Stocks have surged since the White House backed away from sweeping tariffs imposed in early April, although U.S. tariff policy remains uncertain and is a potential driver of continued volatility. Higher tariffs could slow economic growth while raising inflation—which is still above the Federal Reserve's 2% target rate—complicating the Fed's move toward cutting interest rates. Meanwhile, emerging-market stocks have outperformed U.S. stocks so far this year, similar to their performance during 2017, the first year of President Donald Trump's first term.
U.S. stocks and economy: Stocks rebound
Stocks jumped on May 12th after the White House announced a 90-day reduction in U.S.-China tariffs. But even before that, the S&P 500 index had surged 13.7% between April 8th and May 8th, the biggest one-month gain since 2020, as stocks recovered from a steep plunge (into or near bear-market territory, depending on the index) after Trump announced stiff tariffs on dozens of countries.
That swift plunge was enough to send many investor sentiment metrics into "extreme pessimism" territory. As is typically the case when that happens—at extremes, investor sentiment tends to be a contrary indicator—it created fertile ground for a positive catalyst to help jolt stocks into the opposite direction. The question now is whether the market plunge we experienced was more of a pandemic-like dip and recovery, or the start of a longer, protracted bear market.
We follow both attitudinal and behavioral measures of investor sentiment. The former tracks how investors feel—or what they're saying—about the market, whereas the latter tracks what investors are doing with their money. At times, there are major differences between both, and at crucial turning points in cycles, the difference has important implications for future returns.
Arguably, the most popular attitudinal metric is the weekly Investor Sentiment Survey published by the American Association of Individual Investors (AAII), which asks investors whether they are bullish (expecting stock prices to rise), bearish (expecting stock prices to fall) or neutral looking out over the next six months. The spread between the share of bulls and bears collapsed swiftly in April (meaning bears outnumbered bulls) to a level consistent with the lows seen toward the end of the bear market in 2022.
For behavioral sentiment, the story is a bit different. AAII also tracks members' positioning and exposure to bonds, equities, and cash on a monthly basis. As shown in the chart below, equity positions have dipped a bit over the past couple of months, but not dramatically. In short, investors have been telling AAII that they feel as if we're in a deep bear market but haven't reflected that in their stock exposure—a dynamic akin to what we saw in June 2022, when the then-bear market was only halfway complete.
Despite the disconnect between attitudinal and behavioral metrics, the weakness in the former was enough to send most aggregate measures of sentiment into zones consistent with the ends of bear markets. For example, the Smart and Dumb Money Confidence Indexes tracked by SentimenTrader—which track "smart," or institutional investors, compared with "dumb," or retail investors—reached extremes during the April lows, doing exactly what they tend to do when stocks reach a maximum point of pain. "Smart" money was correct in its contrarian stance while "dumb" money was chasing the trend lower (note that these index labels are SentimentTrader's, not ours). The trend-chasing crowd historically has often been wrong at extremes—that is, bull market peaks and bear market troughs.
When it comes to stocks, nothing is perfect: History is not a perfect guide and sentiment is not a perfect market-timing tool (as if a "perfect" market-timing tool even exists). Animal spirits and recent price action are still in bulls' favor for now, so we wouldn't be surprised to see a continued grind higher for stocks from here. However, given the unique nature of the current volatility backdrop, we also wouldn't be surprised to see stocks struggle at the first hints of deteriorating hard data. Up until this point, the market has priced in a panic and subsequent reversal of the worst-case tariff outcome, but the next phase is digesting a backdrop of tariff rates that are both well into double digits and a constant moving target. We expect significant index-level volatility to persist.
Fixed income: Tariffs remain a threat
Rapid changes in trade policy continue to roil the fixed income markets. Yields (which move inversely to prices) surged on news of the 90-day pause in the trade dispute with China. The bond market reaction reflects the view that tariffs represent a greater threat to the economic growth outlook than to the inflation outlook. The challenge is that ever-changing policies require recalculating risks frequently. Based on what we do and do not know about tariffs, the volatility is likely to continue.
