Navigating Economic Shifts: Recession Risks and Market Signals

Financial markets have been in turmoil due to President Donald Trump’s shifting tariff policies. The swift implementation of these tariffs initially led to sharp market declines, raising concerns among investors about the stability of both domestic and global economic conditions. However, stocks surged after the president authorized a 90-day pause on some tariffs.

During volatile times like this, we believe several time-tested principles of long-term investing are more crucial than ever. Adhering to these principles can help guide your financial journey and may improve your chances of success.

1. Time is on your side. Despite periods of short-term decline, the market’s recovery over the long term has rewarded those who remain invested.

2. Stick with your plan. With market alerts, financial TV programs and breaking headlines, news can lead investors to make emotional decisions now more than ever. Sticking with your plan means resisting the urge to buy high when the markets are going up and selling when they go down.

3. Diversification matters. No one can predict tomorrow’s winners, but diversification is a strategy that has stood the test of time. A diversified portfolio of stocks, bonds and cash may give you the best chance of reaching your long-term goals.

The Macroeconomic Environment: Rapid Changes and Recession Risk

What a difference two months can make. The U.S. economy is usually more like a cargo ship than a speed boat, moving slowly but steadily in one direction without making hairpin turns or quickly reversing course. However, the recent wave of major new government policies has the potential to significantly impact our economy in a short time.

The Federal Reserve Bank of Atlanta’s “GDP-Now” model forecasts a decline in gross domestic product (GDP) during the first quarter of 2025 after adjusting for inflation. Just two months ago, no economist participating in a much-watched consensus estimate called for anything close to a recession in 2025. Now several are doing so.

What’s causing this abrupt shift? The possibilities include:

1. The potential for tariffs to reduce economic activity and cause inflation.

2. The effects of Department of Government Efficiency (DOGE) personnel cuts on unemployment.

3. Two surveys of consumer sentiment/consumer confidence that moved sharply lower.

4. A recent sharp decline in retail sales.

5. Increasingly pessimistic surveys of manufacturing activity.

To be fair, economic forecasts can be overly sensitive to monthly data. However, we think the probability of a recession will rise if certain policies, like tariffs, continue to spread further.

Balancing Act: The Short-Term Pain vs. Long-Term Gain Debate

There’s no question that President Donald Trump’s agenda is designed to break more than a few glasses, taking a “shock and awe” approach to managing the economy. However, some question whether it’s breaking some glasses or being a bull in a china shop.

According to Trump, much of this is intentional, with the rationale that there will be short-term pain but longer-term gains. While inflation cooled to 2.4% in March, it may still be too high to justify cutting interest rates soon. We also note that consumer expectations of future inflation rose to 5.0% for a one-year horizon — much higher than in the recent past.¹

Tariffs: Good or Bad for the U.S. Economy?

New tariff proposals are drawing comparisons to the Smoot-Hawley Tariff Act. Enacted in 1930, this legislation was sponsored by Senator Reed Smoot and Representative Willis Hawley and signed into law by President Herbert Hoover. It raised import duties on over 20,000 imported goods, including agricultural imports, by an average of 40% to 60% and aimed to protect U.S. businesses and farmers from foreign competition.

Although most economists don’t believe the Smoot-Hawley Tariff Act directly caused the Great Depression, it significantly worsened the economic downturn. The law prompted other countries to impose retaliatory tariffs, which resulted in a sharp decline in global trade and further aggravated economic conditions.

The similarities to today may help explain the market's severe reactions to the Trump administration's plans and actions. However, unlike the Smoot-Hawley tariffs, which involved congressional oversight, the Executive Branch is now alone in threatening to implement trade policies that most economists view as extreme without any input from Congress.

Who Pays?

Import duties (tariffs) are paid by the importer, typically a domestic firm. The importer can choose to pass the costs to the consumer, eat a portion of the costs or try to get the company that exported its products to the U.S. to lower its prices. So, not all tariffs end up hitting consumers, but most do. Some studies say the tariffs being discussed and imposed on Canada, Mexico, Europe, China and elsewhere, could raise U.S. inflation by 0.50% to 0.80%.²

Many believe Trump uses tariffs as a negotiating tool but doesn’t intend to spark an all-out, long-lasting trade war. However, U.S. trading partners may retaliate and have indicated they will do so. For example, Canada has removed U.S. liquor and wine from retail shelves, and the province of Ontario proposed tariffs on the electricity it supplies to U.S. states on the northern border (since rescinded).

Tariff revenues are generated only when goods are imported, and domestic manufacturing would increase only if imports declined. Regardless of the motivation, the administration’s actions have created an atmosphere of uncertainty that is roiling the markets.

Measuring the Size of an Economy – Should We Redefine GDP?

What do people mean when they say an economy is growing or shrinking? It comes down to GDP, which measures the value of all the final goods and services an economy produces over a given period.

Total GDP is the sum of four components, as shown in Figure 1.

Since economist Simon Kuznets first developed the concept in 1934, we've measured GDP this way. It has been widely used to measure a country’s economy and make international comparisons since 1944.

Some members of Congress and the administration are discussing the possibility of redefining GDP by excluding government spending from the calculation. Why redefine GDP to exclude goods and services produced by the government — currently about 17% of the U.S. GDP? Consider this:

The recent and imminent layoffs of government personnel and other government spending cuts will likely lower GDP as it’s currently measured. If we removed government spending from the definition of GDP, then GDP would be less likely to go down enough to “qualify” as a recession. But changing the rules in the middle of the game is deceptive and doesn’t make economic sense.

In our view, redefining GDP to hide the negative effects of any administration’s policies is a bad idea — this applies equally to all administrations. I much prefer Treasury Secretary Scott Bessent’s take. He admits the economy is starting to “roll” a bit (in his words) as we move away from government spending to private sector spending and says this may cause short-term pain for (hopefully) long-term gain. This admits GDP is going to decline in the near term, but, in Bessent’s opinion, it will move higher after inefficient government spending shifts to more efficient and effective private production. He may or may not be right about that, but at least he's not trying to mask the facts.

Market Signals: What Investors Need to Know

U.S. equity markets are indicating investor concern. In other markets, interest rate futures now show bond investors expect the Federal Reserve to cut interest rates at least twice this year, driven by rising recession fears. Just a few weeks ago, that market was signaling there might be no rate cuts at all in 2025. The U.S. dollar is sinking against other major currencies and is now down to pre-election levels. Gold, often seen as a safe haven in troubled times and an inflation hedge, continues to climb.

It’s a lot to absorb, and it’s all happening at once. In the meantime, we urge investors to stay informed and take a long-term approach when navigating the current market environment.