Q1 2025: The Wall of Worry

The quarter at a glance

The first quarter of 2025 was marked by increasing concerns that rising tariffs and sharp cuts in government spending and employment could push inflation higher and potentially slow economic growth. Given high equity valuations to start the year, these fears dragged down equity returns as the quarter ended, with the US large cap growth and technology segments especially hard hit.¹ Many of the policies dominating investor focus are still evolving and their ultimate impact on the economy and markets are hard to forecast. In addition, current economic conditions remain relatively solid, with unemployment low and consumer spending relatively strong. Still, investor and consumer sentiment for the future conditions deteriorated sharply over the quarter.

While the current equity market sell-off reflects multiple factors (including shifting momentum between high and low valuation segments, softening growth and sticky inflation), the headline causes of investor worry are the unusually dramatic shifts in government policies. Chief among those are tariff policies and the potential escalation of a global trade war. Indeed, the sharp declines in equities across the board following President Trump’s tariff and trade policy announcements on April 2nd show how worried investors are about the potential impact these policies could have on inflation and growth.

Amidst all of the political and policy noise, it is important to remember that the signals that are most important to investment results over the longer term are driven by more fundamental features of the economy. It is also important to reaffirm the importance of a diversified portfolio in times of heightened uncertainty and guard against the natural instinct to time markets.

• Tariffs and trade policy as well as cuts to government spending and employment dominated investor focus in Q1.
• The President’s April 2nd announcement on tariffs provided some clarity on trade policy, but greatly increased worry of the economic impact relative to what investors seemed to have priced into equity markets.
• The S&P 500 and NASDAQ have fallen sharply from the record highs in a relatively short time.
• International equities bucked the negative trend, handily outperforming US stocks.
• The Fed kept short term policy rates unchanged in March but longer term rates fell steadily over the quarter.²
• Consumer spending eased slightly in March, but remains a source of support for the economy.
• Inflation remains stubbornly above the Fed’s 2% target, especially for their preferred PCE measure.³
  

Don't forget to RSVP for our next Compound Conversation about the current State of the Market with Compound Planning's Chief Investment Officer, Steve Dean, CFA®, and Principal Wealth Advisor, Tara Shulman.
‍
📆 Date: Apr 10, 2025
🕚 Time: 11am PT / 2pm ET

Steve and Tara will break down the most impactful trends across public and private markets, geographies, industries, and asset classes, cutting through the noise to focus on what truly matters in today’s economic and market landscape.

US stocks fall from record highs while International stocks rally 

Equity markets saw reversals of past trends along regional lines. US stocks started off the year strong, but fell sharply in March, with both the S&P 500 and the NASDAQ well off their record highs reached in February and last December, respectively. On the other hand, international stocks, both developed and emerging markets, rallied in Q1, a long awaited result for diversified portfolios. The reversal also took hold among sectors, with technology related stocks down substantially for the month and quarter while more defensive industries posted positive returns.

• The S&P 500 fell 5.83% in March and is off nearly 9% since hitting its all time high in February.
• International developed market equities are up over 7% for the year.
• US Small Cap stocks did not participate in the valuation reversals, declining on their sensitivity to economic conditions.
• Defensive sectors led the way in March and Q1 while tech names fell sharply.
  
  • Energy stocks are up over 10% for the year.
  • Utilities, healthcare and consumer staples are each up over 5%.
  • Technology and consumer discretionary sectors are down over 10% for the year.
    
    • The AI sell off and Tesla specific weakness has dragged down both sectors.

Short rates steady, long rates falling

While the Fed continues to hold off on interest rate cuts, rates on the longer end of the yield curve declined so far this year. Ten year treasury yield fell 35 basis points over the first quarter to end March at 4.23%. The declines at the longer end reflect a weakening outlook for economic growth leading to an inverted yield curve that we discuss later.

• TIPS returns led all categories for March and Q1 on rising inflation expectations.
• For the year, bonds have provided a counter balance to equities, something that was missing in the 2022 bear market.
• Treasuries, both long and short term, have posted solid returns so far in 2025.
• Returns have been weaker for riskier segments of the bond market like EM and High Yield bonds and preferred stocks.

