Tariffs and Inflation: The New Economic Balancing Act

Tariff uncertainty continues to buffet the U.S. economy and markets. While concerns about potential levies had been simmering since the beginning of the year, those worries shifted into high gear on April 2, when the administration announced plans to implement reciprocal tariffs on virtually all U.S. trading partners. The announced tariff rates varied by country, but the overall impact, when taken with some previously announced tariffs, was estimated to bring average levies up to the mid- to upper 20-percent level, up from just 2.5 percent in 2024. The newly announced rates were much larger than expected and resulted in an acceleration of selling pressure that had begun shortly after the S&P 500 reached a new all-time high on February 19, 2025. The market downturn resulted in a nearly 20 percent drawdown by April 8. This is when the much discussed “Trump Put” arrived—when the president, in response to what he termed investors getting “a little bit yippy, a little bit afraid,” announced a 90-day pause on the implementation of reciprocal tariffs. A report from the Wall Street Journal at the time noted that the president was aware his policies could tip the economy into recession but wanted to avoid the potential for a depression. The pause was driven by not just the sell-off in stocks but also steeply rising bond yields, as investors feared a toxic combination of potentially rising inflation and stalling economic growth.

The pause marked the beginning of a pull-back in trade tensions that culminated with the announcement of a framework for a trade agreement between the U.S. and the United Kingdom on May 8 followed by a de-escalation in U.S.-China trade tensions on May 14. The cooling of trade tensions with China tariffs resulted in a 90-day pause during which levies on goods from China were reduced from 145 percent to 30 percent, while taxes imposed on goods from the U.S. went from 125 percent back to 10 percent. These moves helped propel the S&P 500 back to a near all-time high of 5,963 on May 19, only to be temporarily interrupted once again by the president announcing the potential for 50 percent tariffs on the eurozone on May 23. Like many of the other tariffs, the 50 percent levies on Eurozone products were subsequently put on hold, this time until July 9, while the two sides agreed to fast-track negotiations.

While many investors hoped that the steps taken by the administration would mark a turning of the page from maximum trade uncertainty, a ruling by the Court of International Trade dashed those hopes. Under the ruling, the tariffs announced under the guise of the International Emergency Economic Powers Act (IEEPA) were found by the Court to be illegal and as such must “be vacated and their operation permanently enjoined.”

The tariffs imposed under IEEPA included:

• The “universal” 10 percent tariff on all countries;
• The 25 percent tariff on non-USMCA-compliant goods from Mexico and Canada;
• The 30 percent China tariffs (negotiated down from 145 percent); and
• The prospective July 9 “reciprocal” tariffs, which haven’t been imposed but are being negotiated.

The ruling does not apply to:

• The 10 percent tariffs that President Trump imposed on China during his first administration;
• The 25 percent tariffs on autos and auto parts;
• The 25 percent tariffs on steel and aluminum; or
• Potential tariffs on semiconductors, pharmaceuticals, copper, lumber and ships.

The administration quickly appealed the ruling and won a temporary pause of the Court’s decision. As a result, all existing tariffs remain in place for now, including most importantly the 10 percent universal tariff. The administration has signaled that if it loses the appeal, it will appeal the case to the Supreme Court. Regardless of the ultimate decision, we believe the president and his advisors will likely use other sections of trade law to continue pursuing their goal of restructuring and rebalancing how the U.S. operates in global trade and defense while also creating revenue to help the offset the ever-expanding U.S. fiscal deficit. Since this ruling, the administration has once again ratcheted up trade tensions with China while announcing a doubling of steel and aluminum tariffs to 50 percent from 25 percent.

Interestingly, we note that the administration’s other large priority, passing its “One Big Beautiful Bill” spending bill that is currently making its way through Congress, contains tariff-like taxes within it. Section 899, which is titled “Enforcement of Remedies Against Unfair Foreign Taxes,” proposes increasing tax rates for individuals and companies from countries whose tax policies the U.S. deems “discriminatory”—mainly countries such as Canada, the United Kingdom, France and Australia that impose “digital services taxes” on large U.S. technology companies. The clause also targets countries that are part of a multi-country agreement to charge a minimum corporate tax. This includes raising tax rates on foreign investors in U.S. income. While there is clarity needed on which assets would fall into the category (for example Treasurys are believed to be exempt), approval of this section could cast a wide net given that foreign investors currently own more than $31 trillion of U.S. long-term securities, comprising roughly $9 trillion of U.S Treasurys/Agencies, $4.7 trillion in U.S. corporate debt and $17.5 trillion of U.S. equities. Should the policy go into effect, foreign investors may reconsider how much they are willing to pay for these assets, as the taxes would reduce gains for investors.

While many question the implementation plan of tariffs and whether the policies will work or if they might have negative consequences, such as raising U.S. interest rates or pulling back U.S. equity valuations given less foreign demand, the administration is clearly committed to the idea of tariffs. This is evident not just in the often passionate and direct words of President Trump but also in recent speeches by Treasury Secretary Scott Bessent and Council of Economic Advisors (CEA) Chair Stephan Miran. The trade deficit has likely produced some benefits for the U.S. For example, foreign investors and countries have recycled trade surplus dollars back into U.S. investments, which has likely led to lower interest rates and higher stock prices. However, the administration believes that the trade imbalance has increased U.S. costs and has led to larger U.S fiscal deficits and risked U.S. national and economic security while hollowing out the U.S. manufacturing sector, which has harmed average, everyday Americans.

CEA Chair Miran highlighted this view in his speech at a Hudson Institute Event in early April.

