Q2 Economic and Financial Market Outlook

By Peter R. Phillips, CFA®, CAIA®
Senior Vice President and Chief Investment Officer
Washington Trust Wealth Management

The U.S. economy, while still strong, is facing headwinds from rapidly evolving developments around tariff policies, a stock market correction, and weakening business and consumer confidence. Are these temporary setbacks or will recession materialize in 2025? 

Q1 Recap: Tariff Uncertainty and Market Volatility

While economic forecasts and the financial markets are just starting to incorporate tariff policy, we will likely be waiting through mid-year or later for a clear final plan on tariffs, contributing to uncertainty and volatility in the market.

The Trump administration’s volatile on-again, off-again approach to tariff policy clouded the U.S. and global economic outlook. The year started with a relatively optimistic outlook for economic growth, based on expectations of a pro-growth agenda (e.g., stable/lower taxes, deregulation, government efficiency). However, tariff policy quickly became a leading administration initiative, resulting in the April 2 tariff announcements that were far broader and more substantial than anticipated. The market responded with its biggest one-day decline since March 2020 among fears of a global trade war that could plunge the economy into a recession. Responding to the negative market reaction, Trump on April 9 announced a 90-day delay of the full tariff implementation for most countries—creating time for trading partners to negotiate more favorable tariff deals—but a baseline 10% tariff remains in place, along with an 125% tariff on China. Despite the reprieve, continuing uncertainty around the tariff policy has dented both business and consumer confidence, which will likely curtail business investment and consumer spending in the near term, slowing U.S. economic momentum. 

U.S. equity markets were negatively impacted by tariff uncertainty. Equity markets started the year strong but came under pressure mid-quarter.[i]  The S&P 500, up as much as 4.6% in mid-February, ended down 4.3% in Q1 on a total return basis.  Growth oriented and small- and mid-cap stocks were disproportionately impacted with the NASDAQ index declining 10.3%, the S&P 400 Mid-Cap Index declining 6.1%, and the Russel 2000 Index (small-caps) declining 9.5%.  Some cover was available in value oriented and dividend stocks.  The S&P 500 Value Index and the Dow Jones Select Dividend Index both increased in Q1, up 0.3% and 3.3%, respectively.

International stocks had a strong first quarter. The MSCI EAFE Index returned 6.9% and the MSCI Emerging Market Index returned 2.9% (both in US$ terms). A selloff in the US$ (due to tariff news) provided a tailwind to international returns. However, we are suspect of this positive performance from international equities, as international markets will not be immune from the impact of tariffs. Additionally, economic growth expectations in international markets started the year much weaker than that in the U.S.

Fixed Income markets produced solid Q1 returns as investors sought safety. The Bloomberg U.S. Aggregate Bond Index returned 2.8% in Q1. A flight to safety outweighed inflation, U.S. government debt accumulation and Fed policy concerns, pushing bond yields lower and prices higher. Two- and ten-year U.S. Treasury yields fell 35 bps and 36 bps, respectively, in the quarter. Credit spreads have started to widen from very tight levels reflecting the heightened risk of economic slowdown. Credit sensitive areas of the fixed income market lagged. 

Other than business and consumer confidence levels, the economy overall remains quite strong, with consensus estimates still calling for a respectable 2.0% U.S. GDP growth rate in 2025. However, we expect growth forecasts to move lower in the coming months.

The U.S. Economy Continues to Grow

Other than business and consumer confidence levels, the economy overall remains quite strong, with consensus estimates still calling for a respectable 2.0% U.S. GDP growth rate in 2025. However, as we will discuss below, we find that estimate suspect and expect growth forecasts to move lower in the coming months.

The Labor Market: Stable But Worth Monitoring

Payroll growth has yet to see much, if any, impact from the tariffs or from staffing cuts by the Department of Government Efficiency (DOGE). 

The U.S. economy added 228,000 jobs in March and a total of 456,000 jobs in the first three months of 2025, a rate of 152,000 per month. This is only slightly below the 168,000 average monthly job gain in 2024. Weekly unemployment claims remain moderate and in line with long-term averages. The 4.2% unemployment rate (as of March 2025) is up from a low 3.4% in 2024; however, this is still relatively low on a historical basis. 

