The Markets
It was an improbable quarter for stocks, as markets rallied from near bear market levels to end the period at new highs. This sharp turnaround erased first-quarter losses and gave investors a renewed outlook for the second half of the year. Concerns over a global trade war and recession have diminished, while confidence in the economy’s resilience has grown. Supportive tax policy and prospective regulatory changes provide a tailwind, even as longer-term worries—such as unsustainable federal debt levels and rising budget deficits—remain largely deferred.
The pullback in equity markets began in late February and intensified in early April following aggressive tariff announcements. Large-cap technology stocks led the initial decline as AI-driven valuations came under scrutiny. However, with easing geopolitical tensions and solid earnings reports, large-cap tech rebounded sharply, leading the recovery. Recent strength in the Financials and Industrials sectors suggests a welcome broadening of market leadership.
Markets also showed notable restraint following Israel’s military strike on Iran. Investors appeared confident that the conflict would not escalate regionally and that any disruption to energy markets would be short-lived—so far, that outlook has held.
The S&P 500 gained 10.9% for the quarter and is now up 6.2% year-to-date. International equities posted another strong quarter, buoyed by increased capital spending, a weaker U.S. dollar, and falling interest rates abroad. Value stocks, which led in Q1, underperformed growth stocks in Q2. Small-cap stocks participated in the rebound but remain slightly negative for the year. We explore the challenges facing small caps in the section below.
In fixed income, intermediate bonds returned approximately 1.5% for the quarter, adding to Q1’s 2% gain—marking the strongest first half for bonds since 2020. Despite sharp fluctuations, bond yields ended the quarter close to where they began. Inflation continues to trend toward the Fed’s 2% target, and fears that tariffs might reignite inflationary pressures have so far proven unfounded.
Why Small-Cap Stocks Have Struggled
Small-cap stocks have underperformed their large-cap counterparts for an extended period and are now trading at some of the most attractive valuations seen in decades. While many investors have called for a resurgence in small caps, citing the unsustainable valuation gap, the broader economic backdrop has not been supportive.
Historically, small caps have outperformed during the early stages of economic recovery—an environment we’ve largely missed over the past decade due to the absence of a traditional recession-reset cycle. Lower interest rates and a weaker dollar typically support smaller companies. The decline in the dollar and prospective rate cuts could contribute to improved relative performance.
Over the past five years, small-cap returns have hovered near their long-term average of 10%. However, large-cap returns have far exceeded their historical norms, driven by investors’ willingness to pay elevated multiples – especially for a handful of mega-cap stocks. Encouragingly, earnings growth for small caps is projected to overtake large caps in the second half of 2025, suggesting potential for performance improvement without relying on multiple expansion.
Another factor contributing to small-cap underperformance is the shift in how companies access capital. Many firms now stay private longer, delaying IPOs for longer, some not until they are of mid-cap size. This trend is fueled by the rise of private equity, which provides abundant early-stage funding and captures much of the value creation before companies reach public markets.
There are signs this trend may be shifting. Higher interest rates have made it more expensive for private equity firms to exit via private sales, increasing the appeal of going public. IPO activity has surged 83% year-to-date through June. While catching the turn in shifts like this is always difficult, we think the risk/reward profile for small-cap equities is increasingly compelling for long-term investors.
A Sidenote About Bonds – (Still with us? Good.)
While stocks usually dominate financial headlines, the bond market briefly took center stage during April’s turmoil. Fixed income—especially the overnight lending market—is often described as the financial system’s “plumbing.” When stress emerges in these markets, liquidity can dry up quickly, affecting both low- and high-quality borrowers. This raises the risk of a systemic event – when a seemingly inconsequential problem initiates another causing an unforeseen domino effect.
A stark reminder of this was the 2008–09 Financial Crisis, when stress in subprime lending cascaded into a global liquidity crisis. Fast forward to April 2025: amid global equity selloffs triggered by tariff announcements, U.S. Treasury yields were rising and the dollar was falling. This reaction contradicted typical market behavior during previous periods of global instability, when investors usually flock to U.S. Treasuries and the dollar as safe havens.
The unusual bond market behavior suggested waning confidence in U.S. creditworthiness and the dollar’s role as the world’s reserve currency—an assessment echoed by multiple credit rating downgrades, the most recent of which came from Moody’s in May.
Reportedly, two senior officials informed the President on April 8 of deteriorating bond market conditions. Later that morning, the administration announced a 90-day tariff reprieve. Bond market liquidity improved, and stocks soared 9.5% that day on the news. This episode is a reminder that financial markets are linked in ways that are not always intuitive, and why stock market moves often take their cues from bond market activity.
