When I was growing up, school holidays weren’t packed with organized activities. Sometimes, to relieve the boredom of a rainy day, I would tackle a jigsaw – I remember one particularly challenging 1000-piece puzzle which, when completed, promised to reveal a charming picture of Dutch skaters on a frozen lake.
Not that I ever got to see the full picture. The puzzle itself was difficult and I’d often head down the wrong path, trying to squeeze pieces into places where they clearly didn’t fit, thus distorting both the pieces and the picture. Moreover, our house, with five boisterous children, was not conducive to the completion of jigsaws. Someone would inevitably barge into the rickety ping-pong table upon which it was being constructed, or knock over the box, losing vital pieces, or just mess it up on me to provoke a quarrel to relieve their own boredom.
Investors trying to get a clear picture of the macro economy today face a similar set of challenges. Entering this year, it was already difficult to assess exactly how the pandemic recession and its aftermath had impacted the underlying pace of economic growth, labor market dynamics and the potential persistence of inflation. However, all of this has been made more complicated by dramatic shifts in tariff, immigration and fiscal policies. These policies are impacting both the economy itself and the data by which we monitor it. Moreover, the policies, particularly on tariffs, keep changing, adding a further layer of uncertainty that is both complicating analysis and, potentially, acting as its own drag on the economy.
Still, interpreting the big picture is important since what happens with growth, jobs and inflation ultimately determines what happens with profits, interest rates and the dollar and these key variables do, in the long run, determine investment returns.
Growth, Jobs and Inflation
Last week’s GDP report showed a revised 0.2% decline in first-quarter output, only marginally better than the 0.3% loss originally reported. However, these numbers very likely still understate economic activity, since the reported pre-tariff surge in imports, which is a subtraction from GDP, swamped estimated gains in inventories, consumer goods spending and business equipment spending which is, presumably, where the imports should have shown up.
Second quarter GDP will likely see the opposite measurement problem as the April advance international trade report, released last Friday, showed a mammoth 19.8% decline in goods imports for the month. Consequently, the Atlanta Fed GDPNow model is now pointing to a 3.8% annualized gain in second-quarter real GDP.
This is probably too high as it doesn’t account for a likely slide in consumer spending and inventory accumulation in May and June. However, it does now appear that second-quarter real GDP gains will more than offset first-quarter losses.
That being said, the general trend is one of slowing growth. Apart from potential declines in goods consumption and inventories, other areas are showing signs of weakness. TSA data point to a 1.7% year-over-year decline in domestic air travel in May while hotel occupancy rates have been down year-over-year in seven of the last eight weeks, according to Smith Travel Research. Inventories of new and existing homes for sale have been rising even as the foot-traffic of prospective buyers has been falling, according to the National Association of Home Builders. And oil drilling activity is beginning to wane in the face of lower prices.
All of this, combined with federal government cutbacks, lower net migration and weakening exports, should result in slower growth or even a GDP decline in the third quarter before fiscal stimulus kicks in to boost activity in late 2025 and early 2026. So overall, despite volatility in quarterly GDP reports, underlying demand growth is likely to remain slow.
Turning to a different corner of the jigsaw, the week ahead will provide an updated view of the labor market.
On Tuesday, the JOLTs report could show a further slide in job openings in April to 7.125 million, after a decline from 7.480 million in February to 7.192 million in March. Openings are now far below their March 2022 peak of 12.1 million and are on the cusp of falling below the total number of people unemployed for the first time in over four years. Private sector surveys continued to point to falling openings in April and May.
Normally, when assessing the labor market, analysts focus on layoffs and recent data from weekly unemployment claims suggest a slight uptick. However, hiring is ultimately more important, because of the underlying dynamism of the job market. According to JOLTs data, in the last year, roughly 65 million people were hired and 63 million left a job, for a net job gain of 2 million. But 65 million were hired – this corresponds to an astonishing 250,000 new hires every business day. Moreover, of the 63 million who left a job, only 20 million were fired or laid off, with the vast majority of the rest quitting to move to another job.
What this means is that, each day, American businesses make roughly three times as many hiring decisions as firing decisions so any hesitancy to hire could have a very negative impact on job growth and the unemployment rate. This is particularly relevant today, since many employers are loath to lay off workers until they see the whites of the eyes of a recession, having had such problems finding suitable workers in the first place.
We expect initial unemployment claims, due out on Thursday, to remain slightly elevated while payroll job growth should have been weaker in May than in April. Still, so far, labor market data continue to point to slow growth rather than recession.
On inflation, both the headline and core personal consumption deflators rose just 0.1% in April resulting in year-over-year gains of 2.1% and 2.5% at the headline and core levels, respectively. Overall, inflation data show the lowest year-over-year gains in over four years. However, the April data are the best we are likely to see for some time as the impacts of tariffs are about to kick in. Currently, we estimate that there is an average tariff rate of about 13% in effect. However, this could rise in the weeks ahead if courts do not block the imposition of so-called “reciprocal tariffs” and the President’s recent threat to double steel and aluminum tariffs on Wednesday kicks in.