Of course, employment conditions can change rapidly, and we will need to closely monitor weekly claims data, which will be one of our best “close time” indicators of the health of the economy. Consumer confidence surveys indicate consumers believe jobs are not as plentiful. Indeed, job openings have moderated and as of February were 7.6 million, down from 8.4 million last February but still above the 7.1 million unemployed, indicating a still somewhat favorable market for job seekers.

Personal Income, Spending, And Balance Sheets Remain Solid

Personal income is growing at a respectable 4.6% annual rate (year over year as of February 2025) and, despite still relatively high inflation levels, real (adjusted for inflation) hourly earnings and real (adjusted for inflation) disposable personal income are both still positive at 1.5% and 1.8%, respectively (as of February).  While real income growth rates have decelerated from last year, current stable labor market conditions are helping to keep income gains positive.

Even with the recent drawdown in stock prices, consumer balance sheets should still be in relatively good shape following two consecutive years of 20%+ gains in the stock market and housing prices up about 50% since before the beginning of the COVID pandemic (12/31/19). 

Personal consumption expenditures are growing at a 5.3% annual rate (year over year as of February) and on a real basis (adjusted for inflation) are growing at a 2.7% rate. 

Consumer Confidence Plummets 

While jobs, income and spending remain intact, consumer sentiment related to their future expectations has fallen to low levels. The expectations component of the consumer confidence index has fallen sharply over the past few months to levels not seen since mid-2022; when inflation was running around 9%, the Fed was aggressively raising interest rates, and both the stock and bond markets experienced steep selloffs. (At that time, the S&P 500 price fell 20.6% for the first six months of 2022, the worst first half of a year since 1970, and the Bloomberg U.S. Aggregate Bond Index fell 10.4%.)

While not an issue now, deteriorating consumer confidence levels could begin to negatively impact future spending.[ii] (Note: Personal consumption expenditures are typically the largest component of GDP growth.)

While not an issue now, deteriorating consumer confidence levels could begin to negatively impact future spending. 

Industrial Activity Appears Intact

Durable goods orders, factory orders, and industrial production all improved early in 2025.February durable goods order growth of 2.1% year-over-year is the fastest pace since late 2022. Factory orders have grown at their strongest pace since late 2023. Industrial production registered its highest year-over-year growth rates in January and February (1.9% and 1.4%, respectively) since late 2022.

Inflation and Fed Policy: Wait and See

Inflation continues to moderate, which could provide room for the Fed to lower interest rates. The Consumer Price Index (CPI) for March 2025 came in at 2.41% on a year-over-year basis, the lowest level since February of 2021. Similarly, Core CPI (excludes Food & Energy Prices) for March 2025 was 2.81% on a year-over-year basis, the lowest level since March 2021. The Fed’s preferred measure of inflation, the Core Personal Consumer Expenditures (PCE) Price Index was 2.79% on a year-over-year basis (as of February 2025).  Improvements in this inflation measure have stalled recently, but the longer-term trend remains one of improvement.

Not surprisingly, many economists believe inflationary pressures may re-emerge due to recent and potential future tariff increases. On April 16, Federal Reserve Board Chair Jerome Powell said that Trump’s tariffs are “highly likely” to spur a temporary rise in inflation, cautioning that those effects could end up being longer lasting.[iii] However, others think tariffs will not be as problematic for inflation, believing that inflation is more dependent on monetary policy and money supply than tariffs. In other words, price increases in some products due to tariffs will leave less money for other goods and services, leaving demand and prices for those goods and services lower, resulting in a stable overall price level.

Controlled inflation could allow the Fed to resume rate cuts, especially if the economy also starts to falter. Lower interest rates would help offset some of the negative growth impacts of tariff policy.

On April 16, Federal Reserve Board Chair Jerome Powell said that Trump’s tariffs are “highly likely” to spur a temporary rise in inflation, cautioning that those effects could end up being longer lasting.

Economic Outlook: No Recession Yet but Risk Rising 

With the delay of reciprocal tariff implementation and the renewed prospect of negotiations with trade partners, we hold out hope that the economy will avoid recession in 2025. However, the risk of recession is clearly rising.

Economic Forecasts: Suspect Given Tariff Uncertainty

As mentioned above, although the FactSet consensus real GDP growth estimate for 2025 is around 2.0%, we expect this estimate to fall in the months ahead. We think economists are struggling to fully comprehend and quantify tariff impacts, especially with incomplete and ever-changing information; and all estimates at this point should be viewed with some skepticism.   While we wait for clarity on tariff policy, we do know that business and consumer confidence has plummeted, which is likely to have a negative impact on business investment and consumer spending, at least in the near term.

