Schwab Market Perspective: 2025 Mid-Year Outlook

The Trump administration's rollout of a sweeping new tariff policy shook stock markets in April and has continued to create uncertainty, although investor reaction has become more muted to each new development. The fear that tariffs will boost inflation and slow economic growth is likely to continue to affect markets in the second half of the year, until and unless there is more clarity on policy. We expect the Federal Reserve to cut short-term interest rates one or two times in the second half of the year.

Meanwhile, international stocks have outperformed U.S. stocks, and we continue to encourage investors to make sure they're appropriately diversified in this area. From a wealth management standpoint, while we're keeping an eye on the tax-and-spending bill making its way through Congress, we suggest investors consider tax-aware planning and investing strategies that may be beneficial no matter what happens in Washington.

U.S. stocks and economy: Under pressure

As we approach the midpoint of 2025, the U.S. economy faces many uncertainties, including the possibility that tariffs will raise inflation, that the tax-and-spending bill currently working its way through Congress will increase the federal debt, and signs that the labor market may be cooling.

In turn, with stocks currently near all-time highs, the bar is relatively high for the market in the second half of the year. It would be beneficial if tariff rates were to decline, the labor market stabilize and inflation remain under control, but predicting those events is extremely difficult. For now, investor sentiment and positive earnings growth remain supportive for stocks, but stretched valuations and the potential that tariff policy will slow economic growth are headwinds.

In early April, the Trump administration unveiled significant tariff increases—followed by subsequent escalations, de-escalations, delays, court decisions, and appeals. Trade negotiations with individual countries are ongoing. But as of this writing, the average effective tariff rate is more than 15%, the highest since the Great Depression in the 1930s.

Average tariffs are at the highest level since the Great Depression

Tariffs may raise prices of certain goods or cut into profits for businesses that don't pass on the tariff cost to customers via price increases. Higher prices may lower consumer demand, which could slow economic growth.

Another issue we're keeping an eye on is the trajectory of the U.S. budget deficit and federal debt. U.S. Treasury Secretary Scott Bessent has called for reducing annual deficits to 3% of gross domestic product (GDP), but that's unlikely to happen if the "One Big Beautiful Bill Act" is passed in anything near its current form. The Committee for a Responsible Federal Budget estimates the reconciliation bill would boost deficits to about 7% of GDP and would remain near that level through 2034. Even with the budget resolution's assumption of 2.6% average real GDP growth—optimistic in the near term and somewhat unlikely over the next decade—deficits would remain well above the 3% target.

As a reminder, the "deficit" refers to the budget deficit, which is the annual mismatch between what the U.S. government takes in and what it spends. Government "debt" is the cumulative effect of running budget deficits. High and rising deficits mean more of the federal budget goes to financing costs, potentially crowding out other spending.

Meanwhile, we believe the labor market is a key factor in the economic outlook. The present environment can be characterized as one in which companies have cut back on hiring plans but aren't yet laying off to any significant degree. As you can see below in the monthly Job Openings and Labor Turnover Survey (JOLTS), job openings have been generally trending lower at a faster pace than layoff announcements have risen.

Job openings have dropped faster than layoffs

While initial jobless claims have been trending slowly higher, continuing claims are at a new cycle high—reflecting the increasing difficulty laid-off workers are having in terms of finding new employment.

Continuing jobless claims have remained elevated

With two-thirds of U.S. GDP tied to consumer spending, consumer confidence remains key to the outlook—and the strength of the labor market is one of the most important supports for consumer confidence and consumption.

How should investors navigate an uncertain environment? We suggest making sure your portfolio is diversified across and within asset classes. Appropriate exposure to international stocks is also important given their strong performance so far this year.

Fixed income: Volatility and a steeper yield curve

Heading into 2025, one thing we were confident we'd see was increased volatility in the fixed income market. And sure enough, the MOVE index, which measures volatility in the Treasury bond market, spiked higher in April as investors responded to rapid and still-evolving changes in trade and economic policies.

The MOVE Index spiked in April

More recently, yields for 30-year Treasury bonds pushed above 5%, the highest level since 2007, amid concern that the proposed tax-and-spending bill will increase U.S. government debt. The market is signaling that adding to government budget deficits accumulated during the last 20 years, when interest rates and inflation were low, will require higher yields to attract investors.

Long-term Treasury bond yields have risen

We expect the Federal Reserve to lower the federal funds rate (the rate banks charge each other for overnight loans) one or two times in the second half of the year, bringing the upper bound of the target range down to the 4% area. The earliest we anticipate a rate cut is the September meeting, as the Fed has indicated it wants time to evaluate the impact of various policies on the economy and inflation.

