There have only been two U.S. recessions since 2001 – the Great Financial Crisis and the Pandemic Recession. Both of these were huge – accounting for two of the only three times since the 1940s that the unemployment rate has vaulted to double digits. However, because the recessions of our recent memory have been so dramatic, investors may not appreciate the risks from a softer sort of slowdown.
This certainly seemed to be the case last week, when the combination of slightly weaker-than-expected GDP and slightly stronger-than-expected jobs supported a continued recovery in stock prices. By Friday, the S&P500 had risen for nine consecutive days and, having been on the brink of a bear market less than a month ago, is now down just 3.3% year-to-date.
While the market rebound is welcome, it’s no reason for complacency. Despite Friday’s jobs numbers, the economy is losing momentum and will, more likely than not, slip into recession without real progress on the trade front or near-term fiscal stimulus. More importantly, if, in the long run, Washington policies result in greater trade barriers, less immigration and even larger budget deficits, then any economic recovery could be anemic, with long-term real GDP growth slipping to well below 2%. This danger suggests a continuing need to add international assets to portfolios that still have a heavy overweight to U.S. stocks.
Monitoring the Slowdown
Real GDP fell 0.3% in the first quarter, as attempts to frontrun the tariffs distorted the data.
In particular, real spending on imports surged at a $333 billion annual pace, far outstripping impressive gains of $131 billion and $69 billion in inventory accumulation and business equipment spending respectively, and a small increase in spending on consumer goods. In truth, the import numbers look a little suspect – it is hard to see where all of the extra imports could have gone if they didn’t end up in inventories or being purchased by business or consumers. To that extent, the first-quarter GDP numbers may have overstated economic weakness.
However, in the second quarter, the wind will be blowing strongly from the other direction. Imports are likely to plunge, as importers hesitate to buy foreign merchandise at much higher prices, particularly from China. Inventories could also fall sharply while consumers and businesses could pull back on purchasing goods that are either unavailable or too expensive.
In addition, we could see a further drag on the economy from a wide swath of service and retail businesses that rely on Chinese supplies. This could well be exacerbated by falling labor supply due to reduced immigration.
In the second quarter, the economy is likely to experience lower federal government spending, (as was the case in the first quarter), with an additional drag from more cautious behavior across a wide range of contractors, health and educational institutions and state and local governments who rely on federal government grants and loans.
Finally, there will likely be an additional drag of lower exports, reflecting the retaliatory tariffs levied by some foreign governments as well as a moderate decline in foreign tourism and, particularly in Canada, a popular movement to boycott U.S. goods.
Given all of this, we expect real GDP growth to be very weak, if not negative, in both the second and third quarters of the year.
Friday’s jobs report was more positive than Wednesday’s GDP numbers, with 177,000 non-farm payroll jobs added in April. However, the labor market may be a little less healthy than suggested by this headline for a few key reasons:
First, the payroll report referred to the pay period that contained the 12th of April. This may have been too soon after the April 2nd tariff announcement for companies to react with increased layoffs or slower hiring. To that extent, the May jobs report, due out on June 6th, should provide a better reflection of the initial impact of tariff uncertainty on firm behavior.
Second, revisions subtracted 58,000 jobs from the payroll gains of the prior two months.
Third, April saw few disruptions to the labor market with just 5,000 workers involved in major strikes and unusually low numbers claiming an inability to work due to bad weather or illness.
Fourth, while the unemployment rate was unchanged, the absolute number of people unemployed at 7.17 million was its highest since October 2021 and almost as high as the number of job openings, which fell from 7.48 million at the end of February to 7.19 million at the end of March.
Finally, employment reacts to real GDP growth with a lag. As demand slows, firms are reluctant to fire workers right away, particularly when they had a hard time hiring them in the first place. However, if real GDP growth is essentially flat for the first three quarters of the year, (as we expect without a favorable resolution of the trade war or near-term fiscal stimulus), job growth could well turn negative over the next few months.
Prospects on Policy
So what are the prospects of a policy turnaround?
On tariffs, it’s still hard to see the administration wrapping up multiple bilateral trade deals by July 9th, when the 90-day pause on so-called “reciprocal tariffs” is supposed to end. Consequently, we expect that for most countries, the pause will be extended, while leaving a 10% universal tariff in place. The Chinese tariff issue is more problematic since, although the Chinese economy is clearly suffering from the impact of these tariffs, the Chinese government may want to play hardball, figuring that the pressure on their government from unemployed manufacturing workers will be easier to absorb than the pressure on the U.S. administration from a lack of Chinese goods for consumers and businesses. That being said, some eventual compromise, at a much lower tariffs than their current triple-digit levels, is likely.