“First, the United States provides a security umbrella, which has created the greatest era of peace mankind has ever known. Second, the U.S. provides the dollar and Treasury securities, reserve assets [that] make possible the global trading and financial system [that] has supported the greatest era of prosperity mankind has ever known. Both of these are costly [for] us to provide.

“In my view, to continue providing these twin global public goods, there needs to be improved burden-sharing at the global level. If other nations want to benefit from the U.S. geopolitical and financial umbrella, then they need to pull their weight and pay their fair share. The costs cannot be solely borne by everyday Americans who have already given so much.

“The best outcome is one in which America continues to create global peace and prosperity and remains the reserve provider, and other countries not only participate in reaping the benefits, but they also participate in bearing the costs. By improving burden-sharing, we can enhance resilience and preserve the global security and trading systems for many decades into the future.”

During the speech he went on to suggest that countries could help cover the costs of the services the U.S. provides by accepting tariffs on exports to the U.S. without retaliation, stopping trading practices the U.S. deems harmful or unfair, boosting defense spending and purchasing arms from the U.S., building factories in the U.S., and writing checks directly to the U.S. Treasury.

While the trade imbalance draws the most attention in discussions, it is important to recognize that tariffs are also important relating to the administration’s efforts on taxes.

This viewpoint was backed up by Treasury Secretary Scott Bessent on several occasions during the past few months, most demonstrably at a speech in Washington to the Institute of International Finance in which he laid out a goal of restoring balance to the global financial system. Like Miran, Bessent noted that the U.S. has run persistent deficits because of what he described as an “unfair trading system.” Policy decisions by other countries, Bessent said, "have hollowed out America’s manufacturing sector and undermined our critical supply chains, putting our national and economic security at risk.” Bessent’s prescription for imbalances around the globe included a call for China to scale back its manufacturing for the export market and instead focus on meeting the needs of its citizens.

While the trade imbalance draws the most attention in discussions, it is important to recognize that tariffs are also important relating to the administration’s efforts on taxes. According to an analysis by the non-partisan Congressional Budget Office (CBO), the Republican spending bill recently passed by the House and under consideration by the Senate would add $2.4 trillion to the Federal deficit over 10 years, with much of the added estimated costs coming during the early years of the bill. Although details of the tariffs are still not settled, a CBO analysis of the levies as they stood between January 6 and May 13 estimated that the import taxes would reduce the debt by $2.5 trillion over 10 years. To be sure, these are estimates and do not reflect all possible economic or inflationary impacts of either the budget or tariffs.

We highlight these not as a judgement on the approach but rather to show the administration’s strongly held beliefs that the current system is unfair to average Americans and has contributed to record debt levels and needs to change. Therefore, we believe the administration will press forward with its effort to restructure and rebalance the current global macroeconomic backdrop. We believe this will have an impact on markets and asset class performance in the intermediate term as the macro-economic backdrop shifts from what has been the trend of low interest rates, low inflation and stimulative monetary policy since the era of Global Financial Crisis of 2007-2009. That trend made risk-taking appealing to investors and led to strong returns in the stock market. The question now with the pivot in policy is whether it will cause an economic hiccup in the near term.

While the president did blink and pull back on some of the announced tariffs as markets declined sharply in April, we think it’s important to recognize that he was willing to push for a dramatic increase in levies even as he recognized they could spark a recession. Much as was the case during his first term, we expect the president will make many attempts to push the agenda while markets are higher and de-escalate economic tensions when markets weaken. This approach carries the same risks we identified during Trump’s first term—will the president misjudge how far he can push change and inadvertently cross the point of no return as recession fears rise? What is different this time, in our view, is the overriding belief of the administration that tariffs and a reordering of global trade is needed so that workers can benefit from the unique position of the U.S. in the world. This sentiment was spelled out by Treasury Secretary Bessent as he talked about the administration's “guiding ethos.”

“For the last four decades, Wall Street has grown wealthier than ever before. And it can continue to grow and do well. But for the next four years, it’s Main Street’s turn to share in the prosperity” that markets have enjoyed since 1980.

Once again, we note this not as a judgment but to show the depth of the administration’s resolve and that it may be less swayed by market fluctuations than many believe. As a result, the president is likely to push harder to enact tariffs than he did during his first administration.

Nearer-term impact

After a post-election spike of optimism for a few months, most survey-based (or so-called “soft”) data has deteriorated sharply. The decline reflects concerns by consumers and business leaders that tariffs could lead to higher prices and slower economic and job growth. This has raised the question of whether the weakness captured in the soft data will begin showing up in hard economic data like inflation readings, labor market reports or shrinking U.S. gross domestic product (GDP).

The hard data that has been released has created mixed messaging and has likely been distorted by consumers, business and importers pulling forward demand toward the end of last year and during the first quarter of this year to get ahead of potential tariffs. Logically, this stocking up before potential tariffs is likely to create a pause in demand as we move through the early summer months. We believe this dynamic caused reported first-quarter U.S. GDP to shrink by 0.2 percent. Imports surged 42.6 percent as companies tried to get ahead of tariffs. The sharp rise in goods from abroad shaved a record 5 percent off overall GDP. Conversely, businesses pulled forward investment spending, which resulted in a 24.4 percent quarter-over-quarter surge in the seasonally adjusted annualized rate, leading to a 3.98 percent contribution to GDP.

