Resigned Optimism

The second quarter of 2025 was defined by an optimism that the global economy will find a path forward, where the initial shock of aggressive tariff announcements was replaced by a period of cautious uncertainty as the resilient and resourceful U.S. consumer provided encouragement for domestic equities. Markets avoided further steep declines and gradually moved toward a course for growth as investors came to terms with tariff uncertainty, inflationary pressures, and slowing global growth.

Markets have been forgiving of the new tariff regime, perhaps correctly anticipating that the most extreme measures are negotiating tactics that will eventually moderate. However, our view is that the current environment introduces substantial volatility and is, on balance, a headwind for the U.S. economy. This reinforces our long-held theme that robust global diversification is essential. The portfolio adjustments we have made, such as increasing allocations to diversified, low-volatility international equities, reflect this. The central challenge for investors is no longer simply investing broadly in the global market but interpreting the relationship between policy actions and economic impact.

The Economy

The primary challenge in assessing the economy today is that traditional models and data signals are being distorted by broadcasted, large-scale policy interventions. Economic data has been noisy and has deviated from usual historical patterns. Therefore, traditional economic models and even statistics like GDP can be misleading. Anticipation of tariffs can induce short-term, atypical behavior like inventory build-ups or pull-forwards in consumption. The market may not be fully accounting for the fact that these economic signals have a different meaning than they normally would, creating a source of risk. While this is not devastating news, it suggests that many of the unknowns do not currently favor the U.S. economy.

The Tariff Impasse and Its Economic Drag

The most impactful development remains the ongoing uncertainty surrounding U.S. trade policy. A fundamental paradox lies at the heart of the tariff strategy: the tariffs cannot simultaneously be a temporary bargaining chip for negotiations and a permanent, predictable policy designed to encourage long-term domestic manufacturing investment. For tariffs to effectively stimulate large-scale capital expenditure—building factories, developing supply chains, and training workforces—businesses require a stable, long-term policy environment. As long as tariffs remain in flux and subject to negotiation, they are unlikely to trigger a meaningful resurgence in domestic manufacturing. To date, while we have not yet seen catastrophic harm from the tariffs implemented, we have also seen little evidence of their benefits.

The lack of a significant inflationary spike thus far can be attributed to several factors: companies may be absorbing higher costs in their margins to protect market share; or the tariffs may be acting as a tax on consumption, leading to a reduction in economic activity that offsets the direct price impact. Regardless of the mechanism, the primary economic effect of the current tariff regime is not a major price shock, but rather a persistent state of uncertainty that discourages investment and clouds the outlook for long-term growth.

The Federal Reserve’s Constrained Pause

The Federal Reserve held rates steady throughout the quarter. This inaction can be interpreted as a pause in the face of conflicting signals. On one side, core services inflation is above the Fed’s target with concerns that tariffs will contribute to additional inflation. On the other, the cumulative effect of past tightening and new policy headwinds presents a clear risk to future growth. It is plausible the Fed may be implicitly giving up on a strict 2% inflation target in an environment where tariffs are actively working against that goal.

While the Fed has so far maintained its independence and pursued a defensible policy path, a significant risk that we believe is underappreciated by the market is the potential for a change in Fed leadership and mandate in the coming years. A Fed chair appointed with a specific agenda could pursue a dramatically different policy path. In this scenario, a sharp drop in interest rates one to two years from now represents a key risk for investors to monitor.

Market Performance

The second quarter of 2025 proved just as volatile as the first, with markets whipsawed by policy uncertainty and geopolitical risks. Early in the quarter, the announcement of unexpectedly large tariffs triggered a sharp selloff across equity and bond markets. The S&P 500 dropped 12% in the span of a week, while U.S. 10-year Treasury yields spiked by roughly 50 basis points. However, sentiment recovered swiftly after the U.S. administration softened its stance, pausing new tariffs and advancing trade negotiations.

Supported by easing trade tensions, a resilient economy, and inflation broadly in line with expectations, U.S. equities staged a robust rebound. U.S. large-cap growth stocks led, surging nearly 19% and outperforming the broader S&P 500 by a wide margin. Overall, U.S. equities returned 10.9%, helping push the index to new highs by quarter-end. Gains were broad-based: all major international regions, including Emerging Markets, Europe, and Asia-Pacific, rose around 12%, supported by reduced trade headwinds and a 7% decline in the U.S. dollar.

