Hello, 

This is David Kelly.

I’m Chief Strategist here at J.P. Morgan Asset Management and I head the team that produces the Guide to the Markets.  Welcome to the Economic and Market Update for the second quarter of 2025.

The U.S. economy entered 2025 with solid momentum. However, tariff whiplash, an equity market correction and weakening economic data have sparked fears of a possible recession and resurgent inflation. Businesses have continued to expand payrolls at a healthy, albeit slower, pace, while consumers have pared back spending. Moving forward, what matters most is whether the weakness in consumer and business sentiment persists, intensifies and translates into a further slowdown in spending activity.

Inflation eased slightly in February but has trended higher since last September. This, in conjunction with policy uncertainty, prompted the Federal Reserve to hold rates steady during the first quarter. Interest rate volatility has remained a feature of the bond market and will likely remain elevated until the policy outlook clears. Across equities, a sharp sell-off in the Magnificent 7 stocks has dragged the S&P 500 into correction territory from all-time highs set in February. Elsewhere, structural factors and shifts in fiscal policy have propelled European and Chinese markets ahead of the U.S. despite mounting trade tensions. That said, it remains unclear whether this momentum can be sustained.

Until policy uncertainty turns to policy consistency, risks to both the economy and markets remain. Investors should remember the basics in times like these. Rebalancing can help right-size portfolio exposures away from the most concentrated and vulnerable parts of the market, while investors can use pullbacks to access quality companies trading at valuations that seemed unattainable just months ago. More broadly, exposure to bonds, international markets and alternatives can help investors play defense in portfolios during times of stress.

The Guide to the Markets is built to illustrate economic fundamentals and investment opportunities and risks. However, it is important to do this concisely. There are over 60 pages in the Guide, but that is far too many for any conversation about the markets.

So, what we do here is boil it down to just 12 slides.  In particular, we assess the recent performance of the markets and economy, considering trends in growth, jobs and inflation and how policies proposed by the Trump administration could impact the path forward.  This is followed by comments on monetary policy and finally, a discussion of the global opportunity set across stocks, bonds and alternative assets.

Coming into the new year, the U.S. economy looked strong, although momentum appears to have faded during the first quarter.  To understand why economic activity has been so resilient, why it has slowed and where it is headed, we can analyze its different components.

Page 18 of the Guide offers a closer look at the key drivers behind recent GDP growth. Given that consumption accounts for almost 70% of the U.S. economy, it’s no surprise that the health of the economy is closely tied to that of the consumer. Supported by impressive gains in household wealth and 22 months of positive real wage growth, consumer spending has powered the economy forward, rising 4.2% during the fourth quarter. Business fixed investment slowed after a string of strong prints, likely reflecting the lagged impact of higher rates, while residential fixed investment improved after two straight quarters of declines. The recent decline in mortgage rates and suppressed level of housing starts in 2024 suggests there is some room for revival in the housing market, but a sudden plunge in immigration could impede housing demand and building activity moving forward. Government spending has helped boost growth in recent quarters. That said, budget cutbacks could limit any meaningful support from federal or state and local government spending in the months ahead.

Policy uncertainty is casting a fog on the economic outlook. Recent data have shown a huge spike in imports, likely driven by businesses trying to front-run tariffs. Should imports remain elevated, it is possible that we get a negative print on 1Q25 growth due to a drag from net exports. On top of that, weaker vehicle and retail sales through February point to a sharp slowdown in consumer spending from its booming 4Q pace, while consumer confidence recently fell to multi-year lows. With policy uncertainty weighing on consumer and business sentiment, it is clear the economy has slipped a gear. That said, it is unclear if this slowdown is the start of a moderation back to trend growth, or the beginning of something more sinister.

The unemployment rate has stabilized near 4% for the better part of the last year. At 4.1% in February, it is meaningfully above its cycle low of 3.4% set in April 2023, but it is still lower than it has been almost 90% of the time over the past 50 years. Importantly, we view last year’s rise in the unemployment rate as a normalization of an economy operating above full employment.

As this year progresses, job growth could slow alongside economic activity but should remain positive. Layoffs have remained low, but any meaningful increase could pressure unemployment higher, although slower labor force growth due to more restrictive immigration policies could help offset this. In fact, if economic activity holds steady, unemployment might even drift lower over the course of the year.

Loosening labor market slack has allowed wage growth to moderate. After peaking at 7.0% in March 2022, wage growth has slowed back to trend with wages for private production and non-supervisory workers rising 4.1% year over year in February, just above the 50-year average. While slower immigration could put upward pressure on wages, sustained strong productivity gains should help limit any pass-through to inflation.