Recently released data shows that the trend has since reversed, with the trade deficit for April narrowing as imports fell a record 19.8 percent in April (driven by a 21.6 percent drop in automative imports), while exports rose slightly. Similarly, business fixed investment viewed through the lens of non-defense core capital goods orders excluding aircraft fell by 1.3 percent in April. Simply put, the yo-yo-like impact of tariffs is currently clouding an accurate reading on the actual underlying trend of the U.S. economy. There has been one area, however, that has seen a consistent trend the past few months—a softening in consumer spending. During the first quarter, spending rose a modest 1.2 percent, down from a strong reading of 4 percent in the fourth quarter of 2024. The pace of spending in the latest quarter marks the weakest total since the second quarter of 2023, when a series of bank failures triggered concerns about the overall health of the economy. April data shows that this trend continued into the second quarter as Personal Consumption Expenditures (PCE) spending was up a modest 0.2 percent nominal (meaning not adjusted for inflation) and just 0.1 percent when factoring in inflation. At the same time, the consumer savings rate increased to 4.9 percent from a low of 3.5 percent to end 2024. This suggests consumers are hunkering down in the face of increasing uncertainty. Indeed, the latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, shows that consumer spending was mixed, with most of the Fed’s 12 districts reporting slight declines or no change in consumer spending. Meanwhile, inflation slowed in February through May after two stronger readings in December and January. While it’s too early to tell for certain, the fluctuations in the pace of inflation could be the result of slowing demand after the surge in activity to get ahead of tariffs.

The reality is that investors and the Federal Reserve are awaiting more hard data to decipher the ultimate impact of tariffs on the U.S. economy. In the meantime, it is becoming clear that tariffs are making their mark. For the month of April, the U.S. collected $16 billion in tariffs and in May $23 billion; both figures are up from an average of $6 billion for the month over the past few years. The question remains: Who is paying the levies? The reality is it will likely be a combination of foreign exporters, U.S. consumers and corporations.

Recent comments by business leaders suggest that some of the burden of tariffs is likely to fall on both U.S. corporations and consumers. It was reported that Amazon was considering displaying import charges on items sold on their website, which they ultimately backed away from after pressure from the Trump administration. During Walmart’s earnings call, management discussed raising prices, which President Trump responded to on Truth Social by saying the company should “eat the tariffs” and not pass along the costs to consumer. Later, the president noted he has a “little problem” with Apple CEO Tim Cook, who was planning to move iPhone production from China to India to lower the impact of tariffs. Trump told Cook that Apple should produce iPhones for U.S. consumers in the U.S.

Once again, our purpose in highlighting these developments is to illustrate that tariffs are likely to result in some financial burden for U.S. consumers through higher prices and/or for U.S. corporations that will likely see their margins shrink if they do not pass along higher costs tied to tariffs to consumers. The question going forward: How much of the cost of tariffs can consumers or corporations absorb before it makes an impact on the economy? Much as in the past few years, the answer is complex and bifurcated with a good news/bad news scenario.

Regarding consumers, the good news is that as a whole U.S. consumers continue to be in good shape. However, the bad news is that there are significant differences under the surface of the overall picture. Specifically, consumers at the lower- to middle-income levels remain under pressure due to interest rates on credit card, auto and student loan debt. The recently released Survey of Consumer Household Debt and Credit for the first quarter of 2025 from the New York Federal Reserve Bank showed that the overall percentage of outstanding consumer debt in delinquency continued to rise during the period, to 4.3 percent from 3.6 percent in the fourth quarter of 2024. Importantly, delinquencies are nearing levels last seen in 2007, before the last consumer-led recession. Interestingly, the percentage of balances that are severely delinquent on auto, credit card and student loans is well above 2007 levels. The overall number of delinquent loans is being held down by mortgage delinquencies, which are only beginning to rise given the sheer number of fixed-rate mortgages that are locked in at relatively low rates. The silver lining is that the number of loans that have just recently become delinquent or those that are heading toward being considered delinquent has steadied. However, this could change should the labor market weaken or prices rise due to tariffs.

Similarly, there is good and bad news as it relates to corporate margins. The good news is that overall corporate margins are healthy and likely provide room for companies to absorb some additional costs. However, this is 1) a company-by-company exercise and 2) further clouded given that investors are currently paying record price multiples on earnings that have been driven by elevated profit margins.

It’s worth noting that despite relatively strong earnings reports during the first quarter of the year, U.S. corporate profits, as measured in the most recent GDP report from the Bureau of Economic Analysis, declined at the steepest rate since the first quarter of 2020. To be sure, profits were still healthy overall, but they fell by 2.9 percent after rising by 5.4 percent in the fourth quarter of 2024. Margins contracted a bit, which is likely the result of companies absorbing cost increases as consumers become more conservative about spending.

The bottom line remains: While there are many possible outcomes that are positive, we continue to believe caution is warranted given the speed of change that is taking place as well as the fact that uncertainty remains elevated and may cause consumers and corporations to pause spending. The narrative during the recent rally driven by individual investors (as opposed to institutional buyers) was that we had likely reached maximum trade uncertainty and yet hadn’t yet seen a negative impact in hard data. This was interpreted by many as an all-clear for buying into the market.

As we hope our analysis shows, we don’t believe the economy has felt the full impact of the administration’s new approach. Perhaps we have seen maximum tariff uncertainty, although we wouldn’t be surprised by further escalation in trade disputes. Interestingly, according to Bloomberg, the word uncertainty was used about 3,100 times in earnings calls during Q1, which is the most in any quarter going back nearly two decades, topping both COVID and the Great Financial Crisis. Simply put, we believe the administration is going to continue to push for change and that the proposed tariffs are more than just a negotiation tactic; they are intended to collect revenue. Most importantly, even if we have hit max tariff policy uncertainty, the economy has yet to experience the full impact of the levies.

