US economy shrugs off trade war and soldiers on

The U.S. economy has shown unexpected resilience against initial trade war fears, with the S&P 500 reaching record highs, as investors are relieved that worst-case tariff scenarios have not materialized and policy predictability has improved. While President Trump significantly scaled back initial tariff threats, and business investment and job growth continued, recent data indicates notable weakening in consumer spending, particularly in discretionary categories, and a softening labor market. Despite a reduced recession probability and the Fed noting limited tariff-driven inflation so far, the average U.S. tariff remains historically high, and new threats persist, posing future inflation risks and challenging the outlook, especially given projected lower GDP growth and declining S&P 500 consumer discretionary earnings.

Analysis

The U.S. economy and equity markets are exhibiting a significant divergence, with the S&P 500 reaching a record high while underlying economic fundamentals show clear signs of deceleration. Investor sentiment has improved primarily due to relief that President Trump's most severe tariff threats have not been fully enacted, reducing the perceived risk of a near-term recession; JPMorgan Chase has lowered its recession probability from 60% in April to approximately one-third. Despite this, the average U.S. tariff now stands at a historically elevated 18.8%, and the economic impact is becoming apparent. S&P Global forecasts annualized GDP growth will slow to 0.8% in the first half of 2025, a sharp drop from 2.5% in 2024. The primary concern is the consumer, as inflation-adjusted consumption fell 0.3% in May, and Wall Street analysts now project a 5.1% year-over-year decline in Q2 earnings for S&P 500 consumer discretionary companies. While business investment has remained resilient and the Federal Reserve has signaled a potential rate cut, renewed trade tensions with Canada and the looming July 9 tariff deadline present ongoing risks that could exacerbate inflation, which Morningstar projects will rise to 3.2% by early 2026.

Key Decisions for Investors

• Investors should exercise caution regarding the divergence between the record-high S&P 500 and weakening economic fundamentals, particularly the sharp forecast deceleration in GDP growth to 0.8%.
• Consider reducing exposure to the consumer discretionary sector, as data shows a 0.3% contraction in May's inflation-adjusted consumption and analysts forecast a 5.1% earnings decline for the sector in the second quarter.
• Closely monitor trade policy developments, as the July 9 tariff deadline and recently broken-off talks with Canada represent significant near-term catalysts that could reintroduce market volatility and inflation risk.
• Anticipate potential Federal Reserve rate cuts as a response to economic softening, which could support equity valuations but also confirms underlying weakness in the labor market and consumer spending.