May 2025: The Tariff Tango

The month at a glance

The tango is characterized by the contrast between slow, controlled movements and sudden, sharp actions. Investors may be feeling like most of the dance between markets and government policy this year has been decidedly more volatile. Still, the market's resilience in May in the face of shifting tariff announcements and broader government policy uncertainty was remarkable. 

That resilience illustrates the importance of fundamental signals relative to political noise. For its part, the Fed continued their “slow, controlled movements” (aka, data dependency) as it balanced relatively solid current fundamental conditions with the uncertain impact of evolving trade and fiscal policies. Two months after the initial tariff announcements on April 2nd, patterns are becoming clear – any good news (trade negotiations, pauses) related to the bad news (tariffs) sparks a market rally. As that pattern becomes widely recognized, the impact of the good news bumps should be more muted.

• Market Performance: The S&P 500 delivered its strongest monthly performance since November 2023, rising 6.2% in May. This brought the index to a modest 0.5% gain for the year after being in negative territory for months. Equity gains were especially strong in the technology sector.¹
• Trade Policy Developments: The US-China agreement on May 12th provided the biggest catalyst to rising equity markets, with tariffs dramatically reduced from 145% to 30% on Chinese goods and from 125% to 10% on US goods for a 90-day period.² However, trade uncertainty persisted with Trump threatening 50% tariffs on EU goods, doubling of steel and aluminum tariffs, and legal challenges to existing tariff policies continuing through the courts.
• Economic Data: The economic backdrop was mixed, with hard data relatively solid while softer survey signals remained challenged. Employment data showed resilience with 177,000 jobs added in April.³ Consumer spending remained strong, rising 5.4% in April from a year earlier.⁴ Core PCE inflation held steady at 2.1% year-over-year.⁵ Consumer sentiment hit its second-lowest reading since 1952 with inflation expectations spiking to levels not seen since the early 1980s, but the latest readings showed some stability after several months of steep declines.⁶ 
• AI and Technology Sector: Nvidia's earnings provided strong support for tech stocks despite $2.5 billion in lost China sales, with AI-related companies rallying on new deals including major partnerships with Saudi Arabia's emerging AI ventures.⁷
• Federal Reserve: The Fed left policy interest rates unchanged, maintaining a cautious stance given relatively solid economic conditions and continued high uncertainty about the impact of trade policy.⁸
• Fiscal Policy: Moody's downgraded US government debt citing fiscal deficit concerns, sending long term treasury rates higher and the dollar lower. While Trump's spending bill faced the same debt concerns, it eventually passed the House, but faces greater challenges in the Senate. As it stands now, the mix of tax cut extensions and modest spending cuts is likely to be a bit more fiscally stimulative in the short-term than expected.⁹

Stocks extend rally, working off initial tariff related sell-off 

Equity markets rallied in May, with the S&P hitting its highest level since November 2023 and returning to positive territory for the year.¹⁰ The strong investor optimism was supported primarily by less bad news on trade policy. While the rally extended across market caps and geographies, May returns showed distinct leadership favoring growth over value and cyclical over defensive sectors. That market leadership points to a market driven by AI enthusiasm, digital transformation, and tech earnings strength, amplified by strong results Nvidia reported at the end of the month.

• The NASDAQ Composite delivered the strongest performance at 9.65% while S&P 500 Growth stocks gained 9.41%, demonstrating investor appetite for tech and growth-oriented companies during the period.
• Beyond technology and growth leadership, the US equity market gains were broad based. The S&P 500 gained 6.29% while the S&P Small Cap 600 rose 5.23%.
• International Developed Markets were up 4.72% and Emerging Markets gained 4.31%, showing the rally extended beyond US borders, though at more moderate levels than domestic markets.
• Investors showed a strong preference for companies with higher growth prospects, with the S&P 500 Growth (9.41%) significantly outpacing S&P 500 Value (3.01%).
• Information Technology led all sectors with an impressive 10.89% gain, driving much of the overall market's strong performance and reflecting continued investor enthusiasm for tech companies and AI-related growth stories.
• Other growth-oriented sectors also surged, with Communication Services (9.63%) and Consumer Discretionary (9.44%) rounding out the top three performers.
• Traditional safe-haven sectors underperformed, with Utilities up just 3.83%, Consumer Staples gaining only 1.81%, and both Energy and Real Estate posting minimal 0.99% returns, indicating investors favored risk-taking over defensive positioning.
• Healthcare was the only sector to post negative returns at -5.55%, potentially reflecting regulatory concerns, policy uncertainties, or rotation away from traditionally defensive healthcare stocks in favor of growth opportunities.

