This week, after a very busy few months, I am putting down my pen, picking up my metaphorical spade and bucket and taking some vacation time. 2025, so far, has been a challenging year for analysts and it is tempting, as I’m trying to clear my desk, to assert that not much has changed over the past few weeks and so I don’t need to update any analysis of federal government policy, the economy and markets. However, the reality is that events in Washington and on Wall Street over just the last two weeks do require a reassessment.
First the good news: On Friday, the S&P 500 rose 0.7%, continuing a remarkable run that has seen a 19.6% rally in less than six weeks, taking the index from the brink of a bear market to a 1.3% year-to-date gain. Meanwhile, long-term interest rates are very close to their levels of the start of the year while the dollar has seen an 8% year-to-date decline.
The primary reason for the recent equity rally has been a relaxation in the administration’s tariff policies from the extreme announcements of April 2nd and the days thereafter. However, the market has also been bolstered by strong first-quarter earnings, resilient hard economic data and the fiscal stimulus embedded in the reconciliation bill that is taking shape in Congress.
All of this being said, there are important reasons for investors to remain cautious.
First, even with recent concessions, tariffs are much higher than at the start of the year. This, along with sharply falling immigration and government spending cuts, will likely drag on both supply and demand, dampening economic growth.
Second, while hard economic data look OK for now, some of this may just reflect lagged effects, maintaining the prospect of slower growth and higher inflation in the months to come.
Third, as the reconciliation bill takes shape, it is becoming more obvious that it cannot provide fiscal stimulus to a soggy economy without further worsening an already alarming deficit trajectory. This reality may impede its passage and limits any potential benefits it might have had for U.S. stocks and bonds. Meanwhile, the Federal Reserve has little incentive to resume rate cuts while policies on the other side of Washington look like they will push inflation higher.
Where Things Stand: On Tariffs
After last weekend’s agreement with China, average U.S. tariff rates have fallen sharply. In the broadest terms, while most countries face a 10% universal tariff, the basic rate on Chinese imports is 30% while Canada and Mexico face much lower average tariff rates since most goods being covered by the USMCA. In addition to this, the administration has imposed further tariffs on imported autos, auto parts, steel and aluminum.
We estimate that this still leaves the average tariff rate at 13.3%, with the pauses on so-called reciprocal tariffs and higher Chinese tariffs due to expire in early July and early August, respectively. All of this still has the potential to increase prices and slow economic growth, while tariff uncertainty could still cause businesses to slow hiring and capital spending.
Where Things Stand: On Immigration
Data continue to show the administration’s success in curtailing unauthorized immigration with migrant encounters at the southern border averaging 12,000 per month between February and April compared to 100,000 per month in the fourth quarter of 2024 and 250,000 per month in the fourth quarter of 2023.
The administration has had less success in expelling resident unauthorized immigrants, with ICE reporting 66,000 deportations in the President’s first 100 days in office. This pace would imply 241,000 per year – far short of the President’s 1,000,000 deportation goal. However, the administration is ramping up its efforts, including reassigning FBI and other justice department agents and requesting the use of 20,000 national guard members to help with immigration enforcement. In addition, the reconciliation bill taking shape in Congress includes huge increases in funding for the arrest, detention and removal of unauthorized immigrants.
We do not have good data on how administration policies are impacting traditional visa issuance – the State Department has apparently stopped publishing monthly numbers, with February representing the latest data. However, if this number falls substantially from last year’s 670,000, the U.S. could see net migration fall to just a few hundred thousand, implying a declining working-age population and a falling labor force.
Where Things Stand: On Government Cutbacks
The last few weeks have seen less progress on reducing the federal workforce. According to the New York Times1, between buyouts and planned and implemented cuts, federal government employment should decline by 280,000 this year. However, between January and April, federal jobs had only fallen by 26,000, while weekly jobless claims show no recent surge from laid-off federal employees. That being said, payroll reductions should accelerate over the next few months and we expect federal government jobs to fall by at least 250,000 in 2025.
