2025 MIDYEAR MARKET OUTLOOK
07/08/2025
Thrivent Asset Management contributors to this report: John Groton, Jr., CFA, director of administration and materials & energy research; Kent White, CFA, VP, fixed income mutual funds; David Spangler, CFA, VP, model and mixed asset portfolios; and Matthew Finn, CFA, head of equity mutual funds
A challenging investment environment is likely to persist due to uncertainty about the impact of tariffs, the outlook for inflation and growing concerns about fiscal stability.
We remain positive on the long-term outlook for the U.S. economy and large-cap stocks. In bonds, favor shorter term Treasuries and high-quality credit, including municipal bonds.
Investors should consider the implications of sustained volatility on their investments goals, making adjustments before spikes in volatility.
In the first half of 2025, the S&P 500® Index fell nearly 20% from its February highs to early April lows and then rebounded 9.4% in a single day—one of its largest one-day rallies in the last century. Unsurprisingly, volatility—as measured by the CBOE Volatility Index (VIX)—reached levels not seen since the COVID-19 pandemic. But volatility wasn’t contained to stock markets. Following the April 2 tariff announcements, 10-year Treasury yields experienced their largest weekly rise in a quarter of a century, while the U.S. dollar steadily eroded, marking its worst start to a year since 1973.
And yet, the S&P 500 Index ended the first half of 2025 up 5.5%, near its all-time high, and 10-year Treasury yields ended the period modestly lower, at 4.35%, down from 4.57% at the end of last year. Is this much ado about nothing or is there a tempest brewing in the teapot? As we look ahead to the second half of 2025, we see a path for volatility to subside but prefer to expect the unexpected and maintain a cautious stance around our longer-term positive view.
U.S. real gross domestic product (GDP) has slowed and the uncertainty dominating headlines in recent months is likely to weigh on businesses and consumers in the months ahead. However, real earnings held up throughout the first half of the year, unemployment remains low and a supportive wealth effect is likely to persist as long as stocks remain up and home prices are stable. Furthermore, consumption has been weaker in some areas, but has held up broadly, and so far, inflation has behaved.
Looking ahead, tax cuts could boost spending and investment, while corporate profitability is likely to benefit from increased deregulation into 2026. In our view, the potential benefits of deregulation are somewhat underappreciated, though understandable given the uncertainty around economic policy to date.
Tariff policy remains broadly uncertain and is likely to result in a modest drag on growth. However, the market has become accustomed to the idea of tariffs and may have already factored in the risks to growth and inflation that an across-the-board 10% import tariff implies. Tariffs rates, however, remain in flux and could be substantially higher for key trading partners. While higher inflation data could—especially in the short term—result in rate cuts being pushed further back and a reevaluation of the economic outlook, the impact on inflation is likely to fade over time.
Looking outside the U.S., weaker global growth also could be a headwind. Despite running a trade deficit in goods, the U.S. runs a trade surplus in services. Should tariffs weigh on European growth (which is more reliant on manufacturing) or China (which is very dependent on trade and is struggling to revive its economy) demand for U.S. services could suffer.
Despite these risks, our view is that the economy does not slip into a recession in the remainder of the year or in 2026. But data in the next few months will shed a lot of light on the impact of existing and anticipated tariff levels, the path of inflation and the possible benefits of the administration’s more pro-business economic policies.
The absolute levels of government debt have become a focus for global markets, particularly the U.S. Treasury market. In our view, the U.S. is on an unsustainable path with spending consistently exceeding revenues and debt levels relative to GDP rising to levels not seen since World War II. Interest payments alone are now over $1 trillion per year, about half of all discretionary spending, significantly limiting Congress’s options to address the fiscal problem.
Treasuries have responded with higher risk premiums—higher yields to compensate for the additional risks, particularly in longer-date bonds. Meanwhile, current credit default swaps (CDS), a derivative security which measures the probability of a bond defaulting, suggest the risk of the U.S. government defaulting on its debt is similar to the risk in Italy, where structural debt problems have long been an issue, and Greece, where financial mismanagement sparked the 2011 European financial crisis. Using CDS as a proxy measure for confidence in fiscal management, current levels place confidence in the U.S. below the United Kingdom (rated AA), France (Aa3) and Spain (A)—all countries with lower credit ratings.
Higher interest rates resulting from this additional risk premium could increase borrowing costs for companies, as well as mortgage rates or car loan rates for consumers, creating a drag on growth. But higher risk premiums also raise the borrowing costs for the government, which could fuel a vicious cycle whereby higher borrowing costs raise risk premiums further, leading to even higher borrowing costs, and so on.
