Q1 recap: markets reverse trend, recession fears increase, and uncertainty rises.

The start of 2025 looked promising for the stock market, continuing the strong performance we’ve seen over the past two years. The S&P 500 reached its highest point ever in mid-February, the economy was showing positive signs, and investors were feeling optimistic.

However, the mood changed in late February when President Trump’s administration began implementing new policies. After two straight years of excellent returns (over 20% gains each year), the S&P 500 ended this quarter with a decline -4.3%. The new administration has focused on changing trade policies, introducing tariffs, and reducing government spending. These changes represent a significant shift from previous policies and have caught the attention of investors and business leaders globally.

The majority of the stock market’s decline happened in the second half of the quarter, after reaching that record high on February 19th. A small number of mega cap companies led the downturn. Technology stocks were hit particularly hard: growth stocks fell by -10.0%, while the Nasdaq 100 dropped by -8.1%.

The recent market decline tells an interesting story when we look at different parts of the market.

Nine out of eleven sectors in the S&P 500 did better than the overall market in the first quarter. Seven of these sectors even showed positive returns, while two remained flat. This is quite different from last year, when only a few sectors drove the market’s strong performance.

International investments performed better than U.S. stocks during the quarter, one of the biggest differences we’ve seen since 2000. This happened partly because those large U.S. technology companies that struggled brought down the overall market performance. European markets did particularly well as their governments announced plans to increase spending, which encouraged investors to move money from U.S. stocks to European ones in hopes of stronger growth there. Emerging markets lagged developed international markets but still outperformed the U.S.

It is important to remember that the performance of the stock market generally doesn’t reflect real-time economic conditions. The market is forward-looking and prices in expectations for what’s to come. Historically equities bottom several months before improvements in earnings, GDP, and payrolls. If an investor tries to sit on the sidelines until it feels like the worst is behind us, they will likely miss a significant part of the eventual recovery.

There were two notable themes in the bond market in Q1: falling U.S. Treasury bond yields and wider credit spreads. The 10-year Treasury yield fell from a peak of around 4.80% in mid-January to 4.15% in early March. It was a reversal from Q4, when the 10- year yield rose more than +0.75% due to renewed inflation concerns. Several factors contributed to the Q1 reversal, including rising policy uncertainty, the potential for tariffs, and concerns about slower economic growth. The combination prompted investors to move money into longer-maturity government bonds, which are viewed as safe havens. Bond prices rise as yields decline, and Treasury bonds provided diversification benefits in Q1, offsetting a portion of the stock market decline.

Another major theme was credit spread expansion. Credit spreads measure the difference in yield between bonds with credit risk and U.S. Treasuries which are (correctly, in our opinion) considered to have zero default risk. Spread levels can serve as a real-time gauge of market sentiment, showing how easy or expensive it is for companies to borrow money. A narrower spread signals that investors view credit risk as low, while a wider spread signals higher perceived default risk.

The high-yield spread narrowed in late 2024 as the Federal Reserve cut interest rates, reaching levels last seen in 2007. However, credit spreads did widen in Q1. The increase indicates investors are becoming more cautious, with the potential for tariffs and slower economic growth leading to higher credit risk.

Despite the recent rise, credit spreads remain low by historical standards. Compared to past periods of market stress, today’s spread levels suggest financial conditions are still relatively stable, a reflection of the U.S. economy’s overall strength. While investors are concerned about policy uncertainty and the potential for slower growth, the market is not signaling financial distress. However, if spreads continue to widen, it could signal tighter financial conditions and raise concerns about potential defaults. The market will be watching spreads closely.