How to invest for intermediate- to longer-term macroeconomic trend changes

Economic forecasting is inherently difficult. Given the seemingly daily changes in trade policy, the challenge in the current environment is even greater. We believe the administration will continue to push for broader change, which leaves the question of whether this shifting backdrop will cause near-term economic and market hiccups. While the answer may not be known for months or even quarters, this is not a call to take dramatic action but rather one that acknowledges that the antidote for uncertainty is not selling and running to cash but rather focusing on diversification and adherence to a financial plan that acknowledges the ups and down of the economy and markets.

The tailwinds of low inflation and low U.S. interest rates that have led to persistently expansionary U.S. fiscal and monetary policy are likely waning.

In the intermediate to longer term, we continue to believe that the macroeconomic backdrop that has driven markets and market leadership since the end of the Great Financial Crisis will continue to shift. The tailwinds of low inflation and low U.S. interest rates that have led to persistently expansionary U.S. fiscal and monetary policy are likely waning. Interest rates are higher today and likely to stay elevated. Inflation has been above the Federal Reserve’s 2 percent target for nearly five years. All this has occurred while U.S debt levels have risen dramatically, and current government deficits compared to GDP remain elevated by nearly 7 percent. If the current proposed spending bill passes as scored by the CBO, we expect that the deficit to GDP level will s become further elevated in the coming years and will need to eventually be dealt with by Washington given that interest payments relative to GDP are projected to exceed 4 percent and push toward 5 percent in the next decade

Indeed, these changes have been simmering in the background for the past couple years, but the shift has been put on hold by the boom in artificial intelligence, which we believe has not only kept the U.S. from slipping into a recession but also supported equity markets as the stocks connected to the boom have driven markets higher. This, as we described in our March Asset Allocation Focus and the most recent Quarterly Market Commentary, has led to the highly bifurcated economy and markets.

We continue to focus on valuation given the stark differences among various asset classes. Historically, over longer periods, it has proven to provide value. For example, we note in data going back to 1995 that U.S. Large Cap stocks are trading at near-record valuation premiums compared to U.S. Small Caps, with the only period higher being the second quarter of 2000, which ushered in a period of Small Cap outperformance over the coming years. We also note that U.S. Small Caps may benefit more from the administration’s next focus, which is likely cutting regulations.

At a minimum, we believe that the U.S. market will broaden from being driven by just a few stocks to one where more equities continue to provide performance. Encouragingly, in 2025, we have seen the equal-weight S&P 500 perform similarly to the market cap weighted index and outperform the Magnificent Seven. This makes sense because, as we have shown in prior commentaries, markets often narrow late in an economic cycle, when the economy has also narrowed, only to see a broadening in the coming years.

Once again, we note that a likely positive side-effect of the administration’s push has been that other areas, such as Europe, now realize they must increase spending on defense and focus on expanding their domestic economies. And as we have noted in this document (and our most recent Quarterly Market Commentary) it is likely that this reality, coupled with the potential for a smaller U.S. trade deficit, points to a potential repatriation of foreign investor capital to their domestic economies and markets. We also come back to our belief that the U.S. administration desires a lower valuation for the dollar. To be clear, we don’t believe the dollar will cede its role as the global reserve currency. Indeed, from 2000 through 2010 the dollar lost 41 percent of its value yet kept its reserve status. However, if the dollar weakens, it likely would help shrink the trade deficit, as U.S.-produced goods would be more competitive globally. Most important, we note that, at least in data going back to 1979, the dollar tends to trade in longer cycles, and when in an up cycle, U.S. asset classes have outperformed. Conversely, international markets outperform when the dollar falters.

The bottom line

The economic and market backdrops are always uncertain, but the ever-changing political background creates added uncertainty for business and market participants to contemplate. We continue to believe the way you deal with uncertainty is through the lens of diversification and long-term focus driven by the outcome of a financial plan. Given near-term uncertainties—coupled with the markets, current levels of concentrated returns, and positioning—we continue to focus on valuation and risk management.

Given the myriad risks that remain coupled with a later cycle economy, we continue to tilt slightly overweight higher-quality fixed income, which has been funded with an underweight to commodities and a slight underweight to equity, all through real estate equities. Within traditional equities, we retain our overweight to the cheaper segments of equity markets, Small and Mid-Cap stocks. We are slightly underweight U.S. Large Cap stocks, and in April 2024 we repositioned some of our exposure from the market cap-weighted S&P 500 to an equal-weight version to amplify our broadening out theme. We remain neutral but incrementally positive toward International Developed Markets while maintaining an underweight to Emerging Markets given our economic concerns surrounding China.

U.S. Large Cap

Volatility returned to equity markets in the second quarter, highlighted by an 18.9 percent drawdown from the February 19 peak in the S&P 500. The sell-off was sharp and short lived, as the market bottomed just a few weeks later on April 8 and recouped losses in the following weeks. Unlike prior corrections, the main downside driver was not sharply higher interest rates or unemployment; instead, it was policy uncertainty surrounding U.S. trade relations. U.S. policy uncertainty has moved more than five times higher as trade negotiations and sharply higher tariff rates caused investors to become increasingly concerned about how the so-called “reciprocal” tariffs announced on April 2 would impact near-term inflation and growth dynamics.

As policy shifted away from the severe tariff scenario unveiled on April 2, U.S. Large Caps have retraced their April losses as concerns over a potential policy-induced recession have generally eased. To put the most recent correction in context, there have been 28 corrections of 10 percent or more since 1960, with the average non-recessionary correction registering an average 16.4 percent drawdown. Corrections that deteriorate into outright bear markets (down 20 percent or more) are typically driven by sharply higher unemployment rates. So far, elevated trade/tariff uncertainty has not yet pushed the unemployment rate higher, which keeps the most recent correction planted in a normal correction classification versus the more severe bear market scenario.

