Markets are shaken, not stirred as we head into Q3
We expect to see core CPI rising to around 3.5% by end-2025 before settling down - fiscal policymakers will need to tread carefully.
The global economy has confronted a series of shocks this year, including trade and geopolitical uncertainty, as well as monetary credibility and fiscal unsustainability. Increasingly, headline fatigue is setting in, enabling a clearer narrative to emerge.
U.S. economic forecasts have been revised sharply lower, but downgrades have plateaued, and importantly, it is expected to avoid recession in 2025. In China, a strong growth performance in the first half of 2025, combined with policy potential, has led forecasts to remain fairly robust. European forecasts have been gradually downgraded, but fiscal action is driving a rise in 2026 growth forecasts.
Shifting global dynamics have prompted investors to question a key long-held assumption: U.S. exceptionalism. This has been reflected in a drop in the U.S. dollar to a three-year low, defying both interest rate differential dynamics and its traditional behavior during times of heightened volatility.
Instead, gold has been a key beneficiary of safe haven flows, while Germany's fiscal stimulus and Asia’s tech expertise have also attracted greater investor interest. Looking ahead, robust macro dynamics and improved policy stability may moderate further USD decline as investors assess the relative return prospects of U.S. assets.
With the Trump administration stepping back from its most punitive tariff announcements, peak trade policy pessimism is firmly in the rearview mirror, and recession odds have been significantly reduced.
Yet, despite these corrective turns in tariff policy, there remains potential for economic scarring, as trade barriers will likely remain higher than they were at the start of the year. We expect the average effective U.S. tariff rate to ultimately settle at around 17%, the highest level since the 1930s Smoot-Hawley tariffs and meaningfully higher than 2% at the start of 2025. This should create a lasting drag on GDP worth about 1.7% and a one-time increase in inflation of 1.6%. While not as severe as initially seemed likely, the ensuing negative impact of these tariffs remains a sizable headwind on U.S. growth in both 2025 and 2026.
Importantly, trade policy uncertainty is likely to remain elevated. Legal challenges to the administration’s ability to act unilaterally on tariffs suggest that a gradual shift toward sectoral rather than country tariffs should be expected. Meanwhile, the administration will likely use tariffs as a negotiating tool going forward, making tariff noise a more permanent feature of the economic backdrop.
Survey data—or soft data—has shown significant pessimism since the start of the year across both households and businesses, although small business confidence has recently bounced back. In contrast, actual economic data—or hard data—remains fairly robust so far, albeit with some cracks. However, as the effects of the trade war begin to sift through the economy, it’s likely that spillovers to the hard data will eventually materialize. While this is expected to be evident by late summer, the exact timing remains uncertain.
How much the data weakens will be strongly impacted by the policy backdrop. Indeed, while non-defense capital expenditure activity remains relatively firm, lasting policy instability would likely lead to shelved investment plans, potentially exacerbating the deceleration in the labor market.
So far, employed consumers continue to spend as personal income growth—implied by average hourly earnings and weekly hours—remains solid. However, if cracks in the labor market were to broaden sufficiently, then a deterioration in retail consumption activity shouldn’t be far behind, with knock-on impacts on the broader economy.
Yet, absent additional shocks, the glide path in growth appears manageable for policymakers to respond appropriately.
Were it not for the tariff shock, U.S. inflation would likely have hit the Fed’s 2% target this year. After a series of lower-than-expected prints, it is tempting to believe that inflation has been officially tamed. Yet, as import tariffs typically take around two to three months to impact inflation, the prints will likely start to head higher in Q3 – although the timing is highly uncertain.
Our estimates suggest that tariffs alone could deliver a one-time inflation shock of around 1.5%, primarily reflected in core goods prices. After acting as a deflationary force last year, core goods prices have been rising—and this upward momentum is likely to persist as new tariffs come into play.
The Fed appears inclined to believe that the tariff impact will not lead to second-round effects, but it also recognizes the risk that pressures become more persistent. So far, long-term inflation expectations remain anchored. Yet, near-term expectations are gaining attention within the Fed and have increased over the past six months, deserving attention.
We expect to see core CPI rising to around 3.5% by end-2025. Sticky wage growth, resulting from tighter immigration controls, suggests that inflation may remain elevated for a few quarters before it begins to return toward the 2% target.
The Federal Reserve is navigating a narrow path. Trade uncertainty is ripe ground for policy missteps, particularly when jobs data remains resilient, inflation is still running above target and likely to see a tariff-induced boost in Q3, and short-term inflation expectations have shifted higher.
The latest Fed dot plot still showed 50bps worth of cuts this year. Yet, with the economy providing little reason for urgent and significant cuts, we continue to expect the Fed to resume rate cuts only in late Q4, followed by a further three cuts next year. A caveat: a more dovish Fed chair could accelerate the easing path—but only if inflation pressures remain contained.
Meanwhile, with increased focus on debt sustainability, fiscal policymakers are equally navigating a difficult path. The new tax bill will be expansionary and, by itself, will likely have a positive impact on growth. However, this will be more than offset by the combined negative effect of tariffs – a de facto tax hike – and a decrease in federal grant spending. This should see a gradual improvement in the budget deficit but at the expense of growth.
Fiscal policymakers need to tread carefully to avoid triggering a sharp slowdown in growth that inadvertently worsens historically elevated budget deficits.
Principal Asset Management
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