The latest data confirm we are now in a stagflationary environment. And since inflation is like kryptonite for equity-investor Supermen, the post-tariff announcement sell-off was just the first salvo. We’re likely to see a lot more bloodletting in equities than we’ve seen so far, especially if we have the recession that looks increasingly likely.

So let’s take stock of what the numbers were telling us about the US economy ahead of so-called ‘Liberation Day’ and what choices the Trump Administration can make to undo damage that his tariffs have already done. Warning, even a full-scale capitulation, an outcome we’re unlikely to see, wouldn’t put the economy back on the path it was on.

The essence of my argument is as follows:

1. The US was already in a stagflationary environment when tariffs were announced on April 2nd.
2. Those new levies — and the prior ones on Canada — were so draconian that the damage can’t be undone. Trade flows will also be redirected out of an abundance of caution from US trade partners, lowering US and global growth.
3. The question now is how much near-term damage will be done. Much of that hinges on Trump’s commitment to tariffs as a policy tool and the degree to which sinking poll numbers, a slumping equity market and the risk of a recession cause him to change course.
4. My base case is he will move but it will be too little — and too late — to prevent a recession and bear market in stocks. The question then becomes how fragile markets are given valuations and whether negative feedback loops exacerbate the downturn. Now is as good a time as any to de-risk, with a recession this fall a distinct possibility.

The bearish backdrop all begins with inflation

You’ve probably noticed a downbeat tone to my pieces in 2025. It all starts with inflation, which I outlined at the beginning of the year as the principle risk to the US economy and the run-up in stocks. The sense I’ve had since January is that inflation was already more of a problem than the market realized, even before tariffs came into play.

And that was essentially confirmed by the batch of GDP numbers that came out Wednesday. We saw the first quarter’s GDP price index bump-up at 3.7%, well above estimates and the prior annualized quarterly price level increase of 2.3%. Combined with the lower spending numbers, it made for what I’ve started calling a stagflationary-lite environment — and begun comparing to the late 1960s — before Trump’s new round of punitive tariff hikes raised new fears of an inflation shock.

The reason high inflation is bad for equities is threefold. First, because it shows up in unexpected places and ways, it tends to dampen demand for price-sensitive and budget constrained consumers. Less demand means lower profits. Second, increased economic volatility from elevated inflation makes it really hard for businesses to plan ahead. And that reduces investment in capital and in people, dampening employment and economic growth. Lastly, the uncertainty around higher prices raises expected future interest rates and the premium investors demand to compensate for the inflation risk of holding long-lived assets. This erodes the value of future cash flows, reducing the multiple of earnings and cash flow investors are willing to pay for assets. 

So you had that stagflationary backdrop as we began the year, something the Fed should have been working harder to fight. Then Trump comes in and puts up high tariffs on the US’s three largest trading partners — Canada, Mexico and China — before offering reprieves after the market reacted negatively. By March, I’d seen enough to handicap four scenarios from best to worst, with a roughly 50-50 split between a positive and negative outcome.

The ludicrously high tariff rates that were unleashed in April tipped the scales considerably toward the negative outcome. The markets have pulled back from the chaos of the past few weeks, but everyone is just waiting for the next shoe to drop.

The uncomfortable reality is that the S&P 500, at this point, is only about 3% below where Trump’s rose garden rollout set off alarms around the world. That’s not much of a drop, considering that his trade war has set forces in motion that will continue even if he pulled them back. His go-it-alone fight with virtually every other country has irrevocably damaged trust in the US’s leading role in the economy, so much so that there’s doubts about whether Treasury bonds will remain a haven. It’s also almost certain to realign geopolitics. In Canada, the Liberal Party, once thought dead in the water under Justin Trudeau, was revived by a ferocious anti-Trump animus that not only won his successor, Mark Carney, a victory but also caused his main contender to lose his seat in Parliament. Carney has said that the US is no longer a reliable partner and that Canada is forced to look elsewhere for trade.

Almost every major company in the world now also faces uncertainties that stall their business plans, delay their investment plans and hurt profits as well as economic growth. With consumer confidence rapidly plunging, spending cutbacks can’t be far behind. Is a 10 or 11% fall in the S&P 500 from record levels — as we have seen since mid-February — enough to compensate for that? I would clearly say no.

And so, the Wall Street dictum “sell in May and go away” — a classic approach to dealing with historically lower returns in the months from May through October — this year may effectively hold as a strategy for the rest of the year. 

