Overview
Recent weeks have seen significant volatility in financial markets, largely driven by shifts in US trade policy and investors’ assessment of the likely implications for the economy and monetary policy. The US April 2nd “Liberation Day” tariff announcements prompted a recalibration of the growth and inflation outlook, along with a repricing of risk premia, particularly for US dollar assets. US equities underperformed global equity indexes, both the US dollar and Treasuries sold off in tandem, and gold rallied. The US asset underperformance was likely exacerbated by market participants’ concerns about US “twin deficit” challenges and threats to US monetary policy independence, with foreign investors reportedly reexamining their large US asset exposures amidst growing geopolitical tensions.
We have since seen a rebound in most asset prices, with the initial market action following US tariff announcements effectively reversing. US equities are now slightly up relative to April 2nd, while corporate credit spreads are still somewhat above pre-tariff announcements levels. Gold prices and US term-premia also remain elevated. Oil prices have continued to decline, reflecting both concerns about global growth and OPEC production increases. The rapid shift in market sentiment despite no tangible resolution of trade tensions may point to an overly sanguine and complacent assessment by investors of the risks to the economic and financial outlook. This raises the possibility of a sudden materialization of economic or financial market tail risks in coming months.
Despite the 90-day pause, the impact of already-enacted trade policy measures and associated economic costs, even though slow to materialize, may become visible in coming weeks and turn out to be significant—for example, in terms of supply chain disruptions, or via pressure on small or medium businesses which often lack the working capital necessary to provide a buffer against disruptions. For most economies, the impact of the tariffs will be deflationary, likely weighing on economic growth. By contrast, for the US the tariffs will be stagflationary, pushing up prices even as they adversely affect economic activity. The question is to what degree and when these effects will start being visible. US policymakers face challenging trade-offs and still-distorted hard-to-interpret economic data and may not be able to provide support to offset an economic slowdown — in contrast to the COVID crisis, when policymakers responded with significant monetary and fiscal easing.
It is possible that the world may not experience a tail risk scenario—business supply chains may prove more adaptable than expected or US consumers may substitute goods for services spending—creating new winners and losers, dampening the stagflationary impacts of the tariffs on the economy. We could also see offsetting positive economic forces dominate — for example, recent AI innovations may trickle out rapidly across the economy, unlocking productivity gains.
Taking a somewhat longer perspective, it is also worth noting that the mirror image of the US persistent trade deficits is large capital surpluses — that is, foreign investors now hold a significant net share of US financial assets as a share of US GDP. This is a vulnerability for US dollar assets, and there are concerns in markets that a trade war may spill over into a “capital war”. While any move away from US dollar assets may occur only gradually and over some period of time, as foreign institutional investors reassess their portfolio allocations and designs, capital shifting away from the US is likely to create opportunity across other markets. For example, while both US and European governments will likely need to issue significant debt in the coming years, European policymakers may find greater global investor appetite for funding those deficits as global demand for alternative safe assets picks up pace.
The charts below highlight recent market action. The rest of the report provides greater details on recent market moves and the key issues to watch from here.
Bloomberg
Market Action Detail
The recent period of market action has been unusual in a few key takeaways. For one, volatility and correlations have been high across asset markets, in both directions, as investors have responded rapidly to sudden swings in policy. Price moves of this magnitude were last seen during the COVID pandemic.
Bloomberg
Second, this period has been notable in the degree of US asset underperformance. The table below shows US vs global equity market pricing over different time periods, in local currency and in US dollar terms. For many investors and for many years, US equities were the only game in town. Owning a portfolio with significant unhedged US equity exposure meant not only that investors saw great outright returns, but this also that their portfolio outperformed more diversified portfolios. Now, in some cases intentionally and in some cases passively (for investors whose portfolios track global benchmarks), many investment portfolios are notably overweight US assets, especially US equities. Price action over the last month was a painful reminder, as US equities have underperformed and the US dollar has fallen.
US equities top of the pack over the last decade (by a significant degree) and now ranking last YTD.
