Equity markets endured a rollercoaster ride in the 2nd quarter (Q2). Markets across the world fell sharply in response to the Trump administration’s “reciprocal tariffs” announced on 2nd April (“Liberation Day”) at the start of the quarter. As a result of much larger than expected tariff increases, the US effective tariff rate on all imports increased from 2.3% last year to around 26%, a 131-year high. Fortunately, President Trump was quick to de-escalate the crisis, leading to a steady recovery in equity markets, so that by the end of the quarter they had more than recouped their earlier losses.

Over the quarter, Japan’s Nikkei 225 index led the way with a 13.7% gain culminating in a 1.5% return for the year-to-date (YTD). The US S&P 500 index increased 10.6% in Q2 and 5.50% YTD, which at face value is impressive but the US dollar lost significant ground due to policy uncertainty. The US dollar index fell 7.0% in Q2 amplifying its YTD decline to 10.7%. As a result of the dollar’s decline, most other markets fared better than the US in common currency terms. Germany’s DAX increased by 7.9% in Q2 and a solid 20.1% YTD, while the UK FTSE 100 gained by a more modest 2.1% and 7.2%, respectively. In China, the CSI 300 index was stable with modest returns over the quarter and YTD of 1.3% and 0.03%. The MSCI All Country World index (USD based), increased by 11.0% in Q2 and 9.1% YTD, boosted by the dollar’s weakness. Likewise, the MSCI Emerging Market index (USD based) increased by 11.0% and 13.7%, helped by solid gains in the tech heavy markets in Taiwan and South Korea. The S&P Global Developed Sovereign Ex-US Bond index is also dollar based, which helped it achieve a sizeable 8.5% return in Q2 and 11.6% YTD. The US 10-year Treasury bond yield barely changed over the quarter from 4.25% to 4.23%, placing it below its 2024 year-end level of 4.57%.

Within a week of Liberation Day, Trump announced a 90-day pause on his reciprocal tariffs, on every country except China. A few days later, the US and China each suspended for 90 days all but 10% of their Liberation Day tariffs and cancelled other retaliatory tariffs. Stability has returned to equity markets. The all-country 90-day pause which expired on 8th July was extended and the corresponding pause on China tariffs which expires on 12 August, is also expected to be extended, allowing for negotiations to continue. The eventual tariff regime is likely to comprise tariffs resembling current levels, being 10% on most countries and 40% on China, which would be close to Trump’s original election pledge, but a substantial pullback from levels announced at the start of the trade war.

Despite trade war uncertainties, global economic data remained solid over the quarter. Although US GDP shrank in Q1 by 0.1% quarter-on-quarter, the setback was due to a once-off surge in imports, ahead of the tariffs, and lower government spending. High-frequency data indicate Q2 economic activity is robust, consistent with the Fed’s target of 1.3-1.4% GDP growth in 2025. S&P 500 earnings grew by a better than expected 14% year-on-year, well above consensus forecasts of 12% and 8% at the beginning and end of the quarter, respectively. The results were helped by a pulling forward in orders ahead of anticipated tariffs. Most companies did not include the potential impact of tariffs in their profit projections, given the level of policy uncertainty. Indeed, earnings are poised to slow although the consensus forecast still projects a robust 7% year-on-year rate of growth in the remaining three quarters of the year.

US inflation continued its gradual decline and surprised to the downside for a fourth straight month in May, with core CPI increasing by just 0.1% month-on-month, while the Citi Inflation Surprise index fell to its lowest in a decade. However, as Federal Reserve Chair Jerome Powell said at the policy meeting on 18th June: “What we’re waiting for to reduce rates is to understand what will happen with the tariff inflation… there’s a lot of uncertainty about that.” As a result, further rate cuts have been delayed and as expected, the Fed left the fed funds at 4.25-4.50%, unchanged since December 2024. Fortunately, there is no urgent need for Fed rate cuts as US economic growth appears to be on a positive trajectory.

There is some concern though that the tariff impact has not yet fully reflected in economic data. As succinctly noted by independent research firm MRB Partners: “Economic models may not fully account for the potential additional negative effects of tariffs on growth. This includes the disruptions to supply chains, the repercussions of squeezed corporate margins, the toll on investor/business/consumer sentiment and reluctance to spend or invest, spillovers into non-trade sectors such as business travel, or the tightening of financial conditions.”

Other major economies will likely end up better off than the US, especially from an inflation viewpoint, with profound implications for central bank policy easing. Eurozone CPI declined from 2.2% in April to 1.9% in May, under the ECB’s 2% target, facilitating 25 basis point rate cuts in March, April and June. The ECB’s deposit rate is now at 2%, less than half the fed funds rate, while a stronger euro, and the absence of tariff induced price increases suggest lower inflation and interest rates ahead. By contrast, the Fed will be hamstrung by rising inflation expectations.

Following years of being overshadowed, the pace of growth in other regions appears to be converging with that of the US. While the US economy shrank in Q1, Eurozone GDP grew by 0.6% quarter-on-quarter, up from 0.3% the prior quarter. The UK economy also grew in Q1 by a solid 0.7%. The emerging market giants, China and India, grew by 5.4% and 7.4%, respectively, both year-on-year rates. Germany is embarking on supply-side structural reforms, which like the US and UK in the 1980s under Ronald Reagan and Margaret Thatcher, could kick-start a prolonged period of improved growth. Newly elected Chancellor Friedrich Merz in his “whatever it takes plan”, has vowed to reinvigorate the economy with debt fuelled spending on infrastructure and defence, tax subsidies for investment, and deregulation. Economists are expecting as much as €1 trillion in additional domestic spending in the next decade, equal to well over a fifth of GDP. Benefits will spill over into the rest of the eurozone, making the policy shift a game changer not just for Germany but for Europe. Europe’s households have been abnormally cautious this decade, building up a €1 trillion stockpile in accumulated excess savings, which could be unleashed if the recent improvement in consumer confidence and retail sales volumes continues to build momentum.

There are three key risks to the global economic and market outlook. First, tariffs will cause inflation to rise in the US. The inflation impact has not shown up yet but is expected to occur according to the recent spike in 1-year CPI inflation swap rates. This suggests a certain amount of inflation has already been priced in but there is a high degree of uncertainty over how much of the tariffs will be absorbed in different parts of the supply chain. Second, there is a risk that the all-important 10-year US Treasury bond yield will move above its previous peak of 5% set in October 2023, driven higher by inflation concerns and anxiety over the growing US federal budget deficit. Once the trade war threat passes, higher bond yields may return as the biggest risk to equity markets. Equity de-rating pressures will intensify if bond yields move to new highs. Trump’s “One Big Beautiful Bill” fiscal stimulus will support economic growth but could exacerbate an already stretched budget deficit and put further strain on Treasury bond yields. Last, the 12-day Iran war has increased geopolitical risk.

There are always risks to the market outlook, but more importantly, the risk of global recession has receded since the de-escalation of the trade war and the signing of Trump’s fiscal stimulus package. Notwithstanding the delayed impact of tariffs and the convergence between US and non-US economic growth, all major economies are poised to generate solid earnings growth over coming months. The positive earnings outlook and the bias towards further monetary easing should drive equity markets higher over the balance of the year.