The narrative around trade has certainly improved in recent weeks, with optimism running high that the US will make material progress in its negotiations with its major trading partners, particularly China. However, the effective tariff rate on US imports will eventually settle around 13%, which is fully 10% above the prevailing level before Trump started his trade war and above the expectations of most forecasters.
Recent ‘hard’ economic data has held up well, reflecting solid economic growth momentum ahead of Trump’s tariff announcements. In addition, whilst Q1 US GDP looks optically weak, the contribution from net trade has been a significant drag as imports were front loaded ahead of tariff announcements. Nonetheless, whilst the long-term goals of Trump’s tariffs are to encourage the reshoring of production to the US and raise revenue for tax cuts, they represent a significant supply side shock to the US economy, raising prices and increasing the cost of production.
Furthermore, the cost cutting activities of the Department of Government Efficiency (DOGE), formerly headed by Elon Musk, are likely to add further near-term downside to the US growth outlook. As a result, we expect ‘hard’ data to play catch up to the weakness in business and consumer confidence data witnessed in recent weeks.
Reflecting the above, market estimates of economic growth and corporate earnings delivery are likely to be lowered. With the US economy likely to bear the brunt of the effect of tariffs this year the negative growth differential with the rest of the world is likely to be uncharacteristically wide as we head through 2025, and two quarters of slightly negative US GDP growth is, on balance, the baseline scenario (60% probability). Elsewhere, the ‘resilient economy’ scenario is a 40% probability.
Against this backdrop it seems likely that corporate earnings expectations have further to fall, particularly in the US, where 8% EPS growth is still the baseline. Although recent US inflation data have been suspiciously weak (potentially echoing China’s massaging of its economic growth data) we continue with the ‘sticky 2025 inflation’ theme and expect the US Core Personal Consumption Expenditures Price Index –the US Federal Reserve (Fed’s) preferred inflation measure – to reach 4% this year, even without second round effects.
Elsewhere, UK inflation is expected to rise a bit less than previously expected, reflecting stronger Sterling, lower energy prices and the redirection of cheap Asian exports originally intended for the US to the UK. The Eurozone, in contrast, is still enjoying the fruits of moderate disinflation and a German-led pivot towards defence and infrastructure spending.
Turning to Asia, whilst Japan is experiencing a ‘good’ increase in inflation, encouraging consumption growth, China is still mired in corrosive disinflation, with more policy reflation clearly required to kick start consumption growth.
The outlook for public finances remains challenging, particularly in the US, where only $5trn of the current $7trn of government spending is financed by tax revenue (representing a 6.9% budget deficit). Moreover, the interest burden on government debt is rising to $950bn by the end of 2025 (20% of government receipts).
Furthermore, there is a bill currently going through Congress (‘the One Big Beautiful Bill Act’), which will allow for an increase in the debt limit by $5trn. Estimates are that after considering the effect on economic growth, the tax-cutting measures contained within the bill are likely to increase the debt/GDP by up to 10% (bringing debt/GDP to circa 140% by 2034).
Borrowing of this magnitude will ultimately require the use of the Fed’s balance sheet to prevent US Treasury market instability, and as has been the case in the past, this type of market intervention should be positive for risk assets, particularly equities.
With ongoing sticky inflation, there is a risk that the Fed could fall behind the curve and be too slow to cut interest rates, creating the risk of a more protracted downturn. However, it is likely that central banks will, in the round, be responsive to the downside risks to growth and deliver sufficient monetary policy stimulus to avert a protracted slowdown in the global economy.
Geopolitics
With reference to the Middle East and Ukraine, whilst adverse geopolitical developments can affect investor sentiment in the short term, it is nonetheless important to have a fundamental framework to assess whether it is safe to be fully invested over a medium to long-term time horizon. The key drivers of equity returns are economic growth, inflation, fiscal policy, central bank policy rates, the liquidity cycle and corporate earnings delivery. Our assessment of these in the round is that they are likely to be reflationary and prove to be a positive backdrop to equity markets heading into 2026 and beyond.
Conclusion
The evolving narrative around trade is that elevated geopolitical risk will keep equity volatility high in the months ahead, with the risk that we could see drawdowns in the 5-10% region. However, the upside to equities ahead of the US Midterm elections in the Autumn of 2026 is somewhat greater. Thus, within equities a modest overweight is preferred, reflecting the potential for more synchronised policy reflation around the world. On an index relative basis, the US remains the least favoured equity market due to a further anticipated unwind of ‘US exceptionalism’, reflecting less favourable long-term capital flows, unfavourable growth differentials versus the rest of the world and still high valuations making the market relatively more vulnerable to a deteriorating earnings outlook. As a result, we are more optimistic on the UK, Eurozone and Asia.
Turning to fixed income, we still like short-dated and intermediate maturity gilts, reflecting our view that the Bank of England will deliver somewhat more than the 0.875% rate cuts the market expects over the next 12 months.
The value of securities and the income from them can fall as well as rise. Past performance should not be seen as an indicator of future returns. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.
