Grinding Through 2025

Key Points:

• Economic growth in the US has slowed in the first half of the year, driven by lower household spending.

• The economy is beginning to feel the effects of tariffs, and we expect a sluggish second half of the year as tariffs are fully digested.

• However, markets may look through this period of weakness as it gives the Fed cover to lower interest rates and there is a widespread expectation of economic recovery shortly after the tariff impact fades.

• As always, there are risks to this outlook. We are most concerned about a larger than expected economic slowdown, current tech valuations and the longer term risk of US election chaos in next-year’s mid-terms.

In this month’s Market Insight, we give an overview of the post-Liberation Day tariff US economic landscape and provide our thoughts on what we think the second half of the year may hold for markets. The first seven months of 2025 were a wild ride, though you wouldn’t think so with where markets are currently. Investors have progressively become more immune to policy announcements coming out of the US, expecting that anything too dramatic will be walked back or negotiated away. That said, the walking back of tariffs has resembled the proverbial boiling frog. Tariff policy as it stands isn’t too dissimilar from what was announced on Liberation Day.

‍

How Is The Economy Tracking?

Contrary to markets, it appears as though this chaos has had some impact on the US economy. As can be seen from our Growth Barometer below, economic growth in the US slowed in the first half of this year. This was driven in large part by the household sector, with weakness pretty broad based across different spending categories. Perhaps this was because of tariffs, with households drawing down savings to front run goods spending in the second half of 2024 in response to expected higher prices in 2025. Overall GDP growth in the US also slowed in the first half of the year, but all economic data at the moment should be interpreted with a high degree of caution. GDP data has been very volatile as imports and inventory levels have swung around, again likely due to tariff front running and inventory building.  

‍

As readers will recall from our February 2025 Market Insight (Make America Tariff Again), tariffs are effectively an inefficient consumption tax, the costs of which will be borne by some mix of consumers or producers depending on the sensitivity of supply and demand to changes in price. They have been ramping up for some months and we can now see their impact (in terms of revenue delivered) in the aggregate. The chart below shows customs duties (tariffs) and total US Federal Government revenue (of which customs duties are a part) since 1950. The increase in duties has been meaningful in isolation, but relatively modest in the context of total government revenue.

‍

So why did the market crash in April? Part of the concern is that there is a mechanical drag on the economy from the tariff implementation. Though the smallish rise in the blue line in the chart above doesn’t look like a lot, it will probably grow by around that much again once tariffs are fully implemented and that represents a bit over 1% of the US economy. A tax hike representing ~1% of GDP is meaningful and will lead to lower growth as it washes through the economy. The other, larger, concern was that the high level of business uncertainty generated by the chaotic Trump policy process will lower investment and hiring intentions from US corporates, dragging on economic growth in excess of the mechanical drag from tariffs. If this were to happen, total weakness could be sufficient to drive the economy into recession.

We have seen some evidence of this theme playing out in the forward-looking economic data. The chart below shows a tracker which aggregates capex intentions components of many individual business surveys in the US. There has been a sharp deterioration in intentions since Trump started announcing higher tariffs. However, the relationship between capex intentions and actual business investment is relatively loose. Intentions were very weak following the Financial Crisis, but businesses still invested heavily. Our expectation is that data centre construction and manufacturing reshoring will continue to be medium term positive thematic drivers of investment in the US and should go a long way to offsetting negativity due to shorter term economic weakness due to tariffs.

‍

Alongside the weakening in capex intentions and soft GDP growth, there has been a slowdown in hiring in the US. Payrolls growth has slowed to stall speed levels. This isn’t necessarily unexpected. Employment growth generally lags economic growth, and economic growth has been slowing. Any further weakness and the unemployment rate will start drifting higher. The good news (from a headline level anyway) is that the breakeven employment growth needed to keep the unemployment rate steady appears to have fallen as net migration (including deportations) has collapsed.

‍

Where To From Here?

With growth currently sluggish, what’s on the cards for the second half the year? The good news is that much of the mechanical drag from tariffs has been implemented, so much of the initial shock value should have faded by then. Also, on the inflation front, the passthrough from tariffs to the overall price index has been relatively limited. This may reflect inventory build-up or longer than expected lags to implement price changes. It could also reflect some corporate margin compression. Regardless, this leaves the Fed in a good position to ease interest rates further from here. If growth slows materially, they can respond very aggressively with interest rates where they currently are. Markets expect around 1.25 percentage points worth of rate cuts in the US over the year, which should move monetary policy from modestly restrictive to stimulatory.

