To make sense of the moves in financial markets witnessed during the first quarter of the year, it’s first necessary to understand what consensus was expecting coming into 2025. Hot on the heels of another year where US stocks outpaced their regional counterparts, many investors felt confident that a new Republican administration would amplify the theme of US exceptionalism. At the same time, a shift towards “America First” policies was assumed to strengthen the headwinds that had already been creating challenges for economic growth in other parts of the world.
However, the story has played out quite differently so far. Elevated uncertainty stemming from the volatile nature of US trade policy has dampened growth expectations in the US, while in Europe, the fiscal response has been much more forceful than many were anticipating.
Against this backdrop, emerging market equities outperformed developed markets, with Chinese and Korean equities both performing strongly. Value stocks outperformed their growth counterparts, while smaller companies lagged, returning -3.6%, as rising trade uncertainty drove concerns around both weaker growth and stronger inflation. Commodities were the top performer over the quarter, boosted by a 19% rise in gold prices.
In bond markets, rising recession risks led to a return of 2.9% from US Treasuries. Conversely in Europe, expectations of much larger issuance to finance new government spending programmes weighed on sovereign bond returns, with German Bunds ending the quarter down 1.6%. Japanese government bonds were the notable underperformer, down 2.4%, as recent data emphasises building inflationary pressures.
Tariff-related headlines buffeted US equity markets throughout the first quarter. Following the imposition of new tariffs on US imports from Mexico, Canada and China in February, March offered little let up. The US administration announced new tariffs on steel, aluminium and autos, while shifting expectations around the severity of pending tariff announcements due on 2 April drove swings in market sentiment. Investors are attentive to any signs that uncertainty is slowing US activity, such as the recent fall in capex intentions evidenced by small business surveys.
Given elevated uncertainty, it’s unsurprising that the Federal Reserve (Fed) decided to take no action on interest rates over the quarter. Fed Chair Jerome Powell did, however, leave the door open to future rate cuts at the bank’s March meeting, suggesting that the Fed was more concerned about the downside risks to growth than the upside risks to inflation. US 10-year Treasury yields ended the quarter at 4.2%, 36 basis points lower relative to the start of January.
The more confrontational approach from the new US administration has had a galvanising impact on European policymakers. European Commission President Ursula von der Leyen announced her proposal for close to €800bn of spending to boost the bloc’s defence capabilities, which comprises both €150bn of new European borrowing, as well as €650bn of additional fiscal space for countries to ramp up defence spending without breaching the EU’s fiscal rules.
Germany’s likely incoming chancellor Friedrich Merz is also loosening the purse strings. Proposals to ease off the debt brake for defence spending, as well as a new €500bn infrastructure spending plan, shocked markets in March. 10-year German Bund yields rose by more than 30 basis points on the day after the announcement, with borrowing costs in other eurozone member states also rising over the quarter. Equity investors were much more welcoming of the improving growth outlook, with Germany’s DAX Index recording its strongest first quarter since 2023.
The European Central Bank (ECB) was similarly positive about the prospect of further fiscal stimulus ahead, with ECB President Christine Lagarde explicitly praising the change in approach at the bank’s March meeting. Eurozone interest rates were cut twice during the quarter, with a further 60 basis points of cuts priced by markets by the end of 2025.
In the UK, investors had to wait until the end of the quarter for the main domestic event. Following a deterioration in the fiscal outlook, UK Chancellor Rachel Reeves was forced to announce new spending cuts to the tune of £8.4 billion to comply with the government’s fiscal rules. UK assets were largely unperturbed by the policy changes, with 10-year Gilt yields ending the quarter just 10 basis points above where they started, and UK equities quietly outperforming many other regions year-to-date.
Asian equity markets have seen high levels of dispersion in the first three months of the year. Chinese stocks outperformed, up 15% year-to-date, thanks to a combination of US tariffs so far proving less punitive than feared, improving sentiment towards Chinese technology companies following DeepSeek’s AI breakthrough in January, and hints of a more supportive policy stance from Beijing. Indian stocks have struggled, down 2.9% year-to-date, while in Japan, a stronger yen driven by narrowing interest rate differentials created headwinds for the equity market.
Despite the threat that tariffs pose to the growth outlook, solid corporate fundamentals have helped to limit spread widening in US credit thus far. While the moves in local government bond markets weighed on European credit returns, European investment grade credit spreads actually came in over the quarter. A weaker US dollar proved supportive of emerging market debt, while a sharp fall in US real yields led inflation-linked bonds to outperform nominals.
The start of 2025 has certainly been a bumpy ride, and at this stage it appears unlikely that the coming quarters will be any less volatile, as markets recalibrate to frequent shifts in government policy. The positive news for investors, however, is that a diversified approach is working well, unlike the extremely concentrated markets that made it more challenging for diversified portfolios to outperform in 2024. This was true in the first quarter for stocks and bonds, with falling yields in the US offsetting equity losses, and the opposite being true in Europe. Within equity markets, diversification is also working at both a regional and sector level, providing investors ample tools to build portfolios that can cut a smoother path through the choppy waters that likely lie ahead.