Such a tipping point could be many years away or be eliminated by a more prudent approach to fiscal policy or higher-than-expected economic growth. But the problem, and the uncertainty, could also persist, leaving the bond markets feeling a bit like Damocles1.
Meanwhile, there is some evidence that demand for U.S. assets has softened, and concern is growing that the significant U.S. dollar weakness seen in the first half of the year could persist, reducing demand further. Foreign demand is vital because foreigners own about $17 trillion in U.S. equities, around $14 trillion in debt securities and have near $17 trillion of direct investments in the economy. Add them all together, and it is significantly larger than the country’s annual GDP.
Unfortunately, a weaker U.S. dollar and higher Treasury risk premiums could feed off each other, as one becomes the excuse for the other to restrain from investing. All this concern has led to talk that the U.S. dollar is at risk of losing its status as a safe-haven asset, which would be a significant structural change to the global financial system. But we are less concerned because there aren’t viable alternatives to the U.S. dollar. Gold has recently been favored by central banks to store value, but there simply is no other market that can offer the size and liquidity of U.S. dollar-denominated Treasuries.
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Looking back at the volatility in the first half of the year, we are reminded that so many quarters have seen unusually high volatility lately, implying that higher volatility is quite usual, or at least becoming more normal. That’s often the case in periods of change, which we have been in since COVID shook up the world.
We have long been clear in our monthly updates that we believe the best way to manage investments in high volatility periods is to stay focused on the factors which drive market returns over the long term. Such an approach is an acknowledgment that it is challenging to assess the risks and rewards of adjusting allocations in periods of extreme volatility and it implies an assumption that no matter how bad things get, markets will eventually recover. While such an assumption is supported by the historical data (the S&P 500 Index continues to set new highs), we understand that it can sometimes take years to recover fully.
While tolerating volatility can be challenging, we believe that cutting or even eliminating exposure to markets that have suddenly been repriced in periods of high volatility can risk missing substantial upside in an eventual recovery, like the S&P 500 Index’s 9.4% single-day rise.
As such, we believe the best time to address the impact of high volatility is before the volatility arrives. In our portfolio construction process, we conduct numerous sensitivity analyses to gauge the effect of different paths for economic growth and inflation, interest rate changes, geopolitical shocks and more. These stress tests provide us with a framework to anticipate the impact of high volatility and thus adjust our risk exposures in advance of periods of extreme volatility.
But such a process also entails making some assumptions about longer-term structural trends. For example, our belief is that the U.S. economy has and will continue to adapt to the challenges it faces and that we are in a secular bull market, fueled by innovation, new technologies, productivity and investment. We also continue to believe that bonds offer compelling diversification benefits from equity exposure over the long term, and that current yields can offer attractive income.
We maintain our overweight allocation to stocks generally and favor large-cap companies in the technology and technology-related sectors as we believe these companies remain the key drivers of innovation, productivity and investment. For example, many mega-cap companies have made a wide range of investments in smaller private companies, acting almost like venture capital funds or incubators. While not every investment in a product or process will be a commercial success, we believe these companies have business models that can support long-term growth.
We continue to monitor the potential for their strength to spread to other sectors of the stock market but currently do not see the conditions to justify significant reallocations. If the economy achieves a soft landing, or if interest rate cuts are more widely expected, we could see some strength in the more cyclical sectors. Alternatively, if economic conditions rapidly deteriorate, prompting the U.S. Federal Reserve (Fed) to cut interest rates, small- and mid-cap stocks could benefit as these stocks typically carry significantly more debt on their balance sheets. Small-caps also tend to perform best coming out of a cyclical downturn as the economy reaccelerates. We have been slowly rotating a portion of our small-cap exposure into private equity funds that invest in smaller to mid-sized companies. This adds diversification away from public markets in addition to providing the opportunity to pick up exposure to an asset class that has long investment horizons and benefits from active ownership.
Turning to the rest of the world, European stocks outperformed U.S. stocks during the first half of the year by the largest margin on record2, in U.S. dollar terms. That is, given that the euro has rallied about 13% relative to the U.S. dollar over the first half of the year, converting a European stock investment made on January 1st back into U.S. dollars at the end of June would have provided a 13% return bonus on top of whatever gains the stock made in local currency terms.