Should tariffs ultimately be implemented as outlined on April 2, we think GDP growth estimates will move materially lower while the probability of recession moves higher.  In addition to the tariffs announced on April 2, there is also the possibility of sectoral (e.g., pharmaceuticals, autos, semiconductors, etc.) and commodity tariffs being added to the overall tariff plan, which would further erode near-term growth prospects

We think economists are struggling to fully comprehend and quantify tariff impacts.  In the meantime, business and consumer confidence has plummeted, which will surely have a negative impact on business investment and consumer spending, at least in the near term.

Recession Risk Hangs in the Balance

A Wall Street Journal survey of 64 economists from April 4 to 8 gives insight into the potential impact of broad, sweeping tariffs in predicting a potential recession. Following the April 2 tariffs announcement, the economists forecast a 0.8% year-over-year real GDP growth rate in the Q4 (down from 2.1% in the January survey) and a 45% chance of recession, up from 22% in January.[iv]Should the 90-day grace period on tariff implementation (announced after the survey) pass with no significant resolutions, we concur with their forecast and predict recession would become the consensus base case. Conversely, successful negotiations with trade partners that yield reductions in reciprocal and retaliatory tariffs would significantly lower the risk of recession, at least temporarily. 

It’s important to note that not all tariff increases are expected to be passed along to end consumers. It is possible that some of the tariff increases will be absorbed throughout the supply chain. Corporations entered 2025 with relatively high profit margins and strong balance sheets and may move to absorb some of the increases to keep demand intact. Further, we may see some positive near-term offsets to tariffs in the form of tax cuts, deregulation, and lower U.S. federal deficits and borrowing.

From a long-term perspective, the reshoring of manufacturing in the U.S. (a key goal of tariffs), if implemented, could boost business capital spending and support job growth.

Financial Markets

The announcement of unexpectedly broad tariff policies sparked a substantial selloff in the equity markets and drove volatility measures to levels as high as experienced during the Great Financial Crisis (GFC) and the early days of the COVID-induced economic shutdown. Volatility is likely to remain high until tariff uncertainty is cleared.

Fixed Income

A tariff induced flight to safety drove Treasury yields lower in the 1q:25, helping fixed income returns.  Although the prospect of tariffs ignites inflation concerns, the risk of recession has also increased; therefore, we still believe adding to duration is appropriate but continue with a preference for high quality. 

Yields. The 2-year Treasury ended Q1 yielding 3.89%, down from 4.24% at the beginning of the year.  The current yield is still relatively attractive in the context of the 0.09%-5.21% 15-year range, moderating inflation levels, and prospects for future Fed funds rate cuts. 

The 10-year Treasury ended the year yielding 4.21%, down from 4.57% at the end of 2024. The current yield is still relatively attractive in the context of the 0.50%-4.99% 15-year range, moderating inflation levels, and the increased probability of economic slowdown and/or recession. 

Inflation. Inflation readings (as measured by the Fed-preferred PCE Core Price Index (e.g., food and energy) continue to hover stubbornly close to 3% (2.8% as of February 2025). However, the CPI Index, including Core CPI, continue to move lower and have reached their lowest levels in four years. We expect the PCE Index to follow. Of course, the threat of tariffs poses an upward risk to inflation; however, many forecasters expect any uptick in tariff-induced inflation to be somewhat transitory and not too severe.

Fed funds rate cuts. Expectations for Fed funds rate cuts have increased with the heightened risk to GDP growth. Fed funds futures now suggest 75bp-100bp of cuts through the end of 2025. 

Credit spreads[v]. Credit spreads widened sharply late in Q1 and in early April, reflecting the increased risk to the economy posed by tariffs.  Spreads still remain below 20-year averages and given tariff uncertainty, there could be more to go.  As such, we continue to believe it may be too early to add exposure to lower quality corporate bonds. 

Investment grade spreads at 94bp, although up from a low of 74bp in November 2024, remain below the twenty-year average of about 149 bp and significantly below spreads during economic slowdowns and recessions. High Yield spreads at 347bp, although up from a low of 253bp in November 2024, remain significantly below the twenty-year average of about 491bp, and significantly below spreads during economic slowdowns and recessions.

