Q1 2025 Review: Navigating Uncertainty

One of the key known unknowns heading into this year was the extent to which U.S. government policies would shape the macroeconomic landscape. Unfortunately, the policies perceived to be less economically-supportive dominated the narrative in the first quarter, while the potentially more growth-additive policies (e.g., tax cuts, deregulation) were put on the backburner. Specifically, there remains an elevated amount of uncertainty surrounding the outcome of trade policy. In addition to the uncertainty drag, consensus tariff expectations have repriced to levels that resemble the risk case scenario of some initial forecasts.

Beyond trade, policy risk from federal layoffs and reduced immigration have added to growth concerns. The net result has been an unfavorable mix of lower growth and higher inflation expectations incorporated into U.S. consensus estimates. Nonetheless, forecasts for real growth in 2025 exited the quarter around 1.5% and included an expectation for continued easing from the Fed.

While the policy spillover into U.S. forecasts was incrementally negative, more positive developments resulted abroad. At risk of less support from the U.S., Germany executed unexpected fiscal reform that lifts the debt brake for defense spending and includes a €500 billion infrastructure fund. At the same time, China has taken a more proactive approach toward stimulating domestic demand as well as more positively engaging with the private sector. While risk of negative tariff shocks remain high, Europe and China made incrementally positive strides during the quarter.

First quarter financial market returns were generally positive aside from losses in U.S. equities. The market backdrop at the onset of the quarter looked quite different from February and March as late-January DeepSeek AI news jolted markets followed by policy uncertainty taking center stage by early February. These impacts were most pronounced in U.S. equities as the S&P 500 quickly corrected by 10% from mid-February through mid-March.

Underlying equity market dynamics shifted with the Magnificent 7 group a large drag (six of the seven were down more than 10%) and more defensive parts of the market leading the way. Despite Mag 7 weakness, broader U.S. equities held up reasonably well with the equal-weighted S&P 500 down only 1% and defensive sectors posting mid-single-digit gains. More notable was the strong performance in Europe and to a lesser extent, emerging markets. Europe equities outpaced the U.S. by about 15% in dollar terms. Both regions benefited from a rebound off a weaker starting point versus the U.S. The historic pivot in German fiscal policy was a major boost for Europe with aerospace & defense companies up 30%-plus for the quarter. For emerging markets, China was a key driver, as heavyweight tech companies were a key source of strength.

On the fixed income side, after rising early on, interest rates moved lower for the quarter while credit spreads widened. This led to modest positive total returns for broader fixed income indexes. Real assets generally outperformed global equities, with stronger performance in natural resources and global listed infrastructure.

Policy uncertainty was the main surprise for the investor community in the first quarter. Trade policy was the focal point with potential widespread implications for both global trade and geopolitical relations. Trade policy announcements were more severe than expected and multiples of magnitude higher than the 2018 trade episode in Trump’s first term. Adding to complexity, the uncertainty has been multi-layered with regard to the timing, exact policy details, how long policies will remain in place and their ultimate expected economic impact.

The U.S. economy remained on decent footing in 1Q. However, policy uncertainty weighed on survey-related economic data, with perceived risks around lower growth and higher inflation. This helped lead to fading U.S. economic momentum versus non-U.S. peers – an advantage over the better part of the last two years. While soft data can be overly influenced by recent events and is not necessarily predictive, key questions remain around how lower confidence translates to economic activity via consumer and corporate behavior.

The central bank reaction functions have varied somewhat globally though with most major developed market central banks still on course to gradually ease policy aside from the Bank of Japan. Central banks have largely shied away from offering direct guidance in relation to rising uncertainty, while generally placing more emphasis on downside growth risks relative to upside inflation risks. The Federal Reserve left policy unchanged in the quarter, while the European Central Bank cut twice and the Bank of England cut once.

The biggest shift in the market backdrop was the underperformance of the U.S. equity markets versus the rest of the world. The confluence of a less-positive outlook for U.S. megacap tech following DeepSeek AI news and broader U.S. policy uncertainty led to notable headwinds for U.S. indexes. U.S. equities reached a 10% correction from mid-February through mid-March while non-U.S. equities were closer to flat. European equities outpaced the U.S. by 15% in the quarter – one of the largest quarters of outperformance on record.

Policy uncertainty weighed on U.S. interest rates. Most of the move in longer-end Treasury yields was driven by lower real yields as market-based inflation expectations were mostly stable. These moves were not consistent globally. In fact, fiscal reform pushed up longer-end real yields in the Euro Area, while yields in Japan continued to rise. Globally, uncertainty was a consistent theme across central bank communications. The Fed slowed the pace of quantitative tightening while opting to leave rates unchanged with a dovish forward-looking posture.

Investment grade (IG) spreads widened 12 bps to 0.89%. High yield (HY) spreads widened 60 bps to 3.47%. Weakness within HY was led by lower-rated credits, which marks a reversal from recent years in which lower-quality credits outperformed. However, overall credit fundamentals were mostly unchanged and spreads still remain below long-term averages. From a return lens, both IG and HY fixed income were positive with support from income yields. For diversified investors, most bonds helped buffer U.S. stock losses.

A significant shift in regional leadership trends left global equities down a percent. In dollar terms, Europe returned around 15% more than the U.S., while local currency returns were lower but still strong. China outperformed the U.S. by around 20% on fiscal support and a tech sector revival. U.S. exceptionalism is under pressure after the S&P 500 Index lost 4% and entered a 10% correction. Tech, growth and cyclical stocks produced outsized drag on overall index returns. The equal-weighted S&P index was down about 1%.

Real assets were another area of the market that provided diversification from U.S. equity market losses. Natural resources led the way with a 7% gain during the quarter, followed by listed infrastructure (+5%) and positive performance from global real estate (+1%) that was sensitive to interest rate movements. Gold made new highs with a 19% gain in the quarter, which brings its trailing one-year return to 40%. Inflation, a weaker U.S. dollar, economic uncertainty and central banks continuing to add to gold reserves were key supports.