Market Review
The benchmark S&P 500 index closed the 2nd quarter up 10.6% to move into positive territory year-to-date, following a 4.6% drop the prior three months. Investors can be forgiven for thinking that outcome would have been unlikely in early April, when the benchmark was down almost 15% for the year. News flow hasn’t seemed particularly bullish for stocks, but in the long-term, stock prices should track earnings, and S&P 500 companies continue to top analyst expectations by noteworthy margins. Corporate earnings beat forecasts by over 7½%, growing a almost 12½% year-over-year. Revenues surprised more modestly, by slightly less than 1%, growing around 4½% versus the prior year. Analysts project that earnings grew a scant 1.3% during the 2nd quarter and will grow a round 5% over the rest of 2025. The Federal Reserve (“the Fed”) left their policy rate unchanged at each of their two meetings during the quarter, exactly as they had during the 1st quarter. The Fed noted the potential for inflation to pick up as goods imported into the US may become more expensive. US trade announcements in April and their eventual delay add an additional unknown to a macroeconomic backdrop policymakers had already described as increasingly uncertain.
The Economy
The U.S. economy actually contracted at a 0.5% pace during the 1st quarter, as U.S. companies pulled forward imports ahead of potential import taxes, after consensus began the quarter calling for a trend-like 1.9% growth rate. Net imports subtract from overall G.D.P. growth, so it was a math issue rather than a U.S. demand issue. Per the Federal Reserve Bank of Atlanta’s GDPNow model estimate, 2nd quarter economic activity will expand around 2½%, in a bit of a bounce-back. First-quarter inflation readings on the central bank’s preferred Core Personal Consumption Expenditures Deflator remained near post-pandemic lows and softened slightly. The Fed’s post-meeting statement in June indicated that labor market conditions remain solid, with the number of job openings and job seekers fairly balanced. Economists anticipate the U.S. economy will grow a below-trend 1.4% during 2025, which would mark an almost 1½% slowdown versus each of the prior two years. The unemployment rate stands 0.8% above the cycle low of 3.4%, and remains quite low by historical standards. Longer-term interest rates rose by up to 0.20% during the quarter, but shorter-term interest rates fell by roughly the same amount, which is probably a wash for both growth and inflation.
Equity Markets
The S&P 500 topped most sectors during the 2nd quarter, trailing only Technology (+23.5%), Communication Services (+18.2%) and Industrials (+12.5%). There was quite a wide dispersion in performance between sectors, stretching from the stellar returns in Technology down to Healthcare dropping 7.6%. The biggest headwind for the Healthcare sector was the prospect of paying import taxes on the portion their pharmaceutical offerings they manufacture overseas and materials that they can’t source in the U.S. The clamor for lower prescription drug costs persists, as does the call for the rest of the world to shoulder more of the burden on research and development costs that the U.S. largely carries. After the excitement over artificial intelligence (“A.I.”) came off the boil in the first quarter, first quarter earnings results told the real story. Demand for the high performance computer chips that enable A.I. and the networking equipment that allows for building powerful clusters of those chips continues to outstrip supply, and that demand is feeding thru into earnings. In the Communication Services sector, Alphabet and Meta enable A.I. via their data center infrastructure and A.I. models. Telecom companies connect users to those data centers and models, and link data centers to other data centers. Industrial companies build those data centers and provide the components that enable them to operate. Those same Industrial companies built and update the grid that transports electricity to power-hungry data centers. The Consumer sector (+7.4%) reflects that U.S. shoppers remain quite resilient. The economy may not be adding jobs at as rapid a clip, but employment remains high. History shows that U.S. consumer class has a propensity to shop and dine out as long as they are working. Financials (+5.1%) benefited from active discussions of lowering regulatory burdens that investors perceive have limited lending and capital markets activity. Real Estate lagged as longer-term interest rates rose. Energy lagged as commodity prices sank on the prospect of higher global supply.
Long-Term View
Trade headwinds and geopolitical concerns haven’t disappeared. A.I. enablers are spending eye-watering sums to build out related infrastructure, with the return on that investment yet to be seen. Commentators wonder whether A.I. will replace jobs or, as in previous industrial revolutions, create new types of jobs. Which companies will A.I. render the next Polaroid or Blockbuster Video? Ah, for a crystal ball. These very real concerns create what has been termed a proverbial “wall of worry” for the market to surmount. The irony is that very wall historically has made the path of least resistance upward for stock prices. That may sound counterintuitive, but perhaps it isn’t. Investors may sense that a worried market has already priced in plenty of bad news stemming from those worries. Perhaps it’s an view that “this, too, shall pass”. Perhaps future prospects look more promising than the present, which may eventually bring reluctant buyers into the market. The expectations bar has been set quite low for 2nd quarter earnings reports, and an upside surprise in results could boost the market further. As the chart at the top of the page illustrates, management teams have established a strong track record of making analyst forecasts look overly conservative, and, as ever, stock prices should align with earnings.
