5 September 2025

Yes, the first eight months of 2025 have been a wild ride. However, the financial market reaction has been quite predictable; collapsing after “Liberation Day”, and rebounding once outcomes have proven to be less damaging than announced. As Autumn approaches, the policy horizon appears a little less eventful, although key trade talks with China, Mexico, and Canada continue. However, the broad framework of the new trade regime is taking shape, and the One Big Beautiful Bill (OBBB) established the broad fiscal outline for the coming period.

Therefore, it’s a good time to take stock of the implications of these sweeping policy decisions (indeed, I have refrained from writing recently until the dust began to settle). To be sure, financial markets are in good spirits. Despite the chaotic nature of policymaking, US corporate earnings remain robust. Likewise, the Federal Reserve recently signaled interest rates cuts would begin in September.

However, will higher tariffs produced the promised manufacturing jobs, productivity gains, and investment boom? Will international firms flood America with foreign direct investment? Does the OBBB address America’s bloated budget deficit and the unstable escalation of public debt? What are the implications of Trump 2.0’s immigration policy and cuts in R&D funding at universities?

Unlike the bullish consensus, I expect the broad themes of my earlier 2025 strategy essay will remain relevant in the period ahead. US markets will post single-digit returns in the coming year. Another 10% correction is probable at some point; likely caused by doubts about US fiscal sustainability and stalling GDP growth. The US dollar will depreciate further. Non-US markets will outperform. Selective Emerging Markets will continue to surprise; focus on large countries where local demand can offset the impact of higher tariffs. I offer an early look at my 2026 market forecasts at the end of this blog (comments are always welcomed).

Trump 2.0 Tariffs: Is Short Term Pain…..

US tariffs now have risen to levels that led to the Great Depression (Chart above). Perhaps unsurprisingly, as US imports as a percent of GDP are four times higher than in the 1920s, some predicted a sharp contraction in American GDP (next Chart). Fortunately, this has not happened: monetary policy mistakes contributed more to the Depression than Smoot-Hawley levies.

However, US growth has decelerated sharply. Indeed, the 1.4% GDP advance in the first six months of 2025 is half the 2.8% recorded last year. Unsurprisingly, as tariffs represent a 1% of GDP tax hike on American households, the sharp slowdown in consumption accounts (up only 1% in H1 2025) for most of the economy’s deceleration. Also, government spending and residential investment have both contracted, 0.4% and 3% resepectively. More positively, AI-led fixed investment surged nearly 8%, suggesting a recession is not imminent. Nevertheless, I expect the US economy to continue to slow: GDP should advance only 1.2% and 1% in 2025 and 2026 respectively (on a Q4/Q4 basis). As economic growth approaches stall speed the risk of 2026 recession is 25%, and rising.

Likewise, the American labour market has weakened: the pace of job creation has slowed to 80,000 per month this year (30K during the past 3 months) — half the 168,000 pace in 2024. What about the promised manufacuring jobs? Well, they have declined 28,000 in 2025.

Presumably, one of the objectives of Trump 2.0 tariffs is to reduce America’s trade deficit and reliance on foreign capital inflows. During H1 2025, however, the external shortfall continued to balloon; from $570 billion to $732 billion, despite a 5% increase in US exports. The culprit is the 14% surge in US imports. This illustrates the US trade deficit stems from America’s seemingly insatiable appetite for foreign goods, not protectionism in overseas markets. Tariffs will only correct this situation if US consumption is compressed much more than so far.

I project tariffs will result in a one-time inflation increase of up to 1.5%. To be sure, corporations may absorb part of shock, and the weaker economy will also ease price pressures. Nevertheless, I expect core inflation to remain near 3% (perhaps slightly above) until mid-2026 before declining towards the Fed’s 2% target, as GDP stalls.

…..Worth the Long Term Gains?

After reluctantly acknowledging the potential for short term pain, President Trump promises his economic experiment will lead to unimagined economic prosperity over the long term. To come to fruition, Trump 2.0’s economic strategy will need to either boost productivity, increase labour supply, or promote capital spending in the USA both by domestic and foreign investors.

