Policy uncertainty and cooling growth

At his press conference after the Federal Reserve (Fed) March meeting, Fed Chair Jay Powell used the word “uncertainty” 10 times. Still, despite a 10% dip in S&P 500 in the first quarter, Wall Street’s main uncertainty index – the VIX – remained remarkably well anchored. Meaningful changes in economic policy may be fueling uncertainty among central bankers and investors alike, but the U.S. economy appears to be slowing rather than stalling.

In our year ahead outlook, we noted that if the new Trump administration put early emphasis on tax cuts and deregulation it could boost the economy and markets; but should it lead on immigration and tariffs, markets might find it harder to digest. The administration’s early focus on tariffs has surely contributed to lower consensus growth forecasts. But the economy had already begun to cool in the wake of restrictive monetary policy and a fading impulse from labor supply.

Our base case for the U.S. economy in 2025 sees below-trend GDP growth of 1.7% and core CPI at 3.1% by year end. Risk of recession has ticked up slightly from 15% to 20%, but we think the Fed has ample scope to cut further and faster than the two cuts we expect this year. Robust corporate and household balance sheets add resilience to the economy even as corporate confidence has dipped.

Around the world, a more bombastic U.S. administration has elicited some strong policy responses. Germany’s fiscal package could add over 70bps to GDP and kickstart the beleaguered manufacturing sector. A brighter outlook for European investment, particularly defense spending, may merely offset the drag of tariffs, but it signals a meaningful – and long overdue – shift in fiscal policy. Arguably Vice President J.D. Vance’s controversial address to European leaders in Munich has done more for European unity than any policymaker since Mario Draghi’s “whatever it takes” speech in 2012.

China, too, is responding to tariff talk. Its looser monetary policy is welcome amid low inflation, and President Xi’s recent meeting with business leaders marks a shift in the government’s stance toward the private sector. Policy actions around the world aim to blunt the impact of threatened tariffs but may also serve to narrow the gap between U.S. and rest-of-world growth in 2025.

Adapting portfolios to balance tariffs and tax cuts

Policy uncertainty weighs downside risks from tariffs with upside risks from tax cuts and deregulation – albeit probably later in the year. In our portfolios we have trimmed overall risk to weather recent volatility and in anticipation of further event risk around tariff policy. We are neutral or very modestly overweight (OW) equity but maintain a higher conviction in our credit OW. Scope for softer growth that could spur the Fed into action supports a small OW in duration. Our quant models tell us that the best opportunities are in relative value positions that capture valuation and policy differentials.

U.S. equity valuations unwound a little of their valuation excess in the first quarter and the outperformance of defensives aligns with softer GDP. We estimate that a 5%-7% hit to S&P 500 EPS growth from tariffs will constrain the upside for U.S. stocks. Our quant models are negative on the U.S. market given high valuations, but large cap tech stocks are a bright spot. Now at their lowest valuation premium to the index since 2017, large cap tech scores well on quality screens.

Globally, our preferred markets are Japan, UK, and emerging markets; our least favored is Australia. Europe – the best performing developed market year-to-date – has overshot potential earnings growth, in our view. While we are optimistic on European policy developments in the longer run, we would not chase today’s extended valuations.

Cooling growth but limited recession risk in the U.S. is a positive backdrop for credit. Spreads are optically tight but all in yields remain attractive in high yield and credit fundamentals such as interest coverage are solid. Low defaults and strong demand in primary markets further increase our conviction that credit will perform well this year. We see U.S. 10-year Treasury yields in a trading range between 4.50% and 3.75% for the time being and we find value in duration at current levels. In international markets we favor Australia and Italy, and we remain underweight Japanese bonds given rising wage settlements and the likelihood of further rate hikes.

Overall risk in our portfolio is lower than in late 2024 given the potential for further volatility as markets calibrate the impact of tariffs. Nevertheless, we are optimistic that as the policy trajectory becomes clearer, and the focus moves towards the tax and deregulation agenda, we will find opportunities to add risk. Should tariff debates resolve without descending into tit-for-tat trade disputes confidence could rebound steadily over the second quarter.

In sum, we see growth cooling but not cracking and believe that the Fed and other central banks have ample ammunition to support the global economy. Trade wars, a pickup in inflation, or overly restrictive monetary policy present risks to our view. But on balance we lean positively through credit today and would look to add equity risk should we see further weakness in stock markets. 

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