S&P 500 earnings grew 10% in 2024, capped off by an impressive 4Q24 earnings season that saw earnings rise roughly 18% year over year and 5% quarter over quarter. Margins were the key driver here, contributing over 13 percentage points to overall growth. Beneath the surface, earnings continued to broaden, with S&P 500 ex-Magnificent 7 earnings rising 15% year over year vs. 31% for the Magnificent 7. In fact, 10 of the 11 S&P sectors contributed positively to earnings growth, led by financials. This trend should continue in 2025.

Analysts are projecting even stronger growth of 11% and 14% in 2025 and 2026, respectively. However, earnings are cyclical, and compared to the long-term average of 7.3%, these estimates seem too rosy, particularly given our expectation for slowing nominal growth. Normalizing GDP growth could limit revenue growth while rising input costs from tariffs could pressure margins despite corporate tax cuts, complicating companies’ efforts to beat expectations.

Against a backdrop of increased uncertainty, markets are already sensitive. Companies that fail to meet expectations may be punished more than usual. In times like these, investors can use active management to play defense in portfolios. This involves limiting exposure to companies burdened by elevated valuations and expectations, while focusing on underappreciated companies that are less susceptible to market sell-offs.

Inflation, while still well below its cycle peak, has accelerated in recent months. Headline CPI came in better than expected in February, rising 2.8% year over year compared to 3% in January. That said, it remains well above last September’s 2.4% print. We still believe that underlying price pressures are easing, but come spring, the effects of tariffs could push inflation higher.

Core goods prices were a steady source of deflation throughout 2024. In recent months, however, prices have moved higher on a sequential basis. New and used vehicles are largely to blame, with prices likely being pressured by increased replacement demand following recent hurricanes and wildfires.  On the more volatile components, energy and food inflation have been running hotter recently, although both eased in February. With tariffs now having been imposed on China, Canada and Mexico – and more likely to come – all these categories could see prices rise meaningfully in the months ahead.

Elsewhere, shelter and auto insurance have remained key contributors to inflation. Shelter accounts for over a third of the CPI basket and, while showing signs of easing recently, has held stubbornly above its pre-pandemic trend. That said, real-time measures of market rent point to more normal levels of shelter inflation ahead. Auto insurance has backed off but still rose 11.8% year over year in February. Fortunately, as last year’s rollover in vehicle prices feeds through the data, this trend lower should continue.

While progress on disinflation has been encouraging, the last leg down to 2% could prove more difficult due to tariffs. In fact, based on what we know about tariffs so far, inflation at or above 3% by the end of the year is not out of the question.

Over time, economic globalization has led to increasingly relaxed trade policies. Indeed, the average tariff rate on U.S. goods imports has steadily fallen since the 1930s. However, geopolitical tensions and supply chain snarls induced by COVID-19 have prompted a re-evaluation of open trade policies. With promises to protect American businesses and address unfair trade practices, tariffs sit at the center of the Trump administration’s policy agenda.

Page 31 of the Guide helps put recently imposed tariffs into context. Tariff headlines are changing every day and tracking them can be difficult. As we are recording this, Trump has signed into effect 25% tariffs on Mexico and Canada excluding energy, 10% on Canadian energy imports, and an additional 10% tariff on China. He has also put into effect 25% tariffs on steel and aluminum, with more targeted tariffs likely to come just days after this video is released. Considering the tariffs that are already in effect, we estimate the current average tariff rate on U.S. imports to be 6.4%, up from 2.3% in 2024 and the highest since the early 70’s. Admittedly, U.S. trade policy remains highly uncertain, and it is unclear what tariffs will be implemented permanently and which will be used primarily as a negotiation tool. Regardless, tariffs have risen and are likely to rise further, under the new administration.

Beyond discouraging imports, tariffs can have negative unintended consequences. Tariffs could lead to higher inflation and trigger retaliation, reducing the demand for U.S. exports.  Overall, aggressive tariffs are adding even more uncertainty to an already foggy economic outlook, complicating the Federal Reserve’s path forward.*

The labor market has normalized from its post-pandemic boom but job growth has settled into a relatively healthy pace. That said, the Trump administration has expressed its intent to meaningfully reduce immigration, which could have meaningful implications for the labor market in 2025 and beyond.