Looking ahead, the incoming data surrounding the labor market, as well as trade-related headlines from Washington, will likely continue to be market-moving events as investors continually reassess the ultimate economic outcome from a global average tariff rate that has effectively moved from 2.5 percent on imports to more than 14percent. The stock market suggests investors are expecting a mild slowdown but, importantly, a slowdown that avoids a contraction. Given the elevated valuations in U.S. Large Caps against the residual policy risks, we continue to hold a slightly underweight position.

U.S. Mid Cap

After a few months of fundamental progress as measured by positive earnings revision trends in U.S. Mid Cap and Small Cap stocks, the shock of April’s trade policy announcements reversed this trend with forward 12-month earnings revisions now falling 4.5 percent, as investors have reduced earnings expectations on the heels of more hawkish trade policy. While this reversal is not unique to U.S. Mid Caps, it has been sharper relative to U.S. Large Caps and International Developed equities given that they are historically more economically sensitive.

While time will tell if this negative earnings revision setback is temporary or the start of a prolonged downturn cycle, we continue to keep our time horizon appropriately gauged to the intermediate term. This is where shorter-term earnings revisions have less of an impact on returns relative to the heightened influence of starting valuation. Despite recently lowered earnings expectations, U.S. Mid Caps trade at more than a 25 percent discount compared to U.S. Large Caps.

We believe that investors expect the recent stronger earnings growth trends in U.S. Large Caps relative to U.S. Mid Caps to continue indefinitely. This is despite history suggesting that there will eventually be a reversion to the mean. Consider the following statistics. Over the last 30 years, using a rolling three-year timeframe, forward 12-month earnings have risen at a faster pace for U.S. Mid Caps relative to U.S. Large Caps 82 percent of the time by a cumulative average of 11.6 percent. Using a five-year rolling time period, that hit rate rises to 86.7 percent, with the cumulative average earnings growth moving up to 20.8 percent. Over the entire period, earnings have risen for U.S. Mid Caps by 9.3 percent per year versus 7.2 percent for Large Caps. We expect the stronger observed historical growth of U.S. Mid Caps will eventually reassert itself as the economy broadens out from the narrow segments of strength we currently see today. We continue to overweight U.S. Mid Caps.

U.S. Small Cap

Despite the elevated volatility of the macroeconomic backdrop, we continue to hold a positive long-term view of U.S. Small Caps. Our take is centered on an attractive combination of relative valuation and a lowered expected earnings bar for the asset class to clear in the near to intermediate term. Over the longer term, we expect a broadening of the economy to occur, which typically has an outsized impact on earnings of small caps. As we’ve previously written, we think that the broadening can occur as the Fed lowers interest rates in response to either softening inflationary pressures or a softening economy. We’ve seen sharp performance leadership in U.S. Small Caps over recent quarters, when investors begin to aggressively price in additional rate cuts from the Federal Reserve, and underperformance when investors believe the Fed won’t act until later than previously forecast. We view patience as the best investor attribute to successfully invest in any asset class, particularly in U.S Small Caps given their cyclical nature.

In the last edition of the Asset Allocation Focus we wrote optimistically, “On the back of four quarter-percent rate cuts from the Federal Reserve accompanied with a global easing cycle, improvement in small business confidence, recovering U.S. Purchasing Manager’s Indices, and a solid consumer spending backdrop, there has been a broadening out of earnings growth expectations in recent months.” Unfortunately, today’s environment has shifted as the uncertainty surrounding U.S. trade policy has weighed on consumer and business confidence, which is likely to put pressure on the recovery story that was playing out in the U.S. data. While policy uncertainty is likely to remain elevated in the near term, we expect this uncertainty to clear in the coming months and potentially be replaced with building optimism regarding deregulation and tax reform that should benefit domestically orientated companies like U.S. Small Caps. We retain our slight overweight to U.S. Small Caps.

International Developed Markets

The eurozone’s core inflation for May pulled back to 2.3 percent year over year, which is the lowest level since January 2022. With services inflation falling to 3.2 percent and wage growth remaining contained, the European Central Bank (ECB) cut interest rates at their June meeting, with the market pricing in another cut in the back half of 2025. This additional easing will potentially help steady the eurozone against the potential for increased U.S. tariffs, with discussions currently being fast-tracked with a deadline of July 9. Additionally, increased spending to build up defense and to stimulate economic growth is likely in the coming years. This is particularly likely in places like Germany, which has suffered from weak economic growth over the prior years and has the fiscal space to do so.

Japan’s inflation remains well above the Bank of Japan’s 2 percent target, which has been the goal during the past few years. This has provided a backdrop that has shifted wage dynamics in Japan from one in which lackluster to negative real wage growth weighed on the economy and provided a fertile ground for deflation to one in which real wage growth has been positive, which has supported underlying higher inflation and appears to have created the conditions to end Japan’s decades-long deflationary spiral. As a result, monetary policy appears to be on a path toward further gradual tightening. Indeed, Governor Kazuo Ueda recently hinted that the Bank of Japan is likely to continue to slow the pace of government bond purchases in the new fiscal year while balancing predictability and flexibility. Importantly, Governor Ueda emphasized his belief that the wage-driven inflation cycle in Japan is likely to persist even if U.S. tariffs weigh on the economy. This is important given that recent Japanese bond auctions have been met with weakening demand amid higher debt levels, which has pushed longer-term interest rates to record levels.

Nearer term, we remain cautious in our outlook for both regions amid global uncertainties that are likely to weigh on growth. Central banks in both regions will continue to navigate a tight balance between inflation and economic recovery. However, we believe these markets have attractive relative valuations and are set to possibly benefit from renewed investor interest and potentially repatriation of investment dollars from the U.S. toward their domestic economies and markets. Importantly, we note our earlier comments on the U.S. administration’s likely goal of weakening the U.S. dollar, which from a purchasing power parity perspective is expensive relative to the euro and the yen. We note that historically when foreign currencies have appreciated relative to the dollar, international stocks have outperformed U.S. equities, especially in dollar terms.

