On Tuesday, we will release our third quarter 2025 Guide to the Markets. On Wednesday, we will host conference calls with financial professionals to discuss the outlook.
It’s an outlook dominated by the impact of dramatic policy changes on a relatively slow-growing U.S. economy. The result, in the short run, may resemble a wave, as the economy cools down in the second half of this year, heats up in early 2026 and then cool down again. However, in the long run, the net effect of these policy changes could be an economy with slightly slower growth and higher interest rates than seemed likely at the start of the year. This being the case, it is hard to justify this spring’s rebound in U.S. stocks to new record highs less than three months after teetering on the brink of a bear market. Consequently, investors should still consider broader diversification in areas such as international equities, value equities and alternative assets.
A Starting Point of Slowing Momentum
While hard data on the economy remain bumpy, the broad trend appears to be one of slowing. Real consumer spending fell by 0.3% in May and we believe it may have fallen again in June, reflecting a continued slide in auto sales from a pre-tariff boom. Homebuilding remains weak, as builders contend with rising inventories of unsold homes, worsening demographics and stubbornly high mortgage rates. Government spending is also generally weak, primarily due to ongoing federal government downsizing. While a plunge in imports should boost real GDP growth for the second quarter, we expect that real domestic final sales, which excludes the volatile international trade and inventory numbers, will grow by just 0.5% annualized in the second quarter and shrink in the third, following a moderate 1.5% gain in the first.
Some labor market data already reflect this gradual weakening with continuing unemployment claims edging up to their highest level in three and a half years last week and fewer consumers telling the Conference Board in June that jobs were “plentiful” relative to “hard-to-get” than at any time since March 2021. Still most analysts expect the June jobs report, due out this Thursday, to show a gain in payroll employment for the month, with very slow labor force growth holding any rise in the unemployment rate to just 0.1%.
On the positive side, inflation remained relatively benign in May, with the Fed’s target year-over-year PCE deflator inflation rate coming in at 2.3% for the month, just 0.1% higher than the 2.2% registered for April.
The Delayed Impact of Tariff and Immigration Policies
Overlaid on top of this, however, is the gradually rising impact of tariff and immigration policies. As we noted last week, the full impact of tariffs on the economy is being delayed by lags between when higher tariffs are announced and when they are actually levied on imported goods as well as the time between the importation and sale of those goods to consumers. That being said, things are beginning to heat up.
We now estimate that the federal government will collect $27 billion in tariffs in June, up from $23 billion in May, $16 billion in April and just $7 billion in June 2024. Assuming an unchanged level of imported goods from last year, this would imply an effective tariff rate of 8.2% in June 2025, compared to 2.5% a year earlier. We expect this to climb further in the months ahead and begin to be reflected in consumer prices. We still expect this to push the year-over-year PCE deflator inflation rate to 3.0% or higher by the fourth quarter of 2025. Moreover, as these higher prices erode the real income of lower and middle income consumers, they should exert a further drag on already sluggish consumer spending.
The impact of immigration crackdowns should also increase. Recent press reports indicate that arrests of unauthorized immigrants averaged around 1,200 per day in early June, almost double the pace of the first 100 days of the President’s second term. Moreover, the reconciliation bill winding its way to his desk includes over $160 billion in appropriations to ramp up the arrest, incarceration and deportation of unauthorized immigrants as well as finishing the construction of the border wall. The bill also includes a lengthy schedule of fees for those wanting to pursue asylum. These efforts will very likely lead to a further increase in deportations and continued success in deterring illegal immigration. However, if this also contributes to a decline in legal immigration, demographic trends suggest that the working age population in the United States will decline, hampering long-term economic growth, although potentially limiting any increase in the unemployment rate, even in a sluggish economy.
OBBBA
We expect the reconciliation bill to pass both houses of Congress and be signed into law in the next few days.
According to the Congressional Budget Office, the Senate version of the bill could add $3.3 trillion to deficits over the next decade, not counting additional interest costs. Adding those in, the increase in accumulated deficits could amount to roughly $4.0 trillion. Moreover, many tax cuts in the reconciliation bill, including eliminating the tax on tips and overtime, allowing for the deductibility of auto loan interest and new $6,000 deduction for senior citizens, are set to expire at the end of 2028. Extending them, as seems likely, could, with interest, potentially add another $1.5 trillion to accumulated deficits over the next decade. In this case, even with additional revenue from tariffs, annual deficits would likely exceed 6% of GDP, boosting our debt/GDP ratio from 98% last fiscal year to close to 130% in ten years time. This will likely continue to put a floor on real long-term Treasury rates.
However, the short-term implications of the bill are also interesting. Many of these new tax cuts take effect as of January 1st, 2025. Assuming that individuals and their employers are slow to adjust their income tax withholding schedules, Americans should see a bumper crop of income tax refunds early in 2026. In rough numbers, and based on calculations from the Joint Committee on Taxation, we expect these short-term tax cuts to boost consumer disposable income by $6 billion per quarter in the second half of 2025, $51 billion per quarter in the first half of 2026, and then $19 billion per quarter in the second half of 2026. If new tariff revenue equals roughly $75 billion per quarter from the fourth quarter on, and consumers end up paying 60% of that, or $45 billion per quarter, then the drag on consumers from higher tariffs will exceed the value of new tax breaks in the second half of 2025 and the second half of 2026 but not in the first half of 2026.
The Fed’s Position
This is at the core of a forecast that, both with regard to growth and inflation, the economy will cool down, heat up and then cool down again over the course of the next 18 months. However, there is, to say the least, a great deal of uncertainty in all of this.
This uncertainty is fully appreciated by members of the Federal Reserve. In speeches over the past week, many FOMC participants have, in particular, stressed uncertainty about the relative impacts of tariffs on inflation and growth. They would, no doubt, also welcome some greater fiscal clarity with the passage of OBBBA and will want to understand the impact of changes in immigration policy on the labor market.
The Fed next meets on July 29th and 30th and, at that time, they will have only one more employment report and one more CPI report than they have now. This being the case, and despite two Fed governors declaring themselves open to a rate cut at the July meeting, we expect the Fed to remain on hold through the summer.
By their meeting of September 16th and 17th, they will have inflation and employment data for June, July and August, will very likely have clarity on fiscal policy and should, for the most part, have a better understanding of long-run tariff policy. If, at that point, the economy appears weak and any tariff-related inflation looks transitory, they will certainly consider a cut. However, the Fed is unlikely to cut aggressively until inflation is trending down again, unless the economy were suddenly to slip into recession.
Investment Implications
For investors, it has been a surprisingly good year so far with the S&P 500 generating a 5.6% total return year-to-date, the ACWI ex-US posting a total return in US dollars of 18.4% and the 10-year Treasury returning 4.6% on the back of a small drift down in yields. That being said, the U.S. economy enters the second half of the year facing rising debt and slowing growth, with much of the U.S. bond market and stock market seeming priced for perfection. While international stocks have outperformed, U.S. investors remain generally underweight international in their portfolios. In addition, large-cap growth stocks have narrowly outperformed both value stocks and small cap stocks so far this year, leaving many investors overallocated to one of the more expensive areas of global capital markets.
It has been a turbulent first half of 2025 and we may all want a calmer economy, with fewer policy and geopolitical shocks, in the second half. However, just because we want it, doesn’t mean we will get it and the start of the third quarter is a good time for investors to reconsider whether they are appropriately positioned for the good, the bad and the unpredictable events that will shape markets in the rest of 2025 and beyond.