Markets have performed well during the first half of 2025, but this certainly masks a lot of volatility and uncertainty. The main recurring theme appears to be false crises. Whether it’s trade, escalating war in the Middle East, terrible sentiment economic data, a spike in credit spreads, or deficit concerns over government bond issuance, all have rattled markets only to see the risks fade. We’re not saying these risks are actually gone, but the market has consistently reacted and then recovered, so for now, we’re placing them all in the “false crises” category.
The trade war isn’t over, there isn’t peace in the Middle East, economic data isn’t good, and deficits are still a problem, but the market says it doesn’t care. Or it doesn’t care at the moment. While 2025 has been a macro-driven year so far, with headlines motivating most of the market moves in both directions, we believe that taking a more calm or non-reactionary approach to headline announcements has proven ideal for one’s portfolio.
U.S. policy has certainly dominated headlines, primarily from tariffs but also DOGE, tax policy and changes to regulation. If this were any other year, policies outside the U.S. would have garnered more attention: Germany relaxing deficit rules, China applying increased fiscal spending with some early signs its real estate crisis may be finally abating, and even Canada’s move towards more business-friendly policy (Yay!). Add the fact that central banks remain in cutting mode, and the takeaway for markets is that while policy uncertainty is a negative, many policies have been supportive of markets.
Perhaps more impactful is that the market is becoming numb, or accustomed, to this level of policy uncertainty. Market reactions to even bad news on tariffs have become muted, as can be seen with the recent flare-up for trade talks between the U.S. and Canada or Japan. Dare we say markets are becoming used to Trump’s steady flow of announcements, or at least not taking them at face value? Once again, this reinforces our strategy of not reacting to the headlines, instead calmly waiting or, if the market does potentially overreact, then taking opportunistic action.
Markets have enjoyed a good start to 2025, albeit with one helluva ride, from initially underreacting to the policy threat of tariffs, then overreacting and now perhaps underreacting to what lies ahead. The important lesson for portfolio construction is to differentiate between event shocks and economic gyrations. Our rule of thumb is that a shock, which can create market weakness, is an opportunity, and you may have to be fast. On the other hand, economic weakness is something that doesn’t resolve itself quickly and may take quarters or years to resolve.
The past 15 years have been great for investors, as one can easily see with markets at all-time highs. This has also reinforced the “buy the dip” mentality. But digging deeper into market corrections during this bull market uncovers a very useful distinction. Corrections caused by an event have proven very short before markets recover and march higher. Covid in 2020 was the big one; the trade policy event in 2025 was similar, albeit not as extreme. Even the carry trade blow-up in the summer of 2023 provides a third example. Down fast, and then up fast.
Other corrections that coincide with periods of economic weakness take a very different path: more gradual on the way down and on the way up, causing these corrections to last much longer. In 2011, markets fretted over a double-dip recession in Europe, while the U.S. & Asian economies were only mildly positive. 2015 and 2018 both saw global economic growth scares led by China, while the 2022 stock market decline, while perhaps inflation-induced, was rather economic in nature.
The economic periods of weakness simply take longer to sort themselves out. It’s not too surprising that these periods also line up with the trajectory of earnings growth. This brings us to our expectations for the second half of 2025. Reflecting upon our 2025 outlook published in early December, not much has changed.
We continue to be more cautious on U.S. equity exposure, leaning more so into international developed and emerging markets. We believe bond exposure remains higher quality with less credit exposure and a good amount of duration. But we’re underweight in bonds, instead relying on different types of diversifiers for defence. Our mantra of not reacting to headline news, like policy announcements, remains.
The only major difference is that we are becoming increasingly concerned about a potential economic growth scare. And if this develops, it could prove to be a longer process to work its way through the system relative to those event-driven periods of weakness.
Economic Growth Scare to Come?
We wouldn’t blame anyone for throwing in the towel on trying to forecast the trajectory of economic growth, especially after 2022. As a quick refresher: to combat inflation, central banks tightened more aggressively than at any period dating back to the 1980s. The yield curve, carrying a perfect record as an early signal of coming recessions, was deeply inverted. Sentiment data was in the dumps. Recession probabilities spiked higher, and the chorus of recession calls grew louder and louder. We were in this choir, but weren’t convinced, as our market cycle indicators did not weaken enough (see chart in Market Cycle section).
With the benefit of hindsight, some big factors helped prevent a recession. The amount of savings accumulated during the pandemic enabled consumers to keep spending despite higher prices due to inflation and higher interest costs. Remember revenge travel?
Meanwhile, employers were finding it hard to find workers as all these savings seemed to encourage people to stay out of the workforce longer. This made the labour market tight and caused wages to move higher. A job for anyone who wants one, at higher wages, with lots of accumulated savings in the piggy bank. That was certainly enough to offset those other signals/factors. Add to this U.S. fiscal spending that kept up at a higher pace. End result: a few small negative GDP prints around the world, but certainly no recession.