Because of tariffs and virtually no price growth in May and June of last year, we expect year-over-year consumption deflator inflation to climb quickly, rising to close to 3.0% by June and then climbing to 3.5% by the fourth quarter. Thereafter, provided there are no further tariff increases, inflation should abate, although fiscal stimulus in early 2026 could delay its decline. Assuming, however, that the economy cools off again in the second half of next year, inflation could finally hit the Fed’s 2% year-over-year target in late 2026.
Rates, Earnings and the Dollar
So what does all of this mean for interest rates, corporate earnings and the exchange rate?
On monetary policy, the Fed released a terse, seven-line statement following Chair Powell’s meeting with the President last Thursday. The statement made it clear that the meeting was at the President’s invitation, that Chair Powell did not discuss his expectations for monetary policy, except to reiterate that it was data dependent, and that decisions on monetary policy would be based solely on careful, objective and non-political analysis.
While the White House press secretary, Karoline Leavitt, reported that the President had told Chair Powell that he was making a mistake in not cutting rates, it doesn’t appear that the White House intends to escalate any confrontation with the Fed at this stage. Moreover, even if the President tries to appoint someone more amenable to his point of view when Chair Powell’s term ends next May, there will continue to be limits on the ability of the White House to direct monetary policy. First, any appointee will have to be confirmed by the Senate which will have a keen interest in maintaining monetary stability. Second, from an institutional perspective, the 12 independent regional Federal Reserve bank presidents and the long staggered terms of Fed governors, make the Fed a difficult target for political influence. Finally, it is not at all clear what members of the Senate would want a new Fed Chair to do differently as, since the inflation surge of 2022, the public appears just as worried about high inflation as slow growth.
All of this suggests that, if the economy avoids outright recession, with inflation rising before falling to 2% by the end of next year, the Fed will have little incentive to ease at all. Consequently we currently expect the Fed to deliver only one 25 basis point rate cut later this year, bringing the federal funds rate down to a range of 4.00% to 4.25% with a further similar cut at the end of 2026.
For the long end of the bond market, positive, albeit slow, economic growth, tight labor markets and still elevated inflation should put a floor under long-term interest rates. Moreover, this floor may rise rather than fall this summer when passage of the reconciliation bill and an increase in the debt ceiling provides both fiscal stimulus and a surge in Treasury issuance. Consequently, it is hard to see a reason for 10-year Treasury yields to fall from their current 4.4% and they could well settle into a 4.5%-5.0% range in the second half of this year.
On earnings, despite negative reported real GDP growth and significant policy uncertainty, first-quarter results were solid. S&P 500 pro-forma and operating earnings saw year-over-year gains of 12.8% and 5.9% respectively while the Commerce Department’s broader adjusted after-tax profit measure posted a 5.1% year-over-year gain. As was the case over the last two years, mega-cap tech stocks saw much stronger growth than the rest of the market with the “Magnificent 7” companies posting a 27.7% year-over-year increase in pro-forma earnings compared to 9.4% for the rest of the market.
That being said, earnings growth should slow going forward as tariffs boost costs for many companies and revenues are impacted by slower U.S. and global economic growth. In addition, tariffs and other trade restrictions imposed on U.S. companies in retaliation for U.S. tariffs could negatively impact earnings. Moreover, companies are unlikely to get a break on financing costs as both short-term and long-term interest rates remain elevated relative to recent years.
There are some positives in the earnings outlook, however. First, despite tight labor markets, wage growth has been relatively subdued and should remain so as companies try to cut costs into a weaker economic climate. Second, the tax bill heading through Congress, while not featuring a cut in corporate tax rates, does include expensing of R&D and equipment purchases backdated to the start of the year.
Finally, U.S. companies should benefit from a cheaper dollar. As of this morning, the DXY dollar exchange rate is down almost 9% year to date. U.S. interest rates remain well above those prevailing in the Eurozone and Japan and the ECB is widely expected to cut its deposit rate from 2.25% to 2.00% this week. However, we entered the year with U.S. and global investors heavily over-weight U.S. assets and the dollar exchange rate, in real terms, at a forty-year high. The administration has accused many countries of using manipulation to depress their currencies thereby leading to high trade surpluses with the United States. Whatever the merit of such claims, any attempt to remedy this by boosting the value of foreign currencies, must, by definition, push the dollar down. Moreover, if tariff policies fail to close the yawning U.S. trade gap, U.S. policy may inevitably tip more generally in favor of a lower dollar.
If this transpires, then the U.S. dollar could continue to drift down in the months and years ahead. This would boost the value of foreign earnings on the income statements of U.S.-based multi-national corporations. However, it would also, very directly, increase the value of foreign stocks in the portfolios of American investors.
Investment Implications
Despite political tensions, ongoing policy changes and heightened inflation and recession concerns, 2025 so far has generated positive returns for investors, with the S&P500 and the bond markets registering small gains and international stocks posting much larger increases. This is no time for complacency, however. The outlook for the economy is for just slow GDP growth, smaller job gains and temporarily higher inflation. This should translate into sticky interest rates, decelerating earnings growth and a falling dollar. At the start of the year, given valuations and portfolio concentration, it made sense for investors to rebalance away from U.S. mega-cap growth stocks and towards more defensive U.S. stocks, international equities and alternatives. Five months into the year, while the macro jigsaw remains complicated, the same advice seems warranted.