Introduction to the Recent Market Trends
Equity markets have staged a significant comeback from the tariff-driven shock that kicked off in March 2025 and accelerated after the “Liberation Day” tariff announcements on April 2. Investors have been wondering if the shock is already over and if markets, along with the U.S. economy, can continue to hum along without falling into recession.
Understanding the Tariff-Driven Shock
Our short answer is that even with relatively few trade deals inked thus far, it’s not surprising that markets have moved on and tariffs are no longer a primary driver of market performance. We classify the recent tariff sell-off as an event-driven bear market, caused by factors separate from the traditional economic cycle. These downturns and subsequent recoveries play out much more rapidly than cyclical bear markets and recoveries. Furthermore, the scope of tariffs proposed by the Trump administration has been reduced significantly to levels unlikely to cause a recession, assuming the batch of tariffs announced by President Trump in July proves to be more bluff than substance.
Economic Conditions and Market Performance
If the tariffs do not have a significant impact, it’s not obvious that markets will see another major impact from tariffs, even if underlying economic conditions weaken in the second half of 2025. As argued in January, the cyclical risk of recession is still looking low. Markets may look through the weakness in data towards a brighter 2026. The economy is expected to slow down in the near term, but the Federal Reserve (Fed) will likely cut interest rates to stabilize the economy and the labor market, focusing on the growth component of its dual mandate.
Inflation and Interest Rates
Some market participants have voiced concerns that high inflation will make it unfeasible for the Fed to intervene and support growth. However, we disagree, as labor, housing, and energy vectors of inflation remain well behaved, even with tariffs impacting consumer prices. The structure of the U.S. economy has changed significantly, making recessions less likely than in decades prior. While the U.S. economy still goes through periodic “micro” recessions affecting specific sectors and industries, obsessively focusing on the threat of a full recession has often led investors astray.
Why Markets Have Moved On
Markets have already moved on from the tariff shock, as exhibited by equity and credit valuations not too different from those in January. Market volatility is low again, with the VIX “fear gauge” back below 20. This has remained the case despite President Trump’s threat of additional tariffs on various trade partners. We do not expect these tariffs to take full effect, and based on valuations and the relatively muted market response, we believe markets do not expect this either. The scale of the tariff war has been roughly halved since Liberation Day, and at the time of writing, the U.S. effective tariff rate is set to rise to about 13%–15% from 2.0%–2.5% at the start of the year.
Impact of Tariffs on the Economy
While this is the largest tariff shock in 100 years, it’s unlikely to cause a U.S. or global recession. Goods imported to the United States represent only about 11.5% of GDP. A quick estimate of the short-run costs to the U.S. economy suggests a 12% increase in the effective tariff rate would create roughly a 1.4% negative growth headwind. As the U.S. economy was growing about 2.5%–3% annually heading into the tariff shock, a 1.4% hit from tariffs wouldn’t be enough to derail the underlying momentum. This is probably the most important reason markets have rebounded from their Liberation Day lows—a generalized pricing out of recession risk across all major asset classes.
Comparison to the Brexit Economic Shock
The Brexit economic shock of 2016–17, which also created extreme trade uncertainty, makes for a useful comparison. The Brexit shock led to a recession in business investment but not in consumer spending. For that reason, to the surprise of many financial analysts, the U.K. economy avoided recession in 2016–2017. Similarly, tariff-driven uncertainty will have additional negative effects on GDP, but it will slow business investment while having less effect on consumer spending.
Conclusion
In conclusion, the U.S. economy and markets have shown resilience in the face of tariff-driven shocks. While there are concerns about the impact of tariffs on the economy, the reduced scope of proposed tariffs and the ability of the Federal Reserve to cut interest rates to stabilize the economy suggest that a recession is unlikely. As markets continue to move on from the tariff shock, investors should focus on the underlying economic conditions and the potential for growth in 2026, rather than obsessing over the threat of a full recession. By understanding the changing structure of the U.S. economy and the impact of tariffs, investors can make informed decisions and navigate the complexities of the market.
