Expect the Expected

Recent labor market data affirm that the key to U.S. economic resilience remains well in place. With the jobs market healthy, household incomes are supportive of continued growth in consumer spending. On the inflation front, the outlook is murky, with recent data indicating a potential upswing in goods inflation. Disinflation (and in some areas, outright deflation) in goods has been an important contributor to the overall decline in inflation, so a reversal here may be a function of increased costs associated with tariffs. The threat of a resurgence in inflation remains a key risk. Some substantial unknowns, however, have been mitigated recently, as the passage of the One Big Beautiful Bill included a $5T increase in the debt ceiling, effectively delaying debate on the contentious issue for one or two years. 

Tariff uncertainty remains a substantial risk. Reciprocal tariffs remain in play, and major trade deals have yet to be finalized. The new deadline of August 1 is looming, while the deadline for a deal with China is set for August 15. We have become accustomed to this “trade can” being kicked down the road, however, and there is little reason to conclude that these are hard deadlines. In short, uncertainty will continue. As noted, economists and investors alike have taken solace in the negotiations, concluding that the worst-case scenario unveiled on Liberation Day will not take place. Yes, tariffs will be higher than January 2025 levels — but, ultimately, the level will be manageable, and the impact likely split among importers, exporters and consumers. That said, we have yet to feel the impact of the tariffs in place, and the true extent of the consequences will be felt with a lag.

The longer duration U.S. Treasury market is not faring well in 2025, with the rise in yields creating a difficult headwind. Higher longer-term yields reflect a decline in the probability assigned to recession, increased uncertainty on the inflation outlook, and likely an increased degree of uncertainty related to the fiscal health of the U.S. balance sheet — particularly with the passage of the recent tax bill. The rise in longer-term yields is not just a U.S. phenomenon, however, with dramatically higher yields seen across much of the developed world, potentially signaling a broad-based reluctance on the part of bond investors to continue to fund profligate spending. It is too early to conclude that bond investors will revolt en masse, but we will be watching carefully.

Financial markets have absorbed numerous shocks in 2025, and today reflect what many view as complacency. Corporate credit spreads have reverted back to near their 2025 lows; market volatility as reflected in the VIX has fallen back to pre-Liberation Day levels; investor sentiment has recovered significantly from the “uber-bearish” stance held earlier this year; and, certainly, valuations in U.S. equity markets reflect optimism.

While we remain constructive on risk assets, we note that there are risks that may not be fully reflected in financial markets today. For example, we do not know the ultimate impact of higher tariffs on either growth or inflation, and uncertainty remains regarding the ultimate impact on corporate revenues and profit margins. We do not know the path of monetary policy in the U.S., muddied by public disagreements across the FOMC as well as the White House — and there is a concern that the Fed could hold the policy rate too high for too long, leaving the U.S. economy vulnerable to a more protracted slowdown. In short, the future remains uncertain. We would anticipate that market complacency may be short lived, and investors should expect bouts of volatility as we manage through 2025. We do not, and will not, react to market volatility, but it is worth reminding investors that this is a “feature, not a bug” of a fully functional market. Expect the expected.