Macro outlook
The economy and markets
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Section 2: The economy and markets
Key points to know
Economic growth is slowing, not stalling.
Although first quarter U.S. GDP growth printed negative for the first time since 2022, underlying growth still remains strong at a 2.5% annualized rate. That level is slightly lower than last year’s pace. Nevertheless, we expect growth to slow over the balance of the year to around 1.0% as tariffs bite more sharply. Although consumption and business investment are weakening, the U.S. economy is entering this period of uncertainty on strong footing. Consumption, growing at a real pace of 2.9% over the last year, has been running stronger than the pre- Covid average. Investment in information processing equipment, needed to support the AI revolution, is running almost 20% higher than last year, vastly eclipsing its more pedestrian pace of the preceding decade. Outside the U.S., we expect similar full-year expansions of around 1.0% in both Europe and Japan.
Tariffs remain the biggest driver of the outlook, as well as the biggest risk to both the upside and downside.
Entering this year, the overall U.S. effective tariff rate was slightly below 3%. The trade war intensified significantly with the “Liberation Day” declarations on 2 April, which imposed a minimum 10% tariff and country-specific duties up to 50%. This marked a major escalation from President Trump’s earlier trade salvos, which had targeted Canada, China and Mexico with industry-specific tariffs on steel, aluminum and automobiles. While some of the more extreme measures are paused, trade volatility has continued.
We have seen specific escalations in the bilateral tariff on China, threats of increases on the EU, and potential additional sector tariffs on copper, lumber, pharmaceuticals, semiconductors, seafood and aircraft. In sum, we expect a new effective U.S. tariff rate of around 10% — almost 4x higher than last year, but notably less aggressive than the peak of above 20% implied by the 2 April announcements (Figure 1). The escalating tensions between Israel and Iran, as well as broader geopolitical turmoil, also add to the uncertainty.
Fiscal risks are back.
After a decade of near-zero term premium, where investors demanded no extra compensation for holding longer-duration government debt, global term premia have energetically returned this year. Depending on the measure and the country, term premia are up around 100 basis points versus 2024 lows. The biggest driver is growing concern about the fiscal outlooks across developed market economies. Although the current budget bill moving through Congress remains subject to change, we expect it to result in wider deficits than the current baseline. That widening is due to renewed and expanded tax cuts, which are partially but not fully offset by spending cuts, tariff revenue and faster growth. Similar fiscal loosening is occurring in Europe, highlighted by the changes to Germany’s “debt brake” to allow more defense spending. On the positive side, near-term growth will likely be better supported, but the risks have intensified of further rate increases, higher interest expenses and ultimately lower growth.
U.S. rates to moderate and global divergences to narrow.
With U.S. and global growth set to slow, we believe most global central banks will remain in easing mode. That said, uncertainty remains high around tariffs, fiscal policy and the associated economic impact. Businesses, consumers and investors are all facing some degree of paralysis, awaiting further clarity before making big decisions. We think central banks will mirror that dynamic. We expect two more Fed rate cuts this year, likely in September and December, pending the incoming data. Tariffs are likely to push near-term inflation higher, adding another reason for policymakers to remain patient. In Europe, we expect the ECB to hold for now following earlier cuts, and anticipate one rate hike in Japan. We anticipate a global economic slowdown, while growth rates across major economies become more aligned. This convergence should be reflected in a narrowing of long-term sovereign bond yields. We forecast a modest rally in 10-year yields for the U.S. and UK, while we expect small increases in Germany and Japan.
Endnotes
All market and economic data from Bloomberg, FactSet and Morningstar.
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