Heading into 2025, investors were fairly blasé about President Donald Trump’s tariff threats assuming they were largely a negotiating ploy. We took the president at his word and assumed tariffs would be higher than what most investors expected. Investors quickly raced to the other side of the ship on Liberation Day and assumed the worst. In the second quarter, we found ourselves leaning in the other direction yet again (bullish). We view Trump as a market-implied President – notoriously focused on his importance vis-à-vis polls and the S&P 500 index. After all, equity markets appear to be the new bond vigilantes willing to discipline foolish public policy.
Macro doomsters are now spinning gloomy narratives about tariffs, inflation and the Fed’s next rate cut. Tariffs are not inflationary. Tariffs are a tax hike[1] and taxes are widely considered anti-growth. The U.S. will generate roughly $100B in tariff duties during the first half of 2025. Yet, consumer prices have remained in a steady downtrend with nary a tariff driven inflation data point. What gives? We suspect that businesses front loaded inventories in anticipation of tariffs and are still likely working down pre-tariff inventories. Businesses are likely reluctant to pass along price increases to customers, especially if trade deals could soon emerge and reduce overall tariff rates. If trade deals do not arrive, then tariffs will show up as either higher prices or will squeeze corporate margins.
We have long thought that Trump’s tariff goals are less about reindustrialization and more about sourcing new tax revenue to finance individual and corporate tax cuts. The U.S. announced an early trade deal with the UK and appears to be close with the European Union. We expect more trade deals to be announced in the next 90 days, mostly likely with Japan, Korea, Mexico, and Canada. We expect tariffs to be negotiated down to an effective rate of ~10% for all countries except China, where we expect a ~30% tariff rate. As with NATO defense spending, the Mad Man Theory negotiating tactic will successfully raise tax revenue and open foreign markets to U.S. exporters, but at a cost to corporate margins.
The more politicians tell the Fed to cut rates, the less likely they will be to cut. The Fed’s dual mandate – jobs and inflation – has them momentarily paralyzed as the former softens slightly while investors wait for the latter to spike. Hard data has eased as the U.S. labor market returns to pre-pandemic levels. There are some signs of weakening labor demand with employers implementing hiring freezes rather than actively trimming their workforces. Inflation lags employment, which lags growth and if the economy continues to cool ever so slightly, then inflation will likely follow, tariffs or not.
While the Fed is unlikely to pre-emptively cut on signs of weakening labor demand before September, its narrative will likely soon shift from whether it is necessary to cut interest rates to how many cuts will stabilize the labor and housing markets. The market is pricing in a Fed Funds rate of 3% by the end of 2026. It’s hard for us to see the Fed Funds rate below this level as yields have increased from the post-financial crisis lows of ~0% for “good” reason, mainly because the economy has shown it can handle higher interest rates.
While most investors will watch the tariff and inflation headlines, we will watch the U.S. labor market. If the labor market softens more, the Fed will cut rates, even if faced with higher than desired inflation. Recessions – lowercase or uppercase – are scarring events economically and the Fed wants to avoid this at all costs. As the summer lengthens, we further expect the Administration to focus more on the “good” stuff (tax cuts, deregulation and growth) and less on the “bad” stuff (tariffs). For example, look for DOGE to shift its focus from cost cutting to regulatory cutting. We expect economic slowdown in the U.S. (but not a recession) as policy uncertainty remains high and fiscal stimulus peters out. The tariff shock shelved capital spending plans, delayed hiring and reduced business confidence. This policy volatility will show up in 3Q data and will take their toll this summer. But a tariff shock is not inevitable, and we think the U.S. economy is resilient enough to trump policy volatility.
Pundits describe Trump’s Big Beautiful Bill (BBB) as expensive fiscal stimulus. This is because the non-partisan Congressional Budget Office scores the legislative proposal against existing law, which sunsets taxes. However, what’s most important for the capital markets are flows. The BBB mostly extends existing tax law permanently, which isn’t stimulative. The BBB doesn’t deliver materially new dollars into the capital markets or real economy. In fact, Trump’s policies – a 10% universal tariff, Medicaid and SNAP cuts, rollbacks of the Inflation Reduction Act – is likely to raise $3T of revenue over the next decade. This is the largest tax hike in a generation. Investors should focus on flows and the BBB doesn’t deliver materially new dollars into the economy but rather takes them out over the medium to long term. This is classic fiscal tightening and an important shift as over the past 15 years, expansionary U.S. fiscal spending has provided liquidity that has likely benefitted domestic markets and helped fuel U.S. outperformance vs. developed international markets.
In a watershed moment, Germany is abandoning a decade of fiscal austerity in favor of fiscal excess. In response to the shifting U.S. foreign and economic policies, Germany has begun implementing its own paradigm shifts after removing its constitutionally enshrined debt brake. The German government intends to increase deficit spending to 5-6% of GDP. The broader European Union is also aiming to boost economic growth primarily driven by significant public spending on infrastructure, digitalization, and defense spending. The tailwinds of fiscal coordination and rate cuts will likely result in positive economic surprises in the coming months in Europe. China is also waiting to fire their fiscal bazooka once they sense Trump’s endgame.
Global growth prospects are looking up as the immediate threat of extreme U.S. tariffs has receded, calming fears of a recession and stabilizing GDP predictions. Structural factors outside the U.S. will continue to weigh on the strength of the USD and lead to a more diversified global trading system and international asset holdings. This is a slow-moving multi-year process which is underappreciated by investors and a key reason why we remain very bullish on Global equities.
1 Per TrendMacro (a macroeconomic firm), a 10% tariff is roughly equivalent to a 1.3% increase in personal income rates.
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