Bloomberg
Typically, during a global risk off event, when global equities retreat, US yields fall and the US dollar appreciates, as investors seek the safety and liquidity of US Treasury securities. In this equity downturn, however, we have seen the US dollar weaken, reportedly reflecting a pullback in foreign capital from US dollar assets amid concerns about growing geopolitical tensions, the US fiscal outlook, and perceived threats to the independence of the Federal Reserve.
Given the substantial needs of foreign capital to fund the large US current account and fiscal deficits, there is a (tail) risk that global investors may meaningfully reevaluate overexposure to US dollar assets. The speed and extent of such repricing of the US dollar is hard to predict. If history is of any help, it is likely to be slow and gradual, especially because there is no immediate, obvious alternative for global investors given the depth and liquidity of US financial markets. Nonetheless, should such repricing accelerate amid continued heightened policy uncertainty and geopolitical tensions, the price impact on US assets could be meaningful given the extent of appreciation of US dollar assets in the past decade or so.
Market environment today is different from what investors have experienced in the last 30 years – dollar and bonds not acting as a diversifier to equities.
These two charts use data only through Mid-April, in order to better illustrate the market action during the global equity downturn. Global equities rebounded in the second half of April.
Bloomberg
Before getting into the issues to watch, this table gives a summary of recent global market moves.
Bloomberg
Issues to Watch
As noted, regardless of future shifts in tariff policies from here, the odds of a significant impact on the global economy and financial markets are notably higher compared to early April. To better understand today’s economic and market environment and the risks to watch for from here, we recommend the following for further reading:
• The April 17th address from IMF Managing Director Kristalina Georgieva: Toward a Better Balanced and More Resilient World Economy
• Yale Budget Lab’s continually updated estimates for announced tariffs impact on US growth and inflation: State of U.S. Tariffs: April 15, 2025 | The Budget Lab at Yale
Global Economic Implications
For most of the world (outside of the US), the announced US tariffs will be a negative demand shock—that is, a negative growth shock putting downward pressure on inflation. The question is how large such a shock will turn out to be. The last fifty years have seen a significant increase in globalization, with goods and services flowing across borders and driving growth for many economies. As a result of increasingly protectionist policies, globalization forces are now set to undergo a meaningful retreat, causing a reorientation of flows. Some economies will be impacted more than others—many emerging market economies depend importantly on good trade with the US, as shown in the right chart below. The policy shifts will also reshape direct investment flows and supply chains (i.e., foreign direct investment to China in recent years have already shifted largely to other economies in South East Asia, and this trend may accelerate and broaden to other geographies).
Globalization trend stalling out and potentially set to run in reverse.
US Tariffs will be a deflationary negative growth pressure across economies with US export demand exposures.
World Bank, OECD, U.S. Bureau of Economic Analysis, U.S. Census Bureau, IMF Data
Global policymakers are likely to respond to a slowdown in economic activity by providing monetary and fiscal support. We have already seen this starting to play out. To give a few examples:
• The European Central Bank cut rates by 25bps in April, noting that the “outlook for (economic) growth has deteriorated owing to rising trade tensions”.
• People’s Bank of China lowered the yuan “fixing rate” below 7.20 for the first time since September 2023. A weaker yuan helps support Chinese export competitiveness. China also took measures to boost the local stock market, including allowing Chinese insurance companies to invest a greater share of portfolios in equities.
• Japan announced an emergency stimulus package, which includes support for corporate financing and subsidies to lower gasoline prices and to partially cover some electricity bills.
As the table below shows, most economies are within striking distance of their inflation targets, and the adverse economic impact of US tariffs will likely put downward pressure on inflation. Interestingly, investors anticipate the Federal Reserve to ease the most (with the exception of Mexico), despite anticipated inflationary pressure from the tariffs (more on this later in the document). Other economies may have more need and more room to ease policy than markets currently expect.
Tariffs are stagflationary for the US – yet US is priced to ease significantly. Other economies are facing deflationary pressures and may have more room to ease.
