MARKET HIGHLIGHTS

President Trump is implementing one of the most ambitious and far-reaching shifts in economic policy in decades. Yet, investors have so far responded to geopolitical events and these efforts with indifference. Perhaps investors are hedging their bets, with some saying, “a new golden age is dawning,” while others believe, “the end is nigh, we are doomed.” Or, less dramatically, perhaps investors are collectively viewing the policy upheaval as sound and fury, signifying little. The dollar has fallen against developed market currencies, and US bonds have underperformed the global market, but US stocks continue to be priced with a premium, with no sign of alarm.

The first half of the year has been filled with bearish challenges. As we enter the second half, investors have successfully processed what seemed like bearish illusions (tariffs, recession, inflation, budget legislation, oh my!) and have climbed a wall of worry. According to AAII sentiment data, the July spread between the percentage of bulls and bears has not been this bullish since January 2025. Likewise, Wall Street strategists capitulated in April on overly bullish index price targets that had outpaced the actual index price level in the fourth quarter of 2025. As we have mentioned before, the index price being ahead of the forecast level is a bullish sign, indicating that institutional money is flowing in. These significant drops in target prices often coincide with market bottoms, offering another bullish tailwind.

The market and sector rotation entering the second half of 2025 is not happening at the expense of market leaders. Nor is the switch to international stocks over US ones, nor the shift from value stocks to growth stocks, nor is it the so-called “end of US exceptionalism,” as many had feared.

In addition to MTD returns, six of these sectors have forward EPS within 1% of an all-time high: Tech, Industrials, Financials, Communication Services, Healthcare, and Utilities. The first four are more cyclical sectors, and having momentum and forward earnings moving higher is an additional bullish tailwind for market forward returns.

Regarding changes in market structure, retail traders have become a more significant force in the markets, influencing market dynamics.  In the past, professional investors dominated the trading markets, with the majority of volume originating from large asset management firms and other institutional investment firms. Following the pandemic ‘meme stock mania,’ retail investors were observed to have an outsized impact. This cohort shuns the set-it-and-forget approach, speculates with very close-to-expiry or zero-dated options, and crowdsources due diligence.  Today’s retail trader is more likely to buy dips than professional investors, believing that the market is always higher one and five years forward.  This year, even as Trump unleashed a storm of volatility early in Q2 2025, and as markets nearly entered bear market territory, retail flows into stocks and ETFs reached a record high in the first half of the year.

In addition, the volume of penny stocks (stocks with prices below $1.00), a market sector notorious for fraud and speculation, accounted for more than 47% of the total market volume in early June.

Examining this mosaic shows that retail traders are increasing their market activity, but they are also taking on much higher risks. Meanwhile, professional money managers stay cautious. Institutional sentiment reflects ongoing worries about an economic slowdown, potential inflation increases, or geopolitical crises, causing them to keep below-average stock allocations in their portfolios.

Polls of institutional advisors continue to reveal elevated concerns over policy and the US economy.  How much of a risk is recession?  The economy is slowing, but consensus economists’ forecasts already fully reflect that. The hard economic data, represented by the US economic surprise index, is failing to confirm the consensus economist expectation of a scenario on the same level as 2020 or 2022, with both positive surprises from growth and record stimulus from the one big bill. Markets may not receive absolute good news, but rather marginally better news than expected, which is actually what drives incremental returns.

Regarding trade, President Trump has threatened to impose sweeping 25% tariffs on goods from a group of trading partners via social media, with the implementation reportedly delayed until August 1. This threat extended to a dozen countries, including Japan, South Korea, South Africa, Indonesia, Thailand, and Cambodia, with similar 25% tariff threats issued consecutively. The president did soften his stance somewhat, saying that the deadline was “not 100% firm” and indicating a possible adjustment in rates. He added, “We are not going to be unfair,” and showed a willingness to reward countries that offer “additional concessions.” The responsibility for any economic downturn or budget deficit blowout now firmly rests with his administration. Our baseline expectation is that negotiations will conclude favorably, even if uncertainty remains throughout the rest of the summer.

The administration has backed away from austerity efforts. It is steering the US economy toward a policy of fiscal and monetary largesse, including trillions of dollars in tax cuts, significant deregulation, and initiatives to bring back industries considered vital for national defense. The high debt levels and large procyclical deficits continue to indicate fiscal dominance over monetary policy, necessitating the monetization of deficits and the implementation of financial repression to keep bond yields low. This suggests a portfolio strategy that focuses on protecting against currency devaluation rather than protection against drawdown, while recognizing that although the overall trend for risky assets is upward, the trajectory will not be smooth.

