“Imagine where the market would be in a world without crisis!”
— a comment in Barron’s, June 23, 2025
Markets remained remarkably resilient this quarter despite high and rising uncertainty. Trade concerns we noted last time persist. Eclipsed more recently by war in the Middle East and other matters, they are expected to gather more attention this month.
Headline inflation continued to moderate, but tensions in the Persian Gulf could still drive oil prices higher, potentially delaying the Federal Reserve’s anticipated rate cuts. On the other hand, the labor market is showing signs of softening, and more weakness could induce the Fed to accelerate rate cuts. Further complicating the Fed’s decision is a persistently weak dollar, which can result in “importing inflation.”
Fiscal concerns are also resurfacing: if Congress fails to enact the bill extending current tax laws, individual income tax rates will rise substantially. If it enacts the bill, deficit spending will increase.
At its June meeting, the Fed modestly raised inflation expectations and slightly trimmed its growth outlook for the rest of the year. Yet it still expects a soft landing, even as three primary recession indicators recently suggested a downturn: an inverted yield curve1, the Leading Economic Index2, and the “Sahm Rule” on unemployment3.
Markets shrugged off these headwinds and more as the S&P 500 set a new high late in the quarter, fully erasing the April crash. Yet performance diverged sharply across asset classes as much cheaper non-U.S. stocks outpaced their U.S. counterparts (Russell 3000) by more than 12% in the first half of the year.
While these near-term developments dominate headlines, long-term investors are better served by focusing on longer-term dynamics. Vanguard’s chief global economist recently noted the global economy is caught in a “tug of war between growing fiscal deficits, on the one side, and the potential for artificial intelligence to boost growth, on the other. All other forces are secondary.” [our italics]
As modern warfare becomes dominated by drones and missiles, AI has become as much a geopolitical imperative as an economic opportunity. As a result, AI development may increasingly resemble an arms race between the US and China, which could further hasten its development pace.
If AI does not evolve into something sentient and hostile—a possibility its creators do not dismiss—it may become the most powerful driver of productivity since electricity. The open question is whether AI-driven growth can be sufficient to offset the drag of persistent federal deficits. If government borrowing exceeds global capacity to save and lend (to our government and others), central banks will be forced to resort to money creation, risking structurally higher inflation.
Which future is most likely: productivity-led growth or high inflation? No one knows, and that may be the greatest uncertainty of all.
Adding to this uncertainty are today’s elevated asset valuations, which historically imply muted long-term forward returns and elevated short-term risk. Taken together, we don’t see the makings of a particularly appetizing investment stew, hence this bid to temper expectations.
That said, there are notable bright spots. Relative returns this year were especially encouraging during the market’s April swoon. Diversification - especially the inclusion of international equities - has meaningfully benefited portfolios this year. Our rebalancing trades during the April dip added value, and some of our “alternative” investments are having a particularly good year. We expect the advantages of our broadly diversified portfolio management approach to persist in the anticipated highly unpredictable environment.
1 The yield curve: The difference between short and long-term Treasury obligations; portends economic slowdown (after lags) when negative.
2 The Leading Economic Index: Published by The Conference Board, the LEI typically falls in advance of a recession.
3 The "Sahm Rule" on unemployment: When the smoothed unemployment rate rises by 0.5%, that tends to precede an economic downturn.