Policy Shocks Disrupt Market Calm

The first quarter of 2025 marked a significant departure from the preceding two years, which had been characterized by an improving global economy and correspondingly positive market returns. Market performance in Q1 was dominated by abrupt, short-term policy shifts rather than longer-term economic trends, and tariffs became the foremost concern for market participants.

This disruption stemmed primarily from abrupt and aggressive US trade policy shifts. As broad-based tariffs were rapidly implemented, investor confidence was rattled, reshaping the global economic and investment landscape into a period of heightened uncertainty. The narrative quickly shifted from underlying economic fundamentals – which remained positive – to the implications of this new protectionist stance. Consequently, we have transitioned from an economy characterized by consistent growth and slowly moderating inflation to a volatile environment where short-term policy uncertainty is temporarily curtailing long-term investment decisions.

Markets reacted swiftly. Capital flowed from previously favored segments, notably U.S. large-cap technology stocks, and moved towards long-overlooked value stocks and international markets. This rotation punished former market leaders while rewarding other segments, underscoring the critical importance of diversification, robust risk management, and adaptable investment strategies capable of navigating sudden shifts. The best-case scenario involves a swift resolution to the current uncertainty; given the relatively modest decline in overall market value thus far, markets appear to be anticipating such a reasonable resolution is likely.

While policy changes often exert a short-term influence, technological innovation and underlying economic resilience matter more for intermediate and long-term investor outcomes. However, the unique status of the U.S. capital market as the world's most significant for over a century lends particular weight to domestic policy shifts and their potential repercussions for the global market.

Market Analysis: Quarter in Review

The quarter witnessed a major sentiment shift. The year commenced with optimism surrounding the potential for a business-friendly environment under the incoming administration. However, this optimism gradually eroded as skepticism grew regarding key components of the administration's policy plans, particularly concerning trade.

State of Equity Markets

Tariff concerns dominated sentiment and capital flows. High valuations in U.S. technology stocks, compounded by the perceived threat of competitive Chinese AI advancements, prompted capital to exit the dominant U.S. large-cap growth segment. This capital sought opportunities in perceived as undervalued regions, such as Europe and China, and U.S. value stocks. India maintained its high valuation, benefiting from relatively robust growth, free capital flow (a rarity among emerging markets), and neutrality amidst major geopolitical tensions. Switzerland also benefited from its neutral stance, though investors seeking a pure safe haven might have found gold to be a more direct investment. The quarter saw historically strong relative returns for European equities versus the U.S., and for value versus growth stocks.

• The Return of Value Investing: Even absent tariff concerns, investors were wary of the AI-fueled valuations of large U.S. technology companies. The emergence of lower-cost Chinese AI alternatives further called these high valuations into question, sending capital into safer, long term “value” investments.
• Crypto and Market Speculation: The cryptocurrency market entered the year with a tenuous investment thesis centered on potential deregulation and the prospect of strategic reserve holdings driving inflows and legitimacy. Conversely, a counterargument posits that appropriate regulation could enhance cryptocurrency value by improving transparency and mitigating risk. Therefore, it’s important to determine whether flows are driven by thoughtful investors or speculators. "Memecoins," which lack any fundamental investment thesis, serve as a barometer for broader market speculation. The multi-billion-dollar market capitalization achieved by tokens like #TRUMP within hours of launch, followed by steep declines, indicated substantial speculative capital remained active in the market early in the quarter.

Fixed Income Review

Fixed income markets navigated the dual challenges posed by tariffs: potential inflationary effects and the risk of an economic slowdown. During the first quarter, intermediate and long-term Treasury yields initially fell as investors sought safety, suggesting greater immediate concern over recession risk (where bonds are desirable) than inflation risk (which erodes bond value). However, more recent tariff developments have brought stagflation fears – simultaneous slowing growth and rising inflation – into sharper focus.

Treasury Stability and the Fed: Despite these strains, Treasury yields have exhibited relative stability, particularly for maturities of two years and longer, showing volatility comparable to the of the past 20 years (see chart). Short-term rates, however, have experienced little volatility as the Fed has been unable to lower rates. This lack of volatility corresponds to the reduced role of the Fed in driving market movements.

Source: U.S. Department of the Treasury.