Investing is all about learning and updating your mental models. But that doesn’t mean what happened last time will happen the next time. So here we are again, with economic data softening and sentiment data in the dumps. Unlike 2022, those savings are largely gone, and those jobs are becoming increasingly harder to find. The uncertainty around tariffs has not helped, but make no mistake: this slowing started before the policy risk rose up.
We could highlight that leading indicators have been declining for a few years now. Or manufacturing PMI data in the U.S. is now back below 50. And housing prices have started to roll over. Sentiment data, which has been weak for a few months, remains so. But now the hard economic data has started missing consensus forecasts based on Bloomberg Economic Surprise tracking.
Meanwhile, the U.S. consumer is not in a position to spend to backstop the economy. On a positive note, the European consumer remains in great shape. And China is starting to improve. Nonetheless, we believe the risk of an economic growth scare (our baseline) is rising. If it’s just a growth scare, this could prove the second buying opportunity of 2025. But its duration may prove longer than many market participants may expect.
Equity Position Check-In
The first half of 2025 was marked by significant market turbulence, largely triggered by the announcement of higher tariffs on Liberation Day at the beginning of April. While global equity volatility normalized quickly after the initial shock, and the V-shaped recovery has been remarkable, equity markets remain susceptible to ongoing policy and geopolitical risks in the second half.
We believe the factors driving equity performance in the second half of 2025 will likely be similar to the first half. This involves a complex interplay of macro factors, geopolitical concerns, and monetary policy. We anticipate a tug of war between weakening macro data from the tariff shock and the underlying resilience of the U.S. and global economy. Deregulation, tax cuts, and potentially lower short-term borrowing rates are expected to be the key drivers, at least in the U.S., to help markets, along with a still dominant AI theme.
U.S. Equities: Resilience Tempered By Concern
Both the U.S. economy and consumers have shown resilience amid extreme policy uncertainty year-to-date. Corporations delivered healthy earnings growth in Q1, with S&P 500 companies showing a solid 7.6% earnings surprise, significantly above the typical quarterly average. This is encouraging from a fundamental standpoint, combined with the Trump Administration’s pivot from tariffs to tax cuts and plenty of cash on the sidelines. The "pain trade" for equities remains to the upside. Markets are back at fresh new highs to begin the second half of the year, and we believe they’ll likely see a continued push higher, but the line certainly won’t be straight.
Retail activity slowed somewhat in June compared to May, and remains well below levels seen during peak 2021 meme stock mania. The nature of retail buying has also shifted. Demand for broad aggregate ETFs was still strong, but interest in single stocks has waned, with profit taking beginning to occur, a pattern that is eerily similar to previous market peaks.
Retail’s buy-the-dip mentality has certainly paid off, and while flows were dominated by ETFs, it’s interesting to see that the surge in demand for U.S. exposure is predominantly homegrown. The chart below shows evidence that foreign (non-U.S.) buying of American equity ETFs may be waning, while domestic inflows continue. Foreign-listed U.S. equity ETFs would be the go-to ETFs for foreign investors looking to gain U.S. exposure. Interestingly, net-flows have been negative for the past three months, with an acceleration of net-selling over the past month. It’s not just Canadians who are going elbows up; that same sentiment is taking hold globally.
We remain wary, with a slight underweight to U.S. equities due to several factors:
Underperformance – In the first half, the S&P 500 rose 6.2%, and only 0.6% in Canadian dollars, significantly lagging international markets, which rose 20.3% or 13.9% in Canadian dollars. Canada also managed to outperform so far this year, with the TSX up 10.2% YTD. It’s quite the spread, and we believe the relative underperformance will persist.
Elevated Valuations – U.S. stocks are currently overvalued relative to their historical averages, with a forward P/E of 22x, the S&P 500 is currently trading 23% above its 10-year average. The chart below outlines valuations across the globe, and the U.S. remains the only outlier. Though valuations in Canada and international equities are currently at one-year highs, they remain at least somewhat in line with long-term averages, trading at a 7% and 5% premium, respectively. Valuations are a key factor dictating potential future returns. Much like the beginning of the year, the current setup still favours equities outside of the U.S.
Narrow Market Leadership – In a backdrop of sluggish growth and higher-for-longer rates, we are likely to see a repeat of the 2023-2024 playbook of unhealthy narrow market leadership and high market concentration. The U.S. market rebound since April has been led by big tech once again, limiting broader market participation. Breadth isn’t completely terrible, on a technical basis new highs continue to outnumber new lows, and the percentage of companies above key moving averages remains constructive. What is actually more concerning is the dispersion of the so-called Mag 7. As of June 30th, only three of the seven (META, MSFT, NVDA) are in positive territory. Given the group makes up nearly a third of the market cap of the S&P 500, if they are not all moving higher, it limits the potential upside of the broader index.
