yield curve when the economy was recovering from the Great Financial Crisis, and inflation was also continually running below the Fed’s 2% target. Some level of US federal budgetary deficit spending was tolerable as a temporary measure while rates were low and we were recovering first from the Great Financial Crisis and then from the Covid-19 pandemic. Now we are incurring 6%-7% deficits in an ostensibly healthy economy growing approximately 5% in nominal terms with no end in sight.
Ranting about the federal debt and deficits is a common refrain in our Quarterly Market Perspectives. Our concern isn’t that a default is imminent, but rather that the massive debt and deficits are presently weighing on the entire investment landscape, affecting how asset prices behave. The federal government now spends more on interest expense than it does on national defense or Medicare.
Interest expenses affect the deficit, and the deficit can affect interest rates, putting the two in a feedback loop for better or worse. When interest rates were falling, lower interest expenses offset at least some of the increases in the primary deficit.
More recently, politicians have been increasing primary deficits while interest expenses have been rising. Federal debt held by the public grew from 35% of GDP in 2007 to 97% last year. The CBO forecast that it would grow to 156% by 2055 before taking either OBBBA or tariffs into account. Our burgeoning debt may cause holders of US Treasuries to demand higher rates, or the Fed may be compelled to buy them, which would be tantamount to printing money. Inflation would ensue.
When the Fed cut the fed funds rates by a full percentage point in the second half of 2024, long-term rates went up by a percentage point. Even if the Fed cuts short-term rates over the coming year, long-term rates might not necessarily follow. Long-term rates are set by market forces, and as such should already incorporate expectations about the path of short-term rates. Long-term rates may rise anticipating more inflation, with higher long-term rates working at cross-purposes to Trump’s exhortations for the Fed to cut rates. Cutting short-term rates would be stimulative at the margin, but the stimulative effects could be offset by the contractionary effects of higher long-term rates. Mortgage rates correlate highly with the 10-year US Treasury yield, for instance. Higher long-term rates could further be a headwind to stock price appreciation. The administration is considering some policy initiatives to bring down long-term rates as well, but since rates are always fluctuating with market forces, it will be hard to tell how effective these measures are.
Reducing the deficit would be contractionary. We’ve gotten ourselves into a catch-22 situation where we run the risk of causing a recession by cutting the deficit. Politicians are understandably reluctant to risk a recession, and yet our debt burden is only getting worse. Neither political party has demonstrated much interest in fiscal responsibility, and to be fair the issue hasn’t captured the hearts and minds of many voters. In order to have a lasting solution, both parties would need to contribute and compromise. The two parties would have to work together to present a coordinated plan to the American public without tearing each other down. President Ronald Reagan formed a bipartisan commission in 1981 to address insolvency of the Social Security trust fund. The commission funded Social Security by curtailing benefits and raising taxes. Spending cuts are necessary now to reduce the deficit—arguably tax increases in some form or other are as well, but it’s hard to see any bipartisan agreements in the current political environment.
Congress tends to defer difficult decisions until there’s a crisis. Even when Reagan’s National Commission on Social Security Reform presented its bipartisan proposal back in 1983, the Social Security trust fund was months away from becoming insolvent. By this logic, the government won’t reduce the deficit until there’s a more palpable sense of crisis, and our national debt certainly seems destined to become a crisis at some point. Unsustainable fiscal deficits are likely to exert upward pressure on long-term rates until we get them under control.
Whenever the next recession comes, Treasury investors should expect that the Fed will increase the money supply, sending long-term interest rates higher and the dollar lower. Higher long-term rates might slow the economic recovery, putting downward pressure on housing and impeding capital investment. With less potential for long-term rates to reinvigorate economic growth, stocks maybe shouldn’t trade at such elevated valuations.