Diversified portfolios have performed well

Fixed income performed effectively within an optimized portfolio framework. Our analysis of the previously inverted Treasury yield curve indicated attractive risk-adjusted returns for short-duration instruments like Treasury Bills and Floating Rate Notes, while longer maturities presented significant interest rate risk with little commensurate premium. For riskier fixed income segments such as high-yield and emerging market bonds, we identified inherent risks but also potential premiums. Portfolio optimization added significant value by allocating to fixed income ETFs best positioned to contribute positively to the overall portfolio, considering these risk-reward tradeoffs. Diversified portfolios benefited from the mostly positive performance across fixed income segments. The relationship between risk and return played out as expected – risk didn't always pay off, especially with concentrated bets – reinforcing the value of diversification, particularly when equities exhibited wide dispersion and mega-cap tech faltered.

Market Performance

Equity Markets

After a strong start to 2025, fueled by optimism surrounding U.S. economic leadership and anticipated market-friendly policies, U.S. equity markets reached all-time highs in mid-February. However, sentiment reversed as escalating trade policy uncertainty hurt U.S. growth expectations. While high tariffs directly dampened growth and increased inflation, the uncertainty surrounding their scope and implementation dealt greater immediate damage to market confidence.

Q1 demonstrated significant dispersion in regional equity returns:

• U.S. Equities: Declined over 4% overall, led by a sharp downturn in technology stocks (-10%), while value stocks managed to post gains.
• International Equities: Significantly outperformed the U.S., with notable strength in Chinese and European equities (both rising over 10%). Asia-Pacific markets registered small gains.
• China: Rallied on excitement following breakthroughs in domestic AI (e.g., DeepSeek), the imposition of less severe U.S. tariffs than initially feared (the relatively positive tariff news has since reversed), and signals of more supportive government policies.
• Europe: Benefited from increased defense spending commitments, fiscal loosening trends, and anticipation (later realized) of European Central Bank (ECB) rate cuts.
• U.S. Dollar: Weakened by approximately 4% during the quarter, providing further dollar-denominated returns for international assets.

Rising recession concerns stemming from potential trade disruptions led markets to price in a higher probability of Federal Reserve rate cuts by year-end. This expectation contributed to positive performance across most bond market segments during the quarter. U.S. aggregate bonds gained 2.7% and long-term Treasury bonds returned 4.8%.

In stark contrast to 2024's highly concentrated market environment, Q1 2025 vividly demonstrated the value of optimal diversification across risk factors, asset classes, and geographies. While many risks are inherently unavoidable and often unforeseeable, a well-disciplined, optimized investment process allows portfolios to participate in diverse long-term risk premiums in a risk-controlled manner, rather than chasing concentrated returns. Equity markets were challenging; the extraordinary returns from concentrated AI exposure seen previously did not persist, and measured exposure to broad risky assets through diversification proved beneficial this quarter.

New Frontier Strategy Performance & Rebalancing

In a challenging quarter marked by policy-driven volatility and market rotation, New Frontier strategies generally performed well, outperforming broad benchmarks and concentrated strategies. Overall, New Frontier portfolios performed according to their investment goals, with conservative and moderate portfolios effectively managing risk, while even aggressive portfolios avoided concentration in the worst performing asset classes.

Strategy Performance: Low-risk through balanced-risk profiles notably remained in positive territory, highlighting the benefits of diversification in a difficult equity environment. Positive contributions came from bonds (offsetting U.S. equity losses), international equities, and alternatives.

• Global Core: All fixed income allocations contributed positively. Exposure to long-duration Treasuries and TIPS added relative strength. Within equities, an underweight to the underperforming U.S. large-cap growth segment was a key driver of relative outperformance. Allocations to minimum volatility equities and REITs also enhanced relative results. Gold, held as a strategic diversifier, was a meaningful contributor to both absolute and relative performance.
• Tax-Sensitive: Performance tracked Global Core closely, with slightly lower returns due to the relative underperformance of municipal bonds compared to their taxable counterparts during the quarter.
• Multi-Asset Income (MAI): Delivered a strong quarter, benefiting from the outperformance of dividend-oriented equities. International high-dividend stocks were primary contributors, alongside a diversified mix of regional high-dividend ETFs. Income-focused ETFs like covered call strategies, preferred stocks, and convertible bonds detracted from returns. MAI portfolios currently offer attractive yields in the 4.7%–5.2% range.

