5 Things to consider for the economic outlook

Key messages:

• Equity markets are pricing in a reacceleration of economic growth and earnings growth.
• We think risks remain skewed to the downside given the impact of tariffs on the economy.
• Economic growth looks set to slow as various headwinds continue to drag growth.
• We suggest caution in chasing the equity market rally.

Equity markets have recovered, but has the economy?

Global equity markets recovered their losses following the Liberation day announcements on tariffs. Sentiment improved markedly after President Trump backed down and either repealed or paused the implementation of the largest tariffs. Sentiment improved further after preliminary deals were announced with the UK and China.

But the recovery in equities comes alongside economic growth that is slowing. Equity market valuations have moved to be well above long-run averages. That means earnings growth needs to reaccelerate to justify those valuations. This month, we look at five things to consider for the economic outlook, to see whether those valuations are justified.

1. Tariff rates will be much higher than at the start of the year.

Liberation day promised significant increases in tariffs across the board. The trade war with China saw the tariff rate climb to 145%, with reciprocal tariffs implemented by China at 125%. The collapse in sentiment and rise in US Treasury yields resulted in President Trump blinking, and pausing the implementation of tariffs. But we expect a base line tariff of 10% and an average effective tariff rate closer to 14%. That is materially higher than the 2-3% effective tariff rate at the start of the year.

A higher tariff rate will weigh on growth and add to inflationary pressures. This stagflationary shock is a drag on household consumption and corporate earnings growth.

2. Unemployment may increase.

The US unemployment rate has been resilient over the past six months. But the unemployment rate has increased from 3.4% in April 2023 to 4.2% in April 2025. Fewer jobs are being added each month. And as the economy continues to slow, there is a risk that the unemployment rate continues to drift higher over the remainder of the year. While the absolute level of the unemployment rate may be low relative to history, the trend higher is a risk to sentiment and consumer spending.

The unemployment rate is a lagging indicator, which means by the time it moves higher, the economy will have already slowed materially.

3. Central banks may cut rates later than markets anticipate.

The market is currently anticipating around two 0.25% rate cuts from the Fed this year. The Fed has indicated it will be reactionary to data. In particular, it will likely focus on growth and the labour market instead of inflation. We expect the Fed will not cut rates until the unemployment rate increases another 0.2% points to around 4.3%-4.4%. This may not happen until August or September, making the first Fed rate cut potentially in September.

By the time the Fed cuts, it is likely that the US economy will already be much weaker. The Fed may end up being “too late” to prevent a meaningful slowdown. 

4. Demand for US dollar assets may be reducing.

The US dollar has been weakening post-Liberation day, even as US Treasury yields have backed up and equities have rallied after the initial sell-off. A more hawkish Fed relative to other central banks that are cutting rates would typically strengthen the USD. Now, the weaker USD is raising concerns that the reserve status of the currency has been called into question.

A weaker USD could add to inflationary pressures and could also signal a shift to higher longerterm interest rates.

5. Longer-dated bond yields could remain elevated relative to recent history.

The US 30-year Treasury yield has increased above 5.00%, and the 10-year US Treasury yield is around 4.50%. While the 10-year is lower than where it started the year, it has rebounded from below 3.90% in early April. Higher longer-term yields increase the cost of borrowing for corporates and households. This is happening at a time when goods and input prices are already elevated, and face further increases due to tariffs. This adds pressure to corporate and household balance sheets and could drag on growth over the rest of the year.

Higher longer-term interest rates is offsetting the impact of the Fed’s rate cuts. Monetary policy is potentially less impactful in supporting US economic and earnings growth. 

Conclusion

There are many risks to the economic outlook. But equity markets have taken the view that growth will reaccelerate through 2025 into 2026. This could happen – the economy has proven to be remarkably resilient in 2024 and early 2025. But growth is already slowing. And it is likely to slow further in the near-term. Equity market valuations are elevated and that leaves prices susceptible to any slowing in earnings growth. We do not have a recession as our base case, but we don’t think recession is necessary for the equity market rally to stall. At these levels, we suggest caution in adding exposure to equities.

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