Tariff fears have heightened investor concerns about a potential U.S. economic recession. Tariffs are not the only stressor—rising job-cut announcements and shifts in stock market leadership toward more-defensive sectors also reflect cracks under the economy's surface. Declining Treasury bond yields—which move inversely to bond prices—indicate that investors have become more worried about long-term economic growth than about short-term inflation and are seeking the traditional perceived safe haven of Treasuries. Meanwhile, economic data has exceeded expectations this year in Europe while missing expectations in the United States, and stock indexes for economies such as Germany—like the MSCI Germany Index—are up by double digits while the S&P 500 is currently in negative territory year to date, according to MSCI and S&P Dow Jones Indices as of March 10, 2025.
Will the U.S. slip into a recession? We don't know. But there are worrisome signals and we're keeping an eye on them.
U.S. stocks and economy: Recession risk rising?
U.S. recession chatter has picked up lately for many reasons—not least the uncertainty created by policy announcements coming from Washington. Central to this is tariff and trade policy, which seemingly changes by the day in terms of which countries' imports are targeted and by how much. Adding to stress is that the United States is targeting large, key partners like Mexico and Canada—countries to which U.S. companies have a ton of exposure.
Concern over higher tariff rates has already led to a massive pull-forward in consumer purchases of imported goods. As shown in the chart below, the Atlanta Federal Reserve's GDPNow model is currently down to -2.4%—meaning thus far, data for the first quarter of 2025 indicate a 2.4% annualized quarterly decline. Most of that weakness is being driven by the net exports component, given imports have recently surged relative to exports—again likely reflecting consumers ramping up their purchases in advance of higher tariffs.
It should be noted and emphasized that the GDPNow model is a nowcast, not a forecast, which means the -2.4% estimate is by no means a guarantee. It is also subject to change and will continue to do so as data for the quarter come in.
Importantly, there isn't a large drop-off expected for consumer spending or business investment in the first quarter. That means underlying demand likely remained strong. However, there are still areas of stress that indicate some cracks under the economy's surface are widening. One of those cracks is the recent spike in job-cut announcements. Announcements of job cuts soared to nearly 173,000 in February, according to data from executive outplacement firm Challenger, Gray, & Christmas. As you can see in the chart below, that is a new high for the current cycle and consistent with prior recessions. Most of the increase in announcements was driven by the government and nonprofit sectors, reflecting the impact from the Department of Government Efficiency's goal in reducing the federal workforce swiftly.
Increased recession fears have been reflected in stock market leadership. Over the past year, the S&P 500 Consumer Discretionary sector is now underperforming the S&P 500 Consumer Staples sector, as shown in the chart below. To be sure, the decline in Consumer Discretionary has been disproportionately driven by its second-largest member, Tesla, but even when looking at the sectors on an equal-weighted basis, Consumer Staples has fared better. Consumer staples include needed items people usually continue to buy even in a recession, such as food, detergent and toothpaste. On the other hand, discretionary items—such as new cars, vacations and fast food—are often cut from household budgets when the economy slows.
We think investors should continue to stay up in quality across and within sectors—screening for companies with strong cash flow, high interest coverage and low volatility. As recession risks rise, now is not the time to move down the quality spectrum.
Fixed income: Concerns shift to growth
Bond yields have fallen over the past six weeks as investors focus more on the potential for a growth slowdown than inflation. The prospect of tariffs dampening economic growth and investment, combined with signs of cooling in the labor market, have shifted concerns.
The Institute for Supply Management (ISM) survey of manufacturing firms released in February indicated a weakening in overall conditions, new orders, and employment. The index for employment dropped below the 50 index level, which signals contraction in hiring.
The labor market is also showing signs of softness. The pace of job growth has slowed, and the participation rate has fallen. While the unemployment rate has held steady in recent months, the "under employment rate"—the number of people looking for full-time work that can't find it—has jumped. This seems to corroborate the indications from the weekly unemployment claims report, which shows initial claims holding at low levels but continuing claims rising.
