Since reaching respective all-time highs on February 2025 and December 2024, the S&P 500 Index1 and the Nasdaq Composite Index2 both reached correction territory in Q1 2025, indicating a decline of between 10% and 20% from these record levels. A deeper analysis, however, reveals that the Q1 2025 market environment was impacted by both a broad-based selloff and a market rotation, both of which were triggered by concerns about the prospect of slowing economic growth and the impact of proposed tariffs from the new presidential administration.
On the market rotation front, we believe the Q1 2025 market environment is best characterized by a material shift away from growth-oriented and more economically sensitive stocks to value-focused and defensive equities. Perhaps the best example of this performance divergence is the tech-heavy Nasdaq-100 Index3, which declined by 8.1% in Q1 2025 compared to a comparatively smaller 0.9% loss in the more value-oriented Dow Jones Industrial Average4. In addition, while growth and cyclical sectors lagged, defensive and value focused sectors outperformed5, further demonstrating that the first three months of 2025 were defined by both a broad-based correction and a rotation out of growth and into value.
As a further consequence of this market rotation, market breadth improved considerably, and domestic stock index performance became less reliant on a handful of mega cap technology and technology adjacent stocks. For an example of this trend, consider that after narrowing in Q4 2024, market leadership broadened materially in Q1 2025 as the market-cap weighted S&P 500 Index declined by 4.3% compared to a 0.7% drop in the S&P 500 Equal Weight Index6, indicating a 359 basis point performance advantage for the broader version of the index, which in turn signals broader market leadership.
The improved market breadth did not extend to small and mid-cap (“SMID”) U.S. listed stocks, however, with the SMID-focused Russell 2000 Index7 declining by 9.5% in Q1 2025. SMID stocks in the U.S. were seen as being more vulnerable to both slowing economic growth and tariff-induced inflation, hampering share price performance in this segment of the market. In addition, a more cautious approach to near-term rate cuts by the Federal Reserve appeared to indicate that rates were destined to remain higher for longer, possibly continuing to pressure highly levered SMID companies via elevated interest expense.
After materially lagging U.S. equities for the last several years, international stocks significantly outperformed their U.S. counterparts in Q1 2025. The MSCI World ex USA Index8 appreciated by 6.3% in Q1 2025, led to a large extent by European equities. In the Eurozone, a combination of attractive relative valuations, accommodative monetary policy from the European Central Bank, and fiscal stimulus from countries such as Germany propelled the iShares Core MSCI Europe ETF9 up by 11.4% in Q1 2025.
Emerging market equity performance was only modestly worse than that of developed markets, with the MSCI Emerging Markets Index10 appreciating by 4.5% in the quarter, driven by robust performance from Chinese equities. A significant rally in Chinese stocks, particularly in technology and AI-related stocks, was sparked by optimism surrounding innovations such as the DeepSeek AI model, which was released in early 2025. This enthusiasm was further buttressed by Beijing’s perceived shift to a more supportive policy stance relating to the private sector and technological innovation.
After cutting the federal funds rate by 100 basis points from September 2024 to December 2024, the Federal Open Market Committee of the Federal Reserve System (“the Fed”), opted to stay put at the late January 2025 and mid-March 2025 meetings. In its 3/19/25 press release, although the Fed stated that economic uncertainty has increased and inflation remained elevated, it also highlighted robust growth in economic activity and solid labor market conditions.11 The Fed’s updated Summary of Economic Projections released on 3/19/24 indicated a median expectation among Federal Open Market Committee members of two 25 basis point rate cuts in 2025, down from an expectation of four 25 basis point cuts in September 2024. 30-Day Fed Funds futures prices imply a more aggressive rate cutting path, perhaps in response to more concrete information on tariffs that came to light on 4/2/24. 30-Day Fed Fund futures prices currently suggest an expectation of four 25 basis point rate cuts by year end.12
10-year U.S. Treasury yields were on the rise from the beginning of the quarter until 1/13/25, when a year-to-date peak of 4.81% was reached. This initial surge in yields was driven by a combination of strong economic data, shifting expectations about Federal Reserve policy, and heightened inflationary concerns tied to proposed tariffs from the incoming Trump Administration. From mid-January to the end of the quarter, however, growing pessimism about U.S. economic growth resulted in the 10-year U.S. Treasury yield contracting to close at 4.20% on 3/31/25. The protracted decline in Treasury yields resulted in the Bloomberg Aggregate Bond Index13 increasing by 2.8% in Q1 2025. The biggest gains came from long duration bonds, which tend to be more sensitive to changes in interest rates and interest rate expectations. As a case in point, the iShares 20+ Year Treasury Bond ETF (TLT)14 appreciated by 4.9% in Q1 2025 compared to a 1.6% increase in the iShares 1-3 Year Treasury Bond ETF (SHY).15
On the commodity front, intensifying U.S. sanctions on Russia and Iran, OPEC+ production cuts, and unusually cold weather in the Northern Hemisphere caused the price of Brent Oil to surge by 9.9% from 1/1/25 to 1/14/25. However, Brent Oil prices posted a precipitous decline from mid-January to early March, due to concerns about slowing economic growth and OPEC+ production increases. After bottoming out on 3/4/25, Brent Oil prices increased by 7.8% to close out the quarter on a high note. After taking these movements into account, the price of Brent Oil over the entire quarter was relatively flat.
We look forward to the remainder of 2025 and are hopeful that market volatility will dissipate as the economic outlook and the impact of fiscal policy initiatives become more certain. If the economy is merely slowing and not heading towards a recession, the Fed can continue to keep monetary policy relatively restrictive, combatting sticky inflation without negatively impacting the labor market. Under this scenario, the equity markets could end the year on a high note once economic uncertainty dissipates, bringing the focus back on a relatively solid economic backdrop and strong underlying fundamentals.
