While the start of 2025 brought plenty of unknowns, it was also marked by optimism in markets: continued AI breakthroughs, pro-business policies from a new administration and enormous economic momentum were expected to drive another year of U.S. outperformance, both for markets and the economy. What materialized in the first quarter wasn’t quite as rosy: tariff uncertainty, not deregulation or tax cuts, were Washington’s focus, which soured sentiment and drove concerns of slower growth, higher inflation and mounting tail risks. As a result, investors scrambled for safety, sending U.S. stocks lower, international stocks higher and driving a rally in Treasuries.

What drove these market moves? To understand them, it is important to unpack the dynamics that defined the first quarter of 2025.

• Trade policy drove headlines: The President's fast-evolving stance on tariffs, which was marked by delays, exemptions and changing targets, drove the U.S. Trade Policy Uncertainty Index to record highs. This uncertainty weighed on survey data, including ticks lower in PMIs and reversals in both business and consumer confidence indicators. Deteriorating confidence in turn fed recession concerns, as businesses or consumers unsure of future conditions may tighten purse strings. In addition, the tariffs themselves may have a negative impact on realized U.S. economic conditions, including softer growth and higher inflation.
  
• Rates wobbled, the Fed stayed put and bonds protected: Benchmark rates like the 10-year U.S. Treasury oscillated wildly over the quarter and ultimately settled lower, as markets struggled to digest how policy uncertainty - and policy itself - might affect the U.S. economy. The Federal Reserve, however, notably stayed the course, opting to hold interest rates steady at both of its meetings. Still, the 1Q Summary of Economic Projections (SEP) showed the Fed, too, is concerned: growth expectations were revised lower, while inflation and unemployment expectations shifted higher. Against this backdrop the Bloomberg U.S. Aggregate returned 2.8%, modestly better than the High Yield index as credit spreads widened.
  
• U.S. stocks sank and foreign stocks surged: U.S. equities entered the year priced for perfection—trading roughly 1.5 standard deviations above their long-term average. Yet despite a strong earnings season, changing rate expectations and prolonged tariff uncertainty pushed the S&P 500 down 4.3% on a total return basis, marking its worst quarter since 3Q 2022. The Magnificent 7, which drove much of the market’s gains over the past two years, led the declines by falling nearly 15%; value stocks outperformed growth; and large caps held up better than small caps. Meanwhile, international markets surged, outperforming their American counterparts by roughly 10 %pts, the strongest quarterly outperformance in over 15 years. China jumped on AI breakthroughs, Europe gained on broad fiscal tailwinds, including an unprecedented defense spending plan and the U.S. dollar posted its worst start in nearly a decade.
• Commodities, not crypto, continued to climb: Among major asset classes, commodities topped the charts. Copper and gold both touched all-time price highs: copper, as businesses and traders rushed to front-run tariffs expected later this year, pushing prices up 24%; and gold, as central banks, particularly in emerging markets, accelerated purchases to hedge against geopolitical uncertainty, pushing prices up 19%. Bitcoin, however, often touted as a hedge, failed to deliver, dropping 12% after an impressive rally through last year.

Looking ahead, policy turbulence is unlikely to fade and rate volatility is likely to persist. With U.S. equities still accounting for nearly two-thirds of global markets, concentration risk remains a pressing concern. Investors may need to rethink their allocations and explore opportunities beyond familiar shores to navigate the fog ahead.

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