It should be emphasized, however, that even maintaining a universal 10% tariff, along with higher tariffs on China and on various industries, still has the potential both to raise inflation and to slow economic growth.
On immigration, the administration has largely succeeded in ending illegal border crossings, with total encounters at the southern border falling from roughly 100,000 per month in the fourth quarter of 2024 to less than 12,000 in both February and March.
The administration has been less successful in ramping up deportations. In a press release marking the President’s first 100 days in office, U.S. Immigration and Customs Enforcement (ICE) reported deporting 66,000 unauthorized immigrants so far, a pace which is actually lower than under the prior administration. This likely reflects the sharp decline in illegal border crossings and the reality that it is much easier to deport someone close to the border. The omnibus reconciliation bill will likely contain a substantial increase in resources for the arrest, detention and deportation of unauthorized immigrants, which could increase deportations later this year and in 2026.
Meanwhile, we only have data through February on immigrant visas issued through foreign embassies. In 2024, this amounted to 670,000 visas, up from 591,000 in the prior year. If this number declines substantially going forward, while deportations rise and illegal immigration is reduced to a trickle, U.S. net immigration could fall below 500,000 per year – less than half the pace of the three decades before the pandemic and low enough, given other demographic trends, to lead to a steady decline in the U.S. working-age population.
On the budget, the House Speaker, Mike Johnson, is pushing the Ways and Means Committee to vote on a detailed tax proposal this week. The bill will likely include a full extension of the Tax Cuts and Jobs Act of 2017 (TCJA) tax cuts. It will also likely include many of the President’s proposals to cut corporate taxes and increase tax breaks for domestic production, to eliminate income taxes on tips, overtime and social security, to allow for the deductibility of auto loan interest and to restore state and local tax deductions.
Assuming that a bill gets passed this summer, the crucial short-term question is how fast these and/or other tax cuts could be implemented to inject fiscal stimulus into the economy. From a political perspective, tax cuts that kick in in January 2026 might be sufficient to help the economy ahead of mid-term elections. However, if lawmakers perceive a risk that the economy could fall into recession before then, they might try to frontload some tax cuts or stimulus checks to boost consumer spending.
A bigger longer-term question, however, is what this bill could do to the trajectory of federal deficits. Working from CBO estimates, just extending the TCJA tax cuts would raise the deficit from 6.2% of GDP this year to over 7.0% by 2029 and 7.5% by 2034. Even greater tax cuts would, of course, lead to a higher trajectory, particularly if the federal government avoids making any cuts in defense spending or entitlements, as seems likely.
The Fed will conclude its third FOMC meeting of the year on Wednesday and we expect no change in policy. If, as looks likely, we get some more clarity on trade and tax policy in the next few weeks and if the economy shows further signs of weakness, we do expect a 25-basis point cut at their June 18th meeting. If that weakness morphs into a mild recession, we expect further easing with the federal funds rate falling from its current 4.25% to 4.50% range to 3.00% or lower by the end of the year. That being said, the inflationary consequences of tariffs and potential fiscal stimulus could preclude a quick return to near-zero short-term interest rates.
Investment Implications
The short-term threat of a tariff-induced U.S. recession may account for both a decline in the U.S. dollar and a relative outperformance of international stocks so far this year. As of Friday, the dollar index was down 7.8% year-to-date and, while the S&P500 was down 2.9% year-to-date on a total return basis, the USD-denominated return on the all-country world index ex-U.S. (ACWIexUS) was +11.0%.
However, for investors, the long-term implications of U.S. policies are more important than their short-term effects.
The success of American capitalism has been built on foundations of free enterprise, free trade and the rule of law. This has been bolstered by the world’s faith in the safety of U.S. Treasuries and the independence of monetary policy. Our economy has drawn dynamism from a steady stream of immigrants, some just looking for any work but many others piling into our universities, our research labs, our financial firms and our tech industry. Current policies, taken to an extreme and sustained, threaten much of this.
Of course, these policies could be modified or reversed by the current or future administrations. Other policies to reduce regulatory burdens could help. Still, even after the market moves of recent months, the real trade-weighted value of the dollar remains far above its long-term average while the P/E ratio on the S&P500 is almost 50% higher than on the ACWI-exUS. These valuations have evolved over time partly as a reflection of U.S. exceptionalism. That exceptionalism is now threatened, suggesting a further need for American investors to embrace global diversification.