After falling sharply during the pandemic, labor supply in the U.S. staged an impressive recovery, largely due to increased immigration. In fact, of the roughly 10.6 million individuals that joined the labor force from January 2021 to January 2025, 54% of them were born outside the U.S. With this surge in foreign-born workers, employers were able to fill open job openings without applying upward pressure to wages, helping to explain why strong job creation hasn’t sparked higher inflation. However, restrictive immigration policies could hinder labor force growth, especially given weak domestic demographics in the U.S., and potentially lead to higher inflation through higher wages and slower growth. The impacts of these policies can already be seen. Southwest land border encounters plunged to under 12,000 in February, compared to an average of roughly 100,000 per month in the fourth quarter of 2024 and over 250,000 per month in the fourth quarter of 2023.

Separately, a strong recovery in the labor force participation rate has boosted labor supply. While the continued aging of baby boomers into their retirement years has left the overall labor force participation rate below pre-pandemic levels, participation among prime age workers has fully recovered its pandemic losses.

Moving forward, employment growth is likely to slow throughout 2025, but solid corporate profits should keep it from collapsing. However, severely curtailed immigration could provide a stagflationary impulse, potentially weighing on economic growth while exerting upward pressure on inflation.*

Among other expansionary fiscal policies, the Trump administration has expressed its intent to fully extend the Tax Cuts and Jobs Act, or the TCJA, and reduce the corporate tax rate. It has also promised to dramatically cut costs. In determining whether these policy proposals are feasible, and how they could impact the fiscal health of the U.S., page 23 of the Guide should be particularly useful.

The left chart shows CBO estimates for government spending and how that spending will be financed in fiscal 2025. To reach its cost cutting goals, the incoming administration may have to make some difficult decisions. Non-defense discretionary spending accounts for just 12% of the government’s budget, meaning they may have to explore spending cuts on defense or entitlements. Initial efforts by the newly formed Department of Government Efficiency have focused on federal workforce reduction to cut costs. While the extent of federal layoffs is still largely unknown, their cost savings will likely be negligible. We estimate that less than 6% of the budget went toward federal employee compensation in fiscal year 2024.

The administration has also expressed its intent to use tariff revenues to offset the extension of the TCJA. However, tariffs are only a sliver of current government revenues, and that will likely remain the case. Moreover, higher tariffs, by inviting retaliatory tariffs, would slow the economy, reducing revenues from other areas of income taxation.

On the right, we explore the outlook for the deficit and federal debt. With no revenue or spending offsets, the TCJA is likely to amount to significant stimulus and add to deficits. Every year, the federal deficit gets added to overall debt, which we show on the bottom right. According to the CBO, federal debt is expected to climb to nearly 120% of GDP by 2035 excluding the impacts of a TCJA extension, and nearly 130% with them. That is up from 98.2% in fiscal 2024.

Since the TCJA extension and any additional provisions will need to be passed through the once-a-year budget reconciliation process, they are unlikely to go into effect until early 2026. That said, a slowdown in economic activity could prompt additional fiscal stimulus before then. Not only would expansionary fiscal policy boost deficits, but it could also act as a longer-term source of inflationary pressure.

The Federal Reserve finds itself in an unenviable situation heading into the second quarter. After delivering 100 basis points of rate cuts in 2024, the Fed was confronted by slowing economic activity and stalling disinflation progress in early 2025. The Committee certainly has a preference to continue easing policy until it reaches a neutral stance. However, fiscal stimulus in addition to tariff and immigration policies could make this difficult to achieve.

As expected, the Federal Reserve voted to maintain the federal funds rate within in a range of 4.25% to 4.5%. With tariffs top of mind, the updated Summary of Economic Projections reflected expectations for slower growth and higher inflation in the near-term. The 2025 growth forecast was downgraded from 2.1% to 1.7% while headline and core inflation forecasts increased by 20 basis points and 30 basis points, respectively. Further out, inflation forecasts were largely unchanged, suggesting the Fed, at least for now, expects any inflationary impulse from tariffs to be transitory. With increased uncertainty clouding the outlook, the Committee left its dot plot unchanged. The median FOMC member still expects two rate cuts in 2025 and 2026, and one for 2027. Turning to the balance sheet, the Committee announced it would slow the pace of quantitative tightening. The monthly Treasury redemption cap was lowered from $25bn to $5bn while the mortgage-backed security cap was left unchanged at $35bn. These adjustments support the Fed’s efforts to get back to an all-Treasury balance sheet.

Today, markets are pricing in just under three full rate cuts in 2025, but this likely reflects an average of two scenarios being weighed by investors. Should inflation remain elevated and the economy resilient, the Committee could deliver just one to two cuts this year. On the other hand, a more serious growth downturn could prompt more aggressive rate cuts. All this said, the ultimate impacts of government policy are still unknown, and the pace of rate cuts will continue to hinge on the incoming economic data.

