By
Linda Bakhshian
May 21, 2025
First-quarter and "Liberation Day" recap
Entering 2025, markets reflected optimism in the economic cycle and political change, even as US economic growth
looked set to moderate somewhat from its above-trend pace. Investors and companies were optimistic that the new
presidency would bring much-needed regulatory, energy price, and tax relief, offset by some tariff increases and lower
immigration. However, this picture has become more complex.
Equity markets in the US generally declined during the first quarter of 2025, breaking the recent pattern of quarterly
increases. A considerable amount of global volatility came post “Liberation Day” on 2 April, as markets grappled
with tariff announcements. However, for the first quarter, the weakest performers were US growth stocks delivering
negative returns. Much of the weakness in US large-cap growth style can be attributed to the rise of competition in
the artificial intelligence (AI) space from foreign competitors and questions around the level of capital expenditure and
competitive advantage of the “Magnificent Seven” companies. The only US equity category to deliver a positive total
return was large-cap value. During the quarter, the strongest-performing sector in the S&P 500® Index was energy at
+9%, while the weakest-performing sector was consumer discretionary at -14%.
The picture is somewhat different for equity markets outside the US. In local currency terms, returns during the first
quarter were mostly positive. Moreover, a decline in the value of the US dollar (USD) meant that from the perspective
of US investors, the returns of foreign markets were even better. In USD terms, the top performers were Germany,
Hong Kong, and Switzerland, which all rose more than 10% over the first quarter. The weakest performers during the
quarter were Australia and Japan, which posted negative returns in both local currency and USD terms.
The month of April began with “Liberation Day” tariff announcements and escalating trade tensions, creating
exceptional volatility across US and global equity markets. The chaotic rollout, retaliations, exemptions, changing
narratives, and timing has since created a cloudier economic path for investors and has raised fears of a recession for
both US and global economies. Tariffs, if not used pointedly, can become a blunt tool. They don’t just alter the cost of
goods; they reshape supply chains, disrupt corporate planning, and cloud the outlook for earnings growth.
Even as President Trump moves away from maximum pressure with a 90-day pause on reciprocal tariffs, this looks
to be the largest increase in tariff rates in US history, going back to 1930s. The US government has stated that it
is currently in negotiations with numerous countries, but there is no certainty around timing. We believe that the
effective embargo on imports from China is unsustainable and a solution will be reached, hopefully soon. At the same
time, the Trump administration has been very clear that additional tariffs will likely be enacted on specific sectors,
including pharmaceuticals, semiconductors, and lumber, among others. The universal 10% tariff and sectoral tariffs are
expected to remain in place for some time, meaning that a significant drag from tariffs will likely remain. Of course, the
situation remains fluid and is likely to change again.
One of our primary concerns entering the year was the impact of uncertainty. As shown in Figure 1 below, policy
uncertainty is closely linked with economic growth. This correlation is logical: when companies face an uncertain
future, they are hesitant to increase capital investment or hire new workers. Similarly, consumers react negatively to
uncertainty, particularly when it raises fears about the job market. Although negotiations are likely, we believe tariff
relief is necessary to significantly improve clarity for companies in the coming months.
Figure 1:
Economic policy uncertainty and GDP
Sources: Macquarie, Macrobond, Matteo lacoviello, Economic Policy Uncertainty Index, U.S. Bureau of Economic Analysis (BEA).
Similarly, the first-quarter earnings reports, so far, have been accompanied by cautious management commentary
around consumer response to rising tariffs and the corporate capital expenditure cycle. It is clear that companies
are planning for difficult quarters ahead and hoping for an offramp to emerge. Many companies discussed various
strategies to deal with tariffs, ranging from supply chain reallocations to passing on the cost to consumers. So far,
earnings in the consumer-related sectors are beginning to be revised down, while the technology and financial sectors
continue to deliver. The longer the uncertainty continues, the murkier outlook, end-market demand, and expectations
become.
Regarding the much-anticipated fiscal policy, Congress is working on a reconciliation package that combines an
extension of the Tax Cuts and Jobs Act (TCJA) with tax and spending cuts. Our expectation is the net benefit would be
slightly expansionary, though these benefits may not be felt until 2026. Likewise, deregulation should be a positive for
corporate activity, but this type of impact tends to take some time.
