Q3 Investment Perspectives

By Bruce Thompson on July 11, 2025

Mid-Year Reflections: Rip Van Winkle’s Waking Thoughts

In Short:

Markets staged a remarkable recovery as worst-case tariff scenarios faded. The “not too hot, not too cold” economy continues to show impressive resilience—but there are reasons for caution. Valuations have returned to their January levels—elevated and priced for perfection—yet now accompanied by greater risks, including growing policy unpredictability. Global capital outflows from U.S. assets—reflected in bond market turmoil and a 10.3% drop in the U.S. dollar—demonstrated that there are real-world guardrails on policy risk.

Imagine a Rip Van Winkle investor waking up this summer after a long winter nap. He rubs his eyes and sees the markets are about where they were before he went to sleep in mid-February. He looks out the window and sees the sun is shining, but there are storm clouds as well; still, he feels uneasy. Was it just a bad dream?

Checking under the covers, he discovers he missed a nearly 20% drop in the stock market—a technical bear market—and turmoil in bonds, driven by a host of political and economic turbulence, particularly trade policy. But as the worst-case tariff scenarios faded and recession and inflation fears eased, markets staged a remarkable recovery.

As measured by the S&P 500 Index, stocks ended Q2 with a gain of 10.9% and are up 6.2% year-to-date. The Bloomberg U.S. Bond Index returned 1.2% for the quarter and 4% year-to-date.

But what of the storm clouds—are they coming or going? Is the markets’ recovery real or fiction?

Although the trade war has created volatility in the economy, and the effects may yet fully appear in the data, investors have embraced a Goldilocks “not too hot and not too cold” narrative. While GDP fell in Q1 for the first time in several years due to a pullback in consumer spending, growth is expected to rebound this summer. The mix of moderate growth and stable employment has led investors to expect inflation will remain in check—and that the Fed can maintain a fairly neutral stance on interest rates.

Concerns around a sharp drop in government spending have abated, while the recently passed budget bill and expected deregulation policies may provide a boost.

Market corrections—as the term implies—can serve as healthy checks on speculative excess. The mega-cap stocks that had fueled speculation in recent years bore the brunt of the decline, but investors breathed a sigh of relief when those companies continued to report strong results, reinforcing confidence in AI-driven growth trends.

Still, the near- and multi-year forecast is clouded by considerable uncertainties and reasons for caution. Importantly, valuations have returned to their January levels—elevated and priced for perfection, yet now with more risks.

The more tangible risks include the possibility of renewed trade tensions, particularly since the pause on tariffs is set to expire soon. Investors mostly shrugged off the Middle East conflict, but an escalation could trigger a sharp spike in oil prices and a recession, as has happened many times in the past.

From a broader perspective, Rip awakened this summer peering through a proverbial “Looking Glass” at a world that feels turned upside down. Political norms are shifting, geopolitical relationships are changing, and long-held assumptions are being challenged. While it is impossible to know what impact these developments may eventually have—good or bad—increased policy uncertainty is undoubtedly a fresh source of risk.

Of course, one of the core observations of modern portfolio theory is that risk and return are directly related. As a general rule, higher risks are associated with higher potential returns, and vice versa. For portfolio planning, it makes sense to assume a wider range of both downside risk and upside potential in the period ahead.

Before heading to the beach for yet another nap, Rip reflects on what insights might be gleaned from recent turbulence—as any good investor would. He has two main takeaways. 

For one thing, diversification continues to play an important role in portfolio risk management. Foreign stocks—measured by the MSCI All Country World ex-U.S. Index—returned 17.9% in the first half of the year, outperforming the U.S. market. He notes that the US dollar weakened more than 10%, reflecting an exodus of capital from U.S.-denominated assets. That was the dollar’s biggest six-month drop since 1973, when the U.S. delinked from the gold standard.

Second, the linked international system of capital flows provides critical guardrails on policy risks.

Rip observes that disorder and unanticipated weakness in the U.S. bond markets pressured the administration to soften its more aggressive trade policies and rhetoric. Typically, bond yields fall—and prices rise—when recession fears increase. But this time, prices fell and yields climbed.

This was particularly sensitive in the context of the math and negotiations surrounding the administration’s cornerstone fiscal bill, which is expected to result in even higher budget deficits and depends on growth to offset those deficits. An all-out trade war might both cause a recession and result in higher projected interest rates (government borrowing costs), imperiling the bill which passed narrowly as it is.   

The inconvenient reality is that the US holds lots of strong cards but doesn’t hold all the cards in trade negotiations. At the margin, the US is reliant on borrowing (i.e., selling Treasury bonds) from foreign sources to fund our budget deficits, and is conditioned on confidence in the stability of the country’s finances.

Moreover, it should be recognized that trade deficits—often misconstrued through a political lens—are balanced in national accounts by capital inflows: foreign investment in U.S. assets such as Treasuries, real estate, businesses, and stocks. Reducing trade deficits could inadvertently reduce those capital inflows.

In closing, this year has served as another powerful case for staying invested, diversified, and balanced across asset classes—while recognizing that new, unpredictable risks make market timing more difficult than ever.

We endorse Rip Van Winkle’s long-term investment approach—one designed to let you sleep soundly. Ultimately, success requires making sure your portfolio continues to reflect your unique risk profile as goals and market conditions evolve. That means regularly reviewing and adjusting your asset allocations in light of shifting risks.

Before settling in for what we hope will be a restful summer—now that markets have stabilized—this is an ideal time to revisit your portfolio with your advisor.

That will also provide a good opportunity to consider how the recently passed fiscal bill may impact your taxes and planning. We will offer some general review on tax changes in a future letter.

Please join us on July 22nd at 3 PM for a timely mid-year webinar on markets, policy, and portfolio positioning. Mike Tucci and Brad Long from Fiducient Advisors will share insights on the current market landscape and what they believe matters most in the second half of the year. To register, click HERE.

We wish you a wonderful and relaxing summer!