Q2 2025 Market and Economic Commentary

2025 Q2 Market Review

• U.S. stock markets fully recovered from the Liberation Day drop as tariffs softened, turning positive for the year even in the face of dramatic developments in the Middle East (figure 1).
• International markets outperformed due to reduced trade pressure but lagged slightly at quarter-end due to greater Iranian exposure of European economies.
• Bonds were slightly positive for the quarter, as despite considerable tariff-driven volatility, yields finished mostly unchanged.
• Labor and inflation data remained on solid footing, with jobless claims still in normal territory (though inching upwards) and the CPI still not registering tariff pressure.
• Trade policy during the quarter was mostly a story of walking back Liberation Day aggression, but now the sweeping tariffs are in the Court’s hands.
• The Federal Reserve remained in a holding pattern despite both the outlook becoming “less uncertain” and President Trump ramping up pressure for further rate cuts.
• Middle Eastern tension ratcheted up once again, as Israel and the U.S. launched direct strikes on Iran, sparking fears about regional escalation, but causing little market concern with even oil prices falling (figure 2) as escalating blows were traded.

Market Highlights

For much of the quarter, tariffs were the only market story in town, with stock prices, yields, and the dollar moving almost in lockstep with every new trade development. As would be expected, stocks plunged on the initial Liberation Day dictates, but then quickly reversed those losses as pressure was lessened on nearly everyone (China included) - even before the courts got involved. The primary narrative then abruptly shifted from trade war to real war, as Israel and the U.S. entered direct conflict with Iran. But despite this escalation in Middle East tension, market sentiment remained positive, and both stocks and yields have so far shrugged it off, signaling (for the time being) that further escalation is not the expected outcome.  

Internationally, the post-Liberation Day recovery was much stronger, aided by dramatic shifts in European government spending plans. However, greater exposure to volatility in the Middle East (due both to geographical proximity and energy dependence) led to a softer close for developed markets in June, despite healthy gains for the full quarter.

Economic Outlook

Proxy War No More: Israel’s air campaign against strategic Iranian leadership and nuclear infrastructure, dubbed Operation Rising Lion, represents an unprecedented escalation in direct military engagement and perhaps a marked shift in the global view of Iran’s nuclear future. Despite U.S. leadership initially claiming zero involvement, President Trump’s remarks in the aftermath demonstrated a reinvigorated stance against Iran’s development of nuclear assets - a position that quickly became kinetic when the U.S. launched direct attacks of its own on Iranian nuclear facilities. Thus far, given the limited scope and relative importance of Israel and Iran to global oil supply, the market impact has been largely muted after the initial shock, with even OPEC leadership announcing that the conflict does not justify a change in outlook. Additionally, despite threatening to close down the vital Strait of Hormuz, Iran is very unlikely to move forward with any such plan given the collective pressure of the West, China, and its neighbors in the Gulf, not to mention the potential damage to its own economy. 

Trade’s Day in Court: Trump’s tariff policy is currently in limbo as we await the federal Court of Appeals hearing later this month.  But with the Supreme Court rejecting requests to speed up its consideration, we are likely many months away from a resolution. Nonetheless, there has been encouraging progress despite this lack of clarity, with most of the more disruptive aspects of Liberation Day being rolled back through delays, concessions, and exceptions. And while Trump still has multiple avenues in place to maintain elevated tariffs should the Supreme Court uphold the original Court of International Trade decision, most of these not only force a more limited scope, but may require congressional involvement, resulting in slower implementation and reducing policy uncertainty. That said, the willingness of targeted nations to come to the negotiating table in the meantime may be dampened if they believe they can wait out a favorable court decision, which reduces U.S. leverage.

Economic Softening: Despite the lingering tariff effects and elevated uncertainty, hard economic data has proven relatively robust in recent months. Employment and wage growth have remained steady with no major layoffs materializing, and even with rather negative consumer sentiment, Americans are still spending. That said, while measured inflation has been softer due to falling oil prices, the tariff impact has likely not been felt in the data quite yet. Less encouragingly, our favorite labor market indicator, continuing jobless claims, has actually been trending upwards in recent releases, which, while still in healthy pre-pandemic range (and near historic lows), does signal some potential softening at the margin.  

Fed Standing By: The Federal Reserve’s dual mandate continues to create friction, as policy makers attempt to balance inflation pressure and the potential softening in the labor market in the face of considerable uncertainty. This effort has only been further complicated by increased calls from President Trump for Fed Chairman Jerome Powell resume interest rate cuts. The president even temporarily went so far as threatening to fire Powell, though, for the record, he cannot do that easily, according to the Supreme Court. That said, current economic data appears to support the Fed’s decision to wait on the sidelines before making any policy decisions, as conflicting price and labor signals make a hasty move in either direction imprudent. While the politicalization of monetary policy is an ever-present threat, and one that will need extra attention as we approach the end of Powell’s tenure next year, confidence in the Fed’s ability to stay the course remains steady (as evidenced to us by stable long-term inflation expectations), meaning investors are not yet worried that the Fed will fold to political pressure.   

Congress’ Big Beautiful Bill(s): Regardless of the version that finally makes it to President Trump’s desk given the ongoing discussion and pushback that the Senate version is getting in the House as of this writing, the so-called “One Big Beautiful Bill” is likely to deliver on its major promises: an extension of the Tax Cuts and Jobs Act’s household tax brackets, the elimination of income taxes on overtime and tips, and some pro-business accounting benefits. That said, what looks less likely is progress on reducing the deficit or combatting the national debt, as a reduction of tax revenue is not being met with a reduction in legislated spending - despite former DOGE Chair Elon Musk’s best efforts to get that ball rolling. And while some of the provisions should be expected to boost economic growth, that impact is likely to be modest simply because the most impactful “change” (the tax brackets) was already expected to remain in place, thus limiting the impact on economic activity.

Euro-Strife: Europe’s rearmament campaign has already started to stall, as optimism that was sparked by Germany (and the European Council) deciding to turn on the debt taps ran into the fiscal reality of the rest of the Continent. Spain has become the first country to formally balk at NATO’s spending directives, claiming that it simply cannot afford to increase defense expenditures given other government obligations. And since Spain is not alone in its fiscal woes (Italy and France are also in dire spending straits), it may be difficult to get the EU member state coordination required to put a collective defense plan in motion and reap the potentially pro-growth rewards.  Of course, this is now only further complicated by Europe being more exposed to potential economic disruptions from the Iranian conflict.

This report was created by First Command Advisory Services, Inc. an investment advisor. The information contained herein does not represent a recommendation to buy or sell securities. Nor does this information constitute an offer to sell or a solicitation of an offer to buy any security. Nothing in this commentary should be construed as providing specific investment, tax or legal advice. All information is believed to be from reliable resources; however, First Command makes no representation as to its completeness or accuracy.

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