As we look forward, markets are likely to remain dynamic, with a wider range of possibilities and outcomes as investors
reflect on implications for earnings, consumer, corporate investments, and US federal policy. We continue to believe
that over the long term, equity markets are impacted by actual policies rather than political rhetoric, and that longer-term earnings are influenced mainly by the fundamental strengths and vulnerabilities of individual companies. Longer
term, companies, consumers, and supply chains can adjust to new realities; however, uncertainty is the one factor
markets do not adjust well to. In our view, active management of well-constructed equity portfolios can help protect
investors from being overcommitted to any single theme.
Sticking with quality
Empirical evidence suggests that long-term investors are historically rewarded for dollar averaging into the market.
Additionally, stability, profitability, and quality tend to be the most enduring factors over time. We believe long-term
equity market returns are primarily driven by underlying business earnings and fundamentals, and this is what we
are concentrating on presently. Our teams are dedicated to identifying mispriced companies with attractive growth
prospects, sustainable business models, and clear catalysts when constructing portfolios that yield positive, riskadjusted long-term returns, irrespective of market, economic, or political conditions. By emphasising intrinsic value
– assessing companies’ financial health, competitive strengths, and market positions – we uncover opportunities less
susceptible to short-term fluctuations and uncertainties. Today’s equity market is no different. Although the current
economic path is less clear, applying a consistent risk-adjusted fundamental framework to investments and portfolio
construction while remaining agile to policy changes will guide long-term investors once again.
In constructing enduring portfolios, one approach to assessing their effectiveness is by looking at the long-run returns
for the “style factors” in a multivariate risk model such as the Barra Global Total Market Equity Model. Figure 2 shows
the annualised returns, together with the volatility of those returns, for those style factors from January 1996 to the
end of April 2025.
Figure 2:
Annualised return and volatility of monthly factor returns, January 1996 to April 2025
Notes: Data from MSCI Barra; the chart shows the annualised return and volatility of a 1 standard deviation exposure to the indicated style factor over the full period; details of
methodology available on request.
As Figure 2 shows, over the long term, portfolios that are overweight in quality factors (earnings quality, investment
quality, and profitability) have generally delivered positive returns quite consistently with lower realised volatility.
Similarly, portfolios that are overweight in value factors (book-to-price, dividend yield, and earnings yield) have also
generated positive returns. It is conventional to assume that “value” and “growth” are opposed to each other, but
Figure 2 demonstrates that a balance between these two characteristics would also be rewarded over the long term.
Similarly, over the past decade, being overweight in quality factors and value/growth factors has been rewarded, and
that in most years these were at or above the median factor return. Likewise, being overweight in traditional “risk”
factors such as earnings variability or residual volatility was generally associated with negative performance, though
over the past decade, beta did generate positive returns (with a great deal of volatility!).
From around our network… Diversifying across market caps and regions
When examining the behaviour of equities during historical market drawdowns, large-cap equities generally perform
better at mitigating market dislocations. In contrast, small-cap equities tend to underperform other size segments due
to their higher economic sensitivity. However, this time may be a little different.
Large-cap stocks are typically well-established companies with diversified businesses, significant scale, and stronger
balance sheets compared with small-caps. These characteristics enable large-caps to absorb increased costs and
leverage their position to negotiate better terms with suppliers. Specifically, with tariffs, large-cap companies often
have more diversified international exposure and greater financial and strategic flexibility to adapt their operations to a
changing landscape. The diversification of a more global customer base could also provide additional benefits if the US
experiences economic weakness as a direct result of tariffs.
Beyond the immediate impact of tariffs, President Trump’s other policies, such as the extension of the TCJA, lower
taxes, deregulation, and reduced energy costs, could be beneficial for the equity markets and are likely to create new
economic opportunities. Small-cap equities are poised to benefit significantly from these efforts and may drive the
equity markets higher. Furthermore, if manufacturing does return to the US as President Trump expects, increased
domestic growth and activity could particularly favour small-cap companies.
Currently, market participants are focused on management guidance and the earnings impact from tariffs. If policy
uncertainty continues, we anticipate further downward revisions to earnings in the coming quarters. Small-cap stock
earnings have already been revised down, while valuations remain favourable with balance sheets that are generally
better capitalised. Historically, following the troughs of the Russell 2000® Index during the past seven bear markets,
the average return over the subsequent 12 months has been 54.5%. Hence, this may not be a typical cycle, and
diversification between large cap and small cap may be warranted.
Figure 3:
Small-cap vs. large-cap valuations looks favourable
Sources: Macquarie, Macrobond, Russell Investment Group. Data as of 4/4/2025.