While we maintain a relatively positive longer-term outlook toward these markets, given our overall desire to maintain a somewhat cautious outlook, coupled with the tariff uncertainty, our positioning remains neutral relative to our benchmark.

Emerging Markets

Emerging Market stocks have fared well in 2025 thanks to renewed interest in Chinese equities. The renewed interest stems from the January launch of the AI DeepSeek model, a de-escalation of the U.S.-China trade war and stimulus enacted by the Chinese government to counter the potential impact of already enacted tariffs. While DeepSeek’s future is uncertain, this introduction of the less costly AI model has likely served as a catalyst to increase investor attraction to Chinese stocks. While in early May the U.S. and China announced a truce in the trade war, rolling back the bulk of April’s tariff escalations for 90 days. Importantly this deal was recently agreed upon to begin being implemented at an early June meeting, however the tariffs duties remain in place. Markets cheered this news; however, uncertainty still exists Year to date the MSCI China index was up more than 20 percent, while the broad MSCI EM Index was up nearly 14 percent.

The on-and-off nature of tariffs combined with worries over an ever-increasing U.S. deficit have led to more flows to Emerging and International Developed markets.

Foreign investment inflows have recently returned as investors continue to search for new ways to play the AI story, find more attractively valued equities and add to non-dollar assets. The on-and-off nature of tariffs combined with worries over an ever-increasing U.S. deficit have led to more flows to Emerging and International Developed markets. However, this is counterbalanced by ongoing geopolitical risks between the U.S. and China and increasing levels of Chinese debt coupled with poor demographics and tariff uncertainty. These risks remain as short- and longer-term challenges for the Chinese economy. We caution that the ultimate size of tariffs on goods from China and the possible policy reaction from the country is still uncertain and will likely lead to volatility in the coming months.

The prospect of more protectionist policies in the U.S. coupled with expansionary fiscal policy has ramifications for U.S. interest rates. While the Federal Reserve has cut rates in recent months, bond yields are still elevated in the intermediate to long part of the yield curve, albeit recently trending slightly lower as concerns about economic growth rise. Higher interest rates in the U.S. along with tariffs will likely shape the relative strength of the U.S. dollar versus emerging-market currencies. This is something we continue to watch closely. Regardless of the strength or weakness of currencies, the impact on returns and portfolio diversification in general is something that we feel is underappreciated, as dollar strength has persisted in recent years. This may not always be the case, and we believe it is a reason to have exposure to the International Developed and Emerging Markets asset classes.

The diverse nature of the Emerging Markets asset class has dramatically shifted over the past 20 years, with technology and financials now being the two largest sectors. GDP growth is expected to be higher, and relative valuations versus the developed world continue to sit at historically cheap levels even after the outperformance year to date. Demographics in some developing economies (e.g., India) are very favorable as well. Given this, we believe it is important to have long-term exposure to Emerging Markets in a well-diversified portfolio. However, given economic risk tariffs and geopolitical risk tied to China, we continue to modestly underweight the asset class.

The sharp moves in the bond market have been cause for concern for investors and even politicians. For example, the pause in reciprocal tariffs was by all accounts driven by a rapid rise in yields (bond yields and prices move inversely to one another) in the bond market, not the stock market. Put in President Trump terminology, this was the market that was getting “yippy.”

The reality is that higher interest rates are not limited to the U.S. but have become a global phenomenon.

The heightened attention to the bond market makes sense in the context of potential changes to the economy. For the past 25 years, foreign purchases of U.S. debt have helped to keep interest rates relatively low and allowed the U.S. to pursue an expansionary fiscal policy. The administration’s tariff policy could lead to a reversal of trends that have helped finance the expansive fiscal policy of the U.S. Given that history, consider the potential challenges of increased debt issuance if the “One Big Beautiful Bill Act” increases U.S. deficits. All of these concerns seemingly came to a head on May 16, when Moody’s became the last of the major credit ratings agencies to downgrade the U.S. credit rating from Aaa to Aa1.

The reality is that higher interest rates are not limited to the U.S. but have become a global phenomenon. From Japan to the UK to the eurozone, interest rates are rising as inflation and debt concerns have grown. While we are concerned about the intermediate- to long-term implications of the current U.S. fiscal situation, we continue to believe that U.S. Treasurys will likely offer a port in the storm if an economic slowdown were to occur. Absent a persistent nearer-term inflationary spiral caused by tariffs, we believe that yields on Treasurys currently compensate investors for increasing risks.

We also note the administration’s focus on intermediate-term interest rates. Indeed, if Treasury Secretary Scott Bessent’s 3,3,3 plan, which is a goal of 3 percent real economic growth and bringing the current budget deficit down to 3 percent of GDP while pumping three million more barrels of oil per day, is to come to fruition in the coming years, something has to give on the interest expenses paid on U.S. debt. As it currently stands, interest costs alone are more than 3 percent of total GDP. Perhaps, as the much-discussed Mar-a-Lago Accord suggests, the administration will need to attempt to coerce intermediate-term yields lower.

We continue to overweight Fixed Income in our portfolios, with a focus on quality and a slightly longer duration relative to the Bloomberg Aggregate Index. While we do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle, we believe that fixed income has once again returned to its roots as a real income-generation vehicle that can also provide risk mitigation against the potential for falling equity prices that are caused by or coincide with a slowing economy. While inflation remains a concern, we continue to focus on an allocation to commodities within our portfolios as a better way to hedge that potential risk.