Stat of the Day

Let’s revisit the four economic cases for 2025

The best case scenario that I outlined in March, one in which both inflation and slow growth are short-lived, is pretty much out the window now. Where there was an average US tariff rate of maybe 2.5% previously, the effective rate is now more than 10 times as large, at 28%, according to Yale’s Budget Lab. It hasn’t been that high since 1901. 

The new best case we’re all hoping for is a situation where slower growth doesn’t tip into recession. That could happen because of some combination of consumer resilience, pro-growth policies elsewhere in the Trump agenda and a rollback of the most outlandish tariff rates.  Maybe then we get just a short period of below-trend growth, earnings forecast cuts and a step-up in the price level of tariffed goods. I think the (near-) correction we’ve seen in stocks adequately prices in this outcome. That would imply that once we’re back to better growth, the dip buyers will come back and stocks can continue to rise. But I think that is unlikely to happen. And where I gave it maybe a 40% chance in March, I’d decrease that to 25%.

The reason is that Trump’s belief in the power of tariffs is firm and nobody in the administration appears to be trying to dissuade him. The market still wants to believe that some combination of lower stock prices and sinking poll numbers will pull him away from them, as the auto tariff tweaks suggest. But he talked so much about tariffs during the campaign and has risked so much already that he cannot fully capitulate and save face. He once went so far as to promote a video arguing that he was intentionally tanking the stock market, and when it slipped on Wednesday after the bad GDP data came out, he blamed former President Joe Biden and said his tariffs will release a US production boom as companies shift to the US to avoid them.

Still, given the pause and floated carve outs, it’s still up in the air where tariff rates will settle. Given bipartisan distrust of China, those are likely to be stickiest. We have already heard many stories of cargo shipments falling off dramatically to West Coast US ports like Long Beach, Los Angeles and Seattle. So this disruption is likely to last months, and that means shortages and higher prices for months, too.

The first question is whether the regressive nature of China-focused tariffs helps prevent a recession, given the economy’s increased dependence on the upper 10% of households for growth. We will find out when the shortages appear, likely beginning in mid- to late-May.

The second question is whether there are knock-on effects from a recession that increase its severity. These would include de-dollarization, fire sales of illiquid private market assets, and negative wealth effects from a plunging stock market. The US hasn’t had a real recession since 2009, given that the pandemic downturn triggered an unprecedented government response that quickly offset the toll. So it’s difficult to say how fragile the system is if we face a contraction without that sort of extraordinary stimulus.

Walmart is worth focusing on as an example. It has a rich valuation for perhaps two reasons. The first is that all stocks have seen their valuation multiples rise prodigiously during the bull market that started in 2009. The second is that Walmart benefits when economic uncertainty increases as portfolios become more defensive. Look at this chart from my colleague John Authers, for example.

John notes that:

Walmart Inc. was the only stock in the S&P 500 that rose between the market peak in 2007 and the low in 2009. When it is beating the overall market, it’s a clear sign that investors don’t think much of the economy. And Walmart is doing well of late, hitting an all-time relative to the market.

That’s not a death sentence for market returns, of course, since Walmart’s relative valuation peaked during the QE episodes in the early 2010s before the rest of the market caught up as the US economy enjoyed a long boom. But it tells you something about market psychology. To me, it suggests that while investors acknowledge challenges ahead, they want to remain fully invested in stocks. For example, during the selloff on early Wednesday, as every stock market sector ETF from iShares was down, consumer staples were marginally higher. They are simply rotating to a more defensive allocation until the risks pass. Walmart has benefitted.

Yet given the panic selling we’ve witnessed on multiple occasions over the past year on the mere hint of a recession, investors are clearly fearful. These false alarms end with many buying the dip. An actual recession will be met with a torrent of selling as investors move to mimic Warren Buffett, who already has his largest cash allocation ever.

In the meantime, we just have to wait and see how this all plays out. It’s the showdown with China that will probably decide investors’ fate. And what’s now become a war of attrition more than a game of chicken favors those with a long-term perspective.  That seems to tilt the odds in favor China — and against a comeback for US equities.   

Things on my radar

• Trump racked up the worst first 100 days for the market since Nixon.
• The tariff toll on companies is spreading  both in the US and elsewhere.
• I recently penned a piece on why US markets won’t outperform for a long while.
• This piece on tariffs suggests we are on hold. Therefore, the next market move will be dramatic.

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