Q2 2025 Market Commentary

Hay Hill Wealth Management CIO Stephen Dowds and Investment Director Charles Armitage review key events of second quarter and share thoughts for outlook ahead.

Market Review

The second quarter of 2025 served as a lesson in how markets can one minute move to discount a dramatically bad outcome and the next shrug it off as an unwarranted fear even though fundamentally little might have changed. Donald Trump’s so-called “Liberation Day” tariff announcement startled markets into a sharp correction which saw falls of close to 10% at the beginning of April. The scale and completely random nature of the way that the level of tariffs was to be applied to countries across the world led investors to believe that an inflationary spiral of higher tariffs would ensue as countries responded in like manner and trade wars became the norm. Bond yields (particularly at the longer end of maturities) rose and yield curves steepened. The effect of all this market chaos, however, began to have domestic political ramifications and so, Mr Trump suddenly declared that the new higher tariffs would not come into effect immediately after all but would be delayed by a couple of months to allow countries to come and negotiate better terms than those announced on April 2nd. To investors, this was confirmation that, as some had argued, all of this was just a negotiating ploy and that Trump may not listen to advisers but that ultimately, he was constrained by markets. Markets turned around sharply and began to regain the ground they had lost. This was particularly the case when negotiations with the Chinese resulted in a provisional arrangement which basically gave China everything it had insisted on and the US very little. Thus was born the image of President Trump as a chicken and the label of the TACO president (Trump Always Chickens Out) about which, more below.

Over the quarter, equity markets in sterling terms returned on average 5%, though to a USD investor, the weakness of the currency added to this. On a regional basis there wasn’t a huge difference between the returns seen, other than the differences in currency rates. In a return to the trend seen in 2024, growth outperformed value as optimism about the impact of artificial intelligence (AI) recovered somewhat and the impact of tariffs was felt elsewhere. Government bond returns were more mixed with the UK and Europe outperforming the US, albeit around a low single-digit average return. Within corporates, high yield under-performed investment grade as credit spreads were already fairly tight. As mentioned below, the oil price spiked following the initial attack on Iran’s nuclear facilities but fell back as the conflict died down somewhat and attention focussed on the declaration by OPEC+ that they would increase production over the next several months. Other commodities, notably gold, rose sharply over the quarter given fears of inflation.

Before returning to discuss the US we should note that there were significant developments elsewhere in the world. In Europe the ECB cut rates twice and noted that they believe themselves to be nearing the end of their interest rate cutting cycle. Meanwhile the commitment of the new German Chancellor to increase government spending on defence is a potentially significant turning point for both Germany and the rest of Europe. In Japan, long term bond yields have been rising in response to an increase in inflation and also to concerns that the fiscal position may be worsening as political bargaining requires trade offs which tend to increase spending. In similar manner the UK government has come under increasing pressure to reverse previously stated cuts to spending. However, in the UK’s case this has come from within the governing Labour Party’s own ranks. All of this has raised the stakes for Chancellor Rachel Reeves to find additional tax revenues in her upcoming October budget without damaging the UK growth outlook more.

Outlook

While the TACO meme was not a good look politically, perhaps fortunately for Mr Trump, the opportunity to look tough and decisive presented itself when Israel extended its military campaign in the Middle East and attacked Iran. This was done on the basis that Israeli intelligence believed the Iranians were much closer to building a nuclear bomb than had previously been assumed. The Trump administration quickly stepped in to support Israel, participating in a series of raids designed to destroy Iran’s nuclear capabilities. Although this resulted in a brief spike in the oil price and some fears of a broader conflict, both the US and Iran stepped back from further escalation and the oil price stabilised. Indeed, over the quarter, the price of crude fell following three announcements from “OPEC+” that it would increase production over the coming months.

While tariffs and geopolitics had a major influence on the short-term movements in markets, over the course of the quarter, investors appear to have decided that, since they can’t analyse or predict what the US administration will do from day to day, it may be safer to look through the difficulty, and stay invested in the belief, that over the longer term these things will be resolved without too much damage to the economy.

