Our optimism for the economy and markets in 2025 has been tempered by the fairly large tariffs announced in April. The economy had, on balance, been solid prior to the tariff announcements, although a few signs of weakening had emerged. Some indicators, like credit spreads, equity market breadth, and the labor market were strong while others, like uncertainty around immigration reform, tariffs, and inflation expectations were more concerning. With equity valuations on the high side, any weakness has been penalized by the markets. The tariff announcement makes us incrementally more bearish on both the economy and markets.

Key Data Points to Watch in April

• Q1 2025 corporate earnings reports – expecting 7% earnings growth. Companies start reporting Q1 2025 earnings in the second week of April. Estimates for Q1 2025 year-over-year earnings growth have dropped from 11% to 7% over the past couple of months as some companies reported disappointing outlooks. This is in line with typical declines, as analysts are often over-optimistic early in the year. We expect that as companies report earnings, they will continue to highlight uncertainty in their prepared remarks, particularly with respect to tariffs and other administration policies
• Will 2025 earnings estimates decline further? Estimates for the entirety of 2025 have also declined, from 14.5% to 11.5%, although estimates for 2026 have remained unchanged
• European GDP and earnings. After increasing by about 6% during the first two months of the year, European earnings estimates declined by about half a percentage point in March. Further increases would support those stock markets, but if the declines continue, the increase will have been short-lived
• Atlanta Fed GDPNow. This formula-driven GDP forecast has sharply declined, from 2.2% in mid-February to -3.7% most recently. The initial decline to -2.8% (in February) was driven by unusually high imports, as companies stockpiled imports ahead of expected tariffs. These high imports have continued, but other factors are now contributing to the larger decline, including lower personal consumption and lower capital expenditures, both of which are more concerning
• Jobs April 4. The labor market has been the most consistently bright spot in the US economy over the past several years. Any sign of weakening below the 150,000-200,000 monthly new jobs average could cause the Federal Reserve (Fed) to accelerate interest rate cuts
• Inflation reports on April 10 (CPI) and April 30 (PCE). Inflation has remained stubbornly above the Fed’s 2% target. If the labor market weakens, expect the Fed to ease monetary conditions, even with higher inflation

March Takeaways:

• US equities declined. The S&P 500 Index declined by 5.6%, more than eclipsing the appreciation in January and February. Year-to-date, the index has declined by 4.3%. Small-cap stocks declined even more: the S&P Small Cap 600 Index was down 6.2% in the month and 8.9% year-to-date
• International equities outperformed the US. The MSCI EAFE index declined by 0.3%, outperforming US equities. This brings year-to-date performance to 7%
• Bonds outperformed equities, with the Bloomberg Aggregate Index (up 0.04%) and the Bloomberg Intermediate Government Credit Index (up 0.44%) materially outpacing the S&P 500 Index’s 5.6% decline in the month. Investment-grade credit spreads have now widened by about 0.6% from the lows observed in November 2024.

It is daunting to write about tariff impacts on the economy, markets, and investing in the current environment because the topic has been dissected by many experts over the past few months and details remain fluid (and often contradictory), making analysis challenging. Are the tariffs merely an opening gambit in a series of negotiations, or will they be long-lasting? Understanding the potential economic implications necessitates a careful examination of the details, even as the details are in flux.

The tariffs announced on April 2 were higher than most market participants expected and include a 10% across-the-board tariff, as well as a 34% tariff on Chinese goods, 20% on goods from the EU, 32% on goods form Taiwan, 46% on goods from Vietnam, and many others. More tariffs – including so-called sectoral tariffs on lumber, semiconductors, and pharmaceuticals – are likely to be announced in the coming days.

Why are tariffs being implemented at all? A number of arguments have been presented as justification. One straightforward rationale is that the US currently has lower tariffs than most other countries; this imbalance is perceived as basically unfair. Making tariffs (and other non-tariff barriers) more equitable is intuitive, even if economists would argue that tariffs should be lowered globally rather than raised. Another argument is to rectify trade deficit imbalances. Many countries export more goods to the US than import from the US, particularly the EU, Mexico, China, and Vietnam.

Beyond simple fairness and balancing trade deficits, an economic underpinning justifying tariffs (as proposed by the current chair of the Council of Economic Advisors in a 2024 paper) rests on the disadvantages of the US dollar’s role as the world’s reserve currency; namely, this status results in artificially high demand for dollars compared to other currencies, which leads to artificial dollar strength. Dollar strength in turn makes US exports less competitive and hollows out manufacturing. In this telling, US manufacturing decline has been due to the dollar’s reserve status, and the most efficient way to offset this is to impose tariffs on imports. The proposed tariffs aim to rebalance trade relationships and encourage domestic production. While the tariffs may encourage domestic production, they are also likely to fragment the global trading system and may invite retaliatory actions from other countries.

