Summer squall coming?

Bottom Line

For equity investors, the first half of 2025 was one to remember. Over the last three months, the S&P 500 has rallied 30%, marking the strongest and shortest rebound to a record high after a decline of at least 15%. That’s not a surprise to us, as the Trump administration has been on a roll of late.

First, the 12-day Iran/Israel conflict was resolved without any significant damage to the global energy market. Next, the recent NATO Summit in the Netherlands went well, with our allies agreeing to increase their defense spending to 5% of their countries’ respective GDP budgets. Finally, Congress passed and Trump signed into law  the One Big Beautiful Bill, which permanently extended the 2017 tax cuts, added some fiscal stimulus, reduced federal spending and raised the debt ceiling.

Storm clouds on the horizon? But there are some possible summer squalls on the horizon, which have the potential to induce some modest profit-taking among investors. The stock market tends to be choppy in August and September. In our view, a potential 5-8% correction over the next few months could be healthy, setting the market up for a year-end rally to our full-year target of 6,500.

Top of the list are the ongoing trade negotiations. After the Liberation Day debacle, in which stocks plunged 15% in a week, the administration pushed the new tariff deadline out 90 days to July 9. That deadline has passed, but Trump set a new one of August 1. We don’t know when, with which countries and at what tariff levels the US will sign deals. 

Second quarter results on tap The S&P reporting season begins next week. At the end of March, FactSet consensus expected profits to grow about 9.4% year-over-year (y/y). That take has slowed to 5.0% by the end of this quarter. For reference, profits rose 9.7% in the first quarter. Any gain would mark the eighth consecutive quarter of earnings growth, but 5% would amount to the weakest since the fourth quarter of 2023. Similar story for revenue. At the end of March, the street anticipated the second quarter would see a 4.7% y/y increase but now expects it to be 4.2%. Revenue rose 4.8% in the first quarter. Any gain would mark the 19th consecutive quarter of revenue growth. But net profit margins are likely to shrink in the second quarter due to the decline in productivity and increase in wage costs. 

Labor market showing some cracks On the surface, the June jobs report looked pretty good, with surprisingly higher nonfarm payrolls and a decline in the rates of unemployment and average hourly earnings to 4.1% and 3.7%, respectively. But private job creation was weaker than expected, and the contribution from immigrant labor has slipped in recent months. In fact, June’s overall strength was largely due to the largest gain in state and local hiring (led by education) in more than two years, perhaps due to seasonal quirks that could be revised down in coming months.

Consumer slowing Retail sales in March increased sequentially by the largest amount in more than two years, perhaps related to a pulling forward of auto activity to beat a potential tariff-related price increase. The pace of auto sales declined in May and June, and May’s nominal retail sales dropped sharply. The US is more than a month into the important Back-to-School (BTS) season. But this week, we might get a foretaste via the performance of Amazon’s Prime Day sales, which tend to set the tone for BTS.

Confidence has been volatile In the second half of last year, business and consumer confidence soared to cycle highs due to election-related enthusiasm. It then declined sharply due to fiscal policy uncertainty before improving in recent months. But a key sign of consumer stress is a rise in the personal savings rate; it leapt to 4.5% in May, up from a 17-year low of 2.0% in June 2022.

The spring housing market was a bust There's much to blame: soaring mortgage rates, near-record high home prices, low inventory levels and the worst affordability in 40 years. As a result, the National Association of Home Builders housing market index hit a 30-month low at 32 in June, starts and permits are at five-year lows through May, and new and existing home sales are running just off one-year lows. This is all happening despite enormous pent-up demand.

Inflation softening? Inflation increased during 2024 but improved across the board over the past several months. Core PPI wholesale inflation declined to a nine-month low of 3.0% y/y in May; core CPI retail inflation slowed to a four-year low of 2.8% in May; and core PCE inflation (the Fed’s preferred metric) declined to a four-year low of 2.6% in April 2025. Despite this, Federal Reserve economists expect a tariff-related uptick soon. 

Fed navigating through a rock and a hard place What will the Fed decide at its FOMC meeting July 30, and what might Chair Powell say at its annual symposium at Jackson Hole, Wyo. in August? Trump has been aggressively jawboning the Fed to cut rates. Will the rumors of him creating a shadow Fed Chair materialize to roil financial markets? To date, the Fed has adopted a wait-and-see approach, wanting to digest more data on inflation and unemployment in the wake of the new legislation and tariff negotiations, which have recently heated up. As such, the Fed is likely to cut interest rates twice this year, with the first quarter-point one coming at its September 17 meeting. 

Growth even lower The Commerce Department revised first-quarter 2025 GDP growth from -0.2% to a final print of -0.5%, compared with a gain of 2.4% in the fourth quarter 2024. Tariff-related concerns rocked the boat: a record 38% surge in imports subtracted 4.66 percentage points from GDP growth.

Adjusting our forecasts The fixed-income, liquidity, and equity investment professionals who comprise Federated Hermes’ macroeconomic policy committee met on Wednesday to discuss the state of the economy. 

• We raised our estimate for second quarter 2025 GDP growth from 1.9% to 2.3%, as we expect the first quarter’s sharp swings in imports and inventories to begin to normalize, while the Blue-Chip consensus raised its forecast from 1.1% to 1.9% (within a very wide range of 0.1% to 3.7%). The Atlanta Fed’s GDPNow estimate was reduced from 4.7% to 2.6%. 
• We raised our estimate for third quarter 2025 GDP growth from 1.7% to 2.3%, while the Blue-Chip increased its from 0.2% to 0.5% (within a range of -1.1% to 1.8%).
• We raised our forecast for fourth quarter 2025 growth from 2.1% to 2.5%, while the Blue-Chip consensus increased its from 0.7% to 0.8% (within a range of -0.8% to 1.8%).
• As a result, we raised our full-year 2025 growth estimate from 1.6% to 1.8%, while the Blue-Chip consensus raised its from 1.2% to 1.4% (within a range of 1.0% to 1.8%). 
• Given the sharp decline in inflation over the first half of this year, we reduced our year-end 2025 forecast for core CPI inflation from 3.0% to 2.9% (compared with actual core inflation of 2.8% in March, April and May 2025), while the Blue Chip lowered its from 3.2% to 3.0% (within a range of 2.7% to 3.3%). We also left unchanged our year-end 2025 estimate for core PCE inflation at 2.7% (compared with actual core inflation of 2.7% in May 2025), while the Blue-Chip consensus lowered its from 3.0% to 2.8% (within a range of 2.6% to 3.2%).
• Given stimulative tax cuts from the One Big Beautiful Bill this year and the prospect of lower negotiated tariffs globally, we remain constructive on their longer-term economic impact. Consequently, we raised our projection of full-year 2026 GDP growth from 2.7% to 2.8%, while the Blue Chip increased its from 1.3% to 1.4% (within a range of 0.6% to 2.0%). 
• We left our year-end 2026 estimate for core CPI inflation unchanged at 2.6%, while the Blue Chip reduced its forecast from 3.0% to 2.9% (within a range of 2.4% to 3.6%). We also left our year-end 2026 estimate for core PCE inflation unchanged at 2.3%, while the Blue Chip lowered its from 2.9% to 2.8% (within a range of 2.3% to 3.5%).

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