That may not be the case with the third big source of uncertainty for markets, namely the US deficit and debt position. As we have highlighted on several occasions previously, the US deficit is running at what for most countries would be an unsustainable level (6% of GDP). Moreover, the total level of US government debt as a percentage of GDP is forecast soon to reach levels (almost 120%) we have not seen since the Second World War. Of course, the US has, over that period held the advantage that the US Dollar is regarded as the world’s reserve currency. Even though several members of the US administration have (as part of the justification for tariffs) argued that this acts as a burden on the US, it is quite clearly the opposite. The US for years has been able to borrow at rates far lower and run trade deficits much larger, than otherwise it could were it not the favoured currency of governments, central banks and investors across the globe. As we have seen many times through history (not least Sterling post WWII), this is a position which depends on a high level of trust and should not be taken for granted.

The chart below demonstrates just how strongly inflows into the US have been since the global financial crisis and the support which these investment flows have lent to the trade weighted US Dollar index in both nominal and real terms.

% of US GDP, Quarterly Data. Source BEA (Source: Kallum Pickering, Peel Hunt)                                     

Justification for the dominant position of the US Dollar has over the past few years been supported by the view that the US economy has been “exceptional” in its robustness and performance. But in the first part of 2025 this has begun to be questioned, with the scale of US government indebtedness being a prominent reason. The focus of this in Q2 was the progress of Mr Trump’s signature piece of legislation: the “Big Beautiful Bill” (BBB), an omnibus piece of legislation which included an extension of the tax cuts Trump had made in his first term, along with cuts to spending on social services and Medicaid along with the removal of subsidies for green energy products and electric vehicles (EVs). The net effect, however, is likely to increase the government deficit, pushing it towards 7% of GDP and on some forecasts, total debt will reach 130% of GDP by 2030.

It was this trajectory that caused the spectacular falling out between Pres Trump and Elon Musk following the end of Musk’s period running the Department of Government Efficiency. Musk was angered by the huge build up in government debt implied by the bill as well as some of its specifics (notably subsidies on EVs). Trump managed to cajole / intimidate / mollify just enough Republican lawmakers to relinquish their resistance to aspects of the bill to squeeze it through and into law. Along with many other things, some of which we have mentioned above, the BBB included a $5 trillion increase in the debt ceiling (taking it to $41.1 trillion) which will allow the government to re-start the process of funding itself. This is important because since the government hit the previous debt ceiling in January 2025, Treasury Secretary, Scott Bessent has had to use “Extraordinary Measures” (i.e. using other sources of money) to fund the government rather than be a net issuer of debt). Now the bill has been passed, he is able to start issuing debt again and as we will probably see in the next few months, the Treasury auctions may well be larger than previously. Moreover, his choice as to where along the maturity spectrum Sec Bessent chooses to raise the debt, will influence the shape of the US yield curve. For quite some time, funding has been biased towards the shorter end of the curve and we suspect this will continue. However, there has been significant talk over the past few months that major US investors are completely avoiding the long end of the curve and if this continues, it poses a risk that were one of these auctions to go badly, confidence in the US bond market would be shaken and that would put pressure on the US Dollar.

All these risks are just possibilities but with the level of indebtedness growing to record levels, there is not much room for complacency. Significant rises in inflation expectations would be a particular concern and with pressure from tariff increases, stimulatory fiscal policy and a weaker USD, not to mention concern about the independence of the Federal Reserve, our view remains that inflation in the US will remain higher than desired and that the result will be that interest rates will be slower to fall than the market expects. We also think that the yield curve will steepen, even if short term rates come down and still find long US bonds unattractive.

In summary, the second half of the year is likely to see a continuation of the patterns of the first. Tariff issues, geopolitics and government debt levels are likely to feature strongly on the investment agenda along with the outlook for interest rates towards the end of the year and the early part of 2026. We would not be surprised to see this add up to a more challenging time for USD assets but we also expect that both growth and inflation may well be slightly higher than current consensus expectations.

Commentary as of 15th July 2025.

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