August Investment Comments
The first half of 2025 has presented investors with a paradox. Equity markets have demonstrated remarkable resilience, staging a powerful recovery from the lows of early spring, while the fundamental economic and policy backdrop has become increasingly clouded by uncertainty. This divergence between market sentiment and economic reality has created a complex and challenging environment. Following a sharp, tariff-induced correction in the spring that saw the S&P 500 fall 20%, markets executed a rapid rebound, surging 30% to all-time highs. This rally has been fueled by a persistent risk-on sentiment, with speculative appetite visible in the strong performance of recent Initial Public Offerings (IPOs) and the climb of Bitcoin back to all-time highs.
Market strength has pushed equity valuations into elevated territory. The forward 12-month P/E ratio for the S&P 500 now stands at 22.2, well above its 5-year average of 19.9 and 10-year average of 18.4. Such a premium implies a highly optimistic outlook, one that assumes corporate earnings growth will re-accelerate and policy risks will be resolved without major economic damage. This optimism, however, stands in direct conflict with a deteriorating fundamental picture, as analysts have been actively cutting their earnings forecasts. According to FactSet, while earnings growth was strong in Q1, the outlook for Q2 has deteriorated significantly. The estimated earnings growth rate for the quarter has been slashed from 9.4% to just 5.0%.
While the equity market has been pricing in a rosy scenario, incoming economic data paints a more sobering picture of an economy that is losing momentum. On its face, the June jobs report appeared solid, with 147,000 jobs added and the unemployment rate declining slightly to 4.1%. However, a deeper dive reveals a bifurcated labor market. The headline strength was driven almost entirely by the addition of 73,000 government jobs masking tepid job creation in the private sector of 74,000, a classic sign of a cooling economy. More concerning, continuing unemployment claims, the number of people receiving benefits after the initial week, rose to their highest level since November 2021, indicating that those who become unemployed are finding it harder to secure new positions.
On the inflation front, the latest data complicates the picture further. The Consumer Price Index (CPI) for June showed inflation accelerating for a second straight month, with the headline figure rising 2.7% year-over-year, up from 2.4% in May. Core CPI, which excludes volatile food and energy prices, also ticked up to 2.9% annually. This uptick suggests that progress on bringing down inflation may be stalling, adding a new layer of complexity for the Federal Reserve as key inflation measures remain stubbornly above the 2% target.
The Federal Reserve finds itself in an increasingly difficult position. The minutes from its June meeting revealed a central bank grappling with profound uncertainty and internal division. While the committee maintained the federal funds rate in its current range of 4.25% to 4.50%, the discussion highlighted a growing split. A couple of members were open to a rate cut as soon as July, while some participants argued that the most likely path involved no rate cuts at all in 2025, citing persistent inflation. The primary source of this division is the uncertain economic impact of the administration's aggressive tariff policies.
The American consumer, who accounts for roughly two-thirds of U.S. economic activity, is sending mixed signals. After a surprisingly weak May, which saw retail sales decline for a second consecutive month, June brought a notable rebound. Retail sales increased 0.6% from the previous month and 3.9% year over year. This mixed performance comes despite healthy wage growth and is reflected in conflicting consumer confidence surveys. While the University of Michigan index rebounded in June, the Conference Board’s Expectations Index, a component that looks six months ahead, remained at a level that has historically signaled a recession within the next year. The trajectory of GDP reflects these crosscurrents. While the economy contracted in Q1, this was distorted by a surge in imports ahead of tariffs. Underlying domestic demand was still solid, but growth is widely expected to moderate throughout the rest of the year.
Adding another layer of complexity is the recent passage of a major fiscal package. Signed into law on July 4, the One Big Beautiful Bill makes the individual tax cuts from the 2017 Tax Cuts and Jobs Act permanent and introduces new temporary tax cuts and deductions. While these measures may provide a short-term boost to GDP, independent analyses project the law will add approximately $3 trillion to the national debt over the next decade. This significant increase in government borrowing represents an obstacle to the Federal Reserve's efforts to reduce inflation. However, proponents argue that the increased economic activity and potential for higher future growth generated by the bill could partially offset its total cost by expanding the tax base and generating more revenue.
The most immediate and disruptive policy development is the administration's decision to move forward with a new, aggressive round of tariffs, scheduled to take effect on August 1. This move dramatically escalates global trade tensions. The new levies include a 25% tariff on all goods imported from Japan and South Korea and a sweeping 50% tariff on all copper imports, a critical industrial metal. These actions threaten to cause significant disruptions to global supply chains, with economic models suggesting they will act as a direct tax on American consumers and businesses, leading to higher prices and reduced U.S. real GDP growth.
While the equity market has been climbing a wall of worry, other key asset classes are telling a different, more cautious story. The yield on the benchmark 10-year U.S. Treasury note has remained remarkably stable around 4.4%, reflecting the market's uncertainty as it struggles to price the opposing forces of inflationary and recessionary risks. The standout performer has been gold, typically viewed as a safe haven asset, which has surged to new record highs above $3,300 per ounce. The price of WTI crude oil has fallen into the mid-$60s per barrel, a clear signal that commodity traders are growing concerned that escalating trade conflicts will lead to a slowdown in global economic activity.
The current investment environment is fraught with uncertainty and demands a disciplined, prudent, and long-term approach. Attempting to time the market based on the next policy announcement or economic data release is a futile exercise that is more likely to destroy wealth than create it. As always, identifying and owning high quality companies for the long run, purchased at reasonable prices, will lead to solid returns regardless of the market environment.
Eric Wathen, CFA®