Economic and market progress stalled in the first quarter, as higher-than-expected tariffs and inconsistent implementation created concerns for investors. After a strong start, U.S. stocks fell during the quarter. International stocks posted solid gains, primarily due to depreciation in the U.S. dollar. Bond markets were mixed, benefiting from “safe haven” status while trading cautiously due to the potential for higher inflation.
Economic Headwinds Are Increasing
The U.S. economy grew by 2.4% in the fourth quarter of 2024, continuing the two-year trend of above-average growth. Consumer spending was again the key driver of strong results.
Entering 2025, expectations for continued economic strength were high. But the announcement of tariffs, first against Canada and Mexico and eventually against most countries around the world, changed the expected trajectory. First quarter gross domestic product (GDP) is set to suffer from a surge in imports as companies make purchases ahead of tariff implementation. These imports subtract from GDP growth. This factor, along with recent softness in consumer spending, caused the Atlanta Fed’s “GDP Now” reading to flip from 2% expected growth in the first quarter to a 1.5% contraction.
Inflation expectations are rising, primarily due to the expected impact of tariffs on goods prices. According to Capital Economics, five-year forward inflation expectations rose to 3.9% in March, compared to the most recent Consumer Price Index reading of 2.4%. Higher inflation expectations reduce the likelihood of additional Fed easing should signs of economic weakness arise.
Despite these challenges, the labor market held up well during the first quarter. There were 228,000 new jobs created in March, well above the consensus estimate of 140,000. The jobs numbers were strong even as thousands of government workers were laid off because of the Department of Government Efficiency (DOGE) initiative. For reference, government workers account for only about 2% of the total U.S. workforce. Wage growth continues to be healthy at about 4%.
Given the ongoing pattern of changes and delays to tariff policy, economic data is likely to stay murky in the near term. Once trade policy is set, the forward path of economic growth should start to become clearer.
U.S. Stocks Decline on Policy Uncertainty
Investment results were mixed in the first quarter. International stocks and taxable bonds rose while U.S. stocks and municipal bonds declined. The gains in international stocks were largely the result of a 5% depreciation of the dollar against major foreign currencies.
| MARKET SCOREBOARD | 1Q 2025 | 2024 |
|---|---|---|
| S&P 500 (Large U.S. stocks) | (4.27%) | 25.02% |
| MSCI EAFE (Developed international stocks) | 6.86% | 3.82% |
| Bloomberg Aggregate Bond (U.S. taxable bonds) | 2.78% | 1.25% |
| Bloomberg Municipal Bond (U.S. tax-free bonds) | (.22%) | 1.05% |
| Wilshire Liquid Alternative (Alternative investments) | .76% | 4.33% |
Source: Morningstar Inc, March 31, 2025.
U.S. markets began the year with gains fueled by enthusiasm over artificial intelligence and optimism that the new administration’s policies would support business. But by mid-February, concerns about potential tariff damage cast a negative pall over markets. A series of tariff starts, stops, and delays added to policy confusion and uncertainty. As a result, U.S. stocks experienced their first 10% correction since 2022. This downturn occurred over a span of just three weeks, the seventh fastest correction of the last 100 years. Market volatility spiked to the highest level since the COVID-19 pandemic in 2020.
While government policy uncertainty was the catalyst for the correction, U.S. markets were vulnerable to a downturn given high valuation after two exceptionally strong years of gains. The decline in stock prices reduced the forward price-to-earnings multiple from 21.7 to 20.7 at the end of the quarter, with valuation improving further during the first two weeks of April.
Earnings for S&P 500 companies were expected to grow in the low double-digits in 2025. Combined with better valuation levels, investment fundamentals were becoming more attractive. However, tariffs could have a negative impact on corporate profits this year. The potential magnitude of the impact will be difficult to assess until more clarity around trade policy develops.
Inflation Expectations Impact Fed Policy
Muddied is probably a better descriptor than changed. While the Fed still forecasts two .25% rate cuts for 2025, the path to those cuts is now less clear. The economy entered the year on solid footing. However, the implementation of tariffs caused five-year forward inflation expectations to increase to around 4%. The impact of tariffs on growth is difficult to forecast at this juncture. Wage growth is healthy, and savings are strong. This should allow consumers the continued ability to spend. The uncertainty lies in their willingness to spend, given the recent deterioration in consumer sentiment surveys.
