The first half of the year saw plenty of market surprises, many of which fell into a loosely-defined category of geopolitical events. President Trump’s “Liberation Day” tariff shock nearly pushed stocks into a bear market in April, while events in Iran last month left many market participants worried about spillover effects globally.

While both geopolitical events fueled some short-term volatility, investors appeared to take a longer view toward de-escalation, recovery and growth, with stocks entering a new bull market that drove the S&P500 up 6% between January and June. As we look ahead to the second half of the year, this letter will unpack some of these geopolitical events, along with potential implications for the global economy and capital markets.

Economic events tend to have bigger consequences

When investors think of geopolitics, many focus on armed conflict, natural disasters, or Presidential crises. However, historical events suggest that major economic surprises often have a more dramatic impact on markets. Data on roughly twenty geopolitical events since the 1950s suggests that, on average, security threats and military action often trigger a relatively short-lived one to two-week decline in equity markets, with stocks down in the mid-single digits on a percentage basis.

In contrast, investors tend to worry more about economic disruptions especially those happening during a market “bubble,” when asset prices inflate rapidly. The dot-com boom and bust, the housing bubble, and Great Recession are examples of economic events that caused much more lasting damage to markets than most security or military events.

What’s next for the economy?

While the current Middle East conflict may remain a risk factor, many investors are keeping a close eye on economic policy changes, including upcoming tariff negotiations. The administration had set a July 9 deadline for trade talks, after which the U.S. may instate severe tariff barriers that could impact company earnings and inflation. However, recent signals from the administration have indicated an extension to trading partners who are in serious current negotiations. At the same time, other U.S. policy changes, such as reduced immigration, could impact labor markets and add to wage pressures.

With numerous emerging geopolitical events, the Federal Reserve is starting to see some cracks forming in what has been a durable growth economy. Jay Powell’s team expects the U.S. economy to grow only about 1.4% this year, down from a prior estimate of 1.7% growth and slower than last year’s 2.5% expansion. The Fed also sees inflation running closer to 3%, which is well below a peak of 9% in 2022, but still hotter than its goal of 2%. The Fed also sees a modest worsening in the labor market, expecting the unemployment rate to move towards 4.5%, which is above the red-hot demand for workers we saw coming out of the pandemic when unemployment fell to 3.4%.

This economic slippage puts the Fed in a tricky situation for two reasons. On one hand, big tariffs could heat up inflation, which would suggest keeping short-term rates at the relatively high 4.5% level we’ve had since December. However, on the other hand, if tariffs and inflation lead to a consumer pullback, layoffs and a recession, the Fed would likely cut rates to rev up the economy. It is worth nothing that historically the data dependent nature of the Fed, or the “wait and see approach” often has them behind the curve with policy shifts. While the U.S. economy can take time to turn, once it begins it frequently moves quickly, and the data (and the Fed) are often catching up with the economy’s new reality.

From a timing perspective, markets are betting that current rates will hold until September, when a quarter point rate cut seems more likely. If these market projections are correct, interest rates may remain relatively high for at least a few more months, supporting our continued purchases of longer-term bonds that lock in these attractive rates.

Investor sentiment: U.S. vs. International

The U.S. is seeing some modest challenges to the economy, but the recovery in stocks suggests that investor confidence in long-term growth is increasing. We see some pros and cons here, with stock valuations hitting some of the highest levels seen since the pandemic or the early 2000s. However, on a more favorable note, market performance appears to be broader this year, as a more diverse set of companies drive stocks higher—a shift from last year when a select group of winners largely drove market returns. You can think about this like a sports team with many great players, rather than just one or two all-stars.

While the S&P500 has shrugged off tariff risks to generate modest performance, we are seeing a much different story outside the U.S. From an economic perspective, other developed regions such as Europe may see economic growth pickup on defense spending and higher deficits, along with lower interest rates. Anticipation of slightly faster growth outside the U.S. may be pushing down the dollar and adding to the performance of foreign stocks this year from the perspective of U.S.-based investors. While U.S. stocks have generally outperformed foreign markets in recent years, we view international stocks as offering diversification benefits at this point in the cycle.

As geopolitical events continue to play out across the globe, we remain focused on portfolio positioning with measured equity risk, complemented by stable and attractive bond income. For stocks, we favor companies that can adapt to new tariffs and other policies as they navigate geopolitical risks. We continue to seek out and own a diverse set of stocks and bonds with the potential to meet or exceed investor expectations, ever mindful of your long-term goals and objectives.

We wish you a Happy Fourth of July and all the best this summer.

Michael Bailey, CFA
Director of Research

Michael Mussio, CFA, CFP®
President