Model Allocations

New Frontier uses Intelligent Rebalancing^TM, the Michaud-Esch portfolio rebalance test, to guide portfolio reallocation and rebalancing decisions. This framework allows us to simultaneously consider changes to the risk characteristics of portfolios from price movements, and changes to optimal portfolio exposures from new capital market expectations.

New Frontier rebalanced both Tax Sensitive (February) and Global Core (April) strategies for global equity risk management impacted by policy changes such as tariffs. These rebalances featured broader diversification into equities. Specifically, overall risk decreased from a shift to min vol equities. Diversification among international markets was improved with higher allocations to: Europe (broader diversification), Emerging markets (low correlation, diverse markets), and especially min vol international which is dynamically and tax-efficiently optimized to minimize volatility across countries and sectors.

Taxable fixed income allocations were optimized for sharply lower short-term Treasury rates and generally higher municipal bond yields. The result was a general shift to muni allocations from short-term taxable bonds. Short-term Treasurys and Mortgages allocations were eliminated, although some Treasury Floating Rate Notes are still competitive and useful in low-risk portfolios. Also noteworthy is a modest allocation to TIPS, which had been absent due to tax inefficiency in the high inflation environment, but is now a useful hedge for potential inflation risk.

The Economy

Recent economic trends risk being overshadowed by the focus on tariffs, but the underlying landscape still matters. Although potentially higher borrowing costs and a potentially growing government debt may become significant drags in the future, both the U.S. and the global economy generally maintained positive momentum entering the quarter. The U.S. reported solid jobs growth, and CPI inflation registered a reasonable 2.4% year-over-year through the quarter's end.

Immigration: Economic Impact

Setting aside social implications, the economic consequences of immigration flows are significant. Immigration tends to disproportionately bolster the working-age population. This demographic shift provides a boost to GDP growth potential without necessarily generating commensurate inflation (though with lower wage growth). Fiscal impacts are also likely net positive over time through increased income tax revenue and contributions to social security systems.

Budget, Taxes, and Debt: Economic Impact

There are also potentially large economic implications of budget cuts and tax reductions. Broadly speaking, budget reductions slow the economy by reducing spending, while tax reductions (ignoring tariffs for the moment) stimulate the economy with more disposable income leading to somewhat more consumption. The impact of tax reduction critically depends on implementation – putting too much money in the wrong hands can slow the economy if they don’t spend it, or worse cause inflation if spent irresponsibly and as a substitute for income through productivity as happened during the pandemic.

Currently, there is too much uncertainty to be able to determine the net effect of budget and tax cuts on economic growth, although it will likely take more effort than these two policy changes to achieve economic nirvana. However, the net effect of the cuts is projected to increase debt. While there is no set threshold for a debt crisis, it is worth noting that debt may be more of a concern in a deglobalized economy.

Tariff Policy Developments

The dominant economic narrative shifted dramatically due to tariff policy. Beginning on February 1st targeted tariffs were imposed -- 25% on goods from Canada and Mexico and 10% on goods from China/Hong Kong --justified under an emergency declaration regarding opioid trafficking. The situation escalated on March 4th when the China/Hong Kong tariffs were doubled to 20%. Markets were further surprised on April 2nd by the announcement of broad "reciprocal tariffs," which established a universal 10% baseline tariff on imports from nearly all trading partners (notably excluding Canada and Mexico initially), with the threat of higher rates for countries running trade surpluses with the U.S. A week later, these higher reciprocal tariffs were paused for 90 days and replaced by a near-universal 10% tariff (again excluding Canada/Mexico), while China ultimately faced a 145% tariff, prompting a retaliatory 125% tariff from China on U.S. goods. Markets reacted positively to the pause, but the prospect of severely disrupted commerce between the world's two largest economies remains a significant risk-- one that is likely not yet fully priced into markets.

Reciprocal tariffs, while potentially appealing on fairness grounds, lack strong economic justification. Determining the true effective cost advantage across all goods between trading partners is exceptionally complex. Furthermore, global trade involves multi-party relationships; a system where Country A has a surplus with B, B with C, and C with A can be globally balanced even if bilateral imbalances exist. While thoughtfully implemented tariffs could potentially foster specific domestic industries deemed strategically important or facing unfair competition, the current approach presents significant challenges.