Canadian Equities: Moderation to Come?
The Bank of Canada is adopting a wait-and-see approach amidst declining domestic demand and rising unemployment. The economy is not the stock market, and this is especially so in Canada. Many of the largest sectors (Energy and Materials) are entirely dependent on global supply and demand dynamics and couldn’t care less what happens domestically.
Financials are another matter, and quite frankly, we think the banks have done very well all things considered. TD is the largest contributor to the TSX this year, up 35%; it accounted for 13% of the first half’s return. In our multi-asset portfolios, we remain neutral on Canadian equities.
Flows to Canada have improved recently, but in the second half, Canadian markets would be hard-pressed to meaningfully move much higher without Energy names moving materially higher. Bank valuations are beginning to look somewhat stretched, and we’ve cooled on gold given this year’s advance. Valuations remain attractive, especially relative to our southern neighbours. Without a more positive economic backdrop, we believe it’s hard to be more constructive on Canadian equities given the uncertainty with its largest trading partner.
International Equities Remain Attractive
International assets are viewed as increasingly attractive and have been leading global equities so far this year. Our broader view remains that international markets should continue trading more favorably this year, with European and Asian equities being favoured.
International stocks are currently valued closer to their historical averages, which potentially means greater price appreciation potential compared to U.S. stocks, which appear stretched. In the first half of 2025, European equities were up 16.6% in Canadian dollars. U.S. equities have had a long runway of relative outperformance. The consistency of the outperformance on a rolling five-year basis is impressive, but the relative outperformance is beginning to fade.
Europe’s economy has shown resilience, with data coming in better than expected despite the trade war. The Citi Economic Surprise Index for the Eurozone has been trending higher and stands at 32, compared to -3 for the U.S. Increased infrastructure and defence spending, notably Germany's €1 trillion stimulus package, are positive tailwinds for European growth. Most major non-U.S. central banks are expected to continue the gradual easing of monetary policy, which adds to the tailwind.
International diversification is increasingly paying off. After years of U.S. outperformance, many global portfolios are significantly overweight in U.S. assets, and a gradual rebalancing is expected as investors continue to add to non-U.S. assets. This stat we came across is interesting: a mere 1% shift of value from the 10 largest U.S. stocks to the 10 largest international stocks in the MSCI EAFE Index could increase their market cap by 7.5%. This diversification also provides exposure to different sectors besides big tech.
Emerging Markets: Still Room to Run
We remain neutral on emerging markets (EM) after adding to the space just over a year ago, reversing a longstanding cautious stance. While EM growth will have challenges in the second half due to tariff impacts, the outlook remains constructive.
Again, monetary policy is expected to continue easing across many emerging markets. A weaker U.S. dollar is also helpful for emerging economies as it eases debt burdens, supports commodity prices, and boosts overall economic activity in EM economies. Valuations are also quite attractive, with a forward price-to-earnings ratio of 12.7x, a bargain compared to the U.S. and even other developed markets. Lastly, we have sentiment and positioning. EM exposure remains quite depressed after many years of underperformance.
Final Thoughts:
We have no crystal ball, and if the first half has taught investors anything, it’s that the next three-and-a-half years will be full of ambiguity and bursts of rapid change. Markets reflect the past, but investing is about positioning in the best way possible to anticipate what comes next. Given the uncertainty and our expectations for a bit of a growth scare, we believe focusing on valuations and resilient growth is a good start.
Market Cycle & Portfolio Positioning
Our market cycle indicators are still decently above the danger zone, but the trend is to the downside lately. The weakness is more focused on the U.S. economy. Global economic signals remain stable, with five bullish and three bearish, while fundamentals are also stable. On the U.S. side, the yield curve has flattened, combined with weakness in the two more cyclical components of the economy, namely housing and manufacturing.
PMI and energy demand remained bearish and were joined by rail volumes. With softness in new home sales, all the housing indicators are now bearish.
During the past month, we reduced U.S. equity exposure, adding to short-term Canadian bonds. This was an unwind of U.S. equity we added in the early days of April on market weakness. Overall, this has brought our equity exposure slightly under baseline and softened our underweight in bonds. While we have a defensive tilt, there remains decent equity exposure should this market maintain its optimistic mood into the summer.
However, we expect that economic growth will continue to soften, and at some point, the market may react negatively. With higher quality bond exposure and duration, plus our cash and defensives, there are many options to pivot, taking advantage of any market weakness.
Final Note
While we wouldn’t put ourselves in the bearish camp, the risk-to-reward ratio appears to be at least partially tilted for more risk than reward. This market has moved back from overreacting to bad news to overreacting to good news. As contrarians, this has us dialling back a bit and leaning more on defence. Positioning for uncertainty remains paramount for 2025.
— Craig Basinger, Derek Benedet and Brett Gustafson
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Sources: Charts are sourced to Bloomberg L. P.
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