John Gorlow
| Aug 20, 2025
This summer’s headlines have read like a blueprint on how to derail investor confidence. The Federal Reserve’s independence was called into question, the bearer of unpleasant economic data was abruptly fired, and the National Guard was called in to patrol the nation’s capital. Meanwhile, tariff uncertainty continued to create storm clouds over the global economy. Yet the market rallied on, seemingly unconcerned by economic data that is noisy, worrisome, and often contradictory. Despite the market’s performance, monetary credibility and market trust are two topics very much on investors’ minds.
Wall Street may be upbeat, but it is certainly paying attention. Reshma Kapadia (Barron’s, 18-August 2025) points to what is becoming more obvious by the day: that the dismissal of senior officials, pressure on the Federal Reserve, and public attacks on business leaders are undermining trust in the very systems markets depend on.
A handful of respected financial writers echo that sentiment, noting that an independent Fed is the foundation of trust in the global financial system. The Fed may not always get the timing right, but when inflation heats up, it can be trusted to put on the brakes, consistent with its duty to the economy. If Fed independence falters, assumptions anchoring inflation expectations could unravel, with sudden consequences for markets that have not yet fully priced in that risk.
What would happen if Fed Chair Jerome Powell were forced out? History offers a troubling clue. In May, Goldman Sachs economists studied unscheduled leadership changes at central banks around the world. Their conclusion was stark: inflation tended to run one to two percentage points higher within two years, with no offsetting benefit to growth.
The credibility of the U.S. financial system is clearly being tested. The dollar has begun to slip, gold prices are climbing, and market inflation expectations are edging higher. Data from inflation-protected bonds shows that the expected inflation rate three to four years from now has risen from 2.15% at the end of June to 2.36% today, even after tariff effects are stripped away.
Despite these risks, the S&P 500 has pushed to new highs, recovering all its spring losses and notching further gains as corporate earnings have remained solid. Technology firms have been the driving force, raising forward-looking guidance and insulating the broader index from weaker performance in manufacturing and consumer-facing industries. This resilience has fueled optimism that the market is capable of absorbing shocks that, in other times, might have sent it reeling.
Is AI Losing its Steam?
At the center of market optimism is artificial intelligence, riding high on its glittering throne. Massive capital expenditures by companies such as Microsoft, Google, Meta, and Amazon have sustained market enthusiasm while feeding expectations of broad productivity gains and economic transformation. The sums involved are staggering, and the visionary zeal of AI leaders is boundless. Yet not everyone is convinced that the AI story will continue its current trajectory. Skeptics point out that while AI spending is front-loaded, future benefits are uncertain, uneven, and might be slow to materialize.
Further complicating the AI outlook is the policy volatility of the current administration. This is likely to remain high, writes Katie Martin (Financial Times, 19-August 2025). And in a volatile environment, anything can happen. Martin reminds readers that China’s regulatory surprises left investors with deep short-term losses, and similar unpredictability could torpedo investors in U.S. markets. In real-world stress tests, the market’s darlings often are the first to be knocked down a notch.
On top of policy volatility and uncertainty, it’s possible that the economic and social impacts of AI will fall short of the broad-reaching changes its boosters predict. When the Financial Times asked, “Is AI hitting a wall?” in a feature piece in mid-August, OpenAI chief executive Sam Altman acknowledged that current chatbots are “not going to get much better,” suggesting that recent advances may be bumping up against limits. Still, Altman argued that even without big breakthroughs, AI technology will open doors to new platforms, products, and services that drive practical innovation. In other words, enthusiasm for AI-driven applications is likely to continue, even as expectations for world-changing leaps are dialed back. Indeed, usage is expanding rapidly, valuations remain lofty, and OpenAI has reportedly pushed annual recurring revenue to $12 billion.
Economic Data and Fed Pressures
Putting aside the promise and perils of AI for a moment, current economic data tells a mixed story. Growth in the second quarter exceeded expectations at three percent, but beneath the headline figures, business investment and consumer demand were decelerating. Inflation data showed little sign of easing, forcing the Federal Reserve into a delicate balancing act. The July jobs report revealed clear slowing in the labor market, with significant downward revisions to prior months. Citing allegations of data manipulation, the administration’s dismissal of the Bureau of Labor Statistics commissioner deepened concerns about the independence and integrity of America’s statistical agencies. Commentators rightly pointed out that as confidence in official data erodes, markets face an additional layer of risk that is difficult to quantify.
For now, optimism about corporate earnings, particularly in the technology sector, has more than offset concerns about slowing growth and political volatility. But there is no denying the risks facing the economy. Tariffs are raising costs, inflation pressures may increase, and many questions about governance remain unresolved. Despite market optimism, caution is warranted.
July Market Review
In July, global equity markets offered a mixed picture. The S&P 500 index returned 2.24%, powered by strong earnings from large technology firms and continuing momentum from AI-linked spending. That brought the index’s year-to-date return to 8.6%. Outside the United States, international developed markets declined 1.2% in July but remain solidly positive for the year, up 17.6%. International small-cap and value shares performed better than their large-cap and growth counterparts, adding breadth to returns. Emerging markets advanced 1.95% during the month, though they lagged the U.S. Their year-to-date gains remain impressive, with emerging market large-cap stocks up 17.5%, compared with 11.4% for small caps.
Fixed Income Review
Fixed income markets retreated in July as Treasury yields rose. The Bloomberg U.S. Aggregate Bond Index declined 0.26% for the month but maintained a year-to-date gain of 3.8%. The 10-year Treasury yield closed July at 4.37%, up 15 basis points from June, while the two-year yield rose 24 basis points to 3.94%. Corporate bonds held up fractionally, supported by tightening credit spreads, while Treasuries and mortgage-backed securities underperformed. High-yield corporates advanced, outpacing investment-grade bonds. The Fed left rates unchanged at 4.25%–4.5%, where they have been since December, though two officials dissented in favor of a quarter-point cut. Inflation data showed headline CPI rising from 2.4% in May to 2.7% in June, with core CPI edging up to 2.9% and core PCE (the Fed’s preferred gauge) steady at 2.8%. Municipal bonds slipped modestly but outperformed Treasuries, and TIPS advanced slightly as inflation expectations moved higher.
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Regards,
John Gorlow
President
Cardiff Park Advisors
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