Tariff rollbacks and economic slowdown: What lies ahead?

JACK JANASIEWICZ: I'm Jack Janasiewicz, lead portfolio strategist and one of the portfolio managers on the Natixis Investment Managers Solution strategist models.

BRIAN HESS: I'm Brian Hess, investment strategist. This is Tactical Take. OK, Jack, so we're recording this a couple days after the US-China trade negotiations in Geneva. So I think we should probably start there. We had the US put tariffs on China up to 145%, which was effectively like an embargo. I don't think much was going to be coming in at those tariff rates.

But over the weekend, there was an agreement to roll them back to 30% for Chinese imports into the US, and US imports heading to China will be tariff at 10%. And this will be in place for 90 days while the negotiations continue starting May 14, it looks like. So let me ask, what is your initial thoughts about this shift? It seems pretty important. So how critical do you see it for the evolution of markets over the next couple of months?

JACK JANASIEWICZ: Yeah, sure. Certainly seems like the market thought it was important, too, given the reaction that we had from equities. But I think in general, it was better than expected. I think people were expecting somewhat of a rollback. But the size that we got was probably better than expected, so hence, the market reaction.

But a couple of things to think about there, both positive and negative. From a positive perspective, at least they're talking. At least there's somewhat of a framework in terms of maybe these are some of the things that the US is looking for. So at least China has a little bit of an idea of maybe what they can come back with regard to future negotiations. But at the flip side, though, we're still talking about an effective tariff rate of something close to 15% across the board.

So it's still fairly punitive. We haven't seen something like that since maybe World War II, so good and bad here. But at least we're moving forward with progress and potentially seeing some sort of lasting negotiation on the trade front here.

BRIAN HESS: And then we had the first agreement last week. We're doing the other negotiations on the side. We've got a lot of countries we're talking to. And there was that first agreement with the UK, which seemed pretty constructive, a 10% tariff rate, which is the baseline. So things are moving forward here, and it will be interesting to see how much of a tariff increase there really is at the end of the day.

I mean, I'm starting to wonder if it could be something like what happened with DOGE where there was a lot of really big talk, we're going to find 2 trillion in savings, then it was 1 trillion. And I think it's probably a couple hundred million at the end of the day. It'll be interesting if that's what happens with trade and we end up going huge with these tariffs initially. But at the end of the day, it's just a modest increase that doesn't materially change things. That's what I think the market's trying to grapple with as we've rallied back and taken back significant amounts of the losses.

JACK JANASIEWICZ: Yeah, and I think that's fair because when you look at deconstructing the UK deal, I don't think there was really much to that, so to speak. So we've also heard from Trump-- tariffs are not only a negotiation tool, but a revenue raise. So maybe we should be taking his word for it. So coming back to a baseline tariff rate across the board of 10% as a revenue raise going forward. Maybe that should be somewhat of our baseline projections going forward.

But regardless, I think 10% tariff rate is certainly something that corporate America could work with. I'm sure you'll see some companies-- and again, keep in mind, we're coming from record margins here. So there is some room for companies to absorb some of that. But there'll be some sharing of that tariff costs passed on to the consumer, eaten by the margins on the corporate front. And maybe the suppliers eat some of that, as well. So maybe the 10% sticker shock doesn't get immediately absorbed by one person in here.

But point being is I think 10% is at least manageable. And I think once we get that cloud of uncertainty removed and we actually know it's 10% and we can move forward from there, that, in itself, should be a net positive, I think, for the market, as well.

BRIAN HESS: Yeah, 10% is a lot more manageable to split three ways. So the producer takes a piece, the retailer takes a piece in that sort of situation, and then the consumer maybe gets a bit of a price increase. But if you're talking about a 3.3% price increase on simply goods imports, that's not nearly as inflationary as the risks of 145% tariff on Chinese imports, or even some of the numbers we saw on Liberation Day.

So that brings me to the Fed, which, we also got a Fed meeting last week, the May meeting, where not a lot happened. But Chairman Powell was reluctant to commit to anything and essentially said that he needs more information on trade policy before the Fed is willing to act. But they did highlight that the current situation presents the possibility of both increasing inflation and increasing unemployment rate, which would be the last combination the Fed wanted to see because it would be hard for them to decide, do we ease policy and try to target the weakening in the labor market, or do we have to just really stick to the line on inflation, given that inflation is above target? 

So what were your takeaways from that Fed meeting? And how do you feel about market pricing where, as of this morning, I believe we're looking for two cuts this year starting probably in September. How do you see that?

JACK JANASIEWICZ: Yeah. And I think it was sort of status quo from the meeting as well as the press conference afterwards. And so again, waiting for data. And that's something that they've been pretty consistent with saying for quite some time. And so they're waiting. They're pausing. They want to see how the tariff potentially rolls their way through the economy, whether it is inflationary or whether we begin to see a slowing and you actually get demand destruction there.