Bloomberg
US Economic Implications
For the US, the tariffs will likely be stagflationary, as they put upward pressures on prices (whether temporarily or more permanently will depend importantly on the extent of pass-through on consumer prices and the impact on medium- and longer-term inflation expectations), weigh directly on consumer spending, and negatively impact investment as businesses hold off in the face of high uncertainty. For example, a recently released Federal Reserve Bank of Dallas, however, reports that about 75% of manufacturing firms are planning to pass cost increases to customers. These effects could be mitigated if businesses and consumers prove more adaptable than expected. Firms may be able to absorb higher import prices into their margins, have foreign firms share some of the higher tariffs, or shift supply chains and production quicker than expected (and may be better prepared to do so than they were throughout the 2010s thanks to lessons learned during the COVID supply disruptions). Similarly, consumers may shift spending from imported goods to domestically-produced goods and services, thus dampening the downside economic impact of tariffs on the economy in aggregate. It is also possible that positive economic forces could offset the stagflationary impacts of the tariffs—most notably, we have seen incredible progress in AI innovations in recent years. The roll out of these technologies to the economy may prove productivity enhancing, boosting growth and providing a dampening effect on inflation.
From here, we will be closely monitoring the economic data to measure how the impact of these forces will be netting out. We have already seen a big impact from the policy changes on “soft” economic data like surveys. Two examples are shown below—a significant increase in business uncertainty and a large decrease in consumer confidence. Ultimately, the longer the uncertainty and negative sentiment persist, the greater the extent to which this will weigh on business and consumer spending decisions.
“Soft” (survey) data showing sharp deterioration.
Bloomberg
In terms of “hard” data, we are just beginning to see the impact of tariffs, and there are still challenges in interpreting them. For example, the first-quarter US GDP release was likely significantly distorted by businesses front-running the new tariffs—as evidenced by the large surge in imports and inventories (first-quarter GDP data preceded the Liberation Day tariff announcements but were likely impacted by trade negotiations with Mexico and Canada and the anticipation of further US trade negotiations). April’s payrolls report, released on May 2, pointed to a resilient labor market, as firms may be reluctant to reduce their workforce until they have more clarity about trade negotiations.
Q1 GDP already reflects distortions from tariff front-running.
First “hard” economic data point since the tariffs show continued labor market resilience but the downside impacts will take time to play out.
Federal Reserve Economic Data, Bloomberg
We also have not yet seen the trade war spilling over into services, given that the US economy is much more service-oriented. This would be an additional negative for the US should other economies choose to hit back against US tariffs with penalties for US services providers, as the US tends to run large services surpluses vis a vis the rest of the world (e.g., digital taxes, other barriers or restrictions, decrease in tourism).
Despite the increasingly pessimistic outlook for US companies, financial markets remain relatively sanguine about future earnings. The first chart shows the share of companies revising down their earnings expectations. In the most recent period, companies have revised down earnings at a rate about in line with what we saw in 2020. The right chart shows analyst consensus forward earnings estimates for the S&P 500 in red. While not a perfect proxy for the market, it is interesting that analysts have barely revised down their expectations and are still anticipating reasonable growth (north of 7% earnings growth). However, given that interest rates may remain higher than markets currently anticipate, earnings would need to continue to be very robust to justify current equity valuations.
Companies are revising down expectations but overall consensus is still reasonably resilient despite tail.
Bloomberg
US Policy Constraints and the Potential for “Capital Wars”
US policymakers may find it difficult to respond to any economic weakness as they face more challenging trade-offs and constraints—a sharp contrast to the situation during the COVID crisis when both monetary and fiscal policy were eased significantly. On the monetary side, even before the impact of any tariffs, the disinflationary process appears to have stalled, with inflation still running above the Federal Reserve’s 2% target. On the fiscal side, high government debt levels and a historically large deficit may limit policymakers’ ability to respond with a large fiscal stimulus in the event of a more significant economic slowdown. It is also worth noting that foreign investors now own a significant share of the US Treasuries outstanding, creating a potential vulnerability should they require greater compensation to bear duration risk (see the sharp rise in term premia since the fall of last year).
