Tariffs = Recession: Q2 Outlook
By: Brian Seay, CFA
Investors have lots of questions on their minds. Most importantly, everyone wants to know what the impact of Trump’s proposed Tariffs are to the economy and to investment portfolios. In this episode, we will talk about what I see as the two potential paths forward for the economy and markets based on what we know about tariffs to-date and what those paths mean for your investments.
Transcript:
Let’s start with what’s happened so far this year. On the chart you can see the S&P 500 stock index in the red line. It’s now down more than 13% for the year. Most of the decline coming in March and then accelerating after the “Liberation Day” Tariff announcements last week. Real estate and commodities also sold off on the news as markets started to adjust to a slow down or potential recession, which we will talk more about in a few minutes.
You see gold remains the top asset class for the year. Gold has sold off some in the recent declines, perhaps opposite of what you would expect in an uncertain environment, but my bet is that has more to do with forced selling and deleveraging than a decline in underlying buying from big investors like central banks, we will talk more about gold later on as well. Also, its notable that in the decline, bonds did what they were supposed to do. The aggregate index is up 3.6% for the year, rising slightly as risks to the economy increased providing stability and diversification for portfolios.
Perhaps even more important during times of trouble, the next chart shows long-term historical average returns for the various asset classes. You can see the recent decline in the S&P 500 on the far right edge of the chart, its significant. But if you invested right before Covid in 2020, you are still a happy investor today. If you invested right before the great financial crisis in 2007, you are still a happy investor today.
When we zoom in and look at the past decade, The S&P 500 has returned more than 11% each year on average, Gold is now almost averaging 10%, Real Estate has averaged 5% and Bonds are actually the laggard averaging only 1.6%.
As I mentioned, When you think about the 28 year and 10 year history, you would be a very happy investor today if you invested at the peak of markets before the global financial crisis or right before Covid.
We will take about the current state of the U.S. economy and markets in a minute – but investing solely based on whether we will or will not have a trade war and a recession is a bad idea. Recessions and market drawdowns don’t feel good, I’ve lived through a few myself, but building a portfolio you can stick with through the hard times is the best way to achieve long-term compound returns. Stocks are still compounding at rates far above those required to meet realistic investment goals. So regardless of the rest of this outlook, think about your portfolio and other assets and whether you feel comfortable regardless of the environment – good or bad - going forward. If you have concerns, then it’s probably time to seek out professional advice.
At the beginning of the year, I made the case that returns would be harder to generate than 2023 and 2024. The tariff discussion has only made the outlook even more difficult, so let’s look at some real data on the economy. Once we have a good feel for where the economy was at prior to the tariff news, then we can discuss the impact of tariffs and the path forward for investors and your portfolio.
Real GDP is how we measure whether the economy is growing larger or contracting smaller. Real GDP in the 4th quarter of last year was growing 2.5% a year, down from about 2.7% in Q3 of 2024. You see the covid recession in 2020, the a big spike in GDP growth, the red line. That came with a big spike in inflation, the green line, and then the Fed raised interest rates to cool off the economy. Growth and inflation have come down meaningfully from their post-covid highs because those high Fed interest rates have put the brakes on the economy. We don’t have official numbers on Q1 of this year yet, but you can see from the Atlanta’s Fed’s model, the economy continues to slow significantly. Most forecasters are expecting that the economy will show close to no growth in Q1, or perhaps even a slightly negative print. The stats will be very negative, but a big part of that was the import of Gold to get ahead of tariffs, which counts as a negative for GDP even though its more of a financial transaction than anything representing the real economy. So when you back out the impact of the gold trade, you still get something that looks at best 0% growth for Q1 or perhaps even slightly negative.
What’s more, is that the “slightly negative number” clearly included a lot of buying to front-run tariffs. Cox automotive forecasted car sales at ~200,000 above expectations due to the tariffs. Those are sales that won’t happen later this year. We won’t know about other industries, like furniture, until earnings come out later this month, but my expectation is that there was at least some pull-forward of spend into the first quarter to avoid tariffs on big-ticket items. That means that if we can only produce 0% GDP growth with the benefit of extra sales, GDP will likely fall into negative territory in the second half of the year. That’s right, a recession. Two more points to set the table before I dig in on tariffs. Economic growth has been held up by 3 factors. Investment in AI infrastructure, a strong jobs market and “wealth effect” spending from well-off consumers. AI spending will likely continue, albeit at a slower pace. But consumer spending, which is the largest component of the economy, is dependent on consumers having jobs.
