Reassessing U.S. Growth Momentum: Implications for Equities and Bonds

The U.S. economy stands at a crossroads in 2025, with growth momentum showing signs of both resilience and fragility. While recent data suggests a modest upward revision in GDP projections-1.3% for Q3 2025-the path forward is clouded by risks such as tariff-driven inflation, policy uncertainty, and the lingering effects of elevated interest rates. The CBO report projects this outlook and highlights these downside risks, leaving investors to navigate the dual challenge of capitalizing on pockets of strength while hedging against deceleration.

Growth Deceleration: A CBO Warning and Sectoral Headwinds

The Congressional Budget Office (CBO) has issued a stark warning: U.S. growth for 2025 is now projected to be 0.5 percentage points lower than previously anticipated, driven by the drag from new tariffs and reduced net immigration, according to the CBO. These factors, EY notes, are expected to weigh on business investment and consumer spending, with real GDP growth forecast at 1.7% for 2025 and 1.4% for 2026, as highlighted by Morningstar. The Federal Reserve's response-already cutting rates in anticipation of weakening conditions-signals a recognition of the fragility of the current expansion.

The sectoral implications are equally critical. While the S&P 500 is projected to reach 6,500 by mid-2026, supported by Fed easing and deregulation, the path is uneven. Technology and communication services remain robust, fueled by AI and cloud computing innovations, according to CFRA. However, financials face headwinds from tariff-related costs and reduced consumer spending, while energy and consumer discretionary sectors grapple with volatile oil prices and shifting demand-trends CFRA also discusses.

Equities: Quality Over Momentum

Investors must recalibrate their equity strategies. The Charles Schwab Center for Financial Research advises maintaining a "Marketperform" stance across all 11 S&P 500 sectors but emphasizes the importance of quality over momentum. High-yield and leveraged loan markets, meanwhile, face pressure, with forecasts pointing to wider spreads and rising default rates in 2025–2026. For those seeking exposure, a focus on defensive sectors-such as utilities or healthcare-and active management to navigate policy-driven volatility may offer better risk-adjusted returns.

Bonds: Tight Spreads and Range-Bound Yields

The bond market, too, reflects a tug-of-war between optimism and caution. Corporate bond spreads remain narrow, with investment-grade (IG) spreads at 83 basis points by mid-2025, supported by stable credit fundamentals and investor inflows, according to Breckinridge. However, Morningstar cautions that 10-year Treasury yields are likely to remain range-bound between 3.5% and 5.0%, as sticky inflation and growth resilience temper aggressive rate cuts.

Yet, risks loom. The pause on tariffs expires in mid-July, and renewed trade tensions could trigger a spike in inflation and a re-rating of bond yields, which would pressure current spread levels noted by Breckinridge. For bond investors, a defensive posture-prioritizing credit selection and short-duration instruments-may be prudent. AAM's outlook underscores the potential for a deregulation-focused administration to boost corporate earnings, but cautions that political uncertainties could disrupt this trajectory.

Reallocation Strategies: Balancing Risk and Reward

The key to navigating this environment lies in strategic reallocation. Fidelity highlights that U.S. stock valuations remain elevated, making non-U.S. equities and bonds increasingly attractive for long-term investors. In equities, a tilt toward sectors with pricing power (e.g., tech) and away from those sensitive to tariffs (e.g., consumer discretionary) is warranted. For bonds, a mix of high-quality IG corporate bonds and Treasury inflation-protected securities (TIPS) could hedge against stagflation risks.

Conclusion: A Delicate Equilibrium

The U.S. economy's growth trajectory in 2025 is a balancing act between optimism and caution. While the Fed's rate cuts and deregulation efforts may provide a floor for markets, the risks of tariff-driven inflation and policy uncertainty cannot be ignored. For investors, the path forward demands agility: leveraging sectoral strengths while hedging against macroeconomic headwinds. As the CBO and EY underscore, the next phase of the economic cycle will test the resilience of both markets and policymakers.

References:- CBO report: CBO's Current View of the Economy From 2025 to 2028
- Morningstar: 2025 Bond Market Outlook: Yields Range-Bound but Volatile
- CFRA: U.S. Equity Market Outlook in 2025
- Breckinridge: Q3 2025 Corporate Bond Market Outlook
- AAM's outlook: AAM's 2025 Corporate Bond Outlook - AAM Company
- Fidelity: Economic outlook: Third quarter 2025 - Fidelity Investments