And the outlook for Europe has changed as the region pivots to greater infrastructure and defense spending, while Germany’s economy could benefit from the recent removal of restrictions on the country’s debt limits. That said, it could take years for the benefits of this higher spending to trickle through the broader economy, and we remain of the view that Europe will underperform the U.S. in the long term given the region’s headwinds from challenging demographics, lower productivity and a high-regulation, high-tax business environment. Nevertheless, when the market rebounded after the April lows, we reduced our underweight to international equities on the expectation that U.S. dollar weakness could persist.
Bottom line:
Bonds have provided and should continue to provide valuable diversification benefits in a balanced portfolio over longer periods of time, and while current yields can offer compelling income opportunities, we remain defensively positioned in fixed income as we believe interest rate volatility is likely to persist while longer-term risks are currently skewed to the downside.
Inflation remains a wildcard that is difficult to forecast given the numerous changes the economy is undergoing. While we expect it will remain contained, tariff hikes are often shocks to the economy, putting upward pressure on prices and downward pressure on economic growth. How much one effect overwhelms the other is very difficult to estimate, and we are concerned markets could be underestimating the magnitude of both.
Like investors, the Fed finds itself in a difficult spot, trying to balance its dual mandates of containing inflation and supporting employment. Each piece of data released will inform the Fed’s and our estimates. We expect the Fed to prioritize inflation containment over employment in the coming quarters, keeping rates higher for longer unless we see signs of significant weakness brewing in the labor market.
In the meantime, Treasury risk premiums may continue to rise. Often called a “term premium,” this is the extra yield required by the market to compensate for the risks of lending money and, intuitively, is typically smaller for short-term loans (such as Treasury bills) and larger for long-term loans (such as a 30-year Treasury bond). Just six months ago, the difference between the term premium for a five-year Treasury note and a 30-year Treasury bond was about 0.35%. Today, it is just below 1.0%, signaling increased concern about lending to the U.S. government for the long term.
Given the current concerns over the U.S. budget deficit, the tolerance of foreign buyers and the potential for further U.S. dollar weakness, we favor Treasury investments at the short end of the yield curve. While yields are lower in that segment, investment risk, interest-rate sensitivity and volatility are lower as well, and in the current environment, we think a more cautious approach is appropriate. Also, shorter-term bonds would benefit from Fed rate cuts, while concerns about debt levels could keep longer-term yields higher.
Within corporate bonds, we maintain a bias toward higher-quality borrowers in more defensive sectors, or those that are less sensitive to tariffs or general macroeconomic uncertainty, such as cable or telecom companies and utilities. In the consumer sectors, we have a similar view, remaining underweight sectors that are more sensitive to tariffs, such as the retail and automobile sectors.
One sector of the credit markets that looks more attractive to us is the municipal bond market. It has seen significant underperformance in recent quarters and has lagged other credit markets when stocks led a rebound from the April lows. Also, we have become more positive on agency mortgage-backed securities (MBS) as yields for these highly rated securities are compelling, and higher Treasury rates could slow homeowners paying off their mortgages, benefiting MBS.
Bottom line:
Recent volatility may be the new normal. Given the numerous uncertainties that stock and bond markets face today, including an unclear trade policy, a particularly cloudy outlook for inflation and the effects of ongoing conflicts in Ukraine and the Middle East, it seems reasonable to expect sustained volatility to become the new normal.
As we believe investors should not make significant asset allocation decisions during periods of extreme volatility, we encourage a comprehensive review of portfolio allocations, helping to ensure that any particularly negative period does not compromise the ability to generate compound returns over the long term. Before making a change in your investment portfolio, you may wish to consult with a financial professional to determine how that may align with your long-term goals and objectives.
Media contact: Callie Briese, 612-844-7340; callie.briese@thrivent.com
All information and representations herein are as of 07/08/2025, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Diversification does not guarantee a profit or protect against loss in a declining market.
Real gross domestic product (GDP) is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year.
The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.
The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk, fear or stress in the market when making investment decisions.
Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
Past performance is not necessarily indicative of future results.
1Damocles is a character in an ancient Greek anecdote commonly referred to as "the sword of Damocles," an allusion to the imminent and ever-present peril faced by those in positions of power.
2“European Markets are Becoming Increasingly Difficult to Ignore” Bloomberg. June 30, 2025. https://www.bloomberg.com/news/articles/2025-06-30/europe-stocks-and-currency-outperform-us-as-markets-stage-comeback July 1, 2025.
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