Q1 2025 Equity Market Themes and Recap

The first quarter of 2025 presented significant challenges for equity markets, with several key themes driving market performance. Following the strong returns seen in 2024, Q1 2025 marked a notable shift in investor sentiment and market dynamics. The S&P 500 declined 4.3% during the quarter, its first quarterly decline since Q3 2023, as markets grappled with complex economic and policy developments.

Stagflationary Concerns

The quarter was characterized by mounting fears of stagflation — a challenging economic scenario in which slowing growth coexists with persistent inflation. Economic growth slowed dramatically, with Q1 GDP growth forecasts falling to just 0.3%, compared to 2.3% in Q4 2024, marking the weakest growth since 2022. This deceleration came as Core PCE inflation remained stubbornly above the Federal Reserve’s 2% target, hovering around 2.9% during the quarter. The combination created a dilemma for the Federal Reserve, limiting its ability to stimulate growth amid ongoing price pressures.

Consumer sentiment plummeted to its lowest level since 2021, with the University of Michigan survey showing two-thirds of consumers expecting rising unemployment in the year ahead. This decline in confidence, coupled with elevated inflation expectations, further reinforced stagflationary concerns. The risk of stagflation put particular pressure on cyclical stocks that had previously led market advances, as investors questioned the sustainability of corporate earnings growth.

 

 

Tariff Policy and Trade Tensions

President Donald Trump’s aggressive trade policies became a significant market disruptor during the quarter. The administration implemented 25% tariffs on goods from Canada and Mexico, while tariffs on Chinese imports increased to 20%, effective March 4. These moves, justified on national security and border control grounds, represented the most substantial trade policy shift since Trump’s first term.

The tariff announcements triggered a 10% peak-to-trough S&P 500 correction, with particularly severe impacts on multinational corporations dependent on global supply chains. Companies across sectors reported significant challenges in their earnings calls, with mentions of “tariffs” in quarterly reports increasing 190% quarter-over-quarter. Markets remained on edge throughout the quarter as the April 2 deadline for additional “reciprocal tariff” announcements loomed, creating uncertainty that weighed on equities.

The trade tensions extended beyond North America and China, with threats of tariffs against the European Union further complicating the global trade landscape. Sectors with significant international exposure, including technology, industrials and consumer discretionary, experienced the greatest volatility in response to tariff developments.

AI Sector Revaluation

The artificial intelligence sector, which had been a powerful market driver in 2024, faced a significant revaluation in Q1. Chinese AI company DeepSeek released a remarkably cost-efficient AI model that required significantly fewer computational resources than those of U.S. competitors. This development called into question the massive infrastructure investments made by U.S. tech companies and sparked concerns about the sustainability of their spending.

The technology leaders that had dominated market returns in 2024 experienced a notable pullback, with the Bloomberg Magnificent Seven Total Return Index falling 16% year-to-date by the end of March. Nvidia, the chipmaker at the center of the AI boom, saw particular volatility as investors questioned whether future AI models would require the same level of computational intensity that had driven demand for its advanced chips.

Concerns about escalating costs and uncertain returns led investors to reassess the lofty valuations that had been assigned to AI-related companies. While the long-term potential of AI remained undisputed, the quarter saw a more nuanced view emerge regarding the timeline and capital requirements for realizing that potential, leading to a significant rotation away from the sector that had previously led the market.

Healthcare Policy Shifts

The new Trump administration’s healthcare policy initiatives had measurable impacts on the sector during Q1. The administration moved quickly to implement changes to ACA Marketplace enrollment processes, price transparency requirements and reform of pharmacy benefit managers. These regulatory shifts created both opportunities and challenges within the healthcare sector.

Proposals to direct more Medicare beneficiaries toward Medicare Advantage plans benefited insurers but raised concerns about long-term implications for traditional Medicare. The sector also faced uncertainty regarding the administration’s approach to the Inflation Reduction Act’s drug pricing provisions, particularly the negotiation program set to expand in February with the second set of up to 15 drugs subject to Medicare price negotiations.

Despite these policy uncertainties, certain healthcare subsectors demonstrated resilience. Companies involved in weight-loss drug development, such as Eli Lilly and Novo Nordisk, continued to attract investor interest due to the expanding addressable market for these treatments. The healthcare sector’s defensive characteristics also provided some insulation from broader market volatility.

Consumer Weakness

A notable divergence between labor data and consumer sentiment characterized the quarter. Despite relatively stable unemployment figures around 4.1%*, consumer confidence measures declined for four consecutive months, reflecting growing economic anxiety among households. The combination of inflation pressures and tariff-related price increases raised concerns about the sustainability of consumer spending, which had previously been a pillar of economic resilience.

Retail sales data showed signs of moderation, particularly in discretionary categories, as consumers became more cautious with their spending. This weakening consumer outlook had significant implications for earnings expectations across multiple sectors and contributed to the outperformance of consumer staples relative to consumer discretionary stocks.

The housing sector, which had anticipated benefits from the Federal Reserve’s expected easing cycle, faced headwinds from persistent mortgage rates and affordability challenges. Home improvement retailers like Home Depot and Lowe’s experienced pressure as consumers delayed large renovation projects amid economic uncertainty.

U.S. Market Underperformance

A striking development in Q1 was the underperformance of U.S. equities relative to global peers. The S&P 500 experienced a 10% correction from February highs before staging a partial recovery late in the quarter. This correction represented the most significant drawdown since 2022 and marked a departure from the U.S. market’s previous leadership.

Non-U.S. markets benefited from weaker dollar expectations and generally less exposure to tariff concerns. This global divergence represented a significant shift from the U.S.-dominated returns that had characterized much of 2024. The relative strength of international markets suggested a potential rotation in global asset allocation as investors reassessed geographic exposures.

Fixed income markets reflected the changing economic landscape, with the U.S. 10-year Treasury yield dropping 60 basis points to 4.2% during the quarter as investors sought safety amid equity market volatility. This flight to quality further emphasized the risk-off sentiment that pervaded markets for much of the quarter.

Equity Market Recap

The overall equity market performance in Q1 reflected these complex crosscurrents. The S&P 500’s 4.3% decline was accompanied by elevated volatility, with the VIX index experiencing elevated levels in March. Sector performance diverged significantly, with consumer staples, utilities and healthcare demonstrating relative resilience while technology, industrials and consumer discretionary sectors faced the strongest headwinds.

Despite the challenging quarter, market analysts maintained a non-recessionary base case for 2025, expecting potential stabilization as trade policy uncertainties diminish and companies adapt to the changing economic landscape. The quarter concluded with markets awaiting clarity on several fronts, including the Federal Reserve’s response to persistent inflation amid slowing growth, details of tariff implementation and corporate earnings impacts from these macroeconomic shifts.