Potentially a favorable environment for fixed income. The combination of moderating inflation, Fed rate cuts, and heightened recession concerns should be a favorable environment for fixed income returns (lowering yields and boosting bond prices). However, there is concern that some current and proposed policies of the Trump administration (including the tariff policy) could result in upward pressure on inflation, higher yields, and lower bond prices. 

Despite this risk, on balance, we continue to see an opportunity to extend portfolio duration (that is, extend maturities) and lock in some higher yields for the longer term. Current high money market yields are likely to fall if the Fed does have the opportunity to lower the fed funds rate. Further, yields are still attractive when looked at in context to their decade plus range.

We continue to have a cautious outlook for stock prices.  Even with the recent drawdown, stocks do not appear “cheap.”

Equity 

We continue to have a cautious outlook for stock prices. Even with the recent drawdown, stocks do not appear “cheap.” Further, we expect corporate earnings growth expectations will need to be reduced.  The current price/earnings valuation of 20.8x leaves little room for any disappointing news.

Stock prices in correction/bear market territory. Stock prices started the year on a strong note (at one point in February up 4.6% on a YTD basis) on the expectation that the Trump administration policies would be pro-growth and pro-business, including lower taxes (corporate and personal), deregulation, and a friendlier position towards anti-trust/merger and acquisition activity. However, enthusiasm quickly turned to concern and fear as Trump unveiled tariff policies that were significantly more substantial than anticipated and further exacerbated by the volatile on-again, off-again nature of tariff announcements, rollbacks, and temporary reprieves.    

Stock prices (as measured by the S&P 500) fell 4.3% in Q1, the first quarterly loss since Q3 of 2023. Stock market volatility also spiked, with the CBOE VIX Index (a measure of stock market volatility) reaching a level similar to the Great Financial Crisis and the early stages of the COVID shutdown. Early in Q2 the S&P 500 entered correction territory (defined as down 10%-19.9% from the most recent peak). On April 8, the S&P 500 closed down 15.0% on a YTD basis, and down 18.9% from its most recent peak on February 19, 2025.  As of this writing, stock prices have recovered some of those losses following the 90-day delay on tariff implementation.

Growth oriented and small- and mid-capitalization stocks were disproportionately impacted by the selloff. 

• The NASDAQ Index (heavily weighted towards ‘growthier’ technology, consumer and healthcare companies) was down 10.3% in Q1 and actually entered bear market territory (defined as a drawdown of more than 20% from the recent high) on April 8 when the index was down 24.3% from its high on December 16, 2024.
• The S&P 400 Mid-Cap Index was down 6.1% in Q1 and also entered bear market territory on April 8 when the index was down 24.5% from its recent high on November 25, 2024.
• The Russell 2000 Small-Cap Index was down 9.5% in Q1, also entering bear market territory on April 8 when the index was down 27.9% from its recent high on November 25, 2024.

Value and dividend-oriented stocks did produce positive gains. These stocks entered the year undervalued relative to growth stocks, and dividends offer a bit more perceived safety, although they still carry the risk of stock investments.

• The S&P 500 Value Index (a subset of the S&P 500 with value characteristics such as low price/book, price/earnings and price/sales ratios) returned 0.3% in Q1.
• The Dow Jones Select Dividend Index (representing the U.S. leading stocks by dividend yield) returned 3.3% in Q1.

Despite the recent selloff, the S&P 500’s price/earnings ratio (valuation) is at a relatively expensive level. Even with the current price drawdown, the S&P 500’s current valuation levels leave little room for any disappointment. In fact, the current valuation could be artificially low, as the current earnings estimate does not appear to incorporate much downside related to tariffs and/or economic slowdown/recession. 

As of March 31, the S&P 500 P/E ratio based on 2025 estimates is 20.8x.  This is not a cheap valuation, especially in a still relatively elevated inflationary and interest rate environment, and with the very real prospect of a slowdown in economic growth and earnings. At the recent April 8 low price for the S&P 500 (when the S&P 500 was down 18.9% from its high on February 19), the P/E ratio was still a relatively lofty 18.5x.

And, it should be emphasized, these P/E ratio calculations are based on the March 31 consensus expectation for 11.1% earnings growth in 2025, which we believe will be reduced—potentially significantly—in the weeks and months ahead.

