Looking Ahead: Markets Settling After 2025’s Rough Start

Markets have had a bumpy ride in 2025, with significant drops and subsequent rebounds testing investor resolve. Our analysis points to smoother conditions ahead. As interest rates stabilize and manufacturing investments take root, we see strong potential for growth through year-end, particularly in small and mid-cap sectors.

The Volatility We’ve Weathered

Small caps were hit especially hard during the recent market upheaval. The Russell 2000 plunged into bear territory in April, dropping over 22% from its highs. This correction reflected deep investor concerns about new trade policies and their economic impact.

Throughout this period, the Federal Reserve has maintained a steady course. At its March meeting, the Fed held interest rates at the 4.25% to 4.50% range while projecting two potential rate cuts later this year. Fed Chair Powell has adopted what analysts describe as a “wait-and-see mode” approach, carefully balancing inflation concerns with support for continued economic growth. This measured stance helps stabilize markets during uncertain times.

Reading Between the Economic Lines

The economy appears softer than headline numbers suggest. Regional variations are notable, with some areas showing robust growth while others display early warning signs of contraction. This uneven performance underscores the importance of examining beyond aggregate numbers to gain a comprehensive understanding of the true economic picture.

The interest rate environment remains crucial for both the economy and markets. The relationship between the 2-year Treasury yield and Federal Reserve policy remains instructive, with current 2-year rates around 4.35% indicating where the Fed may need to position its policy rate. Market participants increasingly expect a more dovish Fed stance, with predictions showing a 96% probability of at least two quarter-point rate cuts by December 2025. [As of Apr 24, 2025 via CMEFedWatch]

Our analysis suggests the Federal Reserve will implement 2-3 rate cuts in the second half of this year to maintain economic momentum. The combination of modest inflation pressures and early signs of labor market softening will give the Fed sufficient justification to reduce rates more aggressively than currently anticipated.

The Manufacturing Renaissance Nobody’s Talking About

A significant yet underappreciated economic tailwind is the substantial commitment to infrastructure and manufacturing investment currently underway. Tech giants have pledged over $1 trillion in US investment, with additional commitments from other sectors and international trade agreements. This represents a multi-year commitment to rebuilding American manufacturing capacity across critical industries.

The scale of this investment is already visible in the data, with construction spending in manufacturing reaching a record $238 billion and continued investment in new equipment and intellectual property. Major corporations are leading this push, exemplified by Apple’s commitment to spend more than $500 billion in the U.S. over the next four years.

The economic impact of this manufacturing expansion extends well beyond the direct investment numbers. The manufacturing sector contributes $2.65 trillion to the U.S. economy and employs nearly 13 million workers, creating a powerful multiplier effect throughout supply chains and local economies. As these investments progress from announcement to implementation, they will provide substantial support to economic growth throughout 2025 and beyond.

Government Cuts: Less Dramatic Than Headlines Suggest

The ongoing restructuring of the federal workforce through the Department of Government Efficiency (DOGE) generated significant headlines, but its economic impact should be viewed in proper context. While substantial, with 62,530 federal workers dismissed in the first two months of 2025, analysis suggests the total reduction will likely fall short of the more extreme early projections.

Economic research indicates that workforce reductions may not be as disruptive as initially feared, with most displaced federal workers likely to be rehired quickly given the economy’s near full employment. This mirrors previous episodes of government restructuring, such as the Clinton administration’s cuts in 1993-1994, which ultimately coincided with a period of robust economic expansion.

The timeline for these workforce transitions will be measured in years rather than months, allowing for a more orderly absorption of displaced workers into growing sectors of the economy. Private sector job creation continues to offset public sector reductions, maintaining overall labor market stability.

Deficits Matter, But Growth Matters More

A balanced approach to fiscal policy is essential for long-term economic health. Current budget projections suggest that while deficits will remain substantial, they may begin to moderate from recent peaks. The previous administration’s final budget carried a $2.5 trillion deficit, with expectations that the current deficit will be smaller but still significant, likely in the $2 trillion to $1.75 trillion range.

The critical factor in assessing deficit sustainability is not the absolute number, but its relationship to GDP growth. If economic expansion outpaces deficit growth, the overall fiscal situation improves even with continued deficits. Tax and regulatory policies that support business investment and innovation can help generate the growth needed to improve deficit ratios over time.

A focus on government efficiency, combined with strategic investments in productive economic capacity, represents a more nuanced approach to fiscal management than purely targeting deficit reduction. The key will be maintaining essential public services while eliminating inefficiencies and redirecting resources to growth-enhancing initiatives.

Where We See Investment Opportunities

The current market environment presents particularly compelling opportunities in the small and mid-cap segments. Despite recent volatility, analysts project small-cap earnings growth for Russell 2000 stocks to rise by 44.2% in 2025, significantly outpacing large-cap expectations. Market projections suggest that tax cuts and deregulation could particularly benefit small-cap stocks, creating opportunities for substantial growth as economic conditions stabilize.

Sector-specific opportunities are emerging alongside these broader trends. Technology investments focusing on big data, advanced analytics, supply chain digitization, and data management are likely to see continued momentum. Manufacturing and infrastructure sectors directly benefiting from the trillion-dollar investment commitments will also present attractive opportunities.

Financial services companies are poised to benefit from both the interest rate reduction cycle and the surge in business formation. Regional and small-cap financial institutions with strong connections to growing manufacturing corridors may outperform their larger counterparts as economic activity shifts.

How We’re Positioning Portfolios

As we position portfolios for the balance of 2025, a gradual shift toward cyclical exposure makes sense. While maintaining core positions in quality companies with strong balance sheets, increasing allocations to small and mid-cap sectors poised to benefit from economic recovery offers higher return potential.

Sector allocations should reflect the changing economy, with overweight positions in industrials, select technology, and financial services. Energy and materials sectors leveraged to the manufacturing renaissance also merit consideration. Defensive sectors may underperform as economic confidence improves and interest rates decline.

For long-term investors, current market conditions offer an opportunity to establish positions in structural growth themes that extend beyond the current economic cycle. Areas experiencing fundamental, long-term shifts in demand – such as manufacturing automation, energy transition infrastructure, and advanced materials – warrant particular attention. Portfolio construction should balance these long-term growth opportunities with sufficient diversification to maintain resilience through inevitable market fluctuations.

The View From Here

Between now and late summer, markets should calm considerably, focusing on economic stabilization rather than short-term volatility. While we may have to endure another scary ride down of up to 20%, the overall outlook for 6 -12 months down the road looks positive. With interest rates poised to fall and manufacturing investments beginning to flow through the economy, we anticipate a significant swing back to the upside.

At DCA Asset Management, we remain committed to our active capital approach, providing strategic guidance through changing market conditions. While challenges certainly remain, the combination of expected interest rate reductions, manufacturing investment, and reasonable valuations in many market segments creates a favorable environment for long-term investors. Barring significant geopolitical disruptions, the outlook for markets through the second half of 2025 and into 2026 appears increasingly positive.

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