Spending cutbacks, of course, extend far beyond federal layoffs, with DOGE claiming that it has already saved $170 billion through asset sales, labor force reductions and the cancellation of contracts, leases and grants2. Media reports suggest that these numbers are over-stated3. Nevertheless, reductions in federal funding are having an impact and many organizations may be reluctant to hire in the face of these cutbacks or other cutbacks currently being contemplated as part of the reconciliation bill.
In addition, as noted by our investment bank colleagues4, the resumption of credit reporting and collections on student loans could cut credit availability and reduce discretionary income for those with overdue balances, adding a further drag to consumer spending.
Where Things Stand: On Taxes
Policy changes on tariffs, immigration and government spending will continue to impact the investment environment. However, at this stage, the single biggest policy issue for markets is the omnibus reconciliation bill that has embarked on its journey to the President’s desk.
The bill has started to take shape in the House of Representatives. In April, by a vote of 216 to 214, the House passed a budget resolution as amended by the Senate. While the negotiations between House and Senate are complicated, this resolution essentially authorized up to $4.0 trillion in tax cuts between 2025 and 2034, to be partially financed by $1.5 trillion in spending cuts, with a promise that further tax cuts would be paid for by further spending cuts.
At the time, we believed that the eventual bill would probably include a fair dollop of fiscal stimulus and this certainly is true of the bill as it currently stands. In particular, tax provisions approved by the House Ways and Means Committee last Wednesday would increase the budget deficit by $481 billion in fiscal 2026 and $590 billion in fiscal 2027 but by just $242 billion in fiscal 20315. Why? Because many of the tax cuts proposed, including eliminating income taxes on tips and overtime, increasing the standard deduction, adding a new $4,000 benefit for senior citizens, allowing for the deductibility of auto loan interest and enhanced depreciation of equipment and R&D spending are designed to only be in force from calendar 2025 to 2028.
This has the budgetary advantage of allowing 10 years of spending cuts to partially finance four years of tax cuts. No doubt, as has been the case with the 2017 tax cuts, there would be a move to extend these tax cuts beyond 2028, once that date came into view, with politicians arguing that their expiration would then represent a cruel and deflationary tax increase.
However, the introduction of temporary tax cuts that somehow become permanent is a major reason for our budget imbalance. In fiscal 2016, before the TCJA tax cuts, the federal deficit was $585 billion, or 3.1% of GDP. By fiscal 2019, after they were enacted, the deficit had jumped to $984 billion or 4.6% of GDP. Last year, the deficit was $1.833 trillion or 6.4% of GDP and, we estimate that the reconciliation bill, as it now stands, would boost that to roughly $2.3 trillion or 6.7% of GDP by fiscal 2028, even with tariff revenue and promised spending cuts and even if the economy avoided recession.
By making many of these provisions retroactive to the start of this year, the bill would set up an bumper income tax refund season for early 2026, just in time to boost economic activity ahead of the mid-term elections. It should also be noted that the bill is not as positive for equities as some had hoped since, while there are plenty of corporate tax breaks in the bill, it does not, at this stage, include the President’s promise to cut the corporate income tax rate on domestic production from 21% to 15%.
This sets up two uncomfortable scenarios for markets. If the bill passes in roughly its current form, the Fed will have no incentive to provide further rate cuts. Inflation, which will temporarily rise this year due to tariffs, would then get extended next year due to fiscal stimulus. In addition, long-term interest rates could well drift up due to the rising borrowing needs of the federal government and the psychological impact on markets of further evidence that Washington has no intention of tackling the nation’s worsening debt problem, a view already reflected in last Friday’s downgrade of U.S. debt by Moody’s.
