Tariffs have dominated headlines since Donald Trump took over as president for a second time. Trump has imposed higher tariffs on imports from many trading partners, including the European Union and the UK, while negotiations with major trading partners such as China are still underway. US businesses appear to have absorbed some of the costs. However, comments from corporate America suggest that consumers may bear a larger share of the burden going forward.
The potential pass-through from tariffs has yet to be fully assessed and could push consumer prices higher. The post-Covid surge in prices showed that the risk of second-order effects can’t be ignored even if any price increase is considered a one-off adjustment, which has created an uncertain outlook for inflation.
Tariffs are generally considered a tax on consumers, which could curb spending. The US economy appears to be on a softening path. Recent macro data show clear signs of slowing consumption, a softer job market, and housing constrained by an affordability crisis. We believe that the effect of higher tariffs could be modestly negative for US growth, which could offset any boost to growth from Trump’s One Big Beautiful Bill Act (OBBA).
Even so, a recession still looks unlikely, as several supportive factors underpin the economy, including a dominant services sector, the AI/tech revolution and a robust equity market that contributes to a positive wealth effect.
GDP estimates suggest a slowdown
Will it be goldlicks or something more nefarious?
While cyclical sectors like industrials or homebuilding might experience occasional weakness, we believe the underlying services base could provide a ballast. We are witnessing a pickup in investments in IT infrastructure as a result of AI, which could boost economic growth and ultimately lead to productivity gains.
Given the current macroeconomic scenario, we expect a gradual easing in monetary policy by the Fed and the current market pricing for rate cuts seems realistic, especially after recent revisions to Nonfarm Payrolls. The policy could be eased at a faster rate if the job market were to sharply deteriorate from here. But if tariffs were to generate higher or more persistent inflation, the Fed might reconsider its pace.
Trump’s ongoing tussle with the Federal Reserve has raised concerns over the central bank’s independence, adding another layer of uncertainty. The fiscal trajectory also remains highly uncertain, and we see no evidence that the administration is willing to make structural adjustments to address the deficit problem.
Rate cuts outside US
Outside the US, the picture is different. Major central banks such as the ECB, the RBA and the RBNZ have eased their policies, with inflation slowing close to or below their targets/bands, as they face prospects of slower growth. This environment of policy easing is, on the whole, conducive to government bond markets as well as credit markets.
On the fiscal side, the initial optimism surrounding Germany’s spending plan might be at least partially misplaced. We see increasing complexity in the deployment of new fiscal resources in Germany as slow procurement processes and insufficient industrial capacity might make deploying funds more difficult than approving the expenditure itself.
European industry faces challenges such as increased competition from China and costlier energy in relation to global peers. France’s fiscal position continues to look dire and structural adjustments appear increasingly complex from a political standpoint. Yet, the “periphery” continues to appear a bright spot, thanks to a reduction in government debt to GDP and good performance from the tourism sector.
The UK has experienced sticky inflation and worries over fiscal position. We believe recent inflation worries might be overstated. Growth in the post-COVID years has been relatively disappointing and not much better than in the Eurozone. As volatile and transitory components fade, UK inflation should gradually ease, creating room for the Bank of England to deliver more cuts than currently expected.
Implications for fixed income
The tariff-related inflation makes us less sanguine on prospects for US duration. While current pricing for rate cuts in the US feels somewhat fair, there could be both upside and downside risks. However, we expect fragility in the long end due to fiscal pressures, which could further steepen the bond yield curve.
Overall, we believe ex-US rates offer the best opportunity at present. Yields in UK, Australia, New Zealand and the Eurozone remain elevated and there may be space for more easing. Across emerging markets, we continue to see value in local currency bonds in countries such as Brazil and Mexico.
We are cautiously constructive on credit risk. Spreads might be tight on a historical basis, but numerous factors such as fundamentals or technicals continue to support corporate bonds. This, we believe, will keep defensive sectors such as communication services, healthcare, and consumer staples in play. Financials too offer a decent relative-value opportunity, while energy might be poised to benefit from the increasing demand coming from the AI revolution.
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