“Liberation” day: Inflation now, but gone tomorrow?

The three things investors should know about this week

1. After a brief rebound, risk markets retrenched again, as 2 April - tariff day - nears, and the US stepped up tariffs on autos.
2. Rate risks for the US move to the upside (fewer cuts) and for the rest of the world to the downside (more cuts)
3. Over the short and medium term, markets may perform better than the economy, as sluggish growth could lower the cost of capital and improve returns. However, over the longer term, growth could very likely weigh on earnings enough to cause more frequent corrections.

Summary

This week, 2 April marks the first official day of reciprocal tariffs. US automaker stocks fell significantly after the President’s decision to impose 25% tariffs on car and part imports and the market in general retrenched after a quick rebound. In the next few months, it will be the ratio of winners vs losers + inflation that might very well dictate policy. But it still begs the question: will US inflation really be transitory? We think that there’s a large enough percentage of outcomes to otherwise that should at least give investors pause. Presently the market is pricing in nearly 3x cuts in the US (against the Fed’s 2x average expected cuts). We feel that risks are to the upside (higher rates/fewer cuts) than to the downside. Conversely, in the EU, US tariffs will likely cause a more immediate growth slowdown.

Over the short and medium term, markets may perform better than the economy, as sluggish growth could lower the cost of capital and improve returns. However, over the longer term, growth (or recessions) could very likely weigh on earnings enough to cause more frequent corrections. Meanwhile, in the real economy, slower growth and economic pain could spread. Professionals across the board should make sure that their investment and business plans and decisions capture that uncertainty. 

Week ahead

Wednesday, 2 April, the official unveiling of reciprocal tariffs is the day investors will be looking at. If the US government, which has cultivated expectations for extensive tariffs produces something more measured, we would expect risk markets to rebound sharply. Conversely, if negative expectations are met (or even exceeded) then the sell-off may continue. March's final manufacturing and services PMI numbers should give investors a clue as to where the economy is moving in the first few tumultuous months of the new US administration.

This week, 2 April marks what the US President calls “Liberation Day”, the first official day of reciprocal tariffs.

Big ideas, big outcomes. So, let’s bring them down to one humble item. Say a car engine piston. How is an American piston assembled? First, raw aluminium to manufacture, it is shipped from Michigan to Ontario. Second, the piston is cast and pre-machined, before being sent back to Michigan. Then, it is sent to Mexico to be finished. The piston is sent back to Wisconsin, where it is assembled with rods before being sent to an engine plant in Michigan. It is then placed into an engine in Michigan which is then sent to a vehicle assembly plant in Ontario, before the final vehicle is shipped to the US as Canadian export.

A person with simple common sense might say “This is madness, the piston crosses the border six times. Just imagine the waste and the environmental footprint”. But a Chief Operating Officer (COO), a key role in most modern corporations, would point to a big graph with significant savings and say “This actually saves money and improves quality. It’s more efficient. Behold the marvel that is the modern supply chain”.

A car is comprised of thousands of parts. Six border crossings mean at least 3 tariffs (assuming Canada and Mexico don’t escalate) and a whole lot of paperwork, just for one component. Every time the border is crossed prices are jacked up. Sure, eventually domestic production can expand to produce the piston mostly in the US and reduce the length of the supply chain. So, to import tariffs we can add costs to buy land, design the factory, build, hire workers under Union contracts, reroute supply chains etc. More importantly, it will take time. At best, theory stipulates that it takes a year for a built factory to get production up to speed. Another year to plan and build.

Given time, economic theory suggests that efficiencies will improve, though not necessarily at the same level as those of unconstrained trade. And still, it will take years. Meanwhile, tariff costs occur today.

No wonder that US automaker stocks fell significantly after the President’s decision to impose 25% tariffs on car and part imports and that the market in general retrenched after a quick rebound.

But, as US Treasury Secretary Scott Bessent told us “Cheap goods is not the American dream”, laying the ground for an inflation surge in the next few months. The President also warned about “short-term pain”. Both have said that equity returns are not a priority.

Tariffs also seem to divide the Fed. Two weeks ago, Jerome Powell said that he considers tariff inflation as “transitory”. However, follow-up interviews with other Fed members (Goolsbee, Kugler, Bostic, Barkin and others) suggested that this is highly dependent on them being a one-off without retaliations and with no second-order effects. In other words, an improbable outcome.

We should not expect the Fed to keep lowering interest rates even if inflation picks up. Friday’s core PCE announcement (which still reflects the realities of a pre-tariff regime) further challenged the reassuring rhetoric suggesting that core inflation was already trending higher. 

Expect, thus, big losers and big winners from tariffs, as well as inflation. In the next few months, it will be the ratio of winners vs losers + inflation that might very well dictate policy. That much is very likely.

But it still begs the question: will US inflation really be transitory? There are three eventualities:

• Yes, it will because tariffs are a one-off and the economy will adjust.
• Yes, it will because tariffs will cause a material growth slowdown, eventually alleviating wage pressures.
• No, it won’t because tariffs will likely be ongoing, changing and retaliated, and immigration curbs will increase wages.