America already enjoys a higher level of output per hour than other advanced economies. And, one of the reason the US economy has outperformed Europe and Japan during the past 20 years is that efficiency gains have outpaced the competition. However, as the Chart above illustrates, the trend in American productivity growth has been slowing for decades (as in the rest of the world). AI holds out the potential to correct this uneviable pattern. On the other hand, protectionism leads to a misallocation of resources away from sectors in which America holds a competitive edge towards uncompetitive, slow-growing sectors. Rather than correcting the productivity problem, tariffs will reenforce it.

Perhaps even more damaging to long-term GDP potential would be the adverse impact of mass deportation on US labour supply. During the past two decades net immigration totalled roughly 1 million annually. To be sure, the surge to 2-3 million per year during the Biden administration was unsustainable. However, net migration is likely to be near zero this year. Sustaining such a low level of immigration could reduce America’s long term growth potential by as much as 0.5% annually. POTUS 47’s approach to immigration is already taking a toll on the labour market. After accounting for most of the labour force growth since the pandemic, the supply of foreign workers is now declining (Chart above).

On the other hand, domestic capital spending continues to grow strongly (for now), led by AI investments. However, the belief the imposition of tariffs will attract foreign direct investment is far-fetched. Indeed, during Q1 2025, FDI totaled $55 billion compared to $63 billion last year (early days I know). In recent trade deals, Korea and Japan both pledged to invest $350 billion in the USA in the next five years Chart above). However, FDI into the USA from these two countries has only amounted to $8 and $30 billion respectively during the past 4 years. Similarly, the EU promised $650 billion in new US FDI over 5 years. During the past 4 years, Europe has invested roughly $150 billion annually. Therefore, the pledge does not represent commitments beyond what would be expected anyway.

In addition, the Trump Administration’s plans to cut R&D funding at universities could significantly impact capital spending and productivity. Already, private sector R&D stagnated during the first half of the year. Putting the pieces together, Trump 2.0 trade, immigration, and funding strategy could reduce US long-term GDP growth 0.5-1% annually.

Fiscal Sustainability: The Dornbusch Theorem

Rather than adding to the debate about how much the OBBB will add to US public sector debt, I will make just two observations. By the way, the non-partisan Congressional Budget Office suggests debt will rise $2.5 trillion (nearly 10% of GDP) by 2035 — an estimate I consider reasonable.

What can be said without doubt is the US fiscal policy remains on an unsustainable path with debt surging for the foreseeable future. As I discussed in an earlier blog, stabilising the US debt/GDP ratio will require a combination of tax hikes and cuts in entitlement spending — for which there is little political will or popular support.

Of course, the USA is not alone: all nations face the same problem. But, America’s fiscal position (China’s too) has deteriorated faster than most countries (Chart above). As esteemed Professor Rudy Dornbusch observed (author of my first economic textbook), the timing of the market impact of fiscal crises is hard to pinpoint — and usually takes longer than expected. But, when they come, the consequence are more severe than anticipated. We may have seen a dress rehearsal in early 2025. At present, the UK gilt market is wobbling, and America’s problems are even larger.

Also, the OBBB reveals some of the Administration’s budgetary priorities — the plan harms the poorest 40% of the population with the largest benefits accruing to the wealthiest 10%. The health impact of Medicaid cuts, combined with reductions in Climate investment and university R&D spending may take a toll on future American productivity.

Fed Shifts Dual Mandate Priorities

The Federal Reserve has a dual mandate both to pursue low inflation and to promote full employment. Chairman Powell’s recent comments highlighted the Fed is shifting its focus from fighting inflation to supporting the weakening economy and labour market. As wage growth has not picked up this year, the Fed appears increasingly confident the inflationary impact of tariffs will be transitory.

The Fed’s shift in priorities will have important market implications. If core inflation remains near 3% during the next 6 to 9 months (as I expect), the Fed’s inflation-fighting reputation may be damaged. Likewise, if Potus 47 continues to undermine Fed members, and Jerome Powell is eventually replaced by an inflation dove (both are likely), the Fed’s independence and credibility could come into question.

The market is already discounting a 25bp rate cut in September, and an additional 125bp by the end of 2026. Indeed, following the weak August payroll data, the Fed may well cut rates 50bp this month. Otherwise, I have no problem with that view, although the Fed eventually become a bit more cautious if inflation remains sticky. As a result, I do not expect a huge bond market rally as the Fed eases monetary conditions — with 10-year rates spending a lot of time in the 3.75-4% zone — unless the economy slips into recession. The yield curve will steepen another 50-100bp, perhaps more if a fiscal crisis emerges.

