In a quandary

Economic data

The big event of the week was the US Federal Reserve’s (Fed) interest rate decision, with the central bank deciding once again to hold rates unchanged at 4.25%-4.50%. Market participants were keenly focused on whether the governors would change their expectations for interest rate cuts for the balance of 2025. The previous forecast had penciled in two remaining cuts this year, and there was no change at the meeting, though some expected they could have moved to only one cut for the balance of 2025.

While originally viewed as dovish, Fed Chair Jay Powell’s comments erased that interpretation, but still the bond market’s reaction was rather muted. Powell reiterated that they’re patient and require further data to show inflation moving to their target, while the economy and employment market have remained resilient. On tariffs, Powell did acknowledge that the announced tariffs were well in excess of what the committee had originally forecasted as potential scenarios and with the upsized tariffs their future expectations on inflation had risen. Their higher expectations for inflation were evident by moving both total and core Personal Consumption Expenditures (PCE) inflation by 0.3ppts to 3.1% in 2025. Furthermore, the summary of economic projections also showed real GDP growth slowing by 0.3ppts to 1.4% and another 0.2ppts in 2026 to 1.6%. Although there are signs of the labor market beginning to soften, the Fed did comment that, “The unemployment rate is 4.2%. Real wages are moving up, job creation is at a healthy level, unemployment low, and the labor force participation is in a good place”.

The communication reinforces that the employment market is not showing significant signs of stress which would warrant a reaction by the Fed. The central bank certainly is in a quandary as the path forward is highly unknown. The current administration has shown its preference to keep uncertainty elevated which ultimately makes the central bank’s job of forecasting inflation that much harder. The Fed will have to balance the unknowns of tariffs and their impacts on inflation against an economy which continues to slow.

In addition to the Fed this week, the market got a look at retail sales in the US for the month of May. The headline number disappointed with sales slipping 0.9% for the month, worse than the forecasted -0.6%, and down from -0.1% the previous month. Ex-auto and gas further disappointed, coming in at -0.1% versus expectations of +0.3%. The control group did show signs of strength coming in at +0.4%, higher than the anticipated +0.3%, which left the overall outcome muted and the market reacted in kind with little overall impact. Retail sales for the month of April were also released for Canada which showed the headline number at +0.3% while the control group Ex Auto dropped -0.3%, slightly below expectations of -0.2%. The bigger news was the flash estimate of May which indicated a drop of -1.1% in sales, the largest drop in over a year.

Global market reaction

Geopolitics continued to drive swings in global risk assets as concerns grew over a potential escalation of the conflict in the Middle East. Ambiguous remarks by President Trump further fueled uncertainty about whether the United States would participate in strikes against Iran. Amid the geopolitical noise, trade discussions took a quieter role, but the direction of travel was constructive. During the G7 Summit in Canada, President Trump and Prime Minister Carney committed to finalizing a trade agreement within the next 30 days. Meanwhile, negotiations with other key nations are ongoing, with extensions to the July 9th deadline appearing likely. European Union leaders expressed optimism about the progress being made in trade talks.

Global equity markets were mixed this week. Japanese equities advanced nearly 1%, extending prior gains, while European equities saw a sharp decline of almost 3%. Emerging Market (EM) equities declined modestly, following gains earlier in the month. In bond markets, European yields edged slightly higher, reflecting concerns about rising energy prices. In contrast, Japanese bond yields fell after a successful auction of five-year government notes, which attracted the strongest demand in nearly two years, alleviating recent concerns about declining interest in Japanese government debt. The US dollar rebounded after reaching its lowest level in more than three years during the previous week. The recovery was driven by geopolitical tensions and comments from Fed Chair Powell, who reiterated the central bank's cautious stance on rates as it assesses the effects of tariffs and rising oil prices. In the commodities markets, oil prices surged by more than 10% amid the escalating conflict between Israel and Iran. Cyclical metals remained largely unchanged, as concerns over slowing global growth were offset by tighter copper supply. This was evidenced by strong inventory drawdowns in warehouses of the London Metal Exchange and in China.

Bond market reaction

Yields on the week were relatively unchanged with the 10-year US treasury yield moving only lower by a couple basis points with the interest rate curve moving in a similar fashion with a modest curve steepening. Central bank expectations were also unchanged for the week with the market only expecting one more cut from the Bank of Canada (BoC) for the remainder of 2025 and the Fed with two cuts for this year. The corporate bond market was relatively active this week with Canadian banks tapping their domestic markets for funding. New issues remain well oversubscribed but have only performed modestly in secondary trading with credit spreads nearing year-to-date lows.

Stock market reaction

US and European equity markets are set to end the week lower. Hopes for de-escalation in the conflict between Israel and Iran drove an initial rally to start the week. However, growing concerns about the potential for direct US involvement in the conflict led to stocks falling. The Fed's decision to hold US rates with the view that tariffs could put pressure on economic growth and lead to higher inflation further drove negative investor sentiment. Technology was the strongest performing sector in the US. Marvell and AMD both held presentations outlining significant revenue opportunities related to AI data center buildouts that were well received by investors, leading to both stocks rising about 10%. Healthcare and utilities were the worst performing US sectors. Canadian markets are set to end the week slightly lower. Technology and financials were the top performing sectors while consumer staples and energy performed poorly.

ETF strategy – Tilts & timing

Global markets in 2025 have demonstrated mixed performance, shaped by various macroeconomic and geopolitical factors. While US equities have faced challenges, European and EM stocks have performed extremely well. Defensive sectors, including health care and consumer staples, have outperformed, contrasting with the underperformance of cyclical sectors like consumer discretionary. Commodities, particularly gold, have emerged as standout performers, reflecting heightened demand for safe-haven assets amid ongoing uncertainty. Ongoing weakness in the US dollar has further enhanced the attractiveness of non-US investments.

Recent trends indicate a clear shift in fund flows away from US-centric investments towards regional diversification, with Europe and EM benefiting from substantial inflows. Value as a style continues to outperform growth in international markets while the opposite has occurred in the US with the recent market rally off April lows. Our machine learning model remains positioned similarly as the past few weeks in the US, with an ongoing but moderating bias towards growth particularly in mid and small caps. In Canada, the model remains biased towards commodities though this has begun to soften of late as oil hovers around $75 USD, a level it has struggled at in the post-COVID era. Retail investors have remained net buyers of equities, while institutional investors have largely been sellers, a phenomenon we often see with the psychological chasing of market highs by the former.

Looking ahead, market dynamics will likely hinge on central bank policies, geopolitical developments, and corporate earnings resilience. Defensive strategies that prioritize high-quality stocks with stable earnings are once again attractive as markets struggle near all-time highs. While our regime model continues to point towards a buy signal, the current environment remains fraught with risk. Opportunities in Europe, EM, and alternative assets may offer appealing risk-adjusted returns, underscoring the importance of diversification and strategic asset allocation in navigating a complex macroeconomic and geopolitical environment.

What to watch in markets next week

Next week the market will have a look at Consumer Price Index (CPI) data in Canada for the month of May. Headline inflation is expected to remain unchanged at 1.7%, however, all focus will be on whether core inflation shows any signs of easing as the BoC specifically referenced it as a point of concern.

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Authors: Adam Ditkofsky, Pablo Martinez, Sandor Polgar, Steven Lampert, Craig Jerusalim, Diana Li, Mona Nazir, Mickey Ganguly, Kwaku Apraku, Greg Gipson, Eric Morin, and Vasilios Tsimiklis

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