With trade policy on pause, the market's focus is likely to shift to fiscal policy, where current proposals look likely to expand the budget deficit and add to the overall debt burden longer term. On the margin, higher deficits are likely to keep Treasury yields elevated. There already has been a pullback in foreign capital inflows into the U.S. on prospects for slower growth. Higher yields and a weaker dollar may be needed to fund rising deficits.
Much of this is captured in the term premium—the extra yield that investors require to hold long-term bonds instead of a series of short-term bonds. Since "Liberation Day" on April 2nd the term premium has risen by more than 40 basis points (or 0.40%), reflecting policy uncertainty. It's at the highest level in over a decade. It could rise further if the market becomes increasingly concerned about the federal budget.
We continue to expect yields to drop in the second half of the year as the economy slows and inflation cools. The federal government cuts to various programs that support education, research and health care, along with the workforce reduction, point to slower growth and rising unemployment. Moreover, while tariff policies have been paused, the ongoing rate is still the highest in decades, which would subtract from gross domestic product (GDP) growth. The combination of policies will likely reduce consumers' ability to spend, resulting in slower growth.
The unemployment rate and inflation figures will provide direction for the markets. At 4.2% the unemployment rate remains quite low, suggesting the economy can be resilient in the face of uncertainty. Inflation, however, is still well above the Federal Reserve's 2% target level and tariffs could push it higher over the next few months. Consequently, monetary policy is likely on hold until later in the year. We look for two rate cuts by the Fed this year, probably starting in September.
For investors looking to navigate the cross currents of policy, we suggest keeping average portfolio durations in the intermediate term part of the yield curve—around five to seven years. In addition, we continue to favor higher-credit-quality bonds to mitigate volatility. In the long run, Treasury yields tend to be a function of Fed policy, inflation expectations and the outlook for economic growth.
International stocks and economy: Is EM back?
Developed international stock markets have outperformed U.S. stocks widely so far in 2025, adding to the outperformance over the past two and a half years since the current bull market began. The year-to-date outperformance by emerging-market (EM) stocks also stands out.
EM stocks delivered a total return of about +3% in U.S. dollar terms while the U.S. stock market total return fell about -4% during the first quarter. So far in Q2, EM stocks are adding to their outperformance this year. This echoes the wide outperformance by EM stocks seen in the first quarter of Trump's first term in 2017; EM stocks outperformed in all four quarters of the first year of Trump's first term.
In 2017, the policy uncertainty and trade war threats from the Trump administration did not derail global growth. Instead, economic growth improved in both Europe and Asia to a degree similar to what economists are forecasting for 2025, helping to lift EM stocks, whose performance tends to be highly correlated to global economic growth. The 2017 gains were led by China, which implemented a big stimulus program at the time. A similar package of total deficit spending equivalent to 11% of GDP was unveiled this year by China's leaders at the March 5 National People's Congress.
The 2025 tariffs pose a potential supply shock for the U.S., while for EM countries it poses a potential demand shock. Note that it is easier in the near-term to replace lost demand with domestic stimulus than it is to replace missing supplies with new factories, materials, and workers. This may help to explain why EM stocks have been performing much better than U.S. stocks this year.
The first signs of growth pressure from tariffs have started to appear with China's official manufacturing PMI declining to 49 in April from 50 in March, below the 50 threshold that denotes the difference between economic growth and contraction. In response, China's central bank announced a broad set of policy easing measures on May 7th, including a 10-basis-point policy rate cut, a 50-basis-point cut to bank reserve requirements, and a 25-basis-point cut to the lending rate for its housing support fund. These moves underscore an urgency by China's financial officials to support the economy and financial markets. The reprieve in tariffs on China's exports announced May 12th boosted the sentiment of investors as China's stocks climbed 3% that day.
Should the U.S. dollar continue to slump, it would support EM currencies and boost EM stock market returns in U.S. dollar terms. The MSCI Emerging Market Currency Index, which tracks the currency impact on EM stock market returns gained nearly 2% in the first quarter and added another 3% so far in the second quarter.
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