Figure 1 – Stocks, Treasury Yields and the Dollar
Source: FactSet
US Dollar Weakening
The dollar may continue to decline as the Fed cuts interest rates. We had considered how a stronger US dollar might offset the cost of tariffs, resulting in mostly stable import prices. The US dollar rose for awhile after the election, but has weakened since January, leaving that hope seeming out of reach.
Outspoken rebukes of the Fed and challenges to its independence serve to weaken confidence in the dollar. A weaker dollar is modestly inflationary but is also a positive for corporate earnings, since foreign earnings reported in dollars appear to grow as the dollar weakens. The weakening of the dollar will help accomplish much of what the Trump administration seeks to do by imposing tariffs—discourage imports and encourage exports. Trump’s haranguing of the Fed may be intended to weaken the dollar, but the benefits of a weaker dollar probably don’t outweigh the costs of potentially higher long-term interest rates.
Markets experienced unusual conditions in April when Treasury bond prices and the dollar fell alongside stocks (see Figure 1). Yields move inversely to prices. Treasuries and the dollar are usually safe havens, rising in price when riskier assets fall. Treasury yields initially fell, but in the throes of the bear market, they started to rise. The unexpected response from Treasuries and the dollar might reflect dissatisfaction with the dollar-based world order, a response which could become more common. Other countries have started to diversify their reserves into other currencies and gold. In May, Moody’s downgraded US debt to Aa1 from Aaa during the second quarter, becoming the third major credit rating agency to do so. But trading near the middle of their long-term ranges (see Figure 2), the dollar and US Treasury yields have withstood much greater skepticism. The current pressures don’t seem to be strong enough to threaten the dollar’s status as the world’s reserve currency any time soon.Figure 2 –
Figure 2 – ICE US Dollar Index and 10-Year Treasury Yields – A 30-Year History
Source: FactSet and St. Louis Federal Reserve (ICE is the acronym for Intercontinental Exchange)
Stocks Are Resilient
Trumponomics involves shifting some component of the federal government’s revenue sources from income taxes to tariffs, with tariffs offsetting some of the federal revenue lost by extending the tax cuts from Trump’s first term. Most economists believe tariffs are a less effective way for governments to generate revenue because they restrain commerce and reduce domestic manufacturers’ competitiveness on the global stage. Nevertheless, this president, like the ones who preceded him, does not seem to place much emphasis on reducing the deficit. Burgeoning debt and a gradual erosion of confidence could drive interest rates up, and higher interest rates are likely to make stock appreciation more of an uphill grind than it has been. We want our clients to participate in the market’s upside, but we proceed with an appreciation of the pressures on the system.
Stocks are always adapting to the economic conditions they face. That is one reason we believe holding high-quality stocks is the best way to maintain and grow your wealth. We believe our strategy of holding for the long-term was vindicated through the downturn in the second quarter by the market’s rapid reversal. The recovery from Covid-19 was similarly rapid, and our clients benefited by staying invested. We do look for companies which stand to benefit from the current macroeconomic context, while remaining positioning to exploit specific growth opportunities. Portfolios should be well-diversified in order to ride out market volatility and any number of possible macroeconomic conditions.
Stocks have had a good run. The market seems to be looking past tariffs, geopolitical tensions, war, and fiscal largess, perhaps anticipating lower short-term interest rates. The S&P 500 Index recently traded at 20.6x 2026 estimated earnings, or 16.1x on an equal-weighted basis, reflecting a fair amount of optimism. The difference between market capitalization-weighted and equal-weighted indices reflects the significant premium afforded to the largest capitalization companies. High stock valuations can limit investors’ returns even when the underlying companies continue to have strong prospects. We look to recycle funds from overworked investment themes into newer opportunities.
Clients who may need cash for contingencies may be well served by raising it when valuations are full, such as now, to avoid having to raise cash during a market downturn. We look to add further value by harvesting tax losses to lower your tax bill along the way. If you would like to discuss how any of this applies to your portfolio, please don’t hesitate to contact either your portfolio manager or me.
— Adrian G. Davies, CFA — President