Our June Investment Quarterly (IQ) was held in Columbus, Ohio the week after a significant and surprising geopolitical event. A ceasefire and truce between Israel and Iran were brokered after meaningful military intervention by the U.S. A conflict that added considerable volatility to financial markets, and that might have lasted for years, was swiftly de-escalated within two weeks, removing that volatility. The Federal Reserve (Fed) also met the week before the IQ and supported the market calm by signaling no meaningful policy shift. 

That left the IQ participants focused on the ever-evolving U.S. tariff policy and the One Big Beautiful Bill Act (OBBBA) working its way through Congress.

The group acknowledged that markets had seen tremendous volatility since our previous meeting in March. The combination of U.S. tariffs announced on April 2 that would have raised effective tariff rates to the mid-20% range, and the retaliatory tariffs that had been indicated post Liberation Day, caused a dramatic risk-off event—and briefly raised the probability of recession to the market’s baseline expectation. Then, a tariff pause by the administration, and a de-escalation with trade partners, led to a V-shaped recovery in markets. 

The last three months were also full of other powerful, fast-moving market narratives, including fears that “Sell America” and “The End of U.S. Exceptionalism” might take hold, as the OBBBA caused market participants to focus on the worrisome levels of U.S. debt and deficits ahead. 

For all the volatility, markets have settled back to levels not too distant from where they were pre-Liberation Day. Perhaps it is based on confidence that businesses and households will be able to absorb tariffs, given their balance sheets’ strong starting points. Or perhaps it is complacency that the final state of tariffs will be negotiated away and the OBBBA will be reduced in scale, or that its impact will eventually be perceived as more manageable than previously feared. 

We think the revenue thrown off by tariffs means they are here to stay, and that tariff revenue will ultimately be used to cover the incremental cost of the OBBBA. How all of that is sequenced and what it means for markets is what occupied us for eight hours.

Macro backdrop

After agreeing that a certain level of tariffs is here to stay, we raised our expected average effective tariff rate in the U.S. to 13%–15%, from 10% last quarter. Despite this, we believe that the U.S. is in a good position to avoid recession. While the economy’s real GDP may slow over the second half of 2025, to 0.5%–1.0%, from the current rate of 2%–3%, businesses are well prepared for the impact on prices. 

Moderate price increases should lead to some demand destruction, but not enough to tip the U.S. into recession. This view is based on evidence from rising tariff receipts to the Treasury, coupled with mixed signs of rising end-user inflation in high-frequency measures, a signal that businesses are absorbing into their margins part of the tariff cost increases. Various labor indicators suggest that while businesses are not hiring new workers, neither are they laying them off, on anything like a large scale. 

Evidently, businesses are indeed sensitive to higher prices’ effect on consumption, and their pricing power is not unlimited in a world of already-high price levels and depressed consumer sentiment. Yet businesses are doing their best to navigate through it.

U.S. inflation from tariff policy is ultimately expected to be contained in scope. While the quarterly annualized run rate for inflation may accelerate to the mid-4% level toward the end of this year, what will be important is that the increase remain a one-time price reset, not embedded in inflation expectations.  

There is no reason to believe otherwise, and the group focused on the downside forces for energy prices, and continued moderation in service inflation, as two possible counterbalances to higher transitory goods inflation.

The end of U.S. dollar exceptionalism, and the increased deficit spending in the OBBBA, raised a lot of concern. How to pay for the Congressional Budget Office (CBO) scoring estimate of $2.8 trillion in additional spending over the next 10 years was the primary question. Magically, the CBO scoring estimate of an expected $2.8 trillion in tariff receipts would seem to cover that cost. Importantly, the group did not see any material knock-on effect to international participation in U.S. asset markets. Flows into U.S. fixed income assets continued, although there was some evidence of buyers’ increased interest in hedging their USD exposure back to their home currency.

Outside the U.S., the global economy looked to be in good shape. Germany had just passed a $1 trillion fiscal package, and the broad array of EU member government policies were also skewed toward fiscal stimulus. Within the emerging market (EM) economies, China had expanded fiscal support, and many other EM governments and their central banks had lined up a range of fiscal and monetary measures to cushion the tariffs’ impact. 

We continue to believe that the Federal Reserve is right to pause on any change to monetary policy. The final shape of both tariff policy and the OBBBA have yet to be determined. Once they are finalized, the Fed will have a chance to gauge their impacts on price levels, the economy and ultimately, the labor markets. 

We believe the Fed will have the opportunity to bring rates down at least once this year and expect the 10-year Treasury to settle into a 3.75%–4.50% range.

Scenario expectations

We raised the probability of Sub-Trend Growth, to 65% from 60%, by reducing Recession to 15% from 20%. The significant tailwinds and headwinds—to both growth and inflation globally—seem to be either offsetting or transitory but are nonetheless keeping uncertainty elevated. Further, businesses, households and government policymakers have shown a readiness to manage what lies ahead. We kept the probability of Above Trend Growth and Crisis each at 10%: With so much still in flight over the next couple of quarters, the possibility has not gone away that something could break, or overheat, because of shifting fiscal and monetary policy. But these remain tail risks.

Risk

Signs of fragility can be seen in the U.S. labor market, and pressure on lower-income households facing higher tariff costs on top of already high price levels and structurally higher costs for shelter. Additionally, potential Medicaid coverage cuts, and the restart of student loan default collections and subsequently credit scores, could lead to a breaking point for these households, further exaggerating the existing K-shaped recovery. 

At the other end of the risk spectrum is the lack of fiscal discipline globally. Borrowing and spending may overheat the global economy and markets where the overabundance of COVID-era money is still sloshing around the system. One metric we noted: over $21 trillion in liquidity across U.S. checking, savings, deposit and money market accounts—and that doesn’t even include all the dry powder in the rest of the world. Liquidity continues to grow to record highs and loom over already high asset prices.

Strategy implications

The group saw increased opportunity in non-U.S. exposure through foreign exchange (funded via shorting the USD) and/or emerging market debt. Assets with high carry that would perform well in a continuing soft landing include bank AT1¹ securities and leveraged credit (high yield, broadly syndicated loans, and collateralized loan obligations [CLOs]). The group also favored securitized credit and agency mortgages, given the consumer’s overall financial health and the relentless demand for housing. Lastly, to hedge the risk-on bias: yield curve steepening trades in U.S. and Europe and long duration positions in intermediate maturity U.S. Treasuries.

Closing thoughts

Fed policymakers are right to delay any policy decisions until they see the specifics of fiscal policy finalized and the outcome of trade negotiations—and until they have measured those actions’ impact on the broader economy. As active managers, we must form policy expectations for the intermediate horizon while managing live positions and risks in portfolios. We have and will continue to stay laser-focused on the behavior of businesses and households, along with evolving official policy. Our analysis indicates that the soft landing and carry trade environment will prevail. When we next meet in mid-September, we will see how these policies have played out and how the investing landscape has evolved.

¹Additional Tier 1 bonds are assets that, among others, are part of the capital banks are required to hold against possible stress.

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