Tariff chaos overshadows a strong US economy

Market & Trading Calls

• US Economic Strength Continues: the US economy continues to outperform, with 2024 headline GDP expanding at 2.8%. In Q4, while headline growth came in a bit below expectations, household consumption (70% of GDP) surged to a 4.1% q/q annualized gain, marking the highest pace of expansion in over a year.
• Three Economic Scenarios for Tariffs: if broad-based tariffs remain in place for an extended period of time, two outcomes are possible – either inflation rises, but reshoring supports job growth and sustains GDP growth (>=2%) or inflation spikes without reshoring, dragging growth down to 1 – 1.5%, albeit inflation would also ease back towards 2%. The third and most likely scenario is a middle ground, with tariffs on China persisting for some time while those on Canada and Mexico are resolved quickly, allowing US growth to finish at 2.5%, but keeping inflation in a range between 3 – 3.5% this year.
• Canada and Mexico Negotiations: the White House has shown a willingness to negotiate quickly with its North American partners. We expect a resolution over the next month as negotiations commence, minimizing economic disruption and maintaining trade stability.
• China Trade Tensions to Persist: Unlike Canada and Mexico, tariffs on China are expected to persist and possibly increase in a move to pressure CCP officials. Trump remains skeptical of Chinese commitments following a failure to follow through on a trade deal made during his first term. Trump administration officials would also like to pressure China’s sizeable current account surplus.

Market Analysis

Trump tariff policy creates questions around the outlook for the US economy as Mexico, Canada, and China scramble to negotiate with the White House.

Over the past two years, the US economy has enjoyed a period of true outperformance relative to the rest of the developed world. In 2024, US real GDP expanded at a healthy 2.8%, pacing well ahead of long-run trend (2%). In Q4, while headline growth came in a bit below expectations, household consumption, which represents 70% of the US economy, surged to a 4.1% q/q annualized rate of growth, marking the highest pace of expansion since Q1 2023.

Quarterly US Real Headline GDP (USD tn, left) and Q/Q % Delta Annualized (right)

Source: BEA

Nonetheless, the threat of trade wars and tariff barriers with Canada, Mexico, China, and the EU throw considerable uncertainty into the mix for our US economic outlook. The way we see it, there are two potential outcomes if broad-based tariffs remain in place for a long stretch of time (>6 months). The first is that US inflationary pressures rise amid an increase in import prices, albeit with some potential offset via a stronger US Dollar (USD). Higher domestic prices incentivize high value-added manufacturing production investment. In turn, this limits the drag on consumption as reshoring helps to create jobs and support healthy wage growth. Under this scenario, growth remains at or above trend (2%), and core-CPI based inflation is sticky in a range close to 4%.

The second potential outcome if broad-based tariffs remain in place for an extended period is one where, like our first scenario, inflationary pressures rise amid an increase in import prices, with some offset via stronger USD. However, higher prices fail to incentivize manufacturing reshoring. This in turn exacerbates the drag on household consumption and US economic growth. Under this scenario, we would assume real growth falls to a range between 1 – 1.5%, albeit inflation would eventually ease back towards 2% amid a weak household consumer, eventually providing the Fed space to cut rates if needed.

The true outcome of tariff policy on the US economy is likely somewhere between our “high inflation” and “low growth” scenarios. Tariff threats on Canada and Mexico are likely to be short-lived. Trump’s quick agreement with Mexican President Sheinbaum to push back tariffs to March 1st in an effort to negotiate issues of national security and trade is evidence that the White House is ready to agree on terms and move on. Following the announced tariff reprieve, Sheinbaum made clear she had committed to send 10,000 troops to the US-Mexico border in a first step. As this report went to press, it also appeared that Canada had managed to gain a reprieve from tariffs in order to negotiate with the White House. We see it likely that a deal is finalized this month with both Mexico and Canada.

Monthly Chinese Trade Surplus with Rest of World (USD bn)

Source: NBS

However, it is unlikely that Trump quickly makes a deal with China. The United States, alongside a number of other countries, would like to address China’s sizeable current account surplus. In addition, Trump inherently distrusts CCP officials who failed to follow through on trade agreements in Trump’s first term in office. Our base case is that tariffs are implemented and allowed to slowly build on imported Chinese goods over the course of this year before the White House is ready to go to the negotiating table.

This brings us to our assumption for the US economy. While tariffs on Canada and Mexico will likely be resolved quickly, we believe tariffs on China will remain in place, if not increase from a starting point of 10% over the course of this year. However, USD appreciation against the Chinese Renminbi (CNY) will provide some offset. Ultimately, we forecast a 2.5% rate of growth this year, and a core CPI-based rate of inflation in a range between 3 – 3.5%. It is unlikely the Fed cuts more than once or twice this year, and not until the second half when there is more clarity around economic policy.

On Monday, a number of Fed officials spoke amid the chaos of potential tariff implementation. Raphael Bostic of the Atlanta Fed said that there was “not enough clarity on inflation by March to move,” albeit he is not currently a voting member on the FOMC. Susan Collins of the Boston Fed also advocated for patient approach “It’s appropriate for policy to be patient, careful, no urgency to change rates.” Collins is currently an FOMC voting member.

Monthly US One- and Six-Month Rate of Core CPI-Based Inflation (%)

Source: BLS

The US economy continues to perform well for now. Time will tell whether tariffs take a toll on output.

The US economy continues to find support from the consumer. Across household consumption, which accounts for just under 70% of US GDP, the upward trend in place for the past two years continues apace. Real household expenditures finished December up 3.8% m/m annualized, marking the eighth straight monthly gain. The US labor market also looks stable. Weekly initial jobless claims continue to hold roughly in line with year earlier levels through the month of January. The official unemployment rate has remained in a range between 4.1 and 4.2% since June of last year after steadily weakening through the first half of 2024. In light of previous assumptions made within this update, it is our view that continued consumer strength looks likely.

Monthly US Real Consumption Expenditures (USD tn, top) and M/M % Delta Annualized (bottom)

Source: BEA

We are less certain around the outlook for investment (23% of GDP), which underwent a 5.6% q/q annualized contraction in Q4, a first going back to early-2023. Aggressive tariffs on China could help to kick start some manufacturing reshoring. However, elevated long duration rates create barriers. So far this year, the 10y government bond yield is averaging north of 4.5%, up from 3.95% in Q3 2024, and 4.27% in Q4 2024. We tend to have a bias for higher rates (range of 4.5 – 5%) given inflationary concerns.

Nonetheless, recent monthly data forms a relatively constructive picture for investment after a tough start to Q4. In December, manufacturing production managed a healthy 7.1% m/m annualized increase despite a Q4 decline of 0.8% q/q annualized. In January, manufacturing PMI figures as measured by S&P Global and ISM both simultaneously returned to expansionary territory for the first time since March. The construction market also showed signs of picking up. Housing starts managed a sizeable 14.9% q/q annualized increase in Q4, largely driven by a solid 80% m/m annualized increase in December, albeit starts were still down y/y. Permitting has also ticked up off the lows from October, a good leading indicator.

Monthly US Manufacturing Production Index (top) and M/M % Delta Annualized (bottom)

Source: Fed

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