Reassessing Growth Amid Policy Uncertainty

Key Takeaways:

• Softer real spending in January was a catalyst for traders to reset expectations for growth. Most notable moves were in bond markets as yields dipped on the 10-year Treasury.
• Investors will continue to focus on the uncertain growth trajectory. The odds are rising that the Federal Reserve (Fed) will cut rates three times this year.
• Tariffs stifle free and fair trade, but the impact may not be as bad as the scaremongers say. For example, roughly 75% of Mexican imports are industrial inputs, investment goods, and services. Only 25% are consumer goods. This is a key factor limiting potential consumer inflation pressures.

Slower Growth but Still Positive

We expect the economy to downshift this year but still post growth in the first half of the year. Business spending appears to be on the cusp of improving this year. From this morning’s ISM Services Report on Business, the services sector grew in February at a slightly slower pace than the previous two months, and input prices reaccelerated.

Prices paid by purchasing managers rose in February but remained below December levels, and employment grew in February as business activity warranted additional hirings.

This bodes well for Friday’s job report.

Some businesses reported concerns about tariffs, but they are not reporting any pre-tariff impacts like pulled-forward demand. Potential headwinds to growth this year include the tariffs recently instituted on Mexico, Canada, and China. Overall, roughly 40% of all goods imported come from these three countries, so potential impacts to the broader economy depend on the flexibility and availability of alternative supplies for U.S. businesses and the extent of approved exceptions.

It’s possible that inflationary pressures may not be as powerful as some suggest. Take Mexico for example. Roughly 75% of Mexican imports to the U.S. are industrial inputs, investment goods, and services. Only 25% are consumer goods. This is a key factor limiting potential consumer inflation pressures.

Transmission of tariffs into our daily lives takes time. GDP impact will not likely show up until Q2 or even Q3 since our economy is a cruise ship, not a jet ski.

The bottom line from this morning’s economic data is purchasing managers reported higher input prices which hints to growing consumer inflation, an unwanted pressure on the Fed during a time when the growth outlook has weakened. Policymakers will focus on tactics to keep the economy out of stagflation, perhaps one of the greatest current macro risks.

The Infamous Atlanta Fed Estimate

Providing further support for the idea of a slowdown, the Atlanta Fed released a new nowcast. Although the nowcast isn’t technically a forecast — only a calculation of growth based on available data — it did show a further slowdown in GDP growth for Q1. Softer consumer spending in January, along with fewer capital shipments, and weaker construction spending all combined to have a negative effect on the nowcast. The weak estimate does not anticipate the inevitable impact of activity throughout the remainder of the quarter.

It is important to note that relying on January data is risky due to the seasonal patterns that follow the holidays. Also, uncertainty from shifting trade policy had an impact on the start of the new year as well. While the nowcast is significant information, it can be somewhat misleading to place too much emphasis on the model’s findings this early in the quarter. And as the latest Beige Book highlighted, unusual weather conditions, including California wildfires, will put a dent in Q1 growth figures.

Regardless, we do still think we are positioned for a slowdown and this nowcast supports our view. In addition, investors should remain aware that a slowdown could be more pronounced in the second and third quarters, depending on the magnitude and duration of the tariffs.

Slowing but Still Growing

We expect the economy to downshift this year and return to roughly trend growth of 2%. Tailwinds could come from deregulation, tax cuts, and less wasteful government spending. Headwinds are tariffs, nagging inflation, and an uncertain policy outlook. If the downshift in growth is meaningful, markets could revise expectations up to three rate cuts this year, but only if the inflation backdrop improves.