You can see in the next chart, the 3 month moving average of job growth continues to slow. Monthly net job creation now averages 150,000 each month. On the chart on the right, you can see the jobs indicator is now just slightly below zero, the black line, meaning more people are entering the labor force and looking for jobs than there are jobs available. That means unemployment is starting to rise. The economy can stabilize here, and if it doesn’t get worse, then the outcome can be a continuation of the soft landing. Of course, that’s before tariffs.
The third support to the economy over the last few years has been spending from high-end consumers. The values of 401ks, investment accounts, homes and even businesses have increased and consumer tend to spend more when they “feel rich.” We won’t have the full data for a couple of months, but using a broad market index, the recent decline wiped out about $5 Trillion in equity value, setting us back to the beginning of 2023. That’s real money, an average of $41,000 per household. We know stocks are concentrated among the top 50% of households, so it is likely to be a 6 figure difference. It seems likely that consumers will feel that and change their spending.
So that’s the backdrop we take into Liberation Day for the Tariff announcements last week. A slowing economy, a slowing, but perhaps stabilizing jobs market and a reliance on spending from the top end consumer that is spending from their new found wealth. Expectations, including mine were for slightly positive GDP growth this year and single digit type returns – just getting by.
Then the Tariff shock hits the market.
What did the executive order actually include? I break it down into 3 parts. The first is a 10% tariff on all goods coming into the United States. Part two is the “reciprocal” part of the order that imposes specific tariffs on countries with existing tariffs and trade barriers that the administration deemed higher than 10%. Examples include 35% on China, 20% on the EU and 24% on Japan. Notably, Canada and Mexico are left off this list and U.S. imports covered by the USMCA agreement are tariff free. The third part are specific tariffs for Autos and Metals, which have already been announced at 25%. So 10% minimum, but higher rates ranging from 20-40% for our largest trading partners and then specific 25% rates for autos and metals.
The more we hear Trump administration officials discuss tariffs, the more that it seems like at least the 10% minimum and the Tariffs on “unfair” trading partners are here to stay. So think of the 10% as a new baseline and then anything above that based on their judgement of fairness.
I say “their judgement” intentionally. You can see in the chart, these are not “reciprocal” tariffs. Most countries, including the U.S., have tariffs on some goods. They tend to be in the low single digits. You can see the examples on the chart. What the Trump team did was a back of the envelope calculation that is essentially just the goods trade deficit divided by the foreign countries U.S. imports. Implying that if the U.S. runs a trade deficit with a country, they must be cheating by the amount of the trade deficit. That’s not grounded in any sort of economic theory or frankly good judgement. It seems made-up. If you want to start with high tariffs to speed up negotiations, perhaps just call a spade a spade and make up a high number and tell everyone you did so. I have no idea what they are trying to do here, this will not eliminate the trade deficit.
I’ve covered Tariffs, and why they don’t work, in lots of other episodes, so I won’t spend a ton of time on that here. Check out the episode from last week after the announcement or my podcast on potential Trump policies from January for a deeper dive.
In short, adding a 46% tariff to Nike shoes made in Vietnam does not mean Nike will make shoes in the U.S. The price will go up 46% and they will sell less shoes in the U.S. and more in other counties with lower tariffs. It would cost Nike way more than 46% to bring their production back to the U.S., the same is broadly true across the economy. Case in point, Apple announced they will make more iPhones in India, where rates are lower to avoid high Tariffs in China.
I’m very supporting of incentives that drive modern, smart production into the U.S. to create jobs. Tariffs are just the wrong tool for that job. Trump is hitting the screw with a hammer.
So regardless of your politics, Tariffs act like a tax. They take money from either goods producers or consumers and funnel it to the government, where it is less productive. I thought we were making the government smaller? I digress.
The focus here is the short and long-term impact to the Economy, so let’s get to that. In the next few weeks, many companies will stop shipments and simply pause activity for a while to see if the Tariff regime changes. Why pay a 70% import tariff when you can simply wait a few weeks and see if the environment changes? Consumers tried to front-load purchases, and now they will also wait and see for larger, big-ticket items. That slows spending and economic growth in Q2 immediately. Over the next few months, if the tariffs stay on, companies will do a combination of raising prices and cutting costs to hold their profitability stable. Say you run a business with a very healthy 25% margin. A new 75% tariff probably wipes out all of your profits immediately. So those businesses will lay people off and change their models in an attempt to survive. Larger companies will economize as well. You can read all of that as layoffs rise. Companies likely will not be able to pass much on to those consumers who are losing their jobs and have also just lost a portion of their wealth in the stock market, so profits take a hit. To the extent that prices do rise, the number of goods sold will fall because consumers can’t afford to buy as much stuff. So, in an economy that was moving along at stall speed, perhaps very slight growth, we now have a recession.
