Last weekend, I neglected to finish my Notes on the Week Ahead as I got caught up in watching the Masters. In truth, it was mostly a battle between Rory McIlroy’s emotions, which produced two double-bogeys in his final round, and his exceptional skill, which propelled his second playoff shot to within three feet of the hole. I was particularly happy to see his victory since he hails from the same island as myself, But I was also glad to see him win because, at 35, he is no longer in the first blush of youth. It is a sad truth that in athletics, as in life, no-one soars forever. Twenty years from now, McIlroy will probably still be a fine golfer – training and resilience should see to that. But he may no longer be exceptional.
For many years, the U.S. economy has been exceptional, at least as measured by the financial market fundamentals of profits and interest rates. However, this is an aging expansion, now entering its sixth year and, more importantly, now more than three years after a surging post-covid recovery cut the unemployment rate to 4%. It has been injured too by uncontrolled deficits, on-again/off-again immigration and, most recently, by higher tariffs.
The U.S. economy remains remarkably resilient and could yet escape its current problems without slipping into recession. However, resilience is not the same thing as exceptionalism and investors need to consider whether a continued gradual deterioration in U.S. economic performance warrants both a more cautious stance overall and a broader diversification into international assets.
An Update on Policy
Three months into the new Administration, the pace of policy change has been dramatic, so it is important to review policies before considering the macro-economic outlook.
On tariffs, April 2nd may, in retrospect, represent the high tide of the Administration’s tariff enthusiasm. The stock market’s reaction to the measures announced that day was immediate and violent, with the S&P500 plunging 600 points in two days. In response, the Administration instituted a 90-day pause on so-called “reciprocal” tariffs (apart from a 10% universal tariff) and has made exceptions for computers, smartphones and electrical equipment. In addition, the President mentioned that he is considering some short-term exclusions from the 25% tariffs on imported vehicles and auto parts.
Conversely, however, the Administration has ratchetted up tariffs on China to 145% and is expected to announce new levies on imported pharmaceuticals, lumber and semiconductors in coming months. While the tariff tide may be receding, it is only receding slowly and continues to boost inflation, reduce demand and heighten business uncertainty.
On DOGE cutbacks, a New York Times tally of actual staff reductions, planned staff reductions and buyouts adds up to almost 280,000 workers. However, it appears that less than 40,000 of this total represents actual layoffs so far, with the rest being comprised of planned layoffs, buyouts which leave workers off the job but on government payrolls through September, and those placed on administrative leave rather than fired due to intervention by the courts. Federal government payrolls will likely fall throughout the year, with the biggest declines kicking in in the fourth quarter as buyouts run their course.
On immigration, the latest data show fewer than 12,000 encounters between migrants and immigration officials on the southern border in both February and March, down very sharply from roughly 100,000 per month in the fourth quarter of 2024 and 250,000 per month in the fourth quarter of 2023. However, the pace of deportations, despite some very high-profile cases, appears to be running at similar numbers to the prior administration at less than 1,000 per day and will likely remain at this pace in the absence of a surge in staffing at ICE and the immigration courts and the addition of more facilities to house and transport migrants. There is also no sign yet, in the hard data, of a downturn in the issuance of immigrant visas at foreign embassies. However, this is likely to occur in the months ahead due to staffing cutbacks, increased vetting and reduced enthusiasm about coming to America.
Overall, we’re assuming that net immigration, which averaged 900,000 per year in the decade before the pandemic and then soared to roughly 2.5 million per year in 2023 and 2024, will fall to 500,000 per year going forward. Based on Census Bureau projections, this should imply a monthly growth in the civilian non-institutional population of 95,000 and a monthly decline in the population aged 18-64 of 35,000. Some continued increase in age-adjusted labor force participation rates could still allow the labor force to grow but only very slowly, dragging on both job gains and aggregate demand, though likely limiting any increase in the unemployment rate, even if the economy stumbles into recession.