The Paradox of Tariff Policy: A fundamental contradiction exists: tariffs cannot simultaneously serve as temporary bargaining chips and as a stable, long-term policy to incentivize large-scale domestic investment. Businesses require predictability to commit the substantial capital needed for building factories, developing supply chains, and training workforces. If tariffs are perceived as transient negotiating tactics, such long-term investments are unlikely to materialize. Moreover, calculating tariffs based on bilateral trade deficits is problematic, especially in free-market economies where individual firms act in their self-interest, potentially exacerbating imbalances unintentionally.

Market Reaction: It's plausible that markets had already begun pricing in the risk of disruptive tariff policies earlier in the quarter, contributing to the underperformance of U.S. equities leading up to the official announcements. Therefore, some portion of the tariff impact may already be reflected in current asset prices.

Insights

Private Assets – Should They Be in Your Portfolio?

Private assets – investments not traded on public exchanges, encompassing private equity, private credit, real estate, and infrastructure – have long been a cornerstone of institutional investment portfolios. Endowments, pension funds, and sophisticated family offices often allocate significant portions (e.g., 15-25% or more) to private markets, seeking enhanced returns, diversification, and access to opportunities unavailable in public markets. Historically, access for individual investors was limited due to high minimum investments, long lock-up periods, and complexity. However, the landscape is evolving.

Increasing Accessibility: A private asset ETF is both a holy grail and a contradiction, since it would require illiquid assets to trade like liquid ETFs. Nonetheless, regulatory changes and new fund structures have made progress toward providing access to retail investors. Interval funds and, more recently, certain ETF structures are emerging vehicles designed to offer retail investors exposure to previously inaccessible private assets. Interval funds, structured as closed-end funds, provide periodic (often quarterly) repurchase offers for a limited percentage of shares (typically 5%), allowing them to hold illiquid assets while offering investors constrained liquidity.

Rationale for Inclusion

Market representation: Private markets represent a section of capital markets with at least somewhat different characteristics than public markets, making them a candidate for including in an optimized portfolio. Broadly speaking, the value of public stock and bond markets are each in the order of $100 trillion globally. Private markets are in the order of $10 trillion. This would suggest the average investor should have close to a 5% allocation to private markets.

Enhanced Returns: Private equity has historically been associated with higher long-term returns than public equities, often attributed to an illiquidity premium and access to companies earlier in their growth cycle. Private credit may offer higher yields than traditional fixed income due to illiquidity and complexity premiums.

Diversification: The low correlation of private assets to public markets is often overstated or miscalculated. However the majority of small and mid sized companies are private and private assets are likely to represent parts of the market missing from public markets and enhance diversification.

Challenges for inclusion

Illiquidity: The slow access to capital withdrawal may be intolerable for some investors, and presents a challenge for reallocation and risk management for even the most disciplined of investors. ETFs in this category have continuous market trading but may suffer liquidity-driven price shocks in time of market stress.

Complexity: It can be challenging to accurately estimate return and risk expectations for private assets, making them difficult to appropriately use in a portfolio.

Manager Selection: Performance dispersion among private market managers is significantly wider than in public markets. It is unrealistic to expect the average retail investor will be able to select a top quantile manager.

Fees: Markets are efficient enough that investors should only invest in asset classes they have efficient exposure to. The high fees of many private investments can more than offset their advantages. Compared to the typical “2 and 20” fees of many interval funds, ETFs may have fees of 70 or 80 basis points. This may seem like a bargain to investors, but considering that the desirable exposure to private assets is generally less than 15% of the ETF, scaling up this fee reveals the cost of accessing private assets can be in the order of 5% annual fees. This can be calculated by dividing the ETF expense ratio by the portion of private assets. For example: we can back out the cost of a 80bp ETF with 15% in private assets and 85% in public assets which are available in a comparable ETF for 5bp as: (Expense Ratio) * 15% + 5bp * 85% = 80bp, so for this exposure to private assets, the investor is paying an Expense Ratio= 5.05%

Conclusion

Individual investors now have improved access to private markets as well as other alternative asset classes. Individual investors often have long investment horizons to accommodate illiquidity, so it’s worth considering how they can be used in a portfolio to meet investor goals.