Numerically, trade with China alone was $582 Billion in 2024, or about 2% of U.S. GDP. Doesn’t sound like much, but if you are growing at less than 1%, and say half of U.S. China Trade ceases up for a quarter or two during a trade war, you now have a recession. That assumes the other half continues as usual. In reality, its probably a worse outcome.
So in my view, there are two paths forward. The first is a recession with the current Tariff regime. Even a reduction in Tariffs for all but a few major trading partners would not be enough to stave off a recession. If higher tariffs significantly reduce business activity between either the U.S. and China or the U.S. and the EU, we have a recession.
The second path is a very rapidly negotiated solution. And by rapidly, I mean weeks, not months. All of the indecision I mentioned earlier will be sunk if we spend months debating the proposals. If we get a deal by the U.S. and its major trading partners by early summer, then perhaps we can avoid the worst case scenarios. Maybe we have a blip of a recession in Q2 but then power onward.
One counter argument I hear cited frequently is “but Brian, the good stuff is coming later in the year through the tax program.” Here is the problem, the proposed tax changes being discussed are simply too small. The extension of the prior tax cuts simply maintains the status quo and provides no stimulus. What about tax cuts on social security payments? Income taxes paid on social security benefits go into the Social Security Trust fund, so we know how much taxes were paid, in 2023, that number was $51 Billion dollars. Remember, trade with China alone is more than $500 Billion. The current tax proposals simply aren’t big enough to offset the negative impact of the trade war. Not taxing tips is similar. Taxes on Tips aren’t tracked publicly today, but we know from looking at the tax incidence in the U.S., that the server at your local restaurant isn’t making a big payment to Uncle Sam every year, and rightfully so because their income is likely not very high.
Even if the tax proposals were enough money, the impact will not be felt on the economy until workers receive tax refunds in 2027 for tax year 2026. That’s 24 months from now. The damage will be done.
So it’s a quickly negotiated solution, or a recession. My base case is now a recession, but I hope I’m wrong.
So let’s shift gears and talk through how this economic backdrop sets up for the stock market, bond market, gold and a few other areas as we move into Q2.
I start with stocks because equity exposure generally forms the bulk of portfolios aimed at long-term growth. When we think about portfolio construction, the major question is really how much stock exposure should we have? Equities, both public and private, provide the bulk of portfolio growth over the long-term. After that important question is answered, you can fill in the rest with diversifying assets.
We started the year with analyst’s expecting 12% earnings growth. As I mentioned in the 2025 Outlook, I thought that was an optimistic outlook, everything had to go right for earnings to grow that much. Obviously now, everything is not going to go right. In March, earnings estimates started to drop-down to around 7% and started to fall accordingly. You can see the results since the beginning of the year, the S&P 500 is now down 13%. Is that enough to offset a recession? I would argue not.
Estimates aren’t updated fully to reflect all the tariff Impact, but I think we can consider a conservative case where earnings are simply flat and where they fall only 5% from 2024. Earnings have historically averaged a 13% decline in a recession, so this assumes a very mild recession, just to make my point here. In 2024, the S&P 500 earned $242 per share. The current multiple is 19x earnings, so no growth leaves you with the S&P 500 at 4,598. If earnings go down 5%, the S&P can fall to 4,300 easily. That assumes the multiple – or the price we pay for future earnings – remains constant. That multiple has already fallen from 22 to 19. So further decline to 16 or 17 is on the table in a recession. So the market has not quite priced in a recession at the total S&P 500 level. I don’t make S&P 500 forecasts because I don’t think they are that useful for long-term investors. But understanding the likely direction of travel is important, and obviously my outlook for stocks is bearish if the Tariff situation is not resolved.
International markets have held up surprisingly well so far, I think that has more to do with the sheer overvaluation of U.S. equities – and expectations vs. a weaker reality – than it does anything superb going on abroad. Germany has announced more stimulus for its economy, which is a good thing for the Eurozone long-term, but that is likely priced into stocks now. I think the U.S. remains the long-term driver of innovation and growth for the global economy. That does not mean, however, that if we have a trade war, that international stocks cannot outperform. The stock market is not the economy. International stocks are far cheaper than their U.S. counterparts and thus should hold up better in a sell-off, as seen thus far.