Duration

The story of the second quarter in fixed income has been the long end of the yield curve. The spread (the difference in yield) between two-year and five-year Treasurys is basically unchanged since the last writing of our Asset Allocation focus. However, the spread between two-year and 10-year Treasurys as well as two-year and 30-year are each significantly wider, and all the while inflation breakeven levels on the longer end of the yield curve have come down, which means this is a real yield movement. As the saying goes, the level and direction of rates is “path dependent.” That means that rates are going to go where they are going to go, but the path (as well as the pace of progression on the path) drives investor behavior. What does this mean? The curve on the front end has actually reinverted modestly, meaning that investors are once again expecting the Fed to cut rates. Meanwhile, yields on longer-term bonds have risen in response to those expected cuts. We continue to find high-quality fixed income attractive in the nearer to intermediate term with a slight tilt to duration given that real rates are currently elevated. Simply put, after years of negative real rates that led to “TINA” (there is no alternative) buying of equities, higher real yields today have made fixed income incrementally attractive even with those lingering and possibly growing longer-term concerns.

Government Bonds/TIPS

It has been a busy year so far in the Treasury market, with heightened volatility in February and April giving way to a moderately aggressive steepening of the longer end of the curve recently. This has left the entire spectrum of the yield curve more attractive, in not only government bonds but also high-quality fixed income such as corporates. The market is positioning for the Fed to cut rates yet this year, even as real rates put pressure on the Fed to hold rates steady (recall real rates rose sharply after the Fed cut in Q3/Q4). The minority view that the Fed won’t be able to cut rates this year is gaining momentum. The ongoing slow weakening of the dollar merits watching, as it may actually do the easing work for the Federal Reserve rather than actual rate cuts. While the front end of the curve is positioned for Fed easing, we believe that sentiment may change as the market forces higher nominal and real rates (breakeven rates fall while nominals rise).

Credit

Companies have used the past 15 years of low interest rates to term out their debt and position for the future. While nominal rates have moved higher, spreads have encountered mild hiccups but generally have recovered quickly. The volatility in equity markets from earlier this year did not spill over to credit, and we continue to see high-quality credit as attractive. However, due to the nature of our asset-allocated portfolios, we tend to shy away from high yield in lieu of term structure and other types of risks.

Municipal Bonds

Municipal bonds have experienced an interesting 2025 so far. With potential tax reform on the table, the always simmering questions of the tax-exempt status of municipals have become amplified and a headwind to municipal performance. Selling pressure that began in February accelerated in April as investors sold to raise money to pay taxes. As a result of the selling pressure, municipal bonds offer attractive tax-adjusted yields compared to similar taxable debt. Municipal/Treasury ratios, which reflect the relative attractiveness of yields on municipal bonds compared to equivalent Treasurys, have become more attractive for 10-year bonds. This means that municipals have cheapened in yield, but not return, by about 10 percent relative to Treasurys. So, if a 10-year Treasury yielded 4 percent and a 10-year municipal yielded 3.20 percent, we would say that municipal/Treasury ratio was at 80 percent. If it “cheapened” by 10 percent, it would trade with a yield of 3.60 percent. This move is very welcome, as municipals were fairly expensive since the dramatic rate moves in taxable bond markets in 2022. It is not uncommon for municipals to become expensive for a while after large rate increases in taxable bonds. Approximately 70 percent of municipals are held by individuals and are a long-term-only investment. That means there typically aren’t sellers of municipals other than issuers. As a result, when yields rise in taxable bonds, investors do not sell municipals, which causes them to become more expensive relative to their taxable counterparts. Finally, when tax payments are due and equity markets are volatile, investors sell municipal holdings to pay their taxes, which serves to make them less expensive relative to their taxable counterparts. We believe that, currently, municipals are relatively attractive to their taxable counterparts.

We believe real assets play an integral role in diversified portfolios due to their lower correlation to traditional equities and fixed income. Real assets can provide valuable hedges against unexpected inflation and a strong sensitivity to real interest rates, which we think are important considerations in constructing resilient portfolios over an intermediate- to long-term time frame. The period 2021–22 provided an example of the value of this diversification with the standout performance of commodities in response to rising inflationary pressures and the Russian invasion of Ukraine. The sharp decline in real interest rates from 2010–12 and eye-popping performance of real estate are another example of the value of this diversification philosophy. Put simply, sharp changes on the inflation and real interest rate fronts are very difficult to call correctly from a timing perspective, which underlines the rationale for a structural allocation to real assets.

Throw in higher U.S. and global debt levels coupled with rising yields, and it makes sense to consider the need to include real assets in your portfolios.

For much of the 25 years leading up to 2022, risks to the global economy have been one sided; simply put, it’s been all about slow economic growth and the potential for deflation. This is where fixed income has previously proven to be an effective hedge against most economic and market downturns. However, now both sides of the distribution are seemingly in play, as inflation has been elevated over the past years and tariffs/deglobalization serve only to increase those risks going forward. Given the heightened level of uncertainties that exist, we believe that real assets play an increasingly important role in hedging economic and market downturns. While seemingly an afterthought for many decades, inflation has reemerged as a risk to consider. A key unresolved question remains: What happens to inflation, and will it be allowed to become embedded more permanently in the U.S. economy (as was the case during the 1966–82 time period)? The reality is that given the current tariff situation, this risk is more significant than it has been in decades. Throw in higher U.S. and global debt levels coupled with rising yields, and it makes sense to consider the need to include real assets in your portfolios. We continue to favor the inclusion of real assets and maintain our exposure to commodities. However, with our forecast remaining that an economic slowdown is more likely than an inflationary spiral, we are underweight in commodities to fund an overweight position to fixed income.