The charts below highlight the challenges facing the Federal Reserve. Inflation expectations and businesses input costs are rising at a time when inflation is already above the 2% target. The second set of charts shows private sector debt levels and borrowing rates. On the bright side, the US private sector has been deleveraging for years—a development that lowers the risk of a turndown in borrowing, which would exacerbate an economic slowdown. However, private sector borrowing rates are high compared to recent years following the Federal Reserve’s tightening cycle that started in 2022. As a result, it would likely take a reasonably large decline in rates in order to incentivize a pickup in domestic credit demand that would be able to offset the slowdown caused by tariffs, especially against the backdrop of elevated uncertainty.
Inflation is already above target and expectations and input costs are rising.
Meaningful easing may be required to kickstart private sector credit creation to offset tariff impacts.
Bloomberg
These dynamics are occurring at a time when some of the deflationary forces of the past are likely behind us. The first two charts highlight one such force. In the last 30 years, growth in spending on goods and services in the US has been similar, but the US has been able to reallocate workers towards services, as US corporates offshored goods producing jobs. Offshoring of supply chains has allowed goods inflation to decline sharply for much of the last 20 years (helping offset housing and services inflation). Globalization of goods production has also put downward pressure on wages across industries as workers have been reallocated from goods-producing jobs to other industries.
Foreign born workers were all of the US labor force growth since 2019.
Border apprehensions have fallen significantly.
Bloomberg
In addition, a surge in immigration in recent years has put downward pressure on US wages. Almost all of the growth in the US labor force since pre-COVID has been due to foreign workers. Timely data now shows that the US border has been effectively closed, which will likely result in a tighter labor market in the coming months. Of course, we may still see slack in the labor market due to other economic forces, but on the margin the shift in immigration policies will put an upward pressure on inflation.
Globalization and outsourcing of goods production has been a major driver of goods disinflation.
Goods deflation helped contain inflation for 20 years – more behind than ahead of us as a disinflationary.
Bureau of Labor Statistics, Bureau of Economic Analysis
Finally, US policymakers may be constrained in providing support due to concerns about the fiscal outlook. The ratio of debt-to-GDP has risen sharply since Covid and the current fiscal deficit is unprecedented for a non-recessionary period going back decades (and back to the 1940s for a non-war period).
As the charts below show, US term premia are higher and long duration bonds have repriced notably lower. While concerns so far have been about the speed of the repricing of the long endover a narrow window of time, it is worth noting that the magnitude of such repricing has not been particularly large if one takes a longer-term perspective. For example, the sharp rise in term-premia has been from very compressed (and negative) levels.
Large fiscal deficit and high debt levels require continual flow of capital willing to fund those deficits.
Moves so far are off of compressed levels but tipping points are not obvious in advance.
Federal Reserve Economic Data, Financial Accounts of the United States, Bloomberg
Investors Revisiting Portfolio Diversification and Outsized US Exposures
Against a backdrop of heightened geopolitical risks and rising mercantilist policies, foreign investors are reportedly starting to reassess their US dollar exposures and portfolio design principles. Below, we highlight one market that may benefit from capital reallocations as investors diversify their portfolios – European sovereign fixed income.
Despite the rise in US Treasury yields, German Bund yields have fallen (contrary to past correlations). In Europe, the imposition of US tariffs and a rethinking of the commitment of the US to traditional security alliances have led to a push for greater European fiscal and defense spending, more sovereign borrowing, and greater European-level issuance. With investors reportedly willing to fund higher European sovereign issuance, the rise in French and Italian spreads has been muted (a contrast to what we have typically seen in other periods of growth slowdowns in Europe).
The decline in Bund yields is contrary to the historical rise earlier this year, when news that Germany was reconsidering their long held “debt break” (a constitutional borrowing limit) led to the largest one-time rise in Bund yields since German unification. That said, investors continue to highlight structural challenges in Europe that would need to be addressed before European financial assets become a real alternative to US dollar assets, including lack of a true “centralized” fiscal policy, unfinished banking union, lack of a capital market union, remining internal barriers to integration, and need to incentivize technological innovation.
Bloomberg
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