The Markets
Concerns about a deteriorating macroeconomic backdrop led to a sharp pullback in stocks from early-year highs, while bonds posted modest gains. Investors entered the year with a generally optimistic outlook, expecting the conditions behind two exceptional years of returns to remain in place. However, expectations for steady economic growth, additional rate cuts, reaccelerating earnings, and support from a new pro-growth administration have all come under pressure.
Uncertainty surrounding a potential trade war has dampened consumer sentiment, reignited inflation concerns, and created a more difficult environment for companies to manage their businesses and provide guidance on revenue and profitability. While the potential impact of tariffs was not a surprise to investors, markets were unprepared for the breadth of countries affected and the magnitude of the tariffs now being discussed and implemented. As a result, stock valuations have retreated from their previously lofty levels, reflecting a more cautious outlook on economic and earnings growth.
For the quarter, the S&P 500 declined 4.2%, marking a drop of over 10% from highs set earlier in the period. Growth-oriented stocks bore the brunt of the decline, particularly those in the “momentum” category—stocks that had led performance over recent years.
In contrast, investors rotated into Value and income-oriented stocks, as well as sectors perceived as more defensive during economic downturns—such as Healthcare and Consumer Staples. After multiple years of underperformance relative to growth stocks, value-oriented stocks have closed most of that gap now going back 5 years. A notable surprise came from non-U.S. equities, which outperformed thanks to a weaker dollar, more accommodative foreign economic policies, and attractive valuations.
Intermediate bond indices gained approximately 2% for the quarter, as cooling growth expectations brought down yields and lifted bond prices. At its most recent meeting, the Federal Reserve left overnight rates unchanged. While their bias remains toward further easing, they emphasized a data-dependent approach amid persistent services inflation and mixed economic signals.
The Economy
Economic activity showed signs of slowing in Q1. Business investment softened, and consumer spending began to show early signs of fatigue. Despite this, the labor market remained relatively stable, with the unemployment rate holding at 4.1%. The most recent CPI report came in at 2.8%, slightly below expectations, while the Fed’s preferred measure, Core PCE, came in a bit hotter. More concerning, consumer inflation expectations—a metric closely watched by the Fed—have risen meaningfully as the threat of tariffs has grown.
The combination of slowing growth and potential inflation increases the risk of stagflation—a scenario where economic stagnation is accompanied by rising prices. This environment complicates the Fed’s ability to stimulate the economy through rate cuts, due to the risk of fueling inflation. Seasoned investors may recall the economic malaise caused by stagflation in the 1970s. While we do not see this as the most likely scenario, its potential implications warrant careful monitoring.
Investment Strategies
Value Equity Strategy:
The Value Equity strategy continued its strong relative performance in Q1, supported by defensive sector positioning and disciplined valuation. An underweight in Industrials and strong stock selection in Healthcare—especially among global pharmaceutical names like Roche, GlaxoSmithKline, and Novartis—contributed meaningfully. Standouts also included Siemens AG, a leader in automation and digitization, and Check Point Software, a cybersecurity firm. We exited our position in Salesforce following lackluster forward guidance.
Overall, the Value strategy trades at a meaningful discount on metrics such as price-to-cash flow while offering attractive dividend yield and return on equity. Exposure to high-quality names in Technology and Healthcare helped provide downside protection during a volatile quarter.
Growth Equity Strategy:
The Meritage Growth Equity strategy declined during the first quarter but held up better than its growth benchmark. Less exposure to mega-cap names and overweight positions in Energy and Healthcare contributed positively.
As noted, it was a difficult quarter for growth strategies in general. Unlike prior pullbacks—when select mega-cap Tech and Consumer names were seen as defensive—they have recently become more vulnerable to selling pressure. Higher valuations and a more cautious near-term view of the AI-driven growth narrative have likely contributed to this shift.
Notable performers this quarter included Alibaba Group, which rallied alongside Chinese equities, and Vertex Pharmaceuticals, which gained following FDA approval of a novel non-opioid painkiller. Conversely, several top performers from last year in the semiconductor/AI space—such as Broadcom and Arista Networks, underperformed.