REITs remain highly sensitive to overall changes in real interest rates and have spent much of the past few quarters oscillating between being the best- or worst-performing of the nine asset classes in our models. This is likely because changes in real rates impact real estate more than any asset class in our portfolios, especially when overall REIT fundamentals remain weak. Given our desire to take slightly less overall equity market-like risks coupled with their still weak fundamentals, we continue to underweight REITs.

Real Estate

We’ve maintained a tactical underweight to REITs for an extended period. This is based on our analysis of not only the fundamentals and market structure of the asset class but also potential interest rate volatility and uncertain inflation expectations related to the economy and, more recently, trade and tariff policy as well.

Real estate prices are influenced by several factors, not the least of which hinges on the anticipated trajectory of real long-term interest rates. In addition, REITs have become more correlated with moves in fixed income due to interest rates. The past year has been no exception; real estate prices typically have a direct, inverse relationship with financing costs tied to buying an existing property or beginning a new project. Consequently, the aggressive cycle of rate hikes had adverse effects on longer-duration assets, including REITs. This is in stark contrast to the relatively favorable period for real estate prices during the ultra-low interest rate environment seen shortly after the onset of COVID. It may take some time for this asset class to normalize.

There are some potential bright spots appearing in the world of real estate and a host of potential new headwinds as well. On a historic, relative basis, REITs are trading at a discount to general equites. In the past, such relative valuation levels were followed by periods of REIT outperformance. The real estate market is expecting resilient demand and fairly muted supply growth, which could potentially support current price levels. Cash flow growth may also accelerate if interest rate volatility subsides and allows the market to find clearing levels in some of the most hard-hit REIT sectors.

Indeed, the resiliency of the U.S. economy over the past year has supported stronger than expected net operating income growth, as the general positive correlation between positive GDP growth and REIT performance has held up. We find it encouraging that, broadly speaking, REITs have reduced leverage in recent years, and despite sharply rising interest rates, certain REIT sectors—like data centers, health care facilities and cell towers—have been able to show steady signs of rental growth above inflation.

However, we must consider that increasing macroeconomic uncertainty will drive expectations about interest rates, volatility, economic growth and other factors likely to drive REIT performance. Inflation has remained above the Fed’s target, and while broad measures of inflation have been trending downward, recent readings have started to reveal concerning signs that we aren’t out of the woods quite yet. The Fed may be somewhat constrained in cutting rates further if inflation remains above target, and more rate volatility could be on the way given recent trends in long-term inflation expectations, adjustments in U.S. trade policy, fiscal deficit challenges, unemployment levels and more. Political risks in the U.S. and abroad could play a role in increasing upside risks in both inflation and rate volatility and downside risks in unemployment.

We find this to be an asset class worth watching, and we are evaluating our positioning on an ongoing basis. The income-generating power of real estate can also be a compelling reason to own REITs, but we must weigh the long-duration nature of this asset class against other positions currently held in our portfolio, like long-term Treasurys, that may provide negative correlation to equities if risks to economic growth materialize.

Commodities

Commodity prices sold off sharply in early April but are still up year to date. Recent declines were isolated to the energy and industrial metals sectors, which are more sensitive to global growth concerns and the impact of Trump administration tariff and energy policies. Global trade tensions, particularly between the U.S. and China, are fueling recession fears and market volatility. These tensions are disrupting supply chains, impacting investor confidence and raising concerns about a potential global recession. Agricultural goods, livestock and (especially) precious metals are less sensitive to these factors and continue to post positive returns.

In April, oil prices fell significantly, touching four-year lows as a reaction to the U.S.-China trade war, which dampened oil demand forecasts. Notably, OPEC+ also announced plans to boost oil production, contributing to the price drop. Oil prices are down year to date. Industrial metals such as copper, zinc and aluminum are mostly down this year, with notable subdued price appreciation due to concerns around tariff plans and continued sluggish Chinese demand. Agriculture is up overall with tight supplies across multiple commodities. Good harvests have kept a lid on prices, with coffee a notable exception. Finally, gold continues to remain near all-time highs this summer as investors seek an inflation hedge. Ongoing purchases by global central banks also has put pressure on prices.

Going forward, primary catalysts for higher commodity prices are the reemergence of demand from China, continued higher inflation expectations and a weakening U.S. dollar. In the energy sector, persistent underinvestment, a pivot back to OPEC+ production cuts and a reduction in U.S. production could add additional price pressure. Market expectations for inflation have fallen over the last year but remain embedded in market expectations, which is a plus for commodities.

Our outlook for commodities shifted from mixed to modestly positive, driven by the current economic and political uncertainty. While uncertainties regarding tariff policies have had a material impact this year, the sequence and duration in which the initiatives are implemented will determine the eventual outcome. That is the challenge commodity investors face today.

We remain meaningfully underweight the commodity asset class, preferring fixed income and economically sensitive asset classes like Small-Cap and Mid-Cap U.S. stocks. Overall, we continue to believe the commodity asset class retains positive return expectations and significant diversification benefits.

The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, WI, and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS), a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk.

Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.

Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.

Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards.

Commodity prices fluctuate more than other asset prices, with the potential for large losses, and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts.

Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation.

The U.S. Large-Cap asset class is measured by the S&P 500 Index, which is a capitalization weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country.

The U.S. Mid-Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7 percent of the U.S. equities market.

The U.S. Small-Cap asset class is measured by the S&P Small Cap 600 Index, a market-value-weighted index that consists of 600 small cap U.S. stocks chosen for market size, liquidity and industry group representation.

The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.

The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.

The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.