Our March Investment Quarterly (IQ) was held in New York the day after the Federal Reserve (Fed) left rates unchanged. The Fed tried to convey a sense of monetary policy calm against a backdrop of chaos and volatility emanating from the policy mix coming out of the Trump administration. This is not what we thought would be unfolding when we last met in December at the previous IQ. We believed a pro-growth government would be in place and were looking towards the equity markets as a measure of success. 

We expected that some disruptions could result from trade and immigration policies but believed these would be followed by significant deregulation and fiscal expansion. We also anticipated that the administration’s policies were to be well sequenced and choreographed, such that they would serve as a safety net for the market. Instead, we, like the Fed, are facing a version of  “everything, everywhere, all at once.”

The group quickly realized that we needed to shift our focus to adapt to the rapidly changing macroeconomic backdrop. We recognized that while no one could fully anticipate what was likely to happen, we needed to dive deep into economies and markets to determine their ability to withstand the impact from what was likely to follow. The U.S. was not the only country in the midst of changing policy. Germany was on the precipice of reversing close to a century of austerity and embark on a fiscal spend. China was looking at ramping up fiscal spending as well. And an entire range of countries were poised to respond to U.S. tariffs with their own retaliatory tariffs.

Amidst the volatility and confusion, the group generated a wide range of ideas on where to invest. However, we acknowledged that the volatile environment is likely to persist—perhaps for another three years and ten months.

Macro backdrop

While an escalating global trade war is concerning due to its potential to cause stagflation, the positive news is that businesses and households are in relatively good positions to absorb the shock. The U.S. economy is operating at close to 2% GDP growth, with inflation running in the mid-2% range. We expect the effective tariff rate for U.S. imports to rise and ultimately settle around 10% on average, which should cause GDP to drop by at least 1% and keep inflation temporarily elevated at around 3%.

It’s an uncomfortable economic mix, but not a recessionary one—as long as the inflation effects prove to be temporary, which would allow the Fed to support demand with a few rate cuts. Households appear to be in good shape, as would be expected with both unemployment and wage growth running at approximately 4%.

Corporate America should also be able to withstand the tariffs, as businesses use a combination of strategies to absorb some of the input cost increases while also passing some along to the consumer. Revenue and EBITDA growth has stabilized in Q4 at 5% and 2.6%, respectively, and margins are still relatively high at 15%. 

Under our base case tariff scenario, revenue and EBITDA could slow to 2.5% and 2.3%, respectively, which while not ideal, is manageable. Additionally, if businesses and households were to come under more intense pressure than we are estimating, the Fed has ample room to lower rates and cushion the impact of a tariff war. For now, the U.S. economy can weather a potential storm.

It also appears as though U.S. dollar (USD) exceptionalism has peaked. Ever since the Fed finished hiking rates in 2023 and began to cut them in 2024, investors have been looking for USD strength to fade. However, the lack of an alternate reserve currency to USD and the relative health of the U.S. economy continued to support the USD. In retrospect, the ~$10T in fiscal spend from the flurry of COVID-era programs leveraged the U.S. to a higher growth rate than competing economies. 

For example, German GDP per capita fell from 95% of the U.S. in 2008 to 66% today. Perhaps the U.S. has overinvested in itself, but certainly many economies have also underinvested in themselves. That is clearly changing as France, Germany and the broader Eurozone look at borrowing, spending and stimulating activity through new defense and infrastructure initiatives.

We believe the Fed is right to pause until they have greater clarity on the magnitude and duration of tariff policy. They also have to weigh the impact of the Department of Government Efficiency (DOGE) on the federal workforce and how state and local governments absorb the fallout. 

Nonetheless, the Fed is telling us they are looking for an opportunity to bring rates lower. Their most recent summary of economic projections highlights the downside risk to the economy and the uncertainty ahead. They believe the neutral rate for Fed funds is closer to 3% than 4%. We expect the Fed to cut rates twice more this year to 3.875%. That should allow the ten-year U.S. Treasury to settle into a range around 4%—broadly 3.75% to 4.50%.

Scenario expectations

Above-Trend Growth was lowered to 10% from 40%. We see limited risk of economic reacceleration given the measures coming from the Trump administration leave little room for material fiscal expansion, as any extension of tax cuts will be offset with less spending. Sub-Trend Growth was raised to 60% from 40%. The probability of a moderate slowdown has increased with the announcement of further tariffs on April 2, which have already dampened consumer and business confidence. Recession was raised to 20% from 10% reflecting the potential for a policy error coming from the administration. Crisis at 10% was unchanged. Tariff wars, executive orders, and central banks all in motion create a premium on execution.

Risk

The tail risk of an economic contraction is greater than that of a sharp reacceleration. If the administration holds a philosophical belief that terms of trade are inequitable and must be rebalanced regardless of the economic impact, then retaliatory measures and an all-out trade war could ensue.

Further, DOGE cuts may have started a domino effect of unintended consequences. A reduction in the federal workforce and its programs has shifted a burden to state and local governments. Without federal subsidies, they may be forced to cut workers as well. While the intent to shrink government comes with its positives, it’s worth remembering that hiring in state and local government as well as the interdependent education and healthcare sectors has helped support the labor market since the start of the COVID pandemic.

While the risks of economic reacceleration and inflation are much lower, they are not zero. There is still a lot of money sloshing around in the system, and the potential combination of a reversal by the administration on tariffs and a fiscal spend (negotiated by Congress) could heat things up. The markets are certainly not ready for a Fed that has to hike rates to control inflation.

Strategy implications

Almost 60% of our best ideas involved some form of increasing duration exposure via government debt of longer maturity in the U.S. and U.K., as well as emerging markets. While we are not exiting credit allocations since recession remains a low probability, we are reducing our credit sensitivity either by going up in quality or trimming positions. U.S. and U.K. government bonds with five and ten-year maturities, local emerging market sovereign debt and short duration securitized credit were our best ideas. Agency mortgage-backed securities, investment grade financials and short USD were also featured.

Closing thoughts

While the odds of avoiding a recession or crisis remain at 70%, the mix has changed. The combination of below trend GDP and above target inflation will create a challenging backdrop for markets. There seems to be a complacency in businesses and the markets that tariffs will either be rolled back or negotiated away. It’s important to see how businesses react to higher input costs and if they try to protect margins through workforce reductions. For now, we prefer to wait out the next couple months with longer, higher quality duration. 

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