Lastly, the Mag 7 led the growth in the market last year, and they have led the decline in the market this year. Growth in general has sold off harder than the broader market, again, owing to higher valuations. Now that those valuations have become normalized, I do think considering rebalancing back to growth stock allocations slowly may be helpful as the market continues to move forward. In a recession, growth stocks continue to drive innovation and typically outperform as the broader economy falters. They are less dependent on their surroundings to drive their own profitability. They just need their own innovations to go well.
Moving on from stocks, let’s talk about the diversification part of portfolios. Perhaps never more valuable than the present.
Let’s start with bonds and interest rates.
So far, bonds have provided diversification in a falling market. The aggregate index is up more than 3% for the year. As rates have fallen, longer term bonds have done even better. Those bonds that haven’t done much for several years are providing a floor in portfolios helping to smooth out the volatility so far in 2025. The only real exception is high-yield.
High yield has been a staple in our portfolios for the last few years, but you can see the decline so far with just the hint of a recession over the past few weeks. Spreads, which is a fancy finance word for the difference in yield between a risky high-yield bond and a safer investment grade bond, are still below historical averages, but they can move much, much higher if we have a recession and the risk of company defaults increases. You can see the results in 2020 and 2008. From my perspective, this part of the portfolio is designed to diversify risk, not magnify it, so when there is a chance of a recession, It seems prudent to cut back on risky high-yield credit exposure.
We started the year with the market expecting 2 Fed rate cuts, sticky inflation and of course GDP and earnings growth. In our outlook we discussed that being optimistic. The market is now pricing something closer to my base case which is 4 Fed rate cuts by year end. That means the Fed Funds rate falls to 3.5% by year end. I’m going to stick with that for now because Jay Powell made it very clear in a speech on Friday that the Fed was not going to bail out bad trade policy with rate cuts. I think the Feds hand will ultimately be forced, but not until the data gets worse over the summer, which means they likely only cut 1% in total by year end. So that means bonds probably produce total returns in the 5-7% range for the year if we have a recession. Which will provide at least some offset to negative stock returns.
What about other assets outside of Bonds?
Gold has also provided good returns in a challenging environment, up around 12% for the year. My overall view on gold has not changed, as long as central bank demand remains above average, which it has, then gold should continue to do well. We have also seen inflows from investors recently as market volatility has increased, which is typical. Gold fell during a few of the biggest down days over the past week. My view is that there is some forced selling happening on those biggest down days when leveraged investors have to meet margin calls, when they don’t have stocks to sell, they sell what they can, and that is there gold. I don’t see why it would underperform in a classic recessionary scenario over the medium term.
I covered real estate and crypto in the 2025 outlook and my views there haven’t changed, so check that out for more on real estate or Bitcoin, I’ll cover them briefly here. Generally, investment in real estate is tricky going into a recession. Short-term rentals need to be in places where demand is not susceptible to drops in consumer spending. Commercial properties need to have tenants that can continue to pay their bills. It really goes back to underwriting those transactions. I do think there are opportunities in the current market for properties with forced sellers – where new investors can get a good deal – but that’s what I would be shopping for – not investment real estate more broadly.
Crypto, as you would expect, is down in line with the growth side of the stock market. Again, Crypto is a levered bet on risk taking, not an asset for diversifying equity risk away.
Alright, so I’ll try to summarize it all here.
My view on the economy skating by without a recession has evolved. I now see that as the most likely outcome for the rest of the year. The driver of that is the trade war. If the Tariffs are removed quickly, then perhaps the economy can move on, the outcome is very binary. Stocks have priced in a lot of that risk already, but there is likely a little more downside if a recession emerges. Also, the outcome is very binary and dependent on the Tariff discussions. Today is Monday, April 7th, and the market moved up 7% in a matter of minutes after a false story broke about a 90-day delay in tariffs. So trying to time the ups and downs is a difficult game to play. You likely won’t be able to get back in fast enough if positive news comes out – or conversely sell out fast enough if negative news hits. That means diversification is more important than ever. Holding a mix of assets like stocks, bonds, gold and real estate and even other assets that can mitigate market drops is important. No one can predict the future, so stay focused on your long-term investment goals and own a portfolio that can weather this storm short-term and get you to your goals over the long-term.