Market summary: Increased US policy uncertainty raises market anxiety
Uncertainty about the direction of US policy weighed on financial markets during Q1, as investors digested news about a flurry of executive actions, including tariff hikes, deregulation announcements, cuts to government staffing and programs, and tighter immigration activities.
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Concerns about the economic effects of the tariff hikes on the global economy increased in the days after the quarter ended, following the announcement of reciprocal tariffs on regions and countries with high trade deficits with the US, including China (34%), the European Union (20%), and Japan (24%). The US also announced a 10% universal tariff for non-targeted trade partners.
The tariffs announced on April 2, if fully implemented, would take rates to levels not seen in more than a century. They pose a direct stagflationary risk to the US economy and may provoke meaningful headwinds for countries with large trade surpluses with the US.
Despite increased growth risks, the global expansion remained intact as of the end of Q1. We believe diversification in fixed income assets and non-US assets remains essential.
The S&P 500 Index returned −4.3% for the first quarter, partly due to the performance of growth stocks (−10%). Conversely, gold (+19%) and commodities (+8.9%) generated strong gains amid increased market uncertainty. A drop in the US dollar helped boost the returns of non-US equities (+6.9%), and a decline in bond yields supported gains across fixed income categories.
US exceptionalism narrative at risk?
Entering 2025, our proprietary survey of positioning recommendations by third-party, sell-side analysts showed extreme enthusiasm for US stocks relative to non-US equities and other assets.
During Q1, our survey showed a shift in near-term investor sentiment. Often cited as “US exceptionalism,” the US benefited from foreign capital inflows in recent years and has a record-high international investment deficit, with most stocks and bonds owned by investors in Europe, Japan, and Canada—all traditional US allies.
This sentiment shift helped explain why stock prices of the largest US companies by market capitalization—concentrated in the technology and communications sectors—reversed course in Q1 and underperformed relative to the broader stock market.
Economy/macro: Risks to continued expansion
The global cycle is becoming less synchronized as manufacturing activity and policy decisions diverge.
- The US continued to show indications of both mid- and late-cycle dynamics.
- China has begun to demonstrate signs of positive cyclical momentum, supporting its recovery, although weakness in the property sector remains a headwind.
- Policy easing and improvements in sentiment have helped support the EU outlook.
- Canada has shown signs of early cycle but high exposure to US trade presents a hurdle for its recovery.
Despite the risks to the global cycle, there are potential tailwinds. Non-US developed markets such as Europe and Canada tend to be more rate-sensitive, and households and businesses are likely to benefit from falling policy rates.
In the eurozone, a renewed commitment to fiscal expansion through defense spending, especially in Germany, may spark an upturn in business sentiment.
China is seeing signs of improvement through both a pick-up in industrial activity and regulatory policy easing.
What about inflation?
Consumer inflation remained rangebound at around 3% during Q1, well above the Fed’s 2% target. Our forecasts for the next year continue to anticipate sticky inflation around 3%, with upside risk from tariff hikes.
Consumer inflation expectations have spiked to multi-decade highs, which could make it easier for businesses to pass along higher costs and keep inflationary pressures percolating.
Goods inflation continued to rise in Q1, following an upward trend since early 2023.
Looking ahead, rising manufacturing prices may be a portent of further inflation increases. The rise in tariff rates may add to the inflationary pressures on goods as well.
Consumer and small-business sentiment declines
Consumer economic expectations deteriorated markedly during Q1. Drops in consumer sentiment have historically not accurately forecasted a slowdown in consumer spending unless labor-market conditions also begin to deteriorate.
What about labor? It has remained tight so far, despite rising policy uncertainty, federal funding cuts, and government layoffs. On the supply side, overall labor force participation has stalled below the pre-pandemic rate, driven by slowing immigration and demographic constraints. Low labor force growth may help keep the job market tight, but we’re closely monitoring labor markets for signs of weakness.
Meanwhile, small-business optimism dropped during Q1 after a big post-election spike, as sentiment surveys indicated near record-high uncertainty amid the flurry of tariff and other policy announcements. We find that prolonged uncertainty tends to cause small businesses to reduce their capital spending over time, and we’re monitoring this important sector to see whether prolonged uncertainty or more positive deregulatory policies will gain the upper hand.
