Narrow Market Gains Mask Broader Uncertainty

July 21, 2025

Financial Markets

Equity markets posted solid gains last week, with major indices advancing despite lingering uncertainty around U.S. tariff policy and an ongoing feud between President Trump and Fed Chairman Powell. However, a closer look reveals that the rally was narrowly concentrated. Only a small subset of stocks, primarily in the technology and AI sectors, accounted for the bulk of the market’s performance.

This concentration raises important questions, especially given the ongoing volatility in trade policy. The United States has issued—and rescinded—a flurry of tariffs, leaving investors struggling to assess the longer-term implications. Still, the market’s resilience amid this confusion is notable.

One interesting dynamic is the continued underperformance of small-cap stocks relative to large caps. Historically, small caps have outperformed over extended periods, but the past decade has defied that trend. While it’s unclear when this may change, the current environment—particularly with the resurgence of tariffs—could favor smaller companies. These firms tend to be more domestically focused and less exposed to international trade, potentially insulating them from the worst effects of rising protectionism. Still, these smaller companies may be vulnerable to rising input prices.

Economics

The U.S. economy remains on solid footing, though political headwinds persist. The most visible of these is the friction between President Trump and Federal Reserve Chair Jerome Powell. Last week, speculation swirled that the president was preparing to remove Powell from his post. Markets reacted swiftly, selling off in response. The president later denied the rumor, helping to stabilize investor sentiment and reignite the rally. Still, Trump’s continued threats to fire Powell may have already reduced the Fed’s independence to some extent. The next chair will likely be perceived—rightly or wrongly—as having promised to cut rates. It’s difficult to imagine investors remaining fully comfortable with that backdrop. However, importantly, monetary policy decisions require a majority vote from the Federal Open Market Committee, not just the chair. Larger rate cuts, if implemented, could introduce inflationary pressures. Rising yields driven by inflation expectations and concerns over Fed independence would, in turn, increase the cost of financing the growing deficit.

Tariffs continue to dominate the economic narrative. Their impact is not yet fully understood, but both political and economic risks are rising. The most important unknown may be the effect on the U.S. dollar. Historically strong and globally dominant, the dollar’s supremacy has seemed unshakable. However, the aggressive use of tariffs and trade restrictions has prompted some economists to warn that competing blocs—such as the E.U. or a coalition led by China—could challenge U.S. monetary dominance in the long term. While such a shift remains unlikely, it is no longer unthinkable.

Turning to China, economic data suggest the country continues to struggle. Despite attempts to stimulate growth, policymakers have made little progress. A decade of overinvestment in commercial and residential real estate has left behind significant imbalances. Many homes remain unoccupied, and a growing number of recent buyers now find themselves underwater on their investments. Until these issues are addressed, China’s growth outlook will likely remain subdued.

Conclusion

Forecasting in this environment remains challenging, particularly given the political noise. Nonetheless, several regional trends are clear. China is unlikely to return to its previous growth trajectory in the near term. The European economy shows signs of improvement, while the U.K. continues to muddle through. The U.S. remains the world’s most important economic driver and appears to be holding steady but is showing signs of consumer caution.

We are not forecasting a recession, but a slowdown is likely. The Federal Reserve is expected to ease at some point this year, providing additional support. In the meantime, investors should remain aware of market breadth issues and monitor trade developments closely. Smaller-cap equities, overlooked in recent years, could be positioned to benefit if domestic-focused businesses become more insulated from global shocks.

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