The first quarter of 2025 felt pretty rough, but when you look at the numbers, it actually was not as bad as one would think. Looking first at the U.S. economy, the first estimate of Q1 2025 Gross Domestic Product (GDP) growth was -0.3% on a quarterly annualized basis – a bit worse than expected and down from the 2.4% growth rate reported for the fourth quarter of 2024. Consumer expenditure for the first quarter increased 1.8% compared to the 4.0% increase seen in the fourth quarter. Consumer and investment spending contributed 1.2 and 3.9 percentage points, respectively, to first quarter GDP growth, while government spending and net exports subtracted 4.8 and 0.3 percentage points from growth. We suspect that much of the surge in imports was due to anticipatory buying ahead of increases in tariffs. Consumer price inflation (CPI) in March was 2.4% year-over-year, down from the 2.8% rate seen in February 2025.

Asset markets were weaker in Q1 2025 as recession fears grew, due in part, we suspect, to the possibility of tariffs from the Trump administration. In Q1 2025, on a price basis, the S&P 500^® Index fell almost 5%, while the Nasdaq-100^® Index and the Russell 2000^® Index both fell around 10%. Emerging markets were up slightly over 2% in the quarter, with the Mexican Bolsa up 6%. Developed market equities outside of the U.S. generally rose in the quarter, with the FTSE 100 Index, Cac 40, and Dax up 5%, 6%, and 11%, respectively; only the Nikkei 225 fell, down almost 11%. Interest rates have fallen in the quarter, and the U.S. Treasury curve flattened as the 3-month Treasury rate has decreased by 2 basis points to 4.30%, while the U.S. 10-year Treasury interest rate has fallen by 37 basis points to 4.21%. Corporate spreads have widened as well, reflecting fears of a worsening default environment. Below is a snapshot of market movements since year-end 2024.

On April 2, 2025, President Trump announced the imposition of significant tariffs on U.S. trade partners, which included a 10% universal tariff that took effect on April 5, 2025, as well as additional reciprocal tariffs on 60 countries ranging from 11-50%. Implementation of the tariffs has been delayed as bilateral trade negotiations are ongoing. The market reaction was initially quite negative to the tariff announcements, but we have seen a relatively calm return to the markets at the present time, with most developed markets showing a small decline from the end of March. Credit spreads have widened as fears of a global recession have spiked and economists are rapidly slashing their GDP estimates while raising their inflation estimates for 2025. Overall, the economic and market environment is quite uncertain as we look ahead to the rest of 2025.

We believe a recession could happen this year if tariffs remain in effect as businesses and consumers retrench and cut spending. On the other hand, it is possible that the U.S. just experiences a sharp growth slowdown rather than an outright recession if the Trump administration passes tax cuts and other fiscal stimulus to offset the growth shock from the tariffs. Currently, we have no insight into the prospects for more fiscal stimulus.

When we look at the consumer part of the economy (recall that the consumer sector is almost 70% of U.S. GDP), we see a mixed picture of current strength but future weakening. On the plus side, the charts below show the unemployment rate is still quite low and consumers’ balance sheets and income are still strong as household net worth grew 9% year-over-year thanks to a strong stock market, while disposable income grew almost 5% year-over-year. On the negative side, we see that compensation growth is slowing and consumer confidence is falling as people are more concerned about future employment prospects and inflation. We believe consumer strength will likely fade over the next few quarters as these trends of rising unemployment and slowing compensation growth gather momentum.

The corporate sector is in very similar shape to the consumer sector; balance sheets are strong, demand looks solid, but profits look like they are starting to slow, and capital expenditure plans are being cut.

We continue to be concerned about inflation and strongly believe that inflation and recession fears will be the key driver of market volatility in 2025.

Below is a snapshot of various measures which outline the problem with inflation. Headline CPI in February rose 2.8% year-over-year, but services inflation rose 4.1%, as goods prices were actually deflationary as shown in the following chart. Services inflation tends to stay in a range, unlike goods inflation, which can be quite volatile; and services inflation tends to drive wage inflation as labor demand/supply directly impacts the provision of services in the economy.

While headline inflation has decelerated, tariffs could move that trend in the other direction, at least temporarily. Of note in the latest University of Michigan confidence survey was the sharp jump in inflation expectations. The survey showed that one-year inflation expectations increased to 4.9% while five-year expectations jumped to 3.9%. If inflation is not dead, the Federal Reserve may not be able to cut interest rates outside of a deep recession, which may lead to a number of resulting impacts that are nearly all negative: 1) the equity markets may find it hard to assign a higher multiple to growth stocks because higher interest rates imply lower valuations, 2) mortgage rates will remain high, so housing will stay quite expensive, 3) highly levered firms can’t support their debt so private equity multiples may remain low, and 4) debt refinancing activity likely means higher interest costs for borrowers. The only positive impact from higher interest rates is that savers can get interest rates on their cash, money market holdings, and Treasury Bills that have not been reported since the mid-2000s.

So, let’s talk about tariffs and their possible impacts. We tend to agree with the estimates we have seen of a 1-2% cut to a baseline GDP growth rate of 2.3% in the first year after tariffs are implemented, with our bias toward the bigger GDP impact if no offsetting fiscal stimulus is enacted. An estimated 1.0% increase to baseline inflation of 2.5% seems reasonable as well. However, please remember that these are point-in-time estimates, and proposed tariffs have been changed or delayed due to the negotiating tactics of the Trump administration. Nonetheless, based on what we know now, without offsetting tax cuts, tariffs would likely be bad for growth and bad for inflation, at least over the short term, with no real offset.

