Chief Global Strategist
Three weeks ago, I wrote an article entitled Detangling Solution for the Economic Outlook in which I outlined a baseline forecast for 2026 and into 2027, amidst many distortions and entanglements in economic data and trends.
So much has happened since then, including a raft of new economic numbers, the Supreme Court’s decision on IEEPA tariffs, and, most seriously, the start of an all-out war in the Middle East, that it makes sense to go through the exercise again, or, as the marketers of hair products might say, “rinse and repeat”.
With that in mind, it is worth reviewing the outlook from three weeks ago, how new economic data, tariff news and the war could impact that forecast and where things stand today.
The Outlook as of Three Weeks Ago
Three weeks ago, we expected:
- Real GDP growth of 2% year-over-year by the fourth quarter of 2026, with growth of just 1% for the first quarter, partly due to bad weather, speeding up to 3% over the middle two quarters, as income tax refunds and tariff rebate checks boosted consumer spending, and then slowing down again to 1% in the fourth quarter. AI capital spending and wealth effects from three years of stock market gains were expected to be positives while weakness in construction and government spending were expected to be drags. We also expected growth to slow to 1.5% in 2027, partly reflecting a lack of labor supply.
- On jobs, we noted the weakness in payroll jobs and expected a significant decline in the measured workforce in the March jobs report. Based on the Census Bureau’s estimate of current immigration trends, we estimated that the population aged 18 to 64 was falling by 20,000 per month so that, even with anemic payroll gains of 60,000 per month, the unemployment rate would drift down to end 2026 at 4.0%.
- On profits, we recognized the remarkable performance of S&P500 earnings in logging double-digit growth for a second consecutive year in 2025. However, while optimistic about earnings overall, we were a little skeptical about the ability of companies to continue to generate double-digit earnings growth, given a much slower pace of nominal GDP gains.
- On inflation, we noted a very benign January CPI report. However, considering the feed-through effect of tariffs and an anomaly in shelter inflation caused by the government shutdown, we expected CPI inflation to peak at over 3% this summer before ending the year at close to 2%.
I should finally mention that, in putting together this forecast, we expected the Supreme Court to overturn the IEEPA tariffs at some stage this spring but that they would immediately be replaced by only slightly less onerous tariffs, providing only a little inflation relief for late 2026 and 2027. We also expected the Federal Reserve to cut rates once in the first half of the year, once again in at the end of the year and, potentially, a few more times next year, if both economic growth and inflation fell below 2% entering 2027.
Data and Events
Such were our expectations as of three weeks ago. What have we learnt since then?
Starting with economic data, real GDP came in weaker than expected at 1.4% annualized growth for the fourth quarter. However, the outlook hasn’t changed much with regard to the first quarter. Light-vehicle sales for January and February averaged a 15.3 million unit annual pace compared to 15.7 million units in the fourth quarter and retail sales fell 0.2% in January. However, with better weather, sales should pick up in March. In addition, income tax refunds have been smaller, so far, than we expected this season. However, the IRS only published the forms to take advantage of new deductions in the OBBBA in early March, so we should see a dramatic pick up in income tax refunds in the weeks ahead.
Initial unemployment claims have remained low in recent weeks. However, the February jobs report, released last Friday, was brutal, showing a payroll job loss of 92,000, the fifth month of declines in the last nine. On a year-over-year basis, payroll employment was up just 0.1%. in February. Moreover, with new population controls, the household survey shows a similar trend, with the unemployment rate rising from 4.32% in January to 4.44% in February. According to the household survey, the number of Americans working fell 0.3% year-over-year in February, with a 128,000 increase in native-born workers being swamped by a 519,000 decline in their foreign-born brethren.
Finally, related and more positive trends were evident in last Thursday’s productivity report which showed a 2.2% gain in output per hour in the non-farm business sector in 2025, following strong gains of 2.0% and 3.0% respectively over the prior two years.