So again, on hold, we had sort of thought that July would maybe be the live meeting. Maybe you get a little bit of a setup in June where they hint that there's a potential easing coming. But I don't think the market's really that far off from where it's pricing with two cuts between now and the end of the year. So again, it's going to be the data comes to the Fed. And as a result, the Fed is just going to wait and see in the interim.

So, certainly, we've never been of the camp that the Fed would come and ride to the rescue of the market. It was basically going to let things play out, and that's still-- I don't think has changed.

BRIAN HESS: Yeah, it's hard to have major disagreements with market pricing for two cuts. There are a lot of banks that have been saying all year long they thought the Fed would be on hold because inflation is above target. But we have had this view that the economy was slowing coming into the tariffs, which I'm about to get into. So if that's the case and we continue to get a slowdown, while at the same time tariffs are rolled back to something like 10%, it just seems like that frees up the Fed's hand to be able to ease a lot more so than some of the more punitive tariff levels.

JACK JANASIEWICZ: And I think that that's our base case scenario. Coming in, we expected slowing growth. We always said, though, that we were slowing from an elevated level. So at least maybe you'd be slowing something close to trend. And maybe the market would over extrapolate that into a growth scare. And as a result, the Fed would probably begin to ease at that point and actually create for a good setup. Maybe the timing that's been pushed out a little bit. But I think that's still our base case here, where the economic data is slowing. And the one that we continue to point to is the labor market.

The labor market is showing signs of slowing. You're seeing job ads slow. And you're also seeing wages coming down, which should translate into less consumption, with consumption driving roughly 70% of the growth backdrop in the US. It's not surprising that labor market easing should translate into a slowing economy. And as a result, probably does free up the Fed to start to maybe shift their focus away from the inflation backdrop and a little bit more on the labor side of that mandate and, as a result, more apt to probably cut rates as the economy and, more specifically, the labor market starts to really show some market slowing in there.

BRIAN HESS: And if the labor market weakens like you're expecting, that should, as you say, contain wages, which has a strong correlation with core services. And that's been a little bit of a sticky part of the inflation picture. So that could help for the Fed, as well. Now, our view coming into the year was that we would see a slowdown in the economy. You highlighted the consumer nature of it.

The other thing is that last year, consumption ran well ahead of income growth. So there was a drawing down of savings. And we're thinking savings rate has already hit a level. It doesn't typically go below. Yet at the same time, there's high uncertainty. That's not an environment where you'd expect the savings rate to dip much further. So by that math, it suggests that consumption will be driven by income growth, which you've highlighted is slowing thanks to the labor market and job creation.

The other thing is that with interest rates where they are-- and if the Fed cuts two times, that's probably not hugely game changing for the bond market-- that the housing market is just-- it doesn't seem to be working. At least the existing housing market, there's no turnover. So we've had that. Manufacturing has been held back now because of the uncertainty on tariffs. So we've seen the PMIs roll over.

So we've lost a lot of engines. And even on the fiscal side, state and local governments facing cutbacks, DOGE has weighed on federal spending. Maybe we've got some interesting tax stuff going on, but that's a second half story. So when we looked at the economy and broke it down into all of these different sectors, we thought it was pretty clear we were headed for a slowdown.

But we were also pretty clear that we didn't see a recession as likely. And we pointed to the fact that since the third quarter of 2022, real GDP growth has averaged something like 2.9% for 10 quarters in a row, which was a really solid growth rate. So we thought slowing, but we have enough margin for error. Fast forward past the Liberation Day, and you did put out a note a couple of weeks ago where we're now more open minded to the idea that we might have to experience a recession at some point this year, albeit probably a mild one. 

So can you talk through the change in mindset? What catalyzed the move to recession possibilities, and why do you think it could be mild?

JACK JANASIEWICZ: I think the key is differentiating the definitions of recession. And to your point, we've sort of been putting it into three categories-- severe and average and a mild recession. And when you go back in history and you look at those data points, you can think of something like 2007 and maybe Japan in the early 1990s from a balance sheet recession. And that's what typically falls under that severe recession backdrop. And it's ultimately balance sheet recession, you have the risk of basically being overleveraged.

As things start to slow down, your ability to make those payments to meet those obligations starts to fall, and you get the potential for defaults. And so you can see how that filters its way through the economy. And the problem with that is it takes some time to work your way through that sort of restructuring of those debts. And as a result, you have more money being focused on repaying debts, restructuring the liabilities as opposed to savings, so that when we start to reaccelerate on the other side, you have more consumption shift.