Looking ahead, retail may be overdoing it, but they might also be right. First-half correction bear markets usually predict robust performance in the second half. Sentiment has been reset, and growth expectations, due to extremely high policy uncertainty, are too low. Consensus forecasts for inflation now match potential increases from base rates. This all positions the market to expect better-than-expected growth and earnings, along with disinflation signals from housing, oil, and labor markets, creating a Goldilocks environment of growth, stable inflation, and market optimism.

Stock market seasonal patterns support bullish positioning at least for July. It has been several decades since Yale Hirsch wrote the catchy phrase, “Sell in May and go away,” in the Stock Trader’s Almanac. In recent years, the seasonality has shifted toward a topping pattern in late July. “In late July, say goodbye.” We are not sure it has the same ring to it, but we’ll keep trying. Seasonality in the stock market is now positive on average until the end of July, and so far, the market aligns with this seasonal pattern. Additionally, most technical patterns confirm the seasonal trend, lending further legitimacy to it this year.

Digging a little deeper into the analysis, is explicit Fed tightening expected? Is a recession materializing? With these two additional factors, plus record fiscal stimulus, we may approximate the more sanguine green line scenario, shown below.

The Treasury General Account (TGA), essentially the Treasury’s private checkbook, is used to pay its bills. When the country’s debt ceiling is reached, this checkbook can be used to provide ‘extraordinary measures’ to help meet debt obligations. In 2023, the TGA was nearly drained during the debt ceiling episode. Once the ceiling was lifted, the Treasury worked to rebuild the TGA balance to about $800 billion by issuing almost $1.1 trillion in Treasury bills. In 2025, the TGA decreased by only $370-520 billion, leading fixed income analysts to estimate a smaller need for Treasury bill issuance than in the 2023 rebuild. Nonetheless, this will be a liquidity drain on markets in Q3 2025, assuming no offsetting influence from reverse repos.

The impact on funding markets, according to Joseph Wang, a former senior trader at the Fed’s Open Market Desk, is that the upcoming wave of treasury bill issuance this quarter will reduce bank reserves held at the RRP and potentially halt the Fed’s Quantitative tightening. In other words, a larger supply of T-bills may push rates higher, making them more attractive to money market fund managers who park client cash in the Fed’s reverse repo facility (RRP). QT is being tapered to $5 billion per month; the supplementary leverage ratio (SLR) will be lowered, and issuance will focus on bills rather than notes to mitigate a potential liquidity squeeze following the debt ceiling. In case of an emergency, there is discussion of ‘buyback’ programs, effectively a version of QE, where additional bill issuance would be used to buy back coupons to cap long-term yields at some determined level.

The current administration remains convinced that much of the US fiscal problems, especially a large budget deficit, can be fixed by lowering interest rates, partly through FOMC rate decisions and partly by the Treasury issuing less long-term debt. If only life were that simple, according to Bill Dudley at the New York Fed.

In June, President Trump posted on Truth Social, “Too Late Jerome Powell is costing our country hundreds of billions of dollars. He is truly one of the dumbest and most destructive people in government, and the Fed board is complicit.” The general opinion on Trump’s attacks, along with his stated goal of installing a chair who favors lower rates, threatens to increase inflation expectations and, therefore, push up longer-term bond yields. Any sign that the Fed might give in to the President’s demands would only exacerbate the situation. To counteract the Trump administration’s influence and preserve market confidence, the Fed will need to err on the side of caution, keeping short-term rates higher than it otherwise would.

Bill Dudley of the New York Fed emphasizes that even if technocrats cut rates, market forces still shape long-term yields. If investors view the move as prudent, long-term yields may fall further. However, the main scenario is the opposite. If President Trump attempts to persuade policymakers to push yields significantly lower than what the market considers reasonable, long-term yields could rise sharply. Think back to last year when the Fed was cutting rates due to fears of a resurgence of inflation and the UK’s Liz Truss moment.

The orange line below shows the FOMC policy rate, which begins to decline in September 2024. The blue line represents the 10-year UST yield, which rises exactly in tandem with the policy rates, increasing from a low of 3.63% to a high of 4.79% on January 13, 2025.