Yield-Focus Equity Strategy:
The Yield-Focus strategy delivered a strong gain in Q1, demonstrating resilience amid broad market weakness. High-dividend-paying stocks have shown defensive characteristics, and the strategy’s significant exposure to non-U.S. securities—which often feature more attractive yields—benefited from the declining dollar. Recent purchases have lifted the portfolio’s current dividend yield to approximately 5%.
Top contributors included holdings in Energy Infrastructure, Utilities, and REITs. Technology was the primary source of weakness, though the sector represents only about 10% of the strategy.
Small-Cap Equity Strategies:
The Small-Cap Core Equity strategy posted a slight decline for the quarter but outperformed its benchmark by a wide margin. Both the Value and Growth component of the core strategy outperformed their respective indexes.
Smaller-cap stocks have lagged large-cap peers in 9 of the past 11 years, and their relative valuation is now near a 25-year low. This disparity presents a compelling opportunity for small-cap outperformance, though it is usually seen during the early stages of an economic rebound—historically a favorable period for smaller companies. We believe that the diversification benefits of small-caps are poised to exceed what investors have experienced over the past decade.
Fixed Income Strategies:
Meritage Bond portfolios posted positive returns, benefiting from a decline in yields compared to year-end 2024 levels. Both the Intermediate Duration and Short Duration strategies were conservatively positioned and helped cushion equity weakness.
Though the Federal Funds rate was unchanged during the quarter, the 10-year Treasury yield moved within a wide range—initially rising in response to hotter-than-expected inflation data, then falling sharply to 4.2% as recession fears mounted.
Credit spreads remain tight relative to Treasuries, though this could change if economic conditions worsen. Given the short average maturities of our corporate holdings, we are comfortable maintaining corporate exposure to capture incremental yield.
For additional fixed income commentary, click the link below. https://www.meritageportfolio.com/fixed-income-investment-update-q1-2025/
Looking Ahead
Following two strong years of performance and elevated valuations, a pullback of some consequence during the year would not come as a surprise for most investors. As we noted in our prior update, high expectations left little margin for error if key assumptions veered off course.
Uncertainty was initially cited as the main culprit behind recent market weakness. Now that new policies have been announced, uncertainty remains in terms of how increased tariffs will impact consumer behavior, corporate margins, international responses, supply chains, and other important components of the economy.
At a deeper level, markets are grappling with a shift in long-standing norms and governance. Investor sentiment has swung from giving policy change the benefit of the doubt to pricing in worst-case scenarios. Reality likely lies somewhere in between, but the path there will again test investor resolve.
The moral hazard of policy-driven stimulus to get through difficult financial times has left investors dependent on unconventional tools going back to the 2008-2009 Financial Crisis. Inflation concerns handicap the Fed’s ability to provide aggressive rate support and a more ambivalent stance from President Trump regarding the market’s decline suggests he’s not inclined to provide a quick fix, though that can change quickly.
Markets will also be focused on the accumulation of debt and whether the administration’s effort to create more efficiencies in government can reverse this build-up, especially with plans to extend many of the current tax policies. In the meantime, the risk of recession has increased. In classic fashion, the much-anticipated recession of two years ago never materialized, and now pressure on stocks and economic activity arises just when the economic outlook seemed to have had good fundamental support.
We will use this unsettled environment to strengthen our portfolio holdings and look for other opportunities to enhance long-term returns. This includes not just identifying high-quality companies that may be unfairly punished, but reassessing global shifts that could redefine the investment landscape. Managing client portfolios to stay aligned with their individual policy guidelines remains the first line of defense within our risk management process.
We’ve been through these times before. When markets turn for the better, it usually happens suddenly and unexpectedly. Notwithstanding the uncertainty of how this current cycle moves forward, we continue to believe that common stocks represent the most attractive long-term growth vehicle for investors.
