The beginning of 2025 was marked by volatility, a sell-off in the domestic equity markets, and uncertain policy changes that put the economy in a wait-and-see mode.
As the quarter progressed it was clear that trade tensions were rising, and the world took notice of potential moves by the US that could impact global business.
The looming tariff implementation could make all the difference to a market that feels like it is hanging on by a thread at this point, and there seems to be more questions than answers after an eerie start to the year.
Q1 Equities
The first quarter brought a dramatic reversal of trends that had been in place for years. Domestic stocks (represented by SPY & IWM) lost value, while international stocks (represented by EFA, ACWX, and EEM) led a positive trend. It is extraordinarily rare for the correlation among global equities to break down to this degree. Generally, risky assets tend to move together as investors take or reduce risk across a portfolio.
Developed international equities (EFA) were up over 8% in the first quarter as compared to domestic large cap equities (SPY), which lost over 4% of value. Domestic small cap equities (IWM) fared worse, losing 9.5%. Emerging markets (EEM) gained 4.5%, driven in large part by China’s continued stimulus efforts to restore growth to their economy.
As mentioned in previous updates, the S&P 500 is exceptionally top-heavy with an outsized concentration – almost 40% at the beginning of the quarter – to just a few stocks. This concentration was and still is a risk, and to no one’s surprise it was the biggest stocks that did the most damage during the quarter.
While all stocks within the “Magnificent 7” group lost value during the quarter, Tesla (TSLA) was the standout losing almost 36%. Of course, this same group of stocks powered the exceptionally strong returns for the S&P 500 in 2023 and 2024.
The unique point of this sell-off is that it was primarily self-inflicted. The US administration’s tariff policies have rattled the market and are widely considered to be inflationary. Inflation is the primary factor keeping rates higher, as the Federal Reserve is tasked with managing both inflation and unemployment. Therefore, the market has a negative reaction to inflationary policies because this pushes the prospect for further rate cuts (i.e., cheaper money) further into the future.
As a reminder, tariffs are charged as a percentage of the price that importers (US companies) pay to the sellers of goods made in foreign countries. This is important because tariffs are not paid by the exporter, so the importer, to maintain profitability or even stay in business, has no other choice but to increase prices.
Ultimately, a large portion, if not all, of the tariff’s cost is borne by the consumer (US citizens), effectively making the tariffs a tax on US consumers. For example, the proposed 25% tariffs on automobiles and parts could raise the price of a new car by $5-$10k, according to Dan Ives of Wedbush Securities.
In addition, the US tariffs will not be implemented without a response from the nations we place tariffs on*. These countries will respond with tariffs of their own, which is why it is called a trade war. The end result of a trade war usually looks something like this:
- Consumers in both countries pay higher prices on the tariffed goods
- Companies that produce those goods have lower sales
- Those same companies are forced to lay off workers, which drives unemployment up
- Fewer goods are sold in both economies because fewer people have jobs and/or prices are higher
- Recessions become more probable
*On April 4th, China responded with a 34% tariff in response to the tariffs.
One theory is that higher tariffs will promote more manufacturing and jobs as companies relocate manufacturing to avoid the tariff. While this will happen to some degree, there are two big challenges.
The first is that it takes significant time and investment to move factories. The second is that job growth may be very muted as companies employ more automation/Artificial Intelligence instead of hiring comparatively more expensive US-based workers. As a reminder, the primary reason factories are set up in foreign countries is to take advantage of a lower cost pool of labor.
Q1 Fixed Income
Investors responded to the volatility in the equity markets as they typically do by investing in higher quality bonds, and the yield curve reflected this with yields dropping ~40 basis points at the 3 and 5-year marks. As a result, the yield curve is more inverted now (downward sloping) than it was at the beginning of the year, which is a sign of increased recession risk.
As shown below, the bond types included in our general fixed income strategy appreciated during the quarter. The highest quality/most interest rate sensitive bonds (AGG) performed the best, up 2.7%, while riskier bonds (HYG & FLOT) were up a little over 1%.
We remain heavily overweight floating rate (FLOT) bonds given the current higher yields at almost 8% and our view that rates will stay higher for longer. While AGG was the leader this quarter, we are maintaining an overweight to floating rate given the over 3.5% yield advantage.
Macro Environment
"When America sneezes, the world catches a cold."
The tariff policies have materially changed the risk-taking landscape. While the situation is extremely volatile and fluid, there is no question that a trade war will be bad for risky assets globally.
Just after the quarter, we have learned that “Liberation Day” meant imposing tariffs on all US trading partners. So far, the market has reacted poorly to the news, leaving us with two paths:
- Hope this is more of a negotiating tactic and instead of a Trade War, more reasonable trade deals are worked out with our partners and the markets recover.
- Expect the tariffs will stay in place, other countries respond in kind, a Trade War ensues, and we enter global recession. One step worse would be stagflation, which is characterized by high unemployment, high inflation, and slow growth. Note that stagflation is generally caused by price shocks such as the oil crisis in the 1970’s, and tariffs, by definition, increase prices.
It is impossible to say which it will be, or if there is another variation that will come to light. We remain steadfast in our philosophy to be extraordinarily thoughtful about the asset allocation prescribed for clients, and not to time markets.
Coming into the year our most aggressive portfolios were positioned with no more than 25% public equities, with the balance in high-yielding fixed income and a large allocation to alternative investments (i.e., private credit, private equity, and real assets). Therefore, while the losses are painful in the public equity portion of the portfolio, the diversification we employ serves as a partial hedge to equity market volatility.
On the positive side, equity markets – especially the domestic markets – are much cheaper than they have been in recent memory. Short-term rates are lower than they were at the beginning of 2024, unemployment remains low, and inflation has come down, although not yet to the Fed targets.
Positioning
We expect the equity markets to remain choppy until some sort of clarity is reached on the tariff front.
We are positioned for “higher for longer” within fixed income, and we believe the current policies/inflation data do not give the Fed much room to cut rates.
Our inter-asset class positioning in public equity and fixed income was a modest detractor for the quarter. However, the relatively low allocation to public equity was a significant boost to performance as public fixed income and alternative assets performed much better.
Because of our “higher for longer” belief, and that inflation will be stubbornly high, we remain overweight floating rate bonds and underweight longer duration bonds. The ~8% yields offer a very compelling case and provide a robust income stream for the portfolio.
In the equity markets we will maintain our overweight in the large cap US markets, believing the first quarter’s strong outperformance of international markets is unlikely to continue.
Our allocation to alternative assets similarly remains unchanged.
At LGT we lean heavily on alternatives, specifically the private equity, private credit, and real assets categories. Alternatives typically exhibit slower drawdowns and do not rise as quickly as public markets. We favor private equity secondary investments, have a large allocation to private credit/direct lending, and hold smaller positions in real assets/infrastructure.
The Bottom Line
Our team is always happy to discuss strategic portfolio positioning, especially how it relates to individual goals and objectives. Our team of investment managers and trusted advisors believe a comprehensive financial plan must include a sound investment policy statement to guide investment decisions, and we encourage conversations around aligning a portfolio with wealth goals.
Reach out to our team today to have a better understanding of what you need to feel confident in your financial future.
To learn more, contact one of our trusted advisors.