The Federal Reserve has signaled that it will keep its policy setting on hold for the foreseeable future. Inflation is still stalled above its 2% target and there is the potential for tariffs to raise prices. However, we still see the potential for the Fed to cut rates later this year. The recently released Beige Book, which provides a review of economic conditions from the various Federal Reserve banks, indicated that businesses were very concerned about the impact of tariffs on sales and costs. These concerns are starting to have a negative effect on business investment.
If the unemployment rate begins to rise in a meaningful way, then the Fed will likely lower rates once or twice later this year, even if inflation is above 2%.
For bond investors, the economic outlook suggests that long-term growth concerns are outweighing short-term inflation concerns. We suggest keeping the allocation in portfolios at benchmark levels. We use the Bloomberg Aggregate Bond Index for a benchmark. Its average duration is 6.1 years, which we see as a reasonable level in the current environment. If the growth slowdown trends continue then we will consider extending duration on the expectation of lower long-term yields. We also suggest staying in high-credit-quality bonds, since a slowdown in growth would make it difficult for companies rated below investment grade to keep up with debt service or refinance at favorable rates.
The dollar is likely to continue weakening on the prospects for slower growth in the U.S., especially compared to the euro where the prospect of expansive fiscal policy could provide stimulus for the EU economy.
Global stocks and economy: Europe's safer haven?
Amid the angst over slowing economic growth and tariff uncertainty that seems to be weighing on U.S. stocks, a perceived safer haven could be found in Europe. For example, in Germany—Europe's largest economy—stocks are up nearly 20% this year, as measured by the MSCI Germany Index in U.S. dollars. One reason? Economic data is exceeding expectations this year in Europe, while it is missing expectations in the United States. We can see this in the relative performance of the economic surprise indexes this year. Further interest rate cuts in Europe, such as another 25-basis-point (or 0.25%) cut like we saw last week from the European Central Bank, may add to the economic momentum.
The relative outperformance in European stocks is also being aided by a robust earnings environment that is helping to offset continued risk from U.S. tariffs. Typically, earnings estimates for Europe and the U.S. rise or fall in sync; this year analysts have been raising profit estimates nearly every week for European companies while projections for U.S. companies continued to be reduced. Rising economic momentum is combining with higher bond yields and helping to lift the outlook for earnings in the financial sector. The European Commission proposed easing emissions rules originally scheduled to become stricter for 2025, aiding automakers. Industrials and materials sector companies have brightened their outlook on the prospect Germany may unlock hundreds of billions of euros for defense and infrastructure investments.
After cutting rates last week for the sixth time this cycle, the European Central Bank signaled a slower pace of cuts ahead as monetary policy stimulus hands off to fiscal stimulus. Hundreds of billions of euros in new outlays by European governments appear to be on the way, with implications for a rise in economic growth, inflation, and debt.
The outlook for a further rise in European defense spending got another boost from the meeting in February between U.S. President Donald Trump and Ukraine President Volodymyr Zelensky that made it clear to Europe that the U.S. was looking to reduce support for Europe's defense. Since 2014, the European NATO members have promised to spend at least 2% of their GDP on defense, but actual expenditures only realized that target in 2024. The 2% target may become a floor for EU defense spending going forward, with a higher percentage increasingly likely in the years ahead. Increasing defense spending seems to be one issue that Europeans seem to agree on, with the potential for financing being proposed from either joint European Union debt financing or the exclusion of defense expenditures from EU deficit rules for member countries. Rising confidence in greater EU defense spending stands apart from a world of increasing uncertainty, offering investors the prospect for a new "Magnificent Seven." There are seven stocks in Europe's Defense index, the MSCI EMU Aerospace and Defense Index and they are up nearly 40% this year through yesterday's close, while the U.S.'s Magnificent Seven stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla) are down about 10%.
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