Credit market volatility continues

While May fixed income results were mixed, the fixed income landscape mirrored equity markets' risk-on behavior, with credit outperforming duration and quality.¹⁵ The downgrade of US sovereign credit rating sparked a mid-month sell-off in longer-dated Treasuries, pushing yields higher and raising fundamental questions about the long-term viability of current government borrowing levels and debt trajectories. The weakness in longer duration government bonds extended outside of the US bond markets, but later recovered into month-end, as easing trade tensions and moderating inflation concerns restored some confidence. Higher risk credit markets delivered stronger performance with high yield solidly outperforming both investment grade and government bonds.

• U.S. High Yield Bonds led fixed income returns in May with a 1.68% gain as investors rewarded credit risk.
• Longer-duration bonds suffered meaningful declines, with U.S. Treasury Bonds down 1.03% and the U.S. Aggregate Bond index falling 0.72%, on reduced demand for duration exposure.
• Global Developed Aggregate Bonds declined 0.36% on similar fiscal situation concerts.
• Emerging Market Bonds managed a modest 0.67% gain, benefiting from the general risk-on sentiment.
• U.S. Ultra Short Treasury instruments gained 0.37% as investors looked to shorten duration.

What happened to the small cap premium?

US small cap stocks (measured by the S&P 600 index) posted solid returns in May, but they still lagged the S&P 500 for the fourth consecutive month and have now underperformed the larger cap index by over 15% in the past year.¹⁶ Historically, small-cap stocks have delivered higher returns than large-caps due to their higher risk profile, but this premium has vanished in recent years as large-caps have significantly outperformed smaller companies. In 1981, Rolf Banz of the University of Chicago graduate published his seminal paper that first documented the small-cap premium, showing that smaller firms had higher risk-adjusted returns than larger firms over the period 1936-1975.¹⁷ Subsequent research, most notably from Eugene Fama and Kenneth French, formalized the small cap premium as an important factor in explaining the performance differences in stock returns.¹⁸

While the academic papers documented small cap outperformance over long periods of time, the performance leadership between large and small cap stocks has always gone through cycles that can persist for multiple years. The chart below shows these cycles by plotting the relative cumulative performance of the S&P 500 (large cap) relative to the S&P 600 (small cap).¹⁹ When the line is rising, large cap stocks are outperforming and when the line is falling, small cap stocks are in the lead. The left side of the chart shows a period of large cap outperformance in the late 1990s that was fueled by the “dot com bubble”. That period came to an end in early 2000 and small cap stocks went on to steadily outperform large cap stocks for the next 6 years. More recently, large cap stocks have substantially outperformed small caps. The current cycle of large cap dominance is pushing 8 years during which the S&P 500 has outperformed the S&P 600 by an average of 10% per year.

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Looking at the makeup of the large and small cap indices can help identify the drivers of the large cap outperformance in recent years. One notable difference is in the concentration of the two indices. The top 10 holdings account for 36% of the S&P 500 but only make up 6% of the S&P 600.²⁰ That gap has had a substantial impact on relative performance as the S&P 500's outperformance is largely driven by a handful of mega-cap technology companies, most notably the “magnificent 7” stocks. When excluding the largest seven stocks annually over the past five years, the performance gap narrows dramatically — S&P 500 delivered 11% versus Russell 2000's 10% annually, a much smaller spread than for the full indices.²¹