The other possibility, of course, is that the bill simply doesn’t pass in its current form. While the House Ways and Means Committee approved the tax provisions of the bill on Wednesday, the House Budget Committee voted against advancing the broader bill on Friday before being cajoled into doing so on Sunday with some promised hawkish adjustments. Presuming that the bill does make it onto the House floor this week, further concessions will likely be needed to increase SALT deductions to appease Republicans from New York and California, before negotiations begin with the Senate.
Still, we expect the bill to pass, both because of the economic and consequently political, consequences of its failure and because of the debt ceiling.
The debt ceiling, which had been suspended since 2023, came back into force on January 1st, 2025 at the then level of the debt, namely $36.1 trillion. Because Treasury had borrowed in advance of this event, the government has been able to whittle down cash balances and use other accounting tricks to prevent default to this point. The Bipartisan Policy Center projects that these measures can further postpone default until sometime between early August and October6.
A proposed $4.0 trillion increase to the debt ceiling is included in the reconciliation bill, and this increase will need to be passed either as part of the reconciliation bill or as a stand-alone measure. However, due to Senate rules, a stand-alone bill on the debt ceiling would likely require Democratic acquiescence and, therefore, concessions to the Democrats that the Republicans would like to avoid. Consequently, the President will likely get his “One Beautiful Bill” this summer.
Where Things Stand: On the Economy and the Fed
While consumer and business confidence has clearly been rattled by the tariff turmoil, hard economic data have remained relatively resilient. That being said, last week’s reports showed some softness in consumer and business sentiment, as well as home-building activity. The week ahead should see further confirmation of this weakness, with investors paying particularly close attention to numbers on unemployment claims.
After a 0.3% decline in the first quarter, we expect falling imports to lead to a slight gain in real GDP in the second quarter with a potential relapse in the third. In broad terms, we expect to see real GDP rise by less than 1% annualized over the first three quarters of the year, representing very slow growth but not quite recession. We then think the pace of economic activity will accelerate in the fourth quarter and the first half of 2026 as fiscal stimulus kicks in.
Monthly payroll job gains could well fall to 100,000 or lower for the rest of the year. However, with labor force growth severely constrained by lower immigration, the unemployment rate may only rise to 4.5% from its current 4.2% by the end of the year.
After benign data in April, inflation will likely pick up, and we expect the year-over-year gain in the consumption deflator to be close to 3.5% by the fourth quarter, boosted by higher tariffs and fiscal stimulus. Meanwhile, corporate profit growth should slide, but remain positive, following a 13.2% year-over-year gain in S&P500 pro-forma earnings in the first quarter.
At his last FOMC press conference, Jay Powell made it clear that, if a tension emerged between its inflation and employment goals, the Fed would look at how far the economy was from those goals and how long it might take to achieve them. In their March Summary of Economic Projections, FOMC participants said that they expected, in the long run and under appropriate monetary policy, that the unemployment rate would be 4.2% and that consumption deflator inflation would be 2.0%. It now looks like the Fed will be further above its inflation target than its unemployment target by the end of the year, with fiscal stimulus and supply constraints likely to maintain this situation into 2026. This being the case, we may only see one rate cut, if any, by the end of 2025 and little or no change in 2026.
Investment Implications
While many questions remain, the uncertainty surrounding federal government policy is beginning to diminish. In its wake, it is revealing a landscape of higher tariffs, lower immigration and cuts to federal spending, all of which threaten to diminish economic growth. However, it now appears more likely that a moderation in tariffs, combined with fiscal stimulus, will allow the economy avoid near-term recession.
That being said, these policies, on net, look likely to diminish the long-run growth rate of the U.S. economy, increase budget deficits and modestly raise inflation. As such, they suggest slower-growing corporate profits and higher interest rates, a dangerous combination, particularly for highly-valued mega-cap U.S. equities. To the extent this hurts the performance of U.S. assets, it could also lead to a further decline in the U.S. dollar.
For investors, the message is clear. While the policy storm is winding down, the impact of government policies on the financial environment points to the need for greater diversification into value equities, fixed income, alternatives and international equities.