Fixed income markets also delivered positive returns despite ongoing volatility. Divergent central bank policies—with the European Central Bank cutting rates twice while the U.S. Federal Reserve held steady—alongside dollar weakness, helped international government bonds gain 8%, outperforming U.S. Treasuries. U.S. high-yield bonds returned 3.6% as credit spreads tightened following April’s market turmoil.

Strategy Performance

New Frontier’s ETF portfolios delivered strong returns in the second quarter, participating in the broad market recovery while maintaining disciplined risk management.

• Global Core portfolios posted positive returns across all risk profiles, benefiting from broad-based gains in global equities as markets rebounded sharply. Exposure to high yield and international bonds also contributed meaningfully to performance. However, returns modestly lagged respective blended benchmarks, primarily due to our diversified positioning, which includes less concentration in U.S. large-cap growth stocks and allocations to diversifying assets such as U.S. minimum volatility equities and U.S. REITs—both of which did not add value this quarter.
• Tax-Sensitive portfolios performed in line with Global Core, delivering solid absolute returns while maintaining a focus on tax efficiency. Equity exposure, particularly to U.S. and international stocks, contributed positively, though municipal bonds underperformed taxable fixed income during the quarter.
• Multi-Asset Income (MAI) portfolios delivered resilient returns. While dividend stocks captured less of the sharp, growth-driven equity rebound in Q2, our globally diversified income exposure added value, with international high-dividend equities outperforming their U.S. counterparts. The recently added Franklin dividend ETFs—both U.S. and international—outperformed most traditional dividend funds, further enhancing portfolio returns. Fixed income allocations, including high-yield and emerging market bonds, contributed positively. Convertible bonds added to relative performance by benefiting from underlying exposure to the technology sector. The portfolios continued to meet their objective of delivering attractive and stable income, with yields around 5%.

Overall, the second quarter underscored the importance of diversification across asset classes, geographies, and risk factors. While the market rebound was concentrated in mega-cap growth stocks, our portfolios participated meaningfully in the upside while adhering to their respective risk-managed mandates. We believe this balanced approach remains essential given ongoing macroeconomic and geopolitical uncertainties as we head into the second half of the year.

Model Allocations

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

This quarter, New Frontier rebalanced the Global Core (April) and Multi-Asset Income (May) strategies to manage global equity and fixed-income risk, and to enhance income for the MAI portfolios. A key theme across these rebalances was a shift in fixed income, moving from a concentration in floating-rate Treasury notes toward broader diversification across the yield curve.

• In Global Core, international equity diversification was improved with higher allocations to Europe (for broader diversification), Emerging Markets (for their low correlation and diverse economies), and especially minimum volatility international ETFs, which are dynamically and tax-efficiently optimized to minimize volatility across countries and sectors.
• MAI strategies featured the modest shift from U.S. to international dividend exposure to source more dividend opportunities with the addition of the Franklin U.S. Dividend Multiplier Index ETF (XUDV) and the Franklin International Dividend Multiplier Index ETF (XIDV). These dividend-optimized ETFs contribute positively to expected portfolio income and risk management at a lower expense ratio.

Market & Asset Class Implications

Fixed Income: Diversifying Across the Curve

The unusual risks in the current environment, particularly the disconnect between the Fed’s current stance and potential future policy, underscore the importance of diversifying risk across the entire yield curve rather than focusing on a single duration metric. Different parts of the curve are sensitive to different risks. Long-term bonds are most affected by long-run inflation expectations and concerns over sovereign debt levels. Short-term bonds are tethered to the Fed’s immediate policy.

Intermediate-term Treasuries (e.g., 5-7 years) present an interesting case. They may be uniquely sensitive to a potential interest rate shock 1-2 years from now, should a future, more dovish Fed lower rates dramatically. In this scenario, intermediate bonds may benefit from lower rates in the foreseeable future while long bonds could be dragged down by long-term debt concerns. Spreading risk across the yield curve provides a more robust exposure. We have also observed that longer-term Treasuries are behaving more normally in their role as a hedge against equity risk in a recessionary scenario, restoring a key diversification benefit to portfolios.