We think that the second and third scenarios more completely capture reality than the first. The second scenario, where inflation is indeed transitory as growth drags down demand, essentially would move the US from “inflationary boom” to “deflationary bust”. The third scenario may see the US in “inflationary boom” or “inflationary bust” territory, as inflation persists, even in a growth slowdown. This scenario will likely not cause quick rate cuts from the Fed.

Presently, the market is pricing in nearly 3x cuts in the US (against the Fed’s 2x average expected cuts). We feel that risks are to the upside (higher rates/less cuts) than to the downside. Conversely, in the EU, US tariffs will likely cause a more immediate growth slowdown. So risks for the BoE and the ECB are likely to the downside (lower rates/more cuts). The Office of Budget Responsibility (OBR) already halved the UK’s growth projections for 2025 last week ahead of the budget.

What is the bigger picture? One of short-term US inflation, with a question mark as to whether it will become a longer-term affair, slower growth, especially in Europe, uncertain economic outcomes and macroeconomic volatility. It is no wonder that bond markets remain edgy, even after gains in the first part of the year.

Over the short and medium term, markets may perform better than the economy, as sluggish growth could lower the cost of capital and improve returns. However, over the longer term, growth (or recessions) could very likely weigh on earnings enough to cause more frequent corrections. Meanwhile, in the real economy, slower growth and economic pain could spread.

There are some scenarios where things turn out well. However, “hope is not a strategy”. The base case scenario is that things will become increasingly volatile as tariffs begin to weigh on the global economy. Professionals across the board should make sure that their investment and business plans and decisions capture that uncertainty.

George Lagarias – Chief Economist

Market update

Last week, equities saw a broad sell-off in major stock markets, leading to an overall decrease of global equities of -1.8%. Decreases in the US (-1.7%), EU (-1.5%), EM (-1.2%) and Japan (-2.1%) (all in GBP terms) were seen as the US administration announced new tariffs including a 25% on automobiles. The largest decrease was seen in Japan, where autos make up about one-third of Japan's total exports to the US. Concerns around a broader economic slowdown and weakening consumer sentiment also weighed on equity market sentiment.

In the UK, the annual Spring Statement was delivered with news of the UK economic growth forecast for 2025 halving to 1%, higher unemployment, greater inflation and further spending cuts. On the other side, there were positive updates to the economic growth projected for 2026-2029, while inflation and retail sales figures reported by the ONS came in better than expected, which helped to facilitate a +0.3% increase in UK equities. For more details on the UK Spring Statement 2025 please see the Macro news section below.

Throughout the week both GBP and EUR strengthened against USD by +0.2% and +0.1% respectively, with a greater strength seen in GBP against JPY of +0.6%. Government bond yields in the US, UK and EU ended the week around where they started despite some fluctuations throughout the week, which tracked broader risk sentiment.

In line with equities decreasing amid US trade war concerns, gold has carried on its hike crossing the landmark price of $3,100 (around £2,400), with the Bank of America revising its gold price forecasts upwards for both this year and next.

Macro news

The UK Spring Statement 2025, delivered by Chancellor Rachel Reeves, outlined several key measures aimed at addressing economic challenges, boosting growth, and ensuring fiscal stability:

Economic outlook: The OBR halved its GDP growth forecast for 2025 from 2% to 1%, reflecting weaker economic performance and global uncertainties, including geopolitical tensions and potential U.S. trade tariffs. However, growth forecasts for 2026-2029 were slightly upgraded (1.9%, 1.8%, 1.7%, and 1.8% respectively), suggesting a larger economy by the end of the forecast period compared to the October 2024 Budget. Inflation is expected to rise to 3.2% in 2025 before dropping to the 2% target by 2027.

Welfare reforms: Significant cuts were announced, totaling £4.8 billion in savings by 2029-30. Universal Credit’s health-related element will be reduced from £97 to £50 per week for new claimants starting April 2026 and frozen until 2030, with under-22s losing eligibility entirely. Existing claimants’ payments remain at £97 until 2030, with a top-up for severe conditions. The standard Universal Credit allowance will increase by £14 per week by 2030, down from a previously planned £15.

Defense spending: An additional £2.2 billion was allocated for 2025-26, bringing total extra defense spending since the Autumn Budget to over £5 billion, raising it to 2.36% of GDP next year as a step toward a 2.5% target by 2027. This includes £400 million for defense innovation (e.g., drones, AI), funded partly by cutting overseas aid from 0.5% to 0.3% of gross national income and using Treasury reserves.

Economic growth initiatives: The government committed £13 billion in extra capital spending over the Parliament to support infrastructure, housing, and defense. Planning reforms are projected to boost housebuilding by 170,000 homes over five years, growing the economy by 0.2% by 2030.

Fiscal stability: Reeves emphasised adherence to fiscal rules, restoring a £9.9 billion buffer against the “Stability Rule” by 2029-30, up from a deficit without these measures. This involved £3.6 billion in departmental savings, including reducing the civil service by 10,000 jobs via a voluntary exit scheme.

Tax and compliance: No new major tax rises were announced, but late payment penalties for income tax will double to 10% from April 2025. HMRC will receive extra funding to tackle tax evasion, targeting £570 million in revenue by 2029-30.