ETF Watch

• Private Credit ETFs: These vehicles offer access, though with limited direct exposure to true private credit.
• Bitcoin ETFs: Bitcoin did not continue its rally through Q1. The ETFs function as intended, providing access, but demand remains the primary price driver. Large flows can trigger creation/redemption mechanisms that significantly impact the underlying price.
• Gold & Gold ETFs: Gold continued strong gains; however, focusing on it as a long-term risk management asset (rather than chasing recent returns) is prudent. Remember, U.S. investors face collectibles tax rates (up to 28%) on long-term gains in ETFs holding physical gold.

Looking Ahead: Navigating Uncertainty

The market's response to economic news appears to have passed an inflection point. For much of the prior year, a strong economy was largely assumed, focusing market attention on declining inflation as a prerequisite for Fed rate cuts. As the new administration's policy priorities – particularly tariffs – crystallized, hopes for disinflation gave way to fears of a trade-induced recession.

The first quarter provided ample fodder for market prognosticators, witnessing both new highs and substantial drawdowns. It served as a stark reminder of the dangers of extrapolating recent trends. The perceived invincibility of U.S. large-cap technology and the seemingly boundless ascent of Bitcoin were challenged. Market leadership rotated dramatically, reaffirming that no single asset class provides all the answers. Similarly, consensus forecasts proved fallible. The future remains unwritten.

In this environment of heightened uncertainty, potential regime shifts, and policy volatility, the value of experience and a robust, adaptable investment process is paramount. Navigating markets characterized by trade disputes, potential stagflationary pressures, shifting global dynamics, and technological disruption demands a disciplined approach grounded in sound economic theory and statistical rigor.

This is precisely the environment where New Frontier’s forward-looking Michaud optimization process demonstrates its greatest value. Static, backward-looking allocation models struggle to adapt effectively to structural breaks and changing market relationships. An optimized approach, explicitly accounting for the estimation error inherent in all market forecasts and optimizing for risk-adjusted returns across thousands of potential future scenarios, allows for the construction of portfolios designed for resilience. It provides a disciplined framework for navigating inflection points, managing risk effectively, and capitalizing on diversification opportunities within a complex global landscape.

The challenges presented in Q1 2025 reinforce our conviction that thoughtful optimization is not merely an enhancement but an essential component of successful long-term investing in an increasingly uncertain world. The market’s willingness to quickly forgive policy missteps may indicate underlying confidence in the economy's resilience and the ongoing benefits derived from technological advancements like AI, which continue to enhance productivity across corporations large and small.

Key takeaways

• Fed policy changed: The Federal Reserve's stance has shifted from potentially lowering rates proactively ("because it could") to contemplating rate cuts necessitated by emerging economic risks ("because it might need to"), despite potential inflationary side effects from tariffs.
• Economic impact of tariffs: The strong consensus among economists and business leaders holds that tariffs generally impede economic growth via higher prices and reduced global economic activity, broadly hurting corporate profitability expectations and thus stock prices.
• Uncertainty hurts markets: Q1 demonstrated how quickly policy shifts (like tariffs) can override economic fundamentals in the short term, driving market rotation and highlighting the need for adaptable strategies.
• Uncertainty discourages investments: investments in manufacturing (among others) require substantial time and resources. Shifting policy landscapes inevitably discourage investment as viability and future expectations are reassessed.
• Potential for market Improvement: Recent market declines reflect lowered expectations adjusted for uncertainty, not necessarily an immutable negative economic reality. Should policy clarity emerge, markets are likely to respond positively.
• Markets are priced for some tariffs: Markets price in the impact of expected tariff policy at all times. For instance, U.S. stocks declined in Q1 leading up to the announcements. The full extent and duration of tariffs remain uncertain. Therefore, current prices are well within the upper extremes of a complete and economically beneficial resolution, and the lower extreme of a drawn-out volatile trade war.

• Diversification helps: The resilience of value, international equities, and gold demonstrated benefits of broad diversification across regions, styles, and asset classes.
• Optimization adds value in complex markets: A disciplined, forward-looking optimization process proved crucial for navigating fixed income complexities and constructing resilient portfolios amidst equity market shifts.
• Alternatives are accessible, but scrutiny required: While access to alternatives like private assets is increasing for individual investors, inherent challenges related to illiquidity, complexity, manager selection, and true cost (fees) demand careful consideration.
• Global perspective is prudent: Given that approximately 64% of the global stock market is concentrated in the U.S. – and the potential for domestic policy volatility – maintaining international diversification is key for long-term wealth preservation and growth.