Turning to global markets, with the exception of China, the global reaction to US tariffs has been somewhat restrained
so far – with many countries opting to delay. Over the past few years, US exceptionalism has driven capital to US
markets, potentially creating imbalances within a diversified portfolio. Although there exists numerous variables and
unforeseen consequences to the blunt use of tariffs, there are factors that may offset some of the negative impacts
being priced in currently.
We believe foreign central banks are likely to adopt a pro-growth bias, and governments may provide additional fiscal
support to cushion the downside. Excess production capacity in Asia is expected to have a deflationary impact on the
rest of the world (excluding the US), potentially allowing central banks to cut interest rates and stimulate economies.
The current market weakness has been accompanied by a softer dollar, and if the administration’s policies successfully
reduce trade deficits, it could result in a lower dollar still, which is typically positive for foreign equities.
Additionally, equities outside of the US trade at a significant discount, and several markets, including Japan, Korea,
and Taiwan, are now at levels reached during prior recessions. However, the outlook for earnings is uncertain, and we
remain very selective, assessing companies individually and considering the potential impact of top-down uncertainty
on their capital expenditure plans and financial performance.
The direct impact on China will be significant, but we do believe some compromise will be reached, as the current
standstill and effective embargo cannot be sustainable for global gross domestic product (GDP). Nonetheless, China is
likely to accelerate domestic stimulus, combining fiscal and monetary measures to boost consumption and exports. In
the euro zone, despite efforts to increase fiscal support, a small technical recession is now a possibility. In that scenario,
the European Central Bank (ECB) is likely to ease, and increase in German fiscal stimulus could potentially offset some
trade impacts. Korea and Taiwan are largely driven by the semiconductor cycle, and while semis are exempt from
reciprocal tariffs, separate sectoral tariffs could be added. Smaller Asian markets heavily exposed to trade, like those
in Association of Southeast Asian Nations (ASEAN) and Japan, are more at risk, while India, as a relatively closed
economy, is less affected. We believe the case for global diversification remains very strong while the opportunity cost
to generate alpha rather than beta continues to rise.
Additional observations
The US Federal Reserve (Fed) lowered the overnight borrowing rate three times between September and December
2024, but at its meetings in January and March 2025, it decided to leave the rate at 4.5%. The statement after the
March meeting indicated that although inflation in core consumer prices has continued to decline, the Fed remains
concerned about the economic outlook, having lowered its estimate of growth, and raised its projections for both
inflation and unemployment. As usual, the Fed has stressed that its actions will be driven by data. Our economist Derek Hamilton has suggested that if a recession in the US does occur, then the Fed might cut rates to 2.5% or lower.
The national elections in Germany on 23 February proceeded roughly in line with pre-election surveys. Turnout was
unusually high at more than 80% of eligible voters. As expected, the party winning the largest share of the vote was the
CDU/CSU (aka: The Union parties), causing Friedrich Merz to become the chancellor. The party with the second-highest
vote was the Alternative for Germany (AfD), which dominated most of the former East Germany with the exceptions
of Berlin and part of Leipzig. The Social Democratic Party of Germany (SPD), which had been in power for the past two
decades, came in third in the election. Following the election, the leaders of several parties announced that they would
be leaving politics, notably including the former chancellor Olaf Scholz.
During the second quarter of 2025, other national elections are expected to significantly impact policy decisions on
trade, tariffs and international relations. On 28 April, Canadian Prime Minister Mark Carney’s Liberal Party won the
federal election, after a campaign dominated by the discourse around President Trump and Canada’s relationship with
its most important trading partner. And Australia’s Prime Minister Anthony Albanese won an unexpected landslide
victory over the opposition Liberal party on 3 May, making him the first Labor prime minister to win consecutive
elections since the 1980s. Lastly, South Korea will hold elections on 3 June. The outcome in South Korea is difficult
to analyse because several senior politicians are currently embroiled in court cases, which could affect their ability to
focus on the electoral contest.
Conclusion
A system operates most effectively when its rules are well-defined. In financial markets, uncertainty disrupts the clarity
investors need in order to allocate capital with confidence. Without a well-defined regulatory framework, markets
are likely to remain volatile, valuation bands may become wider, corporate guidance is more uncertain, and investor
sentiment will likely stay on edge. Dislocations are where opportunities arise, and we remain vigilant in identifying such
opportunities. Historical patterns indicate that some of the strongest market rallies occur during crisis periods, hence,
staying diversified across regions, sectors, and factors, while focusing on quality, and managing exposures will be key to
navigating this environment.
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