The worst possible case is that the imposition of tariffs would trigger a recession as consumers and corporations cut spending, or at the very least make a recession much deeper. It’s unclear whether the tariffs proposed would be equivalent to the Smoot-Hawley Tariff Act of 1930 that exacerbated the Great Depression, but we think it’s safe to say that the combination of tariffs and a recession is a bad one. Also recall that we have equity markets that look over-valued and highly concentrated. We also have a housing market that looks over-valued. A recession that hits equity market valuations is standard; a recession that hits housing markets is usually a deep one. Adding up recession + tariffs + housing market downturn = a deep recession. This is not our base case, but we have to acknowledge it is a tail event that could occur.

Let’s also recognize that in the event we do see a sharp market correction, a recession, and a jump in unemployment (usually these events occur in that order, with varied lags), we believe that the Federal Reserve will cut rates sharply and ignore inflation being above their 2.0% target area.

One last scenario worth discussing is stagflation. Investopedia defines stagflation as an economic cycle characterized by slow growth and a high unemployment rate accompanied by inflation. Economic policymakers find this combination particularly difficult to handle, as attempting to correct one of the factors can exacerbate another. However, stagflation can be hard to spot, except in retrospect. Below is a snapshot of average nominal GDP growth by decade, broken down between inflation and the end product, real GDP growth, with an overlay of the average unemployment rate in the decade. We have also included a table that shows how much nominal growth came from inflation as opposed to real growth.

As you can see from the table above, inflation accounted for almost 60% of nominal growth in the 1970s, 1980s, and 2000s, while unemployment was relatively high. That reversed course in the 2010s but then changed course again in the 2020s. The important question is whether unemployment in the 2020s follows the pattern of the 1970s, 1980s, and 2000s. We also saw much choppier equity market returns in those decades; however, interest rates were also relatively higher then as well. If this is the type of environment we should expect, then we should not expect a sustained drop in interest rates outside of a recession; in other words, if a recession does hit and interest rates are cut, they will likely rebound fairly quickly in the recovery phase of the cycle. We think a stagflation environment is a risk as two of the three key elements are in place – low growth and a large share of inflation of nominal growth – but we have not yet seen the third element, a rise in unemployment above 5.0%.

So, where does that leave us? Our base case is that we should expect a sharp growth slowdown and possibly an outright recession, with a negative GDP reading already seen in Q1 2025. While equity markets have stabilized somewhat, we do not expect to see a strong equity market rally until more clarity on tariffs and tax policy is available, which may not be until Q3 2025. Overall, over the next two quarters, we are more likely to see downward pressure on interest rates as, perversely, we think the market will price in less growth rather than more inflation due to tariffs, as well as price in some modicum of fiscal discipline. Credit spreads are apt to move a bit wider, reflecting the weaker growth, and default fears will rise as the market anticipates a recession. The key metrics to watch, as usual, will be corporate profits and stock market returns; if those hold up reasonably well, a growth slowdown is more likely, which will still bring with it an increase in the unemployment rate. Due to tariffs, inflation will likely still be too high relative to the Federal Reserve’s 2.0% target, but a rise in unemployment could offset some of that increased inflation.

Given that some of the actions of the current Trump administration have so far been difficult to predict, investors, consumers, or businesses are probably not willing to take on risk until they have more clarity with respect to the administration’s policies. Once we get through this uncertainty and associated recession risk, we would expect to see confidence recover in Q4 and, possibly, an upward turn in asset markets.

If the Trump administration’s imposition of sweeping tariffs is not reversed, the implications could be profound for the U.S. and the global economy and also have far-reaching geopolitical implications over the medium and long-term horizons. Over the medium term, we believe it is highly likely that there will be round after round of tariff retaliations and protectionist walls set up, which will cool global trade as countries and corporations adjust to the new normal. Then there will be a period of modest thawing of trade relations looking out past 2028, but we believe it is unlikely that we will go back to the regime that existed from 1945 to 2025.

Over the long term, we believe we have entered a new regime of deglobalization marked by generally higher levels of inflation and less open markets. We have argued in the past that the low inflation era of the past two decades is ending as the massive influx of labor from millennials and the opening of China, which has become the world’s largest manufacturer, comes to an end. Now we are faced with a shrinking supply of labor as baby boomers are retiring and China enters a demographic bust; perhaps India and Africa can make up for the loss of cheaper labor from China, but we have our doubts. Tariffs are likely only going to make an already bad inflation picture that much worse. Technology innovation is the one factor that could boost productivity and offset some of the inflationary push from an aging/shrinking labor force and deglobalization, but it is almost impossible to tell if and when a breakthrough will happen on this front.

Eventually, we believe that regional trading blocs will form, which may follow the rough longitudinal breakdown of the Americas, Europe/Middle East/Africa (EMEA), and Asia-Pacific regions, and be dominated by a regional power – the United States in the Americas, Europe in EMEA, and China in Asia-Pacific. These blocs would largely trade within their respective spheres, with trading dominated by the largest regional power’s currency. This is a significant shift away from the current regime and could be quite negative for the United States. For decades, the U.S. has benefited from the exorbitant privilege of being the world’s reserve currency, which has kept U.S. interest rates relatively low. If the world doesn’t need as many U.S. dollars, but we are still running high fiscal deficits, the result will likely be higher interest rates. If tariffs are combined with prudent fiscal policy to address our deficits and debt, then their long-term impact may be neutral to even slightly positive. However, this will require unprecedent amounts of political cooperation that we have not seen since perhaps World War II.