Moving from the data to key events, the Supreme Court struck down the Administration’s IEEPA tariffs on February 20th and the President immediately responded by imposing a broad 10% tariff, promising the next day to increase it to 15%. As this is being written, the 15% tariff rate has still not been imposed. However, the Treasury Secretary has indicated that this hike is imminent and that the broad tariff levels that were in effect before the Supreme Court decision would be restored, using other authorities, within five months. We don’t quite believe this so, instead of assuming a continued effective average tariff rate of 11% throughout the forecast period, we now expect an effective rate of 9.1%.
Third, and most seriously, the U.S. and Israel launched a war against Iran on February 28th. As this is being written, the war is on-going and, as one result, very little traffic is traveling through the Strait of Hormuz. This caused the April WTI oil futures contract to vault to $91.27 per barrel on Friday, boosting regular gasoline prices on Sunday to $3.45 per gallon, up from $2.98 cents just one week earlier.
We expect the U.S. to declare victory fairly quickly and the Administration will likely focus on re-opening the Strait. Futures markets apparently expect them to succeed, with the June WTI contract on Friday trading at $82.56 and the December 2026 contract trading at $69.07. Gasoline prices normally rise by about 30 cents per gallon between January and June due to the use of more expensive summer grades and seasonal increases in demand. Consequently, even with a relatively quick resumption of normal oil production, refining and distribution from the Persian Gulf, gasoline prices may stay elevated until the fall.
A Revised Outlook for the U.S. Economy and Investment Implications
Given all of this, how does it impact our forecast.
First, the outbreak of war, higher gasoline prices, continued tariff uncertainty and clearer signs of a weaker jobs market will likely hurt both consumer and business confidence. This could lead to somewhat lower consumer and business spending and this would only be partially offset by higher government spending to fund the war effort and stronger investment spending on energy infrastructure. Consequently, our expectation for fourth quarter year-over-year economic growth has fallen to 1.8%.
Second, while changes to the household survey population counts were largely as expected, February’s increase in the unemployment rate was not. In addition, increased uncertainty, combined with the possibility of using AI to enhance the productivity of existing workers, could lead to less hiring. Consequently, it is possible that the unemployment rate only drifts down from its current 4.4% to 4.2% by December 2026.
Third, profits should remain on track for high single-digit growth as strong productivity gains and AI capital spending persist and worker gloom holds wage demands in check
Fourth, year-over-year CPI inflation could now peak at 3.5% in June of this year, up from a forecast three weeks ago of a peak at just over 3.0%. However, we still expect it to decline later in the year as gasoline prices retreat and, with slightly weaker growth overall and lower tariffs going forward, it could now ease to 1.9% year-over-year by December and fall further in 2027.
Fifth, we expect the Fed to remain on hold in their March meeting. They will note the potential impact of higher energy prices on near-term inflation. However, they will likely look through these temporary impacts and conclude that inflation is likely to recede later in the year. We consequently still expect two rate cuts in 2026 with some more cuts in 2027. These cuts would stand in contrast to less easing from other central banks, allowing for a resumption of the dollar decline following a brief flight to quality in the face of geopolitical uncertainty.
For investors it has been a difficult few weeks with declines in both U.S. and international markets, a rise in the dollar and increasing Treasury yields.
Going forward, the key question is how long it takes for the conflict in the Middle East to calm down.
If it is relatively quick, global equity markets should resume an upward trend. Moreover, with less of a flight to quality and the prospects for slower U.S. economic growth and inflation by the end of the year, the exchange rate should resume its decline. This suggests that the best returns may still be found in international equity markets.
However, there is no doubt that the outbreak of war has increased uncertainty, with a heightened risk of a “fat-tailed” or improbable event. Such an event would be most dangerous for highly valued and concentrated portfolios. Consequently, even as geopolitical uncertainty replaces uncertainty about economic data, there continues to be an over-riding need for investors to diversify more broadly.