On the budget, we now expect the 2025 omnibus reconciliation bill to contain an increase in the debt ceiling, higher funding for border security, a full extension of the 2017 TCJA cuts, a cut in the corporate tax rate from 21% to 15% for domestic production and a restoration of full expensing of R&D and equipment purchases, also for domestic production.
However, relative to other campaign promises made by the President, we expect to see only an increase in, rather than an elimination of, the cap on SALT deductions and only a partial implementation of proposals concerning the deductibility of auto loan interest and exemptions from income tax for all social security, tips and overtime income.
We do not, at this point, assume DOGE dividends or other stimulus checks to lift the economy out of recession, as we think that the economy will still be teetering on the edge of recession rather than definitively in one when the House Ways and Means Committee releases its detailed proposals for taxes in the bill in early May. If the economy isn’t in recession, then, given deficit concerns, Republicans probably won’t quite have enough votes to pass a bill with significant one-time stimulus checks.
Despite intense pressure from the Administration, the Federal Reserve is also likely to wait for clarity on the pace of economic growth, potential tax cuts and tariffs before cutting interest rates. Provided the April jobs report, due out on May 2nd, shows positive payroll employment growth, we expect that the Fed with remain on hold at their May 7th meeting.
However, by their meeting on June 18th, they will be in receipt of the May jobs report, which will reference the week ended May 17th compared to the April jobs report which will refer to the week that ended April 12th. While the April report could still be too early to show the impact of falling business confidence on the labor market, the May report should, if this effect is ever going to show up in the hard data. By their June meeting, the Fed should also have a much clearer idea on tariff and tax policy, opening the door to a 25-basis point rate cut, if the slowdown in momentum is mild, and something sharper, if the economy appears to actually be in recession.
The Economic Outlook and Investment Implications
For now, like the Federal Reserve, we are cautious about calling for a full-blown recession.
It is true that the age of the expansion, the theoretical impact of policy moves and a wide range of soft data on business and consumer attitudes all point to recession.
In addition, economic growth appears to have been slow in the first quarter, with real GDP tracking just a 0.4% annualized gain. Moreover, a drawdown of inventories and slower hiring is likely to be a feature of the second quarter.
And yet, despite falling confidence, American consumers appear undaunted so far. Retail sales were strong in March, including a surge in auto sales to their best monthly number in almost four years, as consumers sought to buy ahead of tariff price increases. Tracking data on airline traffic, hotel occupancy and restaurant reservations have yet to see a downturn. And, in terms of drivers of consumer demand, wealth is still up sharply over the past few years, gas prices are 50 cents lower than a year ago and year-over-year wage growth has exceeded CPI inflation for 23 consecutive months.
Recession has also yet to show up in the labor market. Despite a spike in announced layoffs, weekly initial unemployment claims remain low. It may well be that employers are reluctant to fire workers for fear they won’t be able to hire them back if the economy avoids recession or recovers from a mild one.
As an economist, I’d have to say the odds still favor the economy slipping into a mild recession later this year as demand is reduced by the impact of the trade war on consumer prices, exports and international tourism, supply is disrupted by the impacts of tariffs on supply chains and immigration policies on labor supply, and businesses freeze hiring and capital spending, given the level of uncertainty.
That being said, this expansion has weathered adversity before and kept going and, as was the case with Rory McIlroy when he double-bogeyed the 13th, it is still too early to give up on the expansion.
What is clear, however, is that 2025 will not be a great year for the economy, with economic growth for the entire year likely coming in well below 2.0%. Moreover, given weakening demographics, declining international trade and lower business confidence, it is quite possible that the U.S. now entering a longer period of more sluggish economic performance. If this is the case, U.S. stocks may no longer be able to command forward P/E ratios which are, on average, almost 50% higher than in the rest of the world, as we show on page 46 of the Guide to the Markets. In addition, the dollar could fall further from a 40-year peak in real terms reached at the start of the year, while the U.S. Treasury may, in the long run, have to pay more to borrow money.
None of this is to deny the resilience of the U.S. economy. It just recognizes that exceptionalism isn’t forever and so investors would be wise to temper their expectations and embrace broader international diversification for the years ahead.