After an impressive rally in 2024, fears of an economic slowdown forced investment grade and high yield credit spreads modestly wider during the first quarter. Even still, both sectors are up over 1% so far this year, and spreads continue to look tight relative to history. This tells us the corporate credit market is not overly concerned about a looming recession.

On slide 37 of the Guide, we show corporate credit spreads over time, and compare current spreads and yields to their long-term averages. Despite the recent spread widening, valuations in both sectors still look expensive. That said, we think investors should embrace credit for the attractive all-in yields. Spreads could widen further from here as economic momentum fades. However, corporate credit is better prepared to weather a slowdown today compared to previous cycles. Indeed, the credit quality of the high yield market has improved since the Great Financial Crisis.

With the outlook for monetary policy, government policy and the economy still largely uncertain, it’s difficult to make any outsized bets on duration right now. For those searching for enhanced yield and higher returns, corporate credit offers an attractive opportunity. That said, not all bonds are created equal, and an active approach to fixed income investing will be key to finding attractive relative value opportunities while limiting exposure to companies that could be adversely impacted by a slowdown.

Despite the strong earnings outlook, elevated uncertainty at elevated valuations is a significant risk for U.S. equities. The concentrated rally of the past two years has left the market with plenty of room for a correction. Indeed, the S&P 500 has had a rocky start to 2025 with a 10% drawdown in the first quarter from February highs. Even with this sell off, the next-twelve-month price-to-earnings ratio is over one standard deviation above its long-term average. Other valuation metrics, like price-to-book and price-to-cash flow, are similarly elevated.

The Magnificent 7 are responsible for a large portion of this distortion and the recent downturn. These companies are profitable, but they are also the overvalued, over owned and an overly large portion of the S&P 500. While many of them could certainly benefit from AI, technological change is unpredictable and disruptive. The new administration is another significant source of uncertainty. Proposals for tariffs, taxes and deregulation have yet to crystalize into policies, and the opposing effects on profit margins are difficult to untangle.

AI and policy are driving U.S. equity markets, and the destination isn’t clear. As such, investors should ensure their portfolios aren’t over exposed to the most overvalued parts of the market, and instead consider formerly “unloved” parts of the market to reduce the impact that a broader downturn could have on portfolios.

Global equity market dynamics shifted meaningfully during the first quarter with international stocks surging ahead of U.S. stocks by the widest margin since the 1990s. Weak expectations for international markets led to depressed valuations, setting the stage for this rebound and reminding investors that valuations still matter. With the U.S.’s share in global market cap still near record highs, this reminder is as important now as ever.

While many international economies continue to face cyclical challenges, sector trends are driving powerful returns. European and Japanese banks have awakened from their long slumber, and on the back of higher interest rates and fee income, are among the performing industries. Meanwhile, European defense and aerospace stocks have jumped higher on the back of an 800-billion-euro defense spending package announced by the EU. China is still stuck in a cyclical bog, but its tech sector has seen strong returns due to better earnings and enthusiasm for AI innovation. Lastly, sectors that benefit from the growth of the EM middle class, like Indian consumer discretionary names and European luxury goods, continue to appeal to investors.

As seen on the left side of page 44, the dollar’s recent decline has boosted U.S. dollar returns for a range of markets. Just as U.S. equities were overvalued, so was the dollar. Investors should always be aware of how currency fluctuations can impact their international equity holdings.

Although investors have benefited from overweighting the U.S. in recent history, the tide can always change. In times of increased uncertainty, investors can play defense by diversifying their equity exposure across global markets. Plus, an active investment strategy can help sidestep risky or lower-quality companies, unlocking the potential for higher returns.

As stocks sold off in early 2025, bonds rallied and helped soften the blow to portfolios. That said, with inflation uncertainty still elevated, stocks and bonds remain positively correlated over longer time horizons. Moreover, elevated equity valuations, even after the recent sell-off, and mediocre levels of income point to less impressive returns from the 60/40 moving forward. Against this backdrop, investors may have to look elsewhere for consistent outcomes across alpha, income and diversification. Investors willing to venture outside of the public markets can leverage a range of different alternative assets to reach their desired outcomes. Indeed, as we show on slide 56 of the Guide, alternative assets can offer low correlations to public markets, diversified income streams and enhanced long-run returns.

Real assets shown towards the left, such as real estate, infrastructure and transport, tend to be less correlated to a traditional 60/40 portfolio while providing robust income. Private equity and venture capital, towards the right, could provide much higher total returns but come with higher correlations to public markets and less income generation.

The classic 60/40 stock-bond portfolio still looks attractive, but adding a sleeve of alternatives can help long-term investors achieve strategic goals through higher alpha, better diversification and enhanced income.

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