Investment Strategies
Growth Equity Strategy:
The Meritage Growth Equity strategy posted its strongest quarterly return in nearly five years, bouncing back from a difficult Q1. The strategy slightly underperformed its benchmark in Q2 after showing relative strength during the Q1 downturn. Technology and Communication Services led the gains, with standout contributions from chipmakers Broadcom, KLA Corp., and Nvidia. Apple lagged, falling 7% due to growth concerns and China exposure. Travel-related services, such as Booking Holdings, continued to perform well. Healthcare remains mixed, with Exelixis rising on positive cancer Phase 3 trial results, while Novo Nordisk (diabetes and GLP1 drugs) struggled with competition and distribution challenges.
Value Equity Strategy:
The Meritage Value strategy continued its strong relative performance in Q2. An overweight position in Technology and an underweight in Health Care contributed positively. Stock selection within Financials—especially positions in Goldman Sachs and JP Morgan—added further value. While Energy underperformed, Industrials delivered the best returns, a promising sign for economically sensitive investments. We are evaluating opportunities to increase exposure to this sector.
Yield-Focus Equity Strategy:
The Meritage Yield-Focus strategy built on Q1’s strong results. While dividend-paying stocks often trail during sharp market rebounds, solid exposure to Financials and Tech/Telecom offset weaker performance in Utilities, REITs, and Energy. The portfolio’s dividend yield ended the quarter at 4.9%, more than double that of the S&P 500. A 32% allocation to non-U.S. holdings also benefited from dollar weakness.
Small-Cap Equity Strategy:
The Meritage Small Cap Core strategy posted gains in Q2, rebounding alongside the broader small-cap universe after a weak Q1. While the strategy lagged during the rebound, its defensive characteristics leave it ahead of the benchmark year-to-date. Gains in 2025 have been driven primarily by growth-oriented companies.
Fixed Income Strategies:
Meritage bond portfolios added to Q1 gains with positive returns in Q2. Yields ended the quarter roughly unchanged, despite volatility. Both Intermediate and Short Duration portfolios remained conservatively positioned, helping cushion bond prices when rates rose in April. The Fed Funds rate was unchanged during the quarter, but markets anticipate a rate cut in September if inflation continues to moderate.
Additional fixed income commentary is available at the link below. https://www.meritageportfolio.com/fixed-income-investment-update-q2-2025/
Looking Ahead
In last quarter’s commentary, we anticipated a potential market pullback given recent strength and elevated expectations. By the time our materials were distributed, signs of this pullback were already evident. We also noted that market recoveries tend to be sharp and unexpected—a fair description of what followed.
We don’t claim predictive insight into short-term market movements, and our view of recoveries is shaped by what history has shown us. If there is a lesson to be learned from 2025 so far, it’s that active movement in and out of the stock market to reduce risk is rarely effective.
Markets have experienced several sharp, V-shaped recoveries in recent years—December 2018, March 2020, and October 2022—all following periods of peak pessimism. The 19% drawdown this past April fits the same mold. Since World War II, markets have experienced 25 corrections of 10%–20% and 14 bear markets (20% or more). Yet, the average annual return for stocks over that entire span is 11.2%. That’s a compelling reason to stay invested.
While we can’t time the turns, we can help ensure your portfolio’s risk profile remains appropriate for all market cycles. That doesn’t mean avoiding discomfort – that’s not an option for equity investors – but rather having the confidence to tolerate temporary setbacks. This is the price long-term equity investors pay for earning superior returns over lower-risk alternatives. If we haven’t recently reviewed your investment policy targets with you, please let us know.
Despite downplaying our crystal ball, we approach the second half with more moderate expectations. While we are encouraged by improving market sentiment, we are mindful of the fine line that could quickly shift it. Further tariff negotiations lie ahead of us and short-term momentum appears to be overbought. Earlier calls for recession by economists now seem reactionary, but economic growth is slowing and a growing number of indicators point to this slowdown continuing into 2026. The all-important labor market looks healthy from headline reports, though both private sector and manufacturing jobs have been falling.
Markets don’t always track the economy, but they are connected. Current stock prices are pricing in stronger earnings growth in the second half. If a slower economy affects the earnings growth rate, good chance the markets will adjust. In that scenario, companies that can still hit or exceed their earnings targets will fare better.
Macro expectations aside, our focus remains on company fundamentals—identifying the most attractive subset of high-quality candidates based on our process criteria, and maintaining portfolio structure consistent with your long-term objectives. We will provide updates on Fed policy, valuation, earnings trends, geopolitical risks, and AI-driven disruption in future commentaries.
