Investment Strategy
by Larry Adam
Chief Investment Officer, Private Client Group

Trade policy shifts put the Fed in a challenging position

April 4, 2025

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Key Takeaways

• Tariff rollout significantly more aggressive than we expected
• Downside risks to growth raise the odds of a recession
• Trade policy shifts put the Fed in a challenging position

Tariff Turbulence. The President’s long-anticipated tariff announcement on April 2 has come and gone. Our hopes for some clarity, so the uncertainty weighing on confidence and the equity market could subside, were dashed after we heard the breadth and magnitude of the administration’s tariff plan. In essence, the new tariffs will push the effective tariff rate to the highest level in over 100 years – nearly 3x our original estimate. The news reverberated across the financial markets, sending risk assets and the US dollar lower, with bond yields benefiting from flight to safety flows. While it appears that uncertainty is going to stick around a little longer than we may like, below we outline our latest thinking on the economy and financials markets. For more information on our updated forecasts and asset class targets, please join our webinar on Monday, April 7 at 4PM.

• Tariff rollout more aggressive than expected | The on-again, off-again tariff announcements over the last two months had captured the markets’ attention, with investors anxiously awaiting the president’s widely telegraphed tariff rollout on April 2. While we had already penciled in a sharp increase in the effective tariff rate, from 2.5% up to ~10% based on earlier announcements, Wednesday’s update went beyond our worst-case expectation. In fact, our updated calculations suggest that the effective tariff rate (assuming they are long-lasting) will rise to ~22.5%—that’s well above the Smoot-Hawley tariffs enacted in the 1930s, to levels unprecedented in modern history. While we are hopeful that the effective tariff rate will eventually settle at a lower level and that the administration is using tariffs as a bargaining chip, the greater than expected increase will have a significant impact on both the economy and the financial markets.
• Downside risks to growth raise the odds of a recession | As our past work suggests, every 1% increase in the effective tariff rate should lead to a 0.1% drag on growth and a +0.1% increase in inflation. Given what we have learned, the president’s more aggressive tariff actions will create significant headwinds for the US economy. We are now expecting to see a sharper slowdown, and the odds of a recession have clearly increased. While our economist still expects the economy to narrowly avoid a recession this year, the longer these punitive levels of tariffs remain in place, the greater the risk that it tips the economy into contraction. Although the economy entered this trade shock in relatively good shape—the labor market remains healthy, the consumer is on solid ground and capex spending remains robust—the risks are clearly skewed to the downside from here and that’s before we know the full extent of retaliatory measures.
• Trade policy shifts put Fed in a challenging position | The Fed’s job just got a whole lot more challenging. Given their dual mandate, Fed officials will need to decide whether to lower interest rates to support the economy as businesses and consumers navigate the uncertainty or keep rates elevated (or dare I say raise them) to tamp down inflation. While Chair Powell indicated that policymakers could look through any inflationary boost caused by tariffs during last month’s press conference, it does not appear that all Fed officials are on board with this view. However, we suspect that growth concerns will dominate, particularly if the labor market starts to crack in a meaningful way. And with the Fed’s monetary policy stance still restrictive, policymakers have ample room to cut rates to respond to any weakness. For now, we are still sticking with two rate cuts this year. However, Powell’s speech today may provide some more insights into the Fed’s latest thinking.
• The equity outlook has been dimmed | Coming into the year, we had a below consensus forecast for S&P 500 2025 earnings ($270 EPS). While earlier tariff announcements led the team to reduce GDP and lower corporate earnings to $265-$267, Wednesday’s Rose Garden update suggests there is further downside from here. Two things we are laser-focused on right now: margin compression (i.e., companies can’t fully pass on higher costs) and the extent of the economic slowdown (which hinges on how long the tariffs remain in place). Our work suggests that the tariffs alone (assuming the higher 22.5% effective rate) could result in a ~4% hit to corporate earnings—reducing 2025 EPS to ~$260/share. Accounting for slower growth (sub 1%) should shave off another 1-2% from corporate earnings, with EPS falling to the $250-$255 range. The bottom line: our 6,375 year-end target is likely to be revised lower to around 5,800 if the tariffs remain elevated longer-term. Keep in mind, this adjustment doesn’t account for a recession (still not our base case). If a recession occurs, earnings may be even lower.
• Yields modestly biased to the downside | We see scope for yields to fall modestly from current levels as the growth scare persists. While the 10-year Treasury yield has shifted lower as the market anticipates a deeper Fed easing cycle, a sustained move below 3.75% - 4.0% is unlikely absent a recession (which we do not foresee at this time). While inflation may temporarily increase from the steeper than expected tariffs, the anticipated hit to economic growth from the escalating trade war will be a bigger driver for bond yields, likely putting some modest downward pressure on our current 4.5% year-end 10-year Treasury yield target. We reiterate our preference for the high-quality sectors of the fixed income markets, which are more insulated from a slowing economy.

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