Cautious Optimism Amid Policy Uncertainty

Despite ongoing policy uncertainty and tariff-related volatility, we are cautiously optimistic thanks to resilient economic fundamentals, broadening equity market performance, and the potential for pro-growth policy shifts later in the second half of 2025.

In our last asset allocation outlook from the market disarray of April, aptly titled The Storm Before the Calm, our central theme was clear: when you look past the geopolitical noise and tariff-induced volatility, the underlying fundamentals of the global economy remained strong. That view very much holds today. While policy uncertainty still lingers and will likely be a catalyst for further bouts of volatility in the short term, we are cautiously optimistic about the outlook for growth and risk assets over the next six to 18 months.

It Turns Out the World Has More Than Seven Stocks

Despite the disruptive uncertainty of President Trump’s initial tariff policies, we argued that these measures were likely an opening salvo rather than a permanent fixture—and that markets, while rattled, would refocus on resilient growth and improving inflation dynamics. In addition, fiscal policy is becoming clearer for the U.S. as the One Big Beautiful Bill nears finalization, while Europe has shifted dramatically toward significant fiscal spending on defense and infrastructure, which has improved the outlook for above-trend growth in that region. These greater uses of fiscal levers may have implications on debt sustainability and bond term premia for years to come, but in the nearer term will help support the growth impulse for consumers and businesses.

These dynamics reinforced our theme of broadening performance in equity markets. Year-to-date (YTD) through June, the Magnificent 7 stocks¹ underperformed the broader market, returning 2.6% versus 6.2% for the S&P 500 Index (total returns). In addition, after lagging for many years, international equities significantly outperformed their U.S. counterparts YTD through June.

Meanwhile, although smaller company U.S. stocks have underperformed, over the second half of 2025 we expect a turn in small caps as the stimulative, pro-business effects of the aforementioned One Big Beautiful Bill take effect. We also believe small caps will benefit from deregulation and, potentially, lower policy rates leading to lower debt costs.

U.S. Dollar Weakness and a Reminder about Diversification

We anticipated outperformance from non-U.S. markets, but we also thought that many investors, wherever they are in the world, had become overexposed to U.S. assets.

Accordingly, with rising uncertainty around the economic impact of new U.S. trade policies, expanding fiscal deficits, and the risk of capital flows shifting toward Europe (amid major fiscal stimulus in the region), we held a cautious view on the U.S. dollar.

As we have discussed before, the breakdown in the correlation between the U.S. dollar and risk assets is a reminder that investors need to be mindful about how they diversify portfolios. A simple allocation to the dollar or U.S. Treasuries may provide less portfolio ballast than it used to. Non-U.S. investors may benefit from higher hedge ratios on U.S. assets, while U.S. investors might consider unhedged European and Japanese assets despite sacrificing some yield in bond investments due to interest rate differentials. Meanwhile, gold and other commodities can help hedge geopolitical shocks and the inflationary potential of tariffs and dollar weakness.

Cautiously Optimistic

While tariff policy uncertainty could begin to weigh on economic data and lead to a temporary slowdown in growth, recent employment figures indicate that these effects have not yet significantly impacted the broader economy. In addition, tariffs may also start to impact inflation, and as a result CPI prints over the next three to six months may not be as benign as they have been.

But we believe these unknowns around trade and inflation do not create an insurmountable “wall of worry.” The worst-case scenarios on punitive tariff outcomes, sharply lower earnings downgrades and recession risks, in our view, have become far less probable, which leads us to remain overweight risk assets. Additionally, efforts to reduce the size of government may dampen demand in the near term, but lay a foundation for more robust, private sector-led growth over time. Should the U.S. shift toward a more predictable and growth-friendly policy stance, it could serve as a powerful catalyst for renewed economic momentum over the next 12 to 18 months.

Finally, it’s important to continue to look through short-term headlines as policy shifts can influence market sentiment rapidly in either direction, with positive developments often sparking swift rebounds just as negative surprises can trigger sharp downturns.