Industry sector differences also explain much of the recent underperformance of small cap stocks. Technology represents almost 33% of the S&P 500 compared with just 13% for the S&P 600. Conversely, the small cap index is more heavily weighted to cyclical industries like financials and industrials. These sector differences have contributed to underperformance of small caps during the strong run of the tech sector in recent years.²²

Current market dynamics may underlie the dramatic differences in the exposure difference to the technology sector. Large companies have benefited from the scale necessary to make technology investments in areas like cloud computing and AI, making it difficult for smaller firms to compete. In addition, the best high-growth companies, many of which are technology companies, now stay private for longer, bypassing the traditional small-cap IPO stage and entering public markets directly as large-caps.²³

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Another important difference between large cap and small cap stocks in recent years has been the gap in earnings. The chart below shows the evolution of operating earnings per share for the S&P 500 and the S&P 600 indexed to Q1 2008.²⁴ The chart combines both actual and forecasted earnings. From 2008 until the pandemic in 2020, large and small company earnings followed a similar path, but since then, small company earnings have been much more volatile. The growth in earnings was also starkly different in the past several years. From Q1 2022 through Q1 2025, small cap company earnings have declined 23% compared with a 17% gain for large cap companies. The solid and steady earnings growth from large cap stocks was a welcome fundamental characteristic during a time of rising interest rates and increased fears of recession.

Part of the explanation in the lagging small company earnings is that the prolonged low-interest-rate environment post-financial crisis favored large-caps, who could borrow cheaply for growth investments. Small-caps face greater challenges as approximately one-third of Russell 2000 companies use floating-rate financing compared to only 6% of S&P 500 companies, making them more vulnerable to the rising rate cycle that began in March 2022.²⁵

One encouraging sign for a recovery in small cap stock performance is the forecasted earnings growth for the next two years. Analysts are often overly optimistic in their forecasts, but given the prolonged underperformance of small cap stocks, any rebound in earnings growth could help fuel a small cap performance rally. 

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The gap in earnings was even more pronounced in the technology sector. In the chart below, we see the same pre-pandemic mirroring of earnings growth between large and small cap tech companies. Since 2022, however, small cap tech companies have delivered volatile and declining earnings growth while tech companies in the S&P 500 have shown steady gains. Given the importance of the technology sector to the overall equity market in recent years, the performance difference between large and small cap stocks generally is at least partly the result of this discrepancy in earnings. Like in the earlier chart, analysts expect a substantial recovery in small cap technology company earnings over the next two years which, if it unfolds, could usher in a rebound in the sector's performance.

Even with the large gap in earnings, both actual and forecasted, the substantial outperformance of large cap stocks in the past several years has led large cap valuations to continue to expand relative to small cap. The price-to-forecasted earnings ratio for the S&P 600 is currently 30% below the ratio for the S&P 500, a level last reached in the late 1990s/early 2000s.²⁷ Of course, it has been at the 30% level for the past two years, underscoring that relative valuation measures are not always a great timing signal. Still some evolving conditions could shift the market in small-caps' favor, with potential Federal Reserve rate cuts benefiting smaller companies disproportionately. Current valuations, improving earnings growth, and U.S. economic policies like reshoring and infrastructure investment could accelerate small-cap earnings and restore their historical outperformance during economic expansion cycles.²⁸

A month like May shows that investors can dance their way through a period of heightened uncertainty in trade, monetary and fiscal policies.  A blend of staying the course on the large cap US tech sector based on its continued steady earnings growth combined with an additional nod to the renewed benefits of international diversification has been rewarded. The last leg of the diversification stool would be a relative recovery in small cap stock performance. While timing market cycles remains inherently challenging, and large-cap leadership could certainly persist longer than many expect, the alignment of attractive valuations, improving earnings prospects, and a potentially more favorable interest rate environment suggests that investors should resist lessening their allocation to small-cap stocks. As market participants have learned from previous cycles, the leadership baton between large and small-caps can change abruptly, and those positioned for the transition often benefit the most from the subsequent performance reversal.