Clay's Q2 Breakdown

“The four most expensive words in the English language are 'This time is different.’” – John Templeton

If you only saw the final numbers, you’d likely think Q2 was a textbook rally: equities broadly higher with tech companies leading the way and volatility appeared nowhere to be found. But the event path was anything but typical.

Markets convulsed in April as the economic narrative flipped quickly, whipsawing investors with policy shocks, interest rate fears, and geopolitical tremors. If we tried to cover all the events and headlines, this would be a long read.

The Volatility Index (VIX) tells the story well. It spiked from 13 to 38 in a matter of days following the April 2 "Liberation Day" tariff salvo.

The cause? Well, the world experienced a live demonstration of hardline trade negotiations.

A surprise volley of tariffs from the U.S. administration triggered a full-blown market rout. The S&P 500 dropped 12% in five trading days. Treasuries sold off. Oil spiked. The narrative turned dire: headlines warned of stagflation, supply chain ruptures, and rising geopolitical tensions.

So how did we go from crisis talk to a risk asset rally? Because the story changed in May. Tariffs were walked back, Q1 earnings came in stronger than many expected, and markets evolved from expecting disruption to rediscovering momentum.

Within weeks, markets not only recovered – they rallied higher. U.S. equities finished the quarter up nearly 11%, the group of the largest tech stocks often referred to as the “Magnificent 7” rose over 18%, and even long-duration bonds began to claw back losses.

Q2 didn’t reward panic. It appeared to favor patience from investors. 

This quarter reminded us that markets are highly reactive to noise, but ultimately recalibrate around fundamentals. Over the long term, they tend to benefit investors who are able to stay the course.

Let’s dive in.

Executive Summary

Q2 was more a test of nerves than it was a victory lap. For all the talk of resilient markets and AI tailwinds, April showed how fast sentiment can fracture and how swiftly it can rebound.

• The S&P 500 rebounded sharply in Q2, finishing +10.9% despite a 12% drawdown during April.
• International equities outperformed their US peers, boosted by a weaker U.S. dollar.
• Core inflation remained sticky, driven by shelter and tariff pass-through, while Q2 GDP growth estimates were revised down to +1.0% (Goldman Sachs) and consumer durables contracted (J.P. Morgan).
• AI remained the prevailing secular theme with capital expenditures continuing to rise.

Key Takeaways from Q2 2025

What Happened

• Markets absorbed a major policy shock and rallied. On April 2nd, the U.S. unveiled sweeping new tariffs under its “Liberation Day” policy. The S&P 500 fell 12% in five trading days, and 10-year Treasury yields spiked 50bps. But risk assets reversed course as tariffs were walked back and a tentative U.S.-China deal emerged.
• Volatility surged, then collapsed. The VIX spiked to 38 – a level last seen during the 2022 inflation panic – before settling below 15 by quarter-end. This round-trip told the story: investors priced in worst-case outcomes, then repriced as the macro data remained resilient.
• Earnings delivered, especially in Big Tech. Quarterly earnings season came in strong. S&P 500 earnings grew ~13% YoY, with the Magnificent 7 leading the charge. Mega-cap tech gained ~18% in the quarter, recapturing YTD leadership after lagging in Q1.
• The U.S. dollar weakened materially. The U.S. dollar index fell 7.1% in Q2, lifting USD returns on international assets and easing pressure on emerging markets. It can favor exporters abroad and U.S. multinationals with foreign earnings, but squeezes U.S. importers facing higher input costs. For investors, it can signal a rebalancing moment as relative value outside the U.S. becomes harder to ignore.
• AI infrastructure spending accelerated with ripple effects. Q2 saw continued capex expansion from hyperscalers and enterprise IT buyers, focused on compute, networking, and memory to support AI adoption. This surge appears to be fueling demand across the semiconductor and infrastructure supply chain, which could create supportive conditions for earnings growth in sectors beyond just mega-cap tech. Investors are increasingly viewing AI not as a speculative theme, but as a potential monetizable productivity driver, and the beneficiaries appear to be widening.

Core inflation remained sticky. Shelter inflation and tariff pass-through kept core CPI elevated, averaging 3.2% across Q2. The Fed held rates steady, but forward guidance appears to be potentially more constructive for risk assets as we head into year end.

The Why

This quarter highlighted market psychology and regime adaptation. Here’s what we saw:

• Policy shocks appear to no longer carry the same weight. Investors have been conditioned to expect reversals. Unlike the 2018-2019 trade war where tariff escalation was persistent and unpredictable, the 2025 cycle (thus far) has been swift and softened within weeks. Markets braced for the worst, but quickly re-rated as policymakers backed down.
• The AI growth thesis is broadening, not breaking. Yes, Q1 was a reckoning. But Q2 appears to have been a recalibration. Semiconductors and hyperscale infrastructure remain in demand. New developments in test-time compute, inference optimization, and memory bandwidth (e.g., OpenAI’s o3, Microsoft’s DeepSpeed initiatives) reinforce the case for continued investment. The AI trend doesn’t appear crowded — we believe it’s evolving.
• The U.S. economy is slowing, not cracking. Real GDP growth is decelerating, in our view. The consumer is weakening. But we believe labor income is holding up, business capex remains strong, and fiscal transfers (like the new Social Security cost-of-living adjustment and pending tax reform) are offsetting private sector drag. It appears that the Fed can afford to wait. December remains the consensus pivot.

Global diversification appears to be working again. This is the first time in years that international and emerging market equities have outperformed their U.S. counterparts. Capital appears to be rotating out of dollar-denominated assets as the U.S. growth premium erodes and the Fed pauses (for now). A new regime of relative outperformance may be underway.

The Path Forward 

We see a disconnect between the negative headlines and what underlying fundamentals appear to suggest. Tariff uncertainty has reduced economic activity at the margin, but steady capital investment continues in AI as companies seek to improve productivity and protect margins.

1. Tariff risk appears to remain real but manageable
   The 90-day "pause" is coming to an end and deadlines are already being pushed back to allow more room for negotiation. Global leaders appear more interested in delay and de-escalation than confrontation. We expect short-lived volatility in trade-sensitive names — and we’re viewing these as potential opportunities to consider, not necessarily risks to hedge.
   
   
2. Growth is cooling — but not cracking
   Q2 GDP estimates have moderated to ~1%, and activity in durable goods and manufacturing is softening. But we believe that beneath the surface, labor income appears to remain resilient, AI-related capex continues, and service-sector momentum is holding up. This may not be a stall-out, it could be a mid-cycle slowdown that may favor selectivity and long-duration assets.
   
   
3. Policy is likely to turn from restraint to support
   With labor market momentum softening, the Fed’s tone appears to be shifting. Markets now see a 54% chance of three rate cuts by year-end. That’s not guaranteed, but the direction of the glide path seems clear. In our view, rates have peaked and the next move could be lower, which may support valuations and broaden participation.
   
   4. Valuations are elevated — but not irrational Yes, the S&P is trading at ~21x forward earnings, but we believe that reflects a market recalibrating around dominant firms with durable earnings power. Mega-cap tech has, in our view, earned its premium and we believe selective international equities and underappreciated compounders may offer attractive upside potential.
   

Disclosures

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