So far, the Fed has taken a cautious stance in light of the tariff drama. Recently, the central bank reduced the growth outlook for the U.S. economy while increasing the inflation forecast. The former argues for rate cuts, while the latter for rate hikes. If the economy weakens significantly, the Fed may be forced to provide support with more rate cuts, even if tariff-induced inflation occurs.
Extension of Tax Cuts Could Provide Stimulus
Congress is moving forward with legislation to extend the Tax Cuts and Jobs Act of 2017 (TCJA), which originally lowered tax rates through 2025. A recent Senate budget resolution adopts a “current policy baseline” when determining forecasted budget deficits. This uses TCJA as the budget baseline, so the cost of making TCJA permanent is not counted. This means no offsets in spending or revenue are needed.
The resolution does allow for $1.5 trillion in deficit expansion, which could be used for further tax cuts. If passed, the legislation may boost growth by 0.40% annually, according to Goldman Sachs (April 9, 2025). The House of Representatives passed the concurrent budget resolution by a 216 to 214 vote on April 10. While an agreement has yet to be reached, the end result should be a modest increase in fiscal stimulus this year.
2025 Market Outlook
Tariff turmoil was by far the dominant factor impacting markets during the first quarter. After a series of starts, stops, and delays, markets became as concerned with the unpredictable nature of implementation as with the tariffs themselves.
Markets dislike uncertainty more than anything. The wide-ranging tariffs announced in early April were double the expected size on average, and the calculation methodology was different than the “reciprocal” approach indicated beforehand. While most would agree that seeking better trade terms for the U.S. is a worthwhile cause, the tariff implementation process has been chaotic. This has caused market volatility to spike and stock prices to decline. Several measures of business and consumer sentiment have also fallen to levels not seen since the pandemic.
Why all this angst about tariffs? First, it is important to understand that tariffs are a tax on the U.S. consumer. The buyer of the imported goods pays the tariff, not the foreign producer. Tariffs are typically levied with certain objectives in mind, including 1) encouraging consumers to buy U.S.-made goods instead of the now higher-priced foreign goods, 2) persuading U.S. and foreign companies to shift manufacturing to the U.S., and 3) generating additional government revenue. The long-run historical record of U.S. tariff policy has been mixed, with some successes and some failures. In the near term, though, the most likely outcomes are an increase in inflation, a reduction in U.S. economic growth, potential supply chain disruptions, and lower corporate profits. Therein lies the problem for U.S. investment markets.
Investors received a reprieve from these worries the second week of April when most tariffs were postponed for 90 days. This essentially “kicked the can down the road” until early July. The exception is China, where the U.S. tariff levy continues to ratchet higher and currently stands at 145%. This is clearly a negotiation tactic, but as of this writing, China has not expressed interest in coming to the table for talks. This situation is important to resolve, as U.S. businesses and consumers purchase more than $400 billion of goods made in China annually.
During the first quarter, the U.S. stock market experienced a 10% correction and then flirted with bear market territory at the beginning of April. The risk of a U.S. and global recession has risen. But there is a bit of good news in the midst of all this turmoil—to date only a small number of tariffs have actually been applied. Most of the more extreme measures have been postponed for now. As such, the actual impact to the economy and corporate earnings has been modest, leaving room for policymakers to course-correct before more significant damage is done.
The development of clarity around tariff policy will be crucial in determining market trends in the second quarter. As indicated in prior notes, the U.S. economy is the most dynamic and resilient in the world, with the proven ability to overcome challenges. Once the rules of trade are set and stable, companies will be better able to adapt and adjust. Until then, business strategy and decision making will remain difficult.
From an investment standpoint, diversification has been very effective in mitigating U.S. stock market losses this year. International stocks, bonds, and alternative investments have all performed better than U.S. stocks, limiting downside participation for diversified portfolios.
The current cloud of uncertainty will eventually lift. In the meantime, we are committed to maintaining portfolio discipline and a long-term perspective. This has proven to be the best approach toward achieving positive investment outcomes over time.
If you have questions about your personal portfolio or financial situation, please contact your Forvis Mazars Private Client team. Thank you for your continued confidence!