Market IQ | Political and capital market insights

Q2 2025 began with the fifth-largest two-day drop in the S&P 500 since World War II, falling over 10% due to Trump’s sweeping “Liberation Day” tariff reveal. Recession fears surged, followed by a rise in long-term U.S. Treasury yields, pushed further by a US credit rating downgrade from Moody’s. After a 90-day pause on reciprocal tariffs with several trade partners including China, markets rebounded sharply, with the S&P 500 reaching a historic high near 6300 by quarter-end. Trade war risks persist, as negotiations with major partners remain uncertain. The dollar weakened amid capital outflows, with international investors favoring non-U.S. assets. Late in the quarter, the potential passing of the “One Big Beautiful Bill Act” (OBBB) raised concerns about the U.S. fiscal deficit. Meanwhile, the likelihood of a Fed rate cut diminished due to inflation fears, keeping borrowing costs elevated. In Europe, the ECB welcomed a strong euro but remained cautious due to weak economic momentum that could impact trade and growth. In China, investor sentiment improved after a negotiated tariff reduction in May, leading to a tech-driven rally, although the current 30% tariff remains high. Japan saw solid underlying inflation, and rising U.S. Treasury yields influenced sentiment around future monetary policy. Tariffs and geopolitical tensions continue to send mixed signals on emerging markets equities and bonds.

Looking ahead to Q3, momentum may continue, with some relief in inflation and slower growth. However, renewed tariffs could trigger fresh market volatility. Depending on inflation and dollar trends, the Fed may adjust its stance over the summer. Overall, tariffs, fiscal deficit concerns, and dollar risks remain elevated, supporting a cautious approach to risk.

Equity market volatility spiked in April, with the average monthly VIX rising to 24.7. Markets rebounded in May and June, with most countries posting gains. For the quarter, the MSCI All Country World Index returned 11.5%. In the U.S., the S&P 500 gained 10.9%, the NASDAQ 100 rose 17.9%, and the Russell 2000 increased 8.5%. Internationally, the MSCI EM Index led with a 12% return, while both the MSCI Europe and MSCI Japan Indexes returned 11.4%.

The new trade environment has impacted U.S. credibility and contributed to dollar weakness, shifting investor demand toward foreign sovereigns. Over the quarter, the Bloomberg U.S. Treasury Index returned 0.85%. The Bloomberg U.S. Corporate Bond Index and High Yield Index returned 1.8% and 3.5%, respectively. The Bloomberg U.S. Aggregate Index returned 1.2% while the Bloomberg Global Aggregate Index returned 4.5%.

We remain underweight equities overall after the Q2 rally pushed the forward S&P 500 P/E to roughly 22x, leaving little cushion should multiples re-rate. Regionally we keep underweights in Japan and Europe, where softer manufacturing surveys and currency headwinds leave earnings exposed to the next tariff volley. We are underweight US small caps as higher long-end yields raise refinancing costs while hard-data momentum such as retail sales and industrial output is rolling over. We stay neutral U.S. large caps given durable cash-flow generation and the AI-driven capex cycle, and neutral EM equities, where local easing buffers may still be a key factor. A key tactical risk is that OBBB accelerates Treasury supply and keeps real rates elevated, a backdrop that could widen the equity risk premium precisely when valuations are already stretched. In addition, the Trump administration’s July 9th tariff reprieve deadline remains an issue that could affect risk markets in the near term.

We are overweight U.S. securitized credit, U.S. investment-grade corporates, and Global Agg ex US bonds, which still provide 110 to 150 basis points of carry over Treasuries with lower macro beta. US IG technicals also remain supportive, as net issuance is running well below 2024 levels while demand from pensions and insurers remains firm. We fund these positions with an underweight in Treasuries, expecting supply-driven yield spikes tied to OBBB and refunding to keep curve volatility elevated. With the Fed likely on hold into Q4, roll-down and coupon income dominate expected returns, so we remain neutral on portfolio duration relative to benchmark while spread duration is slightly long.

We hold an overweight to global infrastructure, where contracted inflation-linked cash flows delivered high-single-digit returns in Q2 and showed minimal correlation to equity drawdowns. Listed REITs remain underweight because cap-rate pressure and refinancing risk persist as real rates grind higher globally. Outside of the benchmark, we are allocated to global natural resources equities as a hedge against tariff-induced supply shocks. This mix gives us inflation protection without the duration drag typical of traditional real-assets, and aligns with our view that growth cools before policy can decisively pivot.