Solid results in private markets⁸

• Private credit funds continued their strong recent performance through year-end, both for direct lending and other private credit categories. With strong asset flow into the category, concerns are that competition will erode returns, but the biggest risk is that economic weakness could push defaults up from current low levels.
• Private real estate funds eked out small positive returns for Q4 and the full year after weakness over the past 2 years. As always, real estate returns differ substantially by category and some infrastructure investments have continued to deliver solid returns.
• Private equity returns ended the year on a strong note, although results vary across managers. There continues to be uncertainty for the category as distributions of invested capital have slowed as managers and owners await better exit opportunities.

Stubborn Inflation…

As we have noted in our commentaries over the past year, the Fed has a dual mandate to maintain price stability and to ensure full employment. While inflation has moderated since earlier peaks, it has also proven to be a challenge to bring down to the Fed’s stated 2% target, especially for the Fed’s preferred PCE measure. While Chair Powell continues to reference the 2% target, an important question is whether the level we seem to be stuck at is acceptable. If so, that would allow the Fed to shift focus to the growth side of their mandate and potentially lower interest rates sooner. Given the still relatively solid employment picture, the current posture is one of holding off on rate cuts. Still, at the most recent meeting on March 19, the Fed decided to slow the pace of its balance sheet runoff, an accommodative shift that perhaps shows an increase in focus on growth concerns.⁹

…and increasing worries about growth 

The US economy has been buoyed by robust consumer spending over the past two years. The latest readings on that spending show a slight weakening in the latest month for both personal consumption expenditures and the more narrow retail sales measure from year earlier levels. The decline is hardly noticeable on the chart and the current year-over-year growth remains close to pre-pandemic levels.

Supporting the solid consumer spending has been a low unemployment rate and generally strong wage gains combined, especially for higher income households, with wealth gains from strong stock markets of the past several years. While the unemployment rate has remained stable, signs of the impact of the substantial cuts in government jobs as well related contractor positions is starting to show up in the data. In February, job cuts measured by Challenger Grey Christmas surged to 172,000, up from 50,000 in January and by far the highest number of job losses since the pandemic.¹¹ Employment is generally considered to be a lagging indicator of economic activity, but perceptions of job stability does have an impact on consumer spending. Investors will certainly be keenly focused on the upcoming March employment report. In recent earrings reports, some large retailers have foreshadowed weakening sales ahead as consumers react to economic growth and inflation uncertainty.¹²

Looking further ahead, we see several measures that suggest that the possibility of a recession has increased. One measure that we have often looked at is the spread between long and short term treasury yields. Historically, when this spread is negative it has often been soon followed by a recession.¹⁵ After providing a false warning sign for much of the last 2 years before returning to positive territory late last year, the spread turned negative in February and March. Will this indicator finally prove accurate in the current cycle?

The New York Fed developed a model that uses the spread shown above to calculate the probability of a recession in the United States twelve months ahead. The most recent forecast of that model for the 12 months ending February 2026 shows an uptick in the probability of recession to 27% from 23% a month earlier, but down from 58% a year ago and a recent peak of 70% in May 2023.¹⁷ While it is comforting that the probability has retreated, it is also notable that readings above 20% have often been followed by actual recessions (the grey bars). The question becomes whether the latest uptick is just temporary or the start of a reversal in the downward trend. Most historical periods have seen the downward trend from above 20% follow a recession and lead to a longer period of no recession. The 2000 post-tech bubble period is an exception and a cycle that some market observers have drawn parallels with the current cycle.

Sentiment deteriorates but is not always predictive

The path of the economy is ultimately the primary driver of market returns, but consumer and investor sentiment can play an important role in the near term. Last month, we noted the sharp rise in investor bearishness for equities.¹⁹ That outlook measure improved a bit at the end of March,²⁰ falling from 60% of investors indicating a bearish outlook at the end of February to 52.5% at the end of March. As we also noted, this measure is inherently volatile and also is often used as a contrarian indicator for actual stock movements, at least at its peaks, but it does reflect the worry investors are feeling. The wealth generated by the bull market of the past several years has certainly helped keep consumer spending high which has allowed the economy to avoid recession in the face of the sharp rise in interest rates during 2022 and 2023. If concern over future market gains persists, that could remove this source of support for consumer spending which is a primary driver of economic growth.