The Fed pause
Amid a highly uncertain backdrop, the Fed kept its policy rate steady during Q1 after cutting rates by 100 bps during 2024. Coming into 2025, the market expected an additional 150 bps of easing, but stubborn inflation reduced market expectations to only 2 more cuts this year. Consistent with prior cycles, stocks and bonds rallied after the Fed’s last hike and before the first cut. Equity returns tend to be more mixed after the first cut, which was the case so far this cycle with roughly flat returns from September 2024 through Q1.
Government cost-cutting efforts
Executive-branch efforts to cut staffing and spending among federal agencies generated considerable headlines during Q1, but it remains unclear to what extent they affected fiscal policy overall. Operating outflows from the Treasury department were consistent with levels in prior years. As the GOP administration and Congress debate new fiscal legislation, interest payments and entitlements are grabbing an even larger share of the budget, deficits are large, and debt levels are projected to rise to all-time highs.
Asset markets: Non-US equities, commodities, fixed income lead
Non-US equities posted widespread gains during Q1, whereas US stocks suffered losses, pulled down by drops in growth and small caps. Gold and commodities advanced amid increased economic uncertainty.
All major global regions registered positive earnings growth in Q1. In a typical seasonal pattern, US earnings growth was revised lower during the quarter. Yet it remained high at 11%. Non-US developed markets experienced a sharp earnings reacceleration and ended the quarter in modestly positive territory.
Investors continue to anticipate broad-based, double-digit global earnings growth across all categories over the next 12 months.
Equities: Europe (+10.5%) and developed-market equities spearheaded the rally, with each benefiting from a weaker dollar. Latin America (+12.7%) also gained notably, whereas Canada (+1.1%) and Japan (+0.3%) eked out gains.
Among US stocks, growth (−10%) and small caps (−9.5%) led the market lower, whereas mid caps (−3.4%) and value (+1.6%) held up better. By S&P 500 Index sector, consumer discretionary (−13.8%) and information technology (−12.7%) declined the most. Energy (+10.2) topped all other sectors in the quarter. Defensive sectors, including health care (+6.5%), consumer staples (+5.2%), and utilities (+4.9%) gained as well.
Valuations for US stocks declined in Q1 but remained high, with the trailing one-year price-to-earnings (PE) ratio remaining well above its long-term average.
Fixed income: Nearly all fixed income categories registered positive returns, with inflation-resistant TIPS (+4.2%) and interest rate-sensitive longer duration bond categories leading the way.
Treasury yields fell and credit spreads widened during Q1, resulting in mostly lower bond yields. High-yield spreads rose from their very subdued levels, as policy-related growth concerns weighed on risk assets.
More conservative segments, such as long government and credit (+3.6%) and Treasurys (+2.9%) led the way in Q1. In comparison, riskier bond categories, including high yield (+0.9%) and leveraged loans (+0.5%) advanced modestly.
Overall, fixed income yields ended the quarter around their 50th percentile, suggesting valuations are roughly in line with long-term averages and provide income in a balanced portfolio.
Currencies: The US dollar depreciated versus other currencies in Q1, a pattern that so far resembles the first several months after President Trump’s 2016 election victory.
Markets initially interpreted America-first trade policies as positive for the US dollar, supported by expectations for higher growth and higher tariffs. The trend reversed as foreign exchange markets grappled with trade policy uncertainty and other factors.
We believe the dollar remains overvalued, and the medium-term outlook for diversification into foreign assets remains attractive.
Outlook: Fidelity’s Active Asset Allocation Board, composed of portfolio managers across a variety of asset-allocation strategies, meets quarterly to discuss macro views and asset allocation positioning. Members expressed concerns about the highly uncertain policy outlook and its impact on real economic activity and corporate earnings.
As of the end of the quarter, portfolio managers held smaller active allocation positions compared to earlier in the cycle.
- Members discussed a growing preference for non-US equities.
- Portfolio managers are modestly overweight risk assets at the end of Q1.
- Several members mentioned gold and commodities to hedge high inflation.