TARIFFS BRING TURBULENCE AHEAD
The second Trump administration has hit the ground running with a slew of measures designed to shake up both policy and the US economy, sending tremors through markets and exposing fault lines in the status quo. The administration’s major initiatives have thus far focused on tariffs, tamping down on illegal immigration, executive branch reform (carried out largely by the newly created Department of Government Efficiency – DOGE), and brokering cease-fires in the conflicts in Israel and Ukraine. Among these, tariff policy has emerged as the most disruptive factor for the economic outlook.
Currently, the Federal Reserve (Fed) is taking a wait-and-see approach. After cutting rates by 100 basis points (bps) in late 2024, the Fed left rates unchanged in Q1 2025 as progress toward its 2% inflation target stalled. The US economy remains in a good place but acknowledged significant uncertainty surrounding the effects of policy changes from the new administration. The futures market is now pricing in roughly three rate cuts by year-end, compared to just 1.5 cuts anticipated before the tariff announcements and subsequent market sell-off. While a recession is not yet evident in the US data, the risk of a recession over the next year has risen, especially if the trade war intensifies and higher tariffs become a reality.
The European economy, in particular, did not enter 2025 firing on all cylinders. Eurozone GDP grew just 0.2% in Q4, following mixed performance in Q3. The industrial sector continues to face headwinds from high input costs and stiff foreign competition. These struggles have fueled concerns about weak growth and potential downside risks to the inflation outlook. Despite core inflation remaining modestly above 2%, the European Central Bank (ECB) has responded by steering policy rates toward neutral. This year alone, the ECB has cut policy rates 50bps, following a 100bps reduction in 2024, bringing the deposit rate to 2.5%. But not all news out of Europe is bleak. NATO governments across the continent have steadily increased military spending, which could provide a stimulative boost to the economy.
The Japanese economy entered 2025 on a stronger footing, with GDP increasing over 2% annualized in Q4 2024 – marking its third consecutive increase. However, inflation remains a persistent concern. While the Bank of Japan (BoJ) left policy rates unchanged in Q4, it kicked off 2025 with a rate hike in January. Adding to inflationary pressures, major companies have agreed to wage increases as part of spring negotiations, which could sustain upward pressure on inflation – and consequently, on policy rates.
China reported robust GDP growth in Q4, allowing it to achieve its 5% annual growth target. The economy was supported by various fiscal and monetary stimulus measures aimed at reversing the slowdown tied to the real estate sector. However, given the challenging external economic environment, these measures may prove insufficient to sustain the target, potentially necessitating further expansion.
RESILIENCE AMID UNCERTAINTY
Today’s investment environment is brimming with economic policy uncertainty, from shifting trade policies to unpredictable fiscal moves. Economic policy uncertainty spiked under both Trump administrations, fueled by abrupt shifts in trade and fiscal policies. These policy swings shape market expectations, influence inflation forecasts, and cloud the Fed’s rate outlook. Yet, despite elevated uncertainty, business confidence remains resilient, while consumer confidence shows signs of weakening.
Understanding this policy-driven volatility is critical for asset allocation, as a forward-looking strategy can help portfolios absorb shocks, capture alpha, and distinguish proactive investors from reactive ones.
NAVIGATING UNPREDICTABILITY IN FINANCIAL MARKETS
Financial market participants have swiftly cast aside their traditional playbooks for predicting market behavior following US elections. Historically, equity markets have turned in muted performance in the run-up to elections, followed by a post-Election relief rally. Initially, markets appeared to follow this pattern, with US equities posting strong gains into early Q1, supported in part by robust economic data despite elevated valuations. However, international equities reacted negatively after then-President-elect Trump announced plans to impose additional tariffs on Mexico, Canada, and China. Subsequently, markets stumbled as the Fed pivoted hawkishly in December. Over the past couple of months, we’ve observed rotations across major asset classes, with US markets lagging due to weaker growth expectations, while China and international stocks have gained amid improving growth prospects and a moderation of extreme tariff concerns. Growth stocks, which were the market darlings of 2024, have lagged value stocks year to date. While the Q1 pullback in US stocks has somewhat improved US equity valuations, potential structural changes – particularly in Europe – could further enhance the strategic appeal of international equities.
The dollar, previously buoyed by a much stronger US economy, has softened, providing support to emerging market assets. Meanwhile, gold and commodities have also benefited from elevated inflation concerns.
Credit spreads have widened slightly, but total return expectations for high yield bonds remain solid, supported by higher starting nominal yields, even as the growth environment remains benign. Global government bonds, however, are generally under pressure. While a slower growth environment and expectations of rate cuts could provide support for bonds, bouts of inflation concerns are likely to keep yields range-bound. Furthermore, the potential support for bond yields from central bank policy may be more limited compared to previous years as major central banks, including the Fed and the BoJ, have been signaling a shift toward higher neutral rates.
Source for all data points: PGIM Quantitative Solutions, March 2025
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