Midyear outlook: The apparent mismatch between high stock prices and policy uncertainty

According to Bloomberg as of June 30, 2025

Three factors will be critical to reconciling optimism with fundamentals

The Trump Administration’s plans for tariffs include fail-safes and backups so that it can leverage a variety of distinct executive powers to carry out its policy plans even if a specific power is halted by the courts or Congress. Such an ambitious approach to reshaping trade policy will inevitably touch broad swaths of the economy.

We see three pillars of support for today’s prevailing investor optimism, all beholden to tariffs to varying degrees: the evolution of expected and realized inflation, the different ways these price pressures could impact economic growth, and the ability of companies to sustain earnings growth. These factors will likely steer the Federal Reserve’s (Fed) monetary policy path and may ultimately determine whether current valuations are justified.

1. Inflation: Balancing realized price changes with expectations

Despite realizing some initial tariff-driven price increases, headline inflation moved downward toward 2% early in the year, and core inflation started the year with the slowest increase since 2020. While the early effects of tariffs were evident in certain goods, their full impact remains unknown, contributing to Fed expectations for higher realized inflation in the second half of the year.

Inflation breakevens suggest investors remain relatively unconcerned about price pressures, but we are wary about how the path of inflation will unfold in the short term. The fundamental question remains unanswered: who will bear tariff costs—suppliers, retailers, or consumers?

If tariffs create meaningful inflation, consumer demand destruction could undermine earnings growth assumptions. Alternatively, if corporations absorb costs through lower margins, achieving 10% earnings growth becomes challenging. Beyond tariffs, consumers and corporations are also contending with rising electricity costs driven by AI, data centers, and peak summer consumption; and a softening housing sector with back-to-back monthly price declines that may offset some inflation pressures.

2. Earnings: Strong performance, high expectations

Earnings growth for first-quarter 2025 exceeded expectations, with companies delivering solid backward-looking results and resilient forward-looking guidance in the face of chaotic tariff-driven headlines. This performance provided crucial support for the market recovery, reminding investors that corporate fundamentals entered this period of policy uncertainty from solid footing.

However, halfway through 2025, markets now price approximately 10% earnings-per-share (EPS) growth for S&P 500 companies over the next 12 months—potentially too optimistic. With rising EPS estimates and PE ratios back to 22x, we believe companies must deliver strong performance to justify these expensive valuations, which leave little margin for error.

The earnings picture becomes more complex when considering tariff impacts. While companies navigated the initial uncertainty well, sustained higher tariff costs—currently averaging about 12%, five-to-six times historical levels—haven't fully flowed through to corporate margins and consumer prices.⁴

3. Economic growth: The unresolved question

We came into 2025 expecting moderation towards sustainable pre-pandemic trend levels to continue as both the economy and labor market normalized. Economic data continues to support our outlook for slower economic growth, but it's important to remember that the starting point was from above-trend levels of roughly 2.8% growth over the last two-plus years.

The outlook for the rest of the year could weaken if growth softens and inflation rises. However, this stagflationary dynamic is difficult to gauge, particularly if tariff rates exceed market expectations.

Despite trade uncertainty, recession still isn't our base case, though tariffs could increase recession risk in the second half of the year and beyond.

The Fed: Patient but data-dependent

The Federal Reserve has articulated a "wait and see" approach, assessing incoming data before adjusting policy given open questions about inflation and economic activity. This patience shows the Fed is waiting for clear signals.

Higher tariffs create uncertainty for both the inflation and employment parts of the Fed’s mandate. The Fed’s job is to support low, stable inflation and full employment. Marked weakening in employment would compel the Fed to lower rates and ease financial conditions, but higher inflation would do the opposite, pressuring the Fed to increase rates and stifle rising price pressures.

The Fed's latest economic projections foresee lower overall economic growth, higher inflation, and two 0.25% rate cuts by year-end 2025, although there’s a pronounced lack of consensus among Federal Open Market Committee (FOMC) members. Those cuts and the accommodation they would provide to the economy hinge on cooperative inflation, which we do not believe is a foregone conclusion. As such, we consider the prospect of monetary policy support conditional rather than assured.

Valuations will likely be tested

Current conditions present a paradox: volatility has meaningfully subsided while valuations have returned to expensive levels typically associated with a stable, high-visibility outlook, which is inconsistent with ongoing trade and budget uncertainty.

Markets appear to be pricing in a scenario where uncertainty fades without material impact on the economy, corporate earnings, inflation, or monetary policy. While we share optimism about U.S. resilience and believe tariff impacts may be offset by tax cut extensions, markets have likely already priced in this favorable outcome.

With the S&P 500 trading at a significant premium to other asset classes and no meaningful upside catalysts in the short term, the risk-reward balance favors caution today. The 4.25% return available on cash may provide compelling compensation to wait for clarity with a measured approach to risk reduction.⁵

A "show me" moment of truth

We believe it’s going to be an interesting summer as we enter what we characterize as a "show me" environment starting in early July. Markets will have a full pipeline of information to digest—starting with the adjustment of the tariff pause deadline from July 9 to the beginning of August—and a lot needs to go right to support today’s valuations.

We believe the economy can likely withstand policy uncertainty and changing trade relationships without tipping into recession this year. However, the risks associated with potential higher inflation, softening demand, business caution, and Fed reluctance may create challenges in the short term without catalysts for acceleration.

We believe patience will be rewarded. Rather than assuming the rebound will continue without interruption, we favor a marginally defensive posture—emphasizing a slight decrease in exposure to U.S. equities in favor of fixed income and cash—until there's more clarity on inflation, earnings, and the economy.

 

 

 

1. According to Bloomberg as of June 30, 2025
2. Historic Rebound Sends S&P 500 to New Highs - WSJ
3. According to Bloomberg as of June 30, 2025
4. Average U.S. import tariff rate based on Tax Foundation data as of June 30, 2025
5. According to the yield on the six-month U.S. Treasury Bill as of June 30, 2025