As the economy weakens and US interest rates decline more than elsewhere, the very overvalued dollar will continue to depreciate — perhaps by up to 10% (Chart above), an outcome Potus47 would welcome.

The Chart above (provided by Yardeni Research) indicates that equities now are fairly valued relative to bonds. In other words, if bond yield don’t decline much (as I expect), higher stock prices will need to rely on earnings growth. As I expect the US economy to weaken further next year, S&P 500 EPS growth may fall short of the lofty consensus for 11% and 13% gains in 2025/26 respectively (9% and 7% is more likely). To be sure, the market is in a bullish mood. However, without a significant decline in bond yields (without recession) or a meaningful productivity boost to earnings, S&P gains may be limited in the period ahead to around 4%, or an S&P target of 6,750.

Europe: Let Stop Call Trump Tariffs Reciprocal

First of all, can we stop referring to the Trump 2.0 tariffs as reciprocal? US-imposed levies are unilateral, and American tariffs now exceed its trading partners by a large margin (Chart above). At first, I was surprised and disappointed by countries’ decision not to retaliate. After reflection, I believe the intention is to preserve the successful, historic free trade regime to the extent possible; hoping the current shock will be shortlived. This is bullish, although the USA may become addicted to the revenues tariffs raise. In addition, I am increasingly concerned Trump 2.0’s strategy will leave American isolated over time. The recent gathering in Beijing to mark the end of WWII illustrates countries will form new relationships that may not be in America’s national interest.

The European Union accepted a 15% tariff on exports to the USA (10% for the UK), and both cut already low levies on US imports. Europe agreed to continue to increase LNG imports and cut levies on US autos. Of course, the previous 10% tax on American vehicles is not why Europeans do not drive American cars. Likewise, the proposed level of LNG imports would require the USA to divert sales from virtually all other foreign customers.

To be sure, European economies will take a hit: reducing GDP by roughly 0.5% over the next year. However, Europe is less vulnerable than other countries (Chart above). And, EU long-term GDP growth will not be subject to the distortions the Trump tariffs will inflict on the US economy. Indeed, EU GDP growth may exceed the USA in 2026 — a rare event indeed. Therefore, my belief that European markets will continue to outperform remains in place. (I will address all these issues in detail in a future blog).

Another reason I favour Europe is the region’s clearer path to low inflation and interest rates. Indeed, the US-Eurozone inflation gap is widening already (Chart above). And, the ECB has already cut interest rates 230 from the peak (100bp in 2025 alone).

In addition, while Europe’s fiscal position is not great, it’s better than the USA’s…with a few exceptions like Italy, France, etc (see earlier Chart). To be sure, Europe will face the challenge of shifting its budgetary priorities away from social spending. However, the urgent need for additional defense spending will provide a fiscal stimulus in coming year.

Emerging Markets: Still Bullish, But Remain Selective

At the beginning of 2025, the consensus on Emerging Markets was bearish. I was more constructive, and advised focusing on countries with large domestic markets to offset the impact of potential tariffs. The scepticism was not unwarranted. Many Asian nations enjoy large and growing trade surpluses with the USA, and in some cases do subject American imports to higher charges and non-tariff barriers (note low export/import ratios in the Chart above). And, the export-oriented Asian economies are especially vulnerable to US protectionism (see earlier Chart).

However, as the dust begins to settle, the case for EM investing is even more favourable (indeed, EM has significantly outperformed this year). The proposed tariff levels are not as bad as expected: most countries in the 15-20% range, similar to the European Union and Japan. Nevertheless, the GDP shock could be 2%, and considerably more in some countries. To be sure, Asian nations will hope to boost intra-regional trade. Brazil and India will face much higher 50% levies; fortunately, they are less exposed to the US market, and will boost ties with China and elsewhere.

To be sure, the uncertain global growth environment hurts the exporting Asian nations. However, the prospect of a weaker dollar and lower US and international interest rates is bullish for EM.

Domestically, the prospect for low inflation and interest rates is clearer in most EM nations than in the USA. In addition, despite the challenging environment for EM exporters, consumer spending and capex remain far stronger in EM than in the advanced economies (Chart above). Therefore, continue to focus on countries with robust local demand to offset the impact of weak global growth. (I’ll write more on this topic later).

Global Strategy 2026 Forecast