That stuff is really not present there. And also, it makes it a little bit harder for Fed cuts to step in. So those sort of issues tend to draw out and make these sort of things a lot deeper. And when we look at the balance sheets from both the corporate side as well as the household side, they're still in pretty good shape. We look at things like interest coverage ratios from the bond market. And those are still very strong. They're still above the longer-term trends.

You look at the household balance sheet side, and I know a lot of people will focus only on the liability side of the equation, but it's also the asset side that matters because that's your ability to make those payments. And the asset side has really become a lot stronger over the last couple of years.

BRIAN HESS: Stocks plus housing.

JACK JANASIEWICZ: Exactly, 100%. And so the household balance sheet has really never been better in the last 15 or 20 years when you look at it from that asset-to-liability perspective. So that sort of rules out that severe recession. And for us—

BRIAN HESS: Not looking for the debt to leveraging, balance sheet type recession.

JACK JANASIEWICZ: Exactly. And then for us, the more mild case, I think, is simply that we could get a technical recession from the definition of what the NBER does for recession. But we think it's also going to be shallow enough because the balance sheets are in such good shape. And I think we're going to see the potential for slowing on the labor front, but not necessarily seeing a ton of layoffs, either. So we might see the unemployment rate drift up again, but not to a point where you're going to basically have a significant cutback in terms of job losses and, as a result, that loss of consumption.

So from that perspective, we think it's going to be somewhat shallow. And when we look at the historicals with shallow recessions, that sometimes can also mean you actually have earnings that still continue to grow even though you have the economic definition of a recession. And that backdrop is what it feels like today. And we usually get about a 20% earnings or a 20% price correction when we get the mild recession.

And if you look at where we were at the bottom of the correction going all the way up to April 8, we were at about a 20% correction. So you're sort of, at that point, pricing in that mild recession backdrop. And that's kind of where we are in terms of how we think about slowing, slowing from a higher level. Balance sheets are in pretty good shape, whether it's from the corporate side or the household side. So a lot of this, again, adds up to if we do have a recession-- it's not our base case-- if we do have a recession, it's a mild recession.

BRIAN HESS: Yeah, that makes sense. When we look at the economy, we don't see major imbalances in too many places, definitely not in the household sector. And keep in mind, there was a major deleveraging there after the GFC. So if you look at 2009, 2010, 2011, household debt, they delevered. Consumption was really weak in the early days of that recovery. So we got through that.

JACK JANASIEWICZ: And the other thing, maybe, just to highlight, as well, is as the economy slows, the Fed's more apt to cut. I think we have a little bit of a confidence overhang. So I think if you get a little bit, the signaling effect of the Fed cutting, maybe that does inject a little bit more greater confidence back into both the business sector and the household sector. And as a result, as that confidence starts to come back, then you start to see things picking back up again. 

So the other difference here is that the Fed can cut, and that probably has a better impact, a much timelier impact with a milder recession than something like the balance sheet recession that we were just talking about.

BRIAN HESS: Yeah, they shouldn't be pushing on a string like they can be when people are trying to pay down debt as opposed to—

JACK JANASIEWICZ: That's the key difference here.

BRIAN HESS: The one imbalance-- and you actually mentioned this yesterday in one of our meetings-- but the one imbalance in the economy, though, is the US budget deficit. So it will be interesting to see if we have a recession where, presumably, tax revenues would fall and transfer payments would rise, what happens there and if that puts pressure on the bond market. We don't need to get into that in too much depth today. I think that's probably a story for another day. But that is the one area I don't want to just paper over it, because there is an imbalance in the economy.

JACK JANASIEWICZ: And if we are thinking about what is the key risk on the horizon, maybe it's not tariffs, but it's actually the reconciliation process here in terms of the budget. Because trying to come up with these payfors, they're struggling. And the issue, I think, is that when you go through the dynamic scoring, you can make these numbers work. But how real are those numbers in the dynamic scoring? And the risk to me is that the bond market sort of sees that we're playing maybe the old shell game here in terms of making numbers fit. And as a result, it just, basically to the bond market, looks like we're just widening the fiscal deficit out. And then how does the bond market react to that?

So we could see a backup in yields. And how does the stock market react to that?

BRIAN HESS: And then the Fed's forced to defend the bond market. So they can't cut as much. That would be a risk scenario.

JACK JANASIEWICZ: Exactly. Yep.

BRIAN HESS: All right, now let's transition to the actual portfolios. We run model portfolios here. And asset allocation is the main goal there. And we recently made a trade which was maybe a little bit surprising to some clients. But we purchased Chinese stocks. We purchased the ETF FXI, which are eight shares, Chinese companies traded in Hong Kong. And I just wanted to talk through the thesis behind that position, what made us move into China at a time when there's this trade war going on.