For much of this year, equity prices seemed to reflect a belief that the initial tariff proposals were the start of trade negotiations that would lead to lower actual tariffs with multiple exceptions and the avoidance of an escalating trade war. As the quarter progressed, that view became much more uncertain. President Trump’s much anticipated tariff and trade policy announcement on April 2nd was expected to reduce that uncertainty and while it made the path of tariffs clearer, that path was not in the direction the investors had hoped – namely, it laid out higher tariff rates and an increase in the likelihood of an escalating trade war. Both outcomes worsen the outlook for inflation and growth in the near-term.

Equity investors may hate uncertainty, but they really can’t tolerate weakening economic growth.

When facing heightened uncertainty in markets, the best course of action is to diversify one's portfolio (or stay diversified) rather than making bold asset allocation shifts (especially moving to cash). Cash rarely outperforms a portfolio of assets diversified across stocks, bonds and real assets.²² An example of this benefit of diversification can be seen in the first quarter where international stocks and US fixed income have provided an offset to declining US equities.

Amidst the fear of the potential impact of government policies, it is best to keep watch on more fundamental elements of the economy, like consumer and business spending and corporate earnings. A downturn in those measures would turn the current market correction into a deeper bear market. Corrections (stocks down 10%) happen often in otherwise strong market environments, but these corrections typically only turn into bear markets (down 20+%) during a recession.

Don't forget to RSVP for our next Compound Conversation about the current State of the Market with Compound Planning's Chief Investment Officer, Steve Dean, CFA®, and Principal Wealth Advisor, Tara Shulman.
‍
📆 Date: Apr 10, 2025
🕚 Time: 11am PT / 2pm ET

Steve and Tara will break down the most impactful trends across public and private markets, geographies, industries, and asset classes, cutting through the noise to focus on what truly matters in today’s economic and market landscape.

‍

Compound Planning, Inc. is an investment adviser registered with the Securities and Exchange Commission and based out of New York. The views expressed in this material are the views of Compound Planning through the period ended March 31, 2025 and are subject to change based on market and other conditions. 

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[1] https://www.spglobal.com/spdji/en/index-family/equity/
[2] https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20241218.htm
[3] https://www.bea.gov/news/2024/personal-income-and-outlays-october-2024
[4] https://www.spglobal.com/spdji/en/index-family/equity/
[5] https://www.msci.com/end-of-day-data-search
[6] https://www.nasdaq.com/market-activity/index/comp/historical
[7] https://www.spglobal.com/spdji/en/index-family/equity/
[8] Cliffwater Perpetual Alternative Funds Report, Q1 2025
[9] https://www.federalreserve.gov/news-events/pressreleases/monetary20250319a.htm
[10] https://fred.stlouisfed.org/series/CPIAUCSL#0
[11] https://tradingeconomics.com/united-states/challenger-job-cuts
[12] https://www.cnbc.com/2025/03/14/delta-walmart-warn-about-consumer-spending-amid-tariffs-inflation.html
[13] https://www.bea.gov/data/consumer-spending/main
[14] https://www.census.gov/retail/sales.html
[15] https://www.newyorkfed.org/research/current_issues/ci2-7.html
[16] https://www.federalreserve.gov/releases/h15/
[17] https://www.newyorkfed.org/research/capital_markets/ycfaq#
[18] https://www.newyorkfed.org/research/capital_markets/ycfaq#
[19] https://info.compoundplanning.com/investment-research/february-2025-politics-and-fundamentals
[20] https://www.aaii.com/sentiment-survey
[21] https://www.aaii.com/sentiment-survey
[22] https://aptuscapitaladvisors.com/aptus-q1-2025-newsletter/