With the prospect of higher yields in the short term and elevated volatility, we continue to favor taking a cautious stance in the fixed income markets. We suggest keeping average duration in portfolios at benchmark or below levels. (We use the Bloomberg Aggregate Bond Index, which currently has an average duration of about six years, as a benchmark.) We think maintaining high credit quality is also important due to the risk of a slowdown in the economy.

But we also see opportunities for long-term investors to potentially capture attractive yields in various segments of the fixed income markets, such as investment-grade corporate bonds, securitized bonds and municipal bonds. Yields in the 4.5% to 5.5% region should provide positive real returns over the intermediate-term horizon. Generally speaking, the income portion of bond investments contributes the majority of the total return. Since all income is positive, current coupons in the 4.5% to 5.5% region should provide offset to potential price declines.

Average yields for a variety of fixed income investments

International stocks and economy: Why international diversification matters

The first half of 2025 is a case study on why investors should consider international diversification as a way to manage market volatility. U.S. stocks have underperformed international stocks so far this year¹ and global investors seem to be reassessing their international allocations amid unpredictable and uncertain policy moves in the U.S., a stable economic and earnings outlook outside the U.S. and a weaker dollar, among other factors. The second half of the year may see continued volatility and international stock market leadership could remain a trend.

Investors, businesses and consumers have had to weigh the impact of tariffs implemented, paused, de-escalated and court-challenged. The worst-case tariff scenarios proposed in early April may be currently off the table, but trade uncertainty remains. Some progress has been made toward trade deals, but there is more work ahead than has been settled. Historically, U.S. trade deals have typically taken 18 months on average for both parties to sign an agreement.

It takes 18 months on average to sign a trade deal

Despite the work ahead, stock indexes are now higher than they were on April 2nd, the day the White House's new tariff policy was announced. Trade deals with the U.K. and China have been viewed by market participants as progress, no matter how thin on substance. Investors may be becoming desensitized to tariff news. The U.S. trade war also has motivated countries outside the U.S. to accelerate trade with each other—already this year, the U.K. and India made a free trade deal, the U.K. and EU struck a landmark post-Brexit reset agreement, and China signed dozens of cooperation agreements with Vietnam and Malaysia. As the year progresses and investors look toward potential resolution, market reactions to tariff news may become smaller as the economic and earnings outlook becomes clearer.

The outperformance of U.S. stocks for most of the past 15 years likely resulted in many investors giving little consideration to the international exposure in their portfolios. The weight of MSCI EAFE (Europe, Australasia and Far East) countries in the broader MSCI ACWI (All-Country World Index) has been cut in half from around 40% at the end of 2009, when the U.S. outperformance began, to around 20% in November 2024. This shift also likely occurred in many investor portfolios, which are now probably underweight to international relative to the longer-term strategic target.

U.S. weight in ACWI has increased, while EAFE has decreased

Attractive valuations may persuade investors to reallocate money away from the U.S. in their portfolios. International stocks are currently valued close to their historical averages whereas U.S. stocks are currently over-valued relative to history, implying greater price appreciation potential for non-U.S. stocks.

Financial planning: Themes for the year

For wealth management, our midyear outlook revisits three themes we laid out at the beginning of the year: anticipating tax changes, handling inflation, and managing risk. While we continue to monitor the progress of tax policy in Washington, we believe there are tax-aware planning and investing strategies that investors can consider regardless of extensions or changes to tax law. These include:

Tap the full range of tax-advantaged investment accounts that may be available to you, including IRAs, 401(k)s, Health Saving Accounts (HSAs), and Roth accounts to help reduce, defer, or eliminate taxes.
Consider tax-efficient strategies including buy-and-hold investing, index funds, less active funds or strategies, and exchange traded funds (ETFs) in taxable brokerage accounts when possible and appropriate to reduce tax drag.
Consider municipal bonds for your bond investments, particularly if you're in the 32% tax bracket or higher (and even the 24% bracket for some investors), in taxable brokerage accounts.

At the beginning of the year, we shared three suggestions to combat inflation: stay invested, consider options to buffer your portfolio from inflation, including Treasury Inflation Protected Securities (TIPS), and maintain some cash reserves to increase your ability and confidence to follow the first suggestion. All three suggestions still apply at the midyear mark.

Having a cushion of more stable investments that may not "beat" inflation, but that provide liquidity for possible short-term needs from your investments (for example, if you are in retirement) is increasingly helpful, in our view. We're also watching interest rates for borrowers. Rates to borrow for mortgages remain high. We don't expect that mortgage rates will drop more significantly soon.

¹ As of 6/10/2025, the MSCI EAFE (Europe, Australasia and Far East) index was up 18.6% year to date and the S&P 500 index was up 2.6% year to date.

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