Loomis, Sayles & Co. Core Plus Bond, Co-Manager Rick Raczkowski
We are certainly living in interesting times. The tariffs imposed on April 2nd turned out to be bigger and bolder than the markets, and frankly what we were expecting. And in our view, that's going to have some pretty significant consequences for the US economy in the near term, if nothing changes on the tariff front. In fact, we were already seeing signs of a stall in the economy during Q1. Consumer and business confidence had started to weaken, largely due to policy uncertainty. And on top of that, government spending had slowed. So the economic backdrop was already shaky before the full impact of tariffs even hit.
Looking ahead, it's tough to say exactly how this plays out because a lot depends on if and when these tariffs get rolled back and also what the potential retaliation from our trading partners could look like. And to be honest, we don't have a great historical roadmap here. None of us have seen tariff increases of this scale. So there's a lot of uncertainty around how it will work. For example, how much of the tariff costs gets passed on to consumers versus absorbed by producers or retailers?
Is stagflation back?
Depending on the percentage changes after negotiations are finalized, our view is that we could see a stagflation-like environment during the tariff phase in. But we don't believe this will be persistent. And in any event, we certainly will not be going back to the 1970s, when the US suffered double-digit inflation and unemployment rates. We just don't think the current economy can sustain that kind of long-term inflation.
Tariffs act like a tax on consumers. They reduce real income and purchasing power. And we were already seeing wages and income growth start to cool before the tariff announcements. The expected hit to real incomes is likely to dampen consumer spending, which in turn should limit how much inflation takes hold in the broader economy. But in the near term, there’s little doubt inflation's going higher, and growth is slowing.
That really puts the Fed in a tough spot. Because I think in a perfect world, the Fed might want to look past a short-term inflation bump from tariffs. But that's a hard ask when inflation's already above their 2% target and likely moving higher. One thing is for sure, the Fed does not want to let inflation expectations take hold. So unless we see a sharp economic downturn or a spike in unemployment, certainly both plausible, but something we're not forecasting right now, it's going to be tough for the Fed to start cutting rates aggressively. And that, in our view, raises the risk that the Fed may keep rates elevated longer than is ideal. So in short, there are a lot of moving parts. We're going to have to wait and see how these tariffs evolve.
Do you see consumer and corporate health deteriorating?
Given what we know about tariffs, we expect credit conditions could get worse, both for consumers and businesses. In our view, tariffs are basically taxes. They tend to push up inflation, while slowing down growth. And that combination is likely to pressure household budgets and company balance sheets, leading to more stress.
The silver lining is that prior to these tariff announcements overall credit health, both for consumers and companies, was in decent shape, albeit with some cracks in the foundations that bear watching. One theme that has been consistent for both consumers and businesses is a divide between the haves and the have nots. On the consumer front, balance sheets look strong overall, and debt levels are relatively low. But that's mostly thanks to wealthier households. The top 10% of earners now make up about 50% of total consumer spending, which is a record. And that group has been able to lock in low mortgage rates and have benefited from rising stock and home prices. But here is the issue: That also means they're more exposed if asset prices, especially stocks, take a hit. And that's of course what's been happening and poses a risk to spending going forward.
Lower-income households, on the other hand, aren't as tied to the stock market. But they're feeling inflation and rising interest rates more acutely. And tariffs mean a loss of purchasing power there. Many lower-income households have floating-rate debt and were already seeing signs of strain, like rising delinquencies on credit cards and auto loans. So far, strong unemployment has helped cushion the blow to these households, but any weakness in the job market could change that fast. On the corporate credit side, similar story. Big investment-grade and high-yield firms took advantage of low rates in 2020 and locked in cheap, long-term debt. On the investment-grade side, credit ratings have been actually improving. We've been seeing more upgrades than downgrades, and default rates for high-yield bonds are still low. In fact, we've seen more companies move up from high yield to investment grade than the other way around.
But investment grade and high yield companies, they're not immune to a potential global slowdown. And under that scenario, which is looking more likely, we should expect credit deterioration. But because the underlying fundamentals were starting from such a strong position, it could limit the impact of spread widening. Where it gets shakier is with mid-size companies that rely on floating-rate bank loans. They're much more sensitive to rising inflation and slowing growth. Default rates have been rising in that part of the market. And it's an area to keep an eye on if a tariff-led, stagflation-type environment becomes more of a reality.