Corporate Earnings. The corporate earnings growth outlook for 2025 remains solid, but suspect.  Consensus S&P 500 earnings estimate as of March 31 call for 2025 earnings per share growth of 11.1%, up from 10.4% growth in 2024. We view the 2025 consensus earnings estimate as too high and we would not be surprised to see this estimate trimmed in the weeks and months ahead due to:

• Historical patterns in the trend of annual earnings estimates (i.e., calendar year earnings estimates tend to fall as the year progresses).
• Concerns about earnings growth concentration.  The Magnificent Seven (Alphabet, Amazan, Apple, Meta, Microsoft, Nvidia, Tesla) were responsible for approximately 70% of the S&P 500’s adjusted net income growth in 2024. We do expect this earnings growth dependence to lessen to approximately 34% in 2025.
• Tariff impacts. Clearly, the tariff impact is very difficult to quantify. We have seen a wide range of estimates related to the earnings impact, some of which suggest that most of the earnings growth expected in 2025 could be erased.
• Heightened recession risk. Should recession become reality, a significant decline in corporate earnings would be expected. The median earnings decline during recession is 22%.[vi]

We have a neutral position on small- and mid-capitalization stocks relative to large cap stocks. Small- and mid-cap stocks look cheap, especially compared to large-capitalization stocks; however, the small and mid-cap indices lack exposure to the “growthier” segments of the economy. Small- and mid-cap stocks are trading at P/E ratios that are at 31% and 27% discounts to their 20-year historical P/E valuation relative to large-cap stocks, respectively. Trump’s potential tariff plans could serve to favor more domestically oriented small- and mid-cap stocks relative to large-cap. However, small- and mid-cap stocks have significantly more exposure to cyclical and interest rate sensitive areas of the economy such as industrials, materials and financials, which probably will not provide any relative performance benefit in an economic slowdown or recession, the risk of which has increased.

International stocks benefitting from a weak U.S. Dollar.  We think adding some exposure to international equities makes some sense due to forecast for a weaker U.S. dollar; however, we remain underweight. Although valuations appear significantly lower than in the U.S., earnings growth rates across the developed international countries are much less attractive, partly due to their more modest exposure to global scale information and medical technology companies. Further, 2025 economic growth projections across Europe are relatively poor and below that of the U.S.—and overseas economies will not be immune to tariff impacts.

In the emerging markets, heightened risks—specifically, geopolitical and tariff risks related to China—keep us cautious. 

Expectations for the U.S. dollar will have a significant impact on unhedged international investment returns. That is, a weak U.S. dollar will boost unhedged international returns, and vice versa.  Year-to-date, the U.S. dollar has weakened approximately 4%, boosting international stock returns (in US$).  Consensus forecasts do call for the U.S. dollar to weaken in the coming year and longer term. This makes sense, especially given the heightened animosity over tariff disputes and negotiations.

It was just three short years ago, in the first half of 2022, that the S&P 500 fell by 21 percent. Even with the current decline, the S&P 500 Index price is down a modest 4.2% over the past year, up 18.2% since the end of the last correction (October 23, 2023), up 39.3% since the end of the last bear market (October 12, 2022), and up 122.7% since the COVID low (March 23, 2020).   

An Important Word About Market Drawdowns

While market drawdowns are not pleasant, putting recent market action into context may help to alleviate some angst and fear. Market drawdowns are not uncommon, arise for varied reasons, and are a natural part of stock market cycles. Market corrections (defined as a 10%-20% decline from the recent market peak) occur about once every 2.9 years, with the last correction occurring between August and October 2023. Bear markets (defined as a decline of more than 20% from a recent peak) occur about once every 6.7 years. Incorporating both corrections and bear markets (that is, all market drawdowns greater than 10%), the occurrence is about once every two years[vii].

It was just three short years ago, in the first half of 2022, that the S&P 500 fell by 21 percent. Even with the current decline, the S&P 500 Index price is down a modest 4.2% over the past year, up 18.2% since the end of the last correction (October 23, 2023), up 39.3% since the end of the last bear market (October 12, 2022), and up 122.7% since the COVID low (March 23, 2020).   

Market volatility and lower stock prices are hard to ignore and can be stressful, but it is always important to keep your focus on long-term investment objectives. In fact, stock market downturns can offer excellent long-term investment opportunities. Please reach out to your wealth advisory team if you have any concerns regarding the financial markets or your portfolio.