Equities: A Search for Rational Premiums

• The Return of the Small-Cap Premium: Last quarter saw a rebound for small-cap stocks and other out-of-favor asset classes. We do not view this as a single-quarter phenomenon. It is difficult to imagine a long-term market equilibrium where small-cap stocks permanently underperform large-cap stocks. From a fundamental economic perspective, it does not make sense that the cost of capital should be lower for smaller, less-established companies. Investors demand a higher expected return for holding less liquid, less understood assets. While this premium may not be large—and much of it can be diversified away—a rational equilibrium requires it to exist. The recent period of underperformance can be explained in hindsight by factors like initial over-allocation based on backward-looking return forecasts and the advent of low-cost funds enabling broad access. In the long term, small-cap stocks must be a reasonable investment.
• The Dollar and Market Returns: The U.S. dollar declined substantially last quarter, boosting international assets. A country’s currency, equity market, and bond market are generally interconnected reflections of its economic health. The U.S. is often the exception due to its dominant market status, but should the U.S. become more economically isolated, we could see a stronger, more dependent link between the dollar and the value of its domestic equity market.
• Dollar Momentum: Currency trends are notoriously difficult to forecast, but a persistent continuing decline in the dollar seems unlikely, as the consequences would be severe. For example, a weaker dollar combined with higher tariffs would represent a substantial price increase on all foreign goods, a shock that would be difficult for the U.S. consumer and the political system to absorb.

Alternatives: Access and Prudence

• Private Assets: The "democratization" of private equity continues, though it is perhaps more accurately described as a democratization of mass marketing. While new vehicles have granted wider access, this influx of capital and new structures will likely alter the risk and return characteristics of private assets from their historical precedents. In fixed income, the convergence of private and public debt through new fund structures may eventually lead to both behaving as a single, broader asset class. The key takeaway for investors is that alternatives are more complex and require thoughtful allocation based on specific investment goals, not a simple "just add 20%" approach.
• Real Assets: The exceptional 14% return of International Real Estate last quarter highlights its value as an attractive diversifier due to its idiosyncratic nature and potential for long-term appreciation. The same diversification argument can be made for assets like Bitcoin, provided one believes in its long-term value.

Featured Insight: AI as the Enduring Productivity Engine

Amidst the noise of short-term policy debates, the transformative power of Artificial Intelligence remains a critical long-term economic theme. AI continues to drive market narratives and, more importantly, has the potential to deliver tangible productivity gains across the economy for years to come. The world’s largest technology companies continue committing vast portions of their free cash flow – some of which was freed up by employee layoffs – to acquiring AI infrastructure at any price to maintain their competitive leadership.

This AI investment and innovation remains heavily U.S.-focused, providing a reason to maintain significant strategic exposure to the U.S. equity market despite current headwinds. While there are concerns about a potential plateau as top models exhaust available training data, the next phase of the AI revolution will likely shift from building foundational models to deploying applications and maximizing efficiency. Competition, particularly from Chinese firms with access to cheaper chips, will force a focus on practical, cost-effective AI solutions. This long-term productivity narrative serves as a powerful potential offset to the economic drag imposed by policy uncertainty.

Portfolio Strategy & Outlook

The current market environment is defined by its challenges. It punishes strong conviction in any single economic outcome and rewards discipline, diversification, and a deep understanding of how broad economic themes translate into long-term investment risks and opportunities. It is a market that demands experience. Asset managers who have navigated multiple regime changes and market crises are better equipped to handle the structural shifts we are witnessing today. The era of earning easy returns by simply allocating to large-cap tech is likely behind us; the time for a more thoughtfully diversified portfolio is here.

Our approach remains strategic. We are pleased with the recent rebalancing actions across our portfolios that have broadened diversification and reduced risk. We believe that in a time of heightened uncertainty, one of the best defenses is robust global diversification. With the U.S. at the center of the current volatility, a globally diversified portfolio may be more prudent than usual. New Frontier’s process, which optimizes portfolios over thousands of unknown future scenarios, is designed precisely for environments like this—to produce portfolios that are likely to perform well in an uncertain future.

Key Takeaways

• Policy Uncertainty is the Primary Risk: Markets have dampened their reaction to tariff news, but the unpredictable nature of U.S. trade policy creates a drag on investment and distorts economic data.
• Diversify Across the Yield Curve: In a complex interest rate environment, focusing on a simple duration measure insufficiently describes risk. Spreading risk across short, intermediate, and long-term bonds provides a more robust fixed income posture.
• Risk Premia Should Prevail: Economic theory suggests that riskier assets like small-cap stocks must be viable assets and offer at least a small return premium.
• AI Contributes to Long-Term Growth: Despite near-term challenges, the U.S.-led productivity boom from AI provides a compelling reason to maintain strategic exposure to domestic equities.
• Global Diversification is Crucial: With the U.S. as the primary source of policy volatility, maintaining a geographically diversified portfolio is a critical tool for risk management.