On the growth front, while tariffs are taking money from US consumers and businesses and delivering it to the Government, the Government is giving some of it straight back in the form of Trump’s One Big Beautiful Bill. While the bulk of the “fiscal stimulus” from the Bill is in the form of extending tax cuts which were due to expire, there are other provisions in excess of this which push additional fiscal stimulus through the economy.

We think the net effect of the above is an economy that mostly muddles through a pretty significant transition in its structure. Even assuming a recession is avoided, the unemployment rate will probably rise a bit as its unlikely businesses feel confident to increase hiring until economic growth begins to recover again. The phrase “begins to recover again” is an extremely important nuance to this current episode. Any slowdown in growth because of a one-off tariff (tax) increase, whether that leads to a recession or not, is almost certainly mechanically transitory. Like the introduction of the GST in Australia, which did lead to a fall in GDP in the fourth quarter of 2000, businesses and households aren’t looking at tariffs the same way that they would a normal recession. The light at the end of the tunnel is much more obvious than high interest rates due to sticky inflation (1970s / 1980s), or a financial crisis (2008) or a multi-year deflation of an asset price bubble (2001).

This probably goes a long way to explaining why markets are priced where they are with the still reasonable risk of a material economic slowdown in coming months. Markets may just be looking through it. Valuations for US large cap growth names are above their 75th percentile. As are valuations for large cap value names for that matter. Australian equities are around as expensive as they have ever gotten. There are cheaper areas of the market. Emerging markets, Europe, UK, small and mid-caps in the US, but all of these have struggled materially to deliver any earnings growth over multi-year periods. No one will pay a valuation premium for no earnings growth.

‍

Speaking of earnings growth, like the 1976 Led Zeppelin concert film, this song remains the same. Tech continues to dominate expectations with the positivity around AI seemingly ceaseless. As noted above, expectations for Australia, Europe and the UK are low. There is little to suggest that this pattern will reverse in the next six months.

‍

‍

What Could Possibly Go Wrong?

Can anything derail this wobbly train? It’s always easy to think about risks, especially with Trump as president. However, we think the risk of more chaotic policy from that administration falls as time moves closer to next year’s mid-term elections. More likely, we expect the focus to shift towards tilting the electoral deck though both legal and legal-adjacent means. Congressional redistricting in Texas, the replacement of Bureau of Labor Statistics Director McEntarfer because of negative looking employment numbers, placing Washington DC police under federal control, threatening to prosecute election officials involved with the 2020 election and executive orders directing policy changes from the Election Assistance Commission are all in the news. While these all represent a continued erosion of democratic norms, we doubt markets will care much. They may care if in 2026 or 2028 election results are not recognised and there is not an orderly transition of power. What would the US look like now if the January 6th protestors had been successful? Regardless, that risk is too far away for markets to worry about now.

Otherwise, the biggest obvious risk is that the growth slowdown from higher tariffs and Trump chaos feeds onto itself and leads to an economic environment resembling something more like a normal recession. The great irony around all this is that what the Trump administration has enacted, effectively a tax hike (although a poorly designed one), was exactly what the US economy needed. Inflation has stabilised a little above target in the US. The labour market is still tight, despite some softening. Most importantly, the future path of fiscal deficits is completely unsustainable. A tax hike would improve the federal budget position, slow the economy and core inflation and allow the Fed to bring interest rates closer to neutral levels. If Biden had proposed a GST in early 2022, it would have achieved a similar (though better, because a GST is better than a tariff) fiscal outcome and been lauded by economists everywhere.

There is also a relatively high amount of structural risk embedded in current market valuations. The index is highly concentrated towards mega-cap technology companies, with investors seeing them as the key beneficiaries of the AI phenomenon. To date, this has been the correct assumption. Even prior to AI these companies had amazing track records of delivering above market earnings growth. This is in stark contrast to the 2000s equity bubble, where valuations were built on hopes and prayers. Still, if it turns out that the addressable market for AI is equivalent to Netflix –$20 per month subscriptions from most households, the capex spent so far won’t be justified and valuations will need to come lower.

‍

‍

‍