We should note that there are also material benefits to reserve currency status: the US can borrow at lower rates than it otherwise would, and it can exert significant influence over global finance via its control of the dollar-based system. Until recently, most analysts and market participants focused more on these positives than the aforementioned negatives.

Our current assessment suggests that the impact of the proposed tariffs is likely to be a fairly large reduction in GDP – on the order of 0.5% to 2% – as well as a 1.0% to 2.0% increase in inflation. The tariffs could reduce corporate earnings by 3-5% or more, while CEO uncertainty may result in delayed capital investments, slowing the economy. These are not insignificant effects and sharply counteract what had been a strong US economy to this point; one that has been underpinned by a strong labor market and solid corporate profit growth. Economists had already been increasing the probability of a recession. According to a survey of economists by Bloomberg, this probability currently stands at 30% – up from 20% earlier in the year – and it will likely continue to increase. The increased recession risk even prior to the tariff announcements suggests a more fragile economic backdrop that may be less able to absorb the negative shocks from higher tariffs.

Survey-based indicators also suggest a softening in economic sentiment. Both CEO confidence and consumer confidence have decreased sharply in recent weeks. While this is “soft data” (survey-based, rather than numbers-based), a sustained decline in both business and consumer sentiment could lead to a weakening in future economic activity, further amplifying the risks associated with tariff implementation.

When analyzing economic and market variables, we often look to the past, and several analyses have been published noting that the 2018 tariffs did not have a materially negative impact on either inflation or GDP, so we should not worry in 2025. However, we believe that the 2018 tariff is not a particularly close parallel to today for a variety of reasons. First, in 2018, the US economy was still benefiting from the tailwinds of the 2017 Tax Cuts and Jobs Act.  In 2025, we are anticipating fiscal contraction, rather than fiscal stimulus. Second, 2025 tariff rates are significantly higher than the 3.5% imposed in 2018, as discussed above. Third, the inflation context is different: in 2018, CPI was under 2% and both businesses and consumers expected it to remain low. Today, inflation has consistently been closer to 3%, leading to higher inflation expectations among both businesses and consumers. As such, businesses may well be more willing to pass on tariff-induced cost increases, fearing less pushback from consumers already anticipating higher prices.

We invest in stocks and bonds of companies, so how will companies respond to these tariffs? Options range from:

(1) passing along higher costs to consumers (which only really works if companies have pricing power);
(2) absorbing the higher costs themselves;
(3) re-directing goods being manufactured outside the US for US sale to be sold in non-US end markets instead; to
(4) re-shoring supply chains onto US soil.

The pricing power option can be quickly implemented but is unlikely to achieve the administration’s goals, while re-shoring supply chains is often a multi-year endeavor and only likely to be undertaken when there is a degree of certainty over future conditions. Companies are unlikely to make these significant investments if they believe that tariffs may be simply negotiated away in the short-to-medium term. The Trade Policy Uncertainty Index has sharply increased as shown in the above chart, highlighting potential reasons for inaction.

Drilling down into investment implications, the companies most negatively impacted include those with high imported parts (technology, autos, apparel, retailers, others), those with a high percentage of revenue outside the US who may suffer other governments’ retaliation (technology, pharmaceuticals, consumer products, others), and those with thin margins (autos, retailers, others). All else equal, companies that focus on services, domestic production and consumption, and those with high margins will fare best.

Taking a big step back, it is clear that many of the tailwinds that have supported both the US economy and markets over the past few decades are now turning to headwinds. Interest rates steadily declined from 1981 to 2020 and spurred economic growth but have moved decisively higher over the past few years. Corporate operating margins steadily increased from 1980 to 2023, driven by lower interest rates, lower taxes, and lower costs enabled by globalization; this dynamic has likely reversed as well. Even after year-to-date declines, US equity valuations remain a few points above their 30-year median, suggesting potential further risk to equity values. In the short term, we expect a negative reaction, as the market assesses the cost to various companies and as other countries respond. Domestically focused companies are likely to outperform. Over the medium and longer term, companies will adjust behavior and adapt to the new rules. As globalization wanes and as governments exercise more control over the private sector, we may observe somewhat lower GDP and corporate earnings growth than over the past couple of decades.

Disclosures