JACK JANASIEWICZ: It really comes up-- it comes back to the idea of the skew here. And the way we were thinking about it is, who has more room to maneuver in terms of trying to negotiate through the potential economic ramifications of a trade war that continues to proliferate and continue to drag on in here? And think about it from a perspective of the fiscal side. Who can really stimulate from a fiscal perspective, whether it be government spending, transfer payments, handouts, whatever that may be? The Chinese are probably in a much better situation than the US is.

And then even from a monetary policy perspective, we could see cuts in rates, whether it be the required ratios, the required reserve ratios there, or just lending rates, whatever it could be. China's still in position to make that sort of a loosening, if you will, whereas the Fed's probably still caught with their handcuffs on.

So when you look at the potential support for Chinese equities, there certainly was much more of a catalyst from both the fiscal and monetary policy side relative to that in the US on top of the Chinese nationals being able to basically step in and actually buy stocks, as well. So we felt like that would give the Chinese equities at least support if this were to continue to drag out. And on the flip side, if we actually get a resolution, both sides, both US equities and Chinese equities, would rally on the back of that. So that skew, I think, was much more in favor of Chinese equities, and hence the swap that we had put on to add some Chinese exposure in here.

BRIAN HESS: Yeah. It seems like China has-- they have fiscal space. They have monetary space. And they have the regulatory tool, which they haven't been shy to utilize, encouraging through moral suasion or even mandating that entities within China buy the stocks to help support the market. So it's nice to have that buyer underneath you providing a floor.

JACK JANASIEWICZ: Exactly.

BRIAN HESS: OK. Makes sense. Now, with that trade, we went back to basically neutral or even slightly overweight emerging markets depending on the model. But with stocks overall, we're still modestly underweight. And so I thought we could talk through how we're thinking about, I guess, the direction of where we'd move next. Are we more likely to add risk, given everything that's happened since the beginning of April, or reduce risk? We've had a rally in recovery, in large part. And then where do we think we would look to make any changes? So we're currently neutral to slightly overweight US equities, I just mentioned, were basically neutral, slightly overweight EM. And our big underweight is in Europe.

JACK JANASIEWICZ: Yep. So I think-- let's be clear on the first one. Our base case scenario is still that we have less than a 50% chance that we do slip into a mild recession. So we're still favoring a non-recession backdrop over a relative mild recession. And I think to summarize that, we're probably looking more at potential opportunities to add risk in here as opposed to sell.

Now, one of the things that may be in the interim that we need to think about is simply, can we continue to grind higher from here? And one of the things that makes us a little bit, I think, hesitant is simply the confidence overhang being one of them until we finally get clarity on whether it be the trade front policy with regard to the Fed. You're still going to have that uncertainty overhang. And that could potentially weigh on the economic backdrop.

And then obviously, the second one, which we talked about at the beginning of this podcast, was just the economy is slowing. And I think there could be a risk here that the market is confusing some of the slowing backdrop by lumping it really all into tariff issues. We would maybe split that out. You have tariff issues. But you also have a slowing economy and really from the labor market stuff that we just talked about.

So maybe we get some resolution on the tariff front, but that still doesn't really clear up the slowing on the labor front side. And as a result, we could still see the economy slowing. And maybe that still poses a headwind, at least in the near term. Because the market runaway to the upside here, we're still a little bit skeptical. But having said that, if we do get any sort of retracing of this recent retracement, if you will, I think we're more apt to look to add risk rather than sell.

So again, skew, maybe at this level we're going to wait. We expect maybe a little bit of a pullback in here. But we're, again, looking to probably add on weakness, as opposed to sell on strength.

BRIAN HESS: So we're still in the mindset of looking for a range trade for the most part because you do have these countervailing forces. I mean, the tariff news more recently has been positive, but there still is a lot of uncertainty. And against the backdrop of a slowing economy, that makes it hard for the S&P to just blast back to new highs, and certainly makes it hard for small caps or mid-caps to do that, given their greater economic sensitivity.

Which brings me to my last question. When we think about de-risking, we're leaning US, probably, would be my guess, and large caps over small caps for the time being. Is that how you're thinking we play it?

JACK JANASIEWICZ: 100%. 

BRIAN HESS: We're not committing to anything. We can change our minds. But how are you seeing it today?

JACK JANASIEWICZ: Yeah, and I think that's how we're thinking about, as well. What's the most beaten down area? And what's the area that has probably the more upside in here is maybe we start to get a little bit more clarity on all these fronts and hedges we just talked about. It's probably the US market.

And so as a result, still want to favor US. Probably still want to favor up in cap. And tech is the growth engine. So you probably want to lean towards the growth side of the equation here. So keeping an eye on US large cap as a potential target to add risk back in, any weakness in here.

BRIAN HESS: Sounds good. OK, thanks, Jack. Good discussion. I look forward to seeing what the next month brings us.

JACK JANASIEWICZ: Can't wait. Thanks, Brian.

BRIAN HESS: Take care.