Stagflation and recession: A double threat looms over the US economy

Amid elevated tariffs and rising inflation expectations, the US economy risks falling into a stagflationary recession.

Joel Phua
|
Published on 18 Apr 2025

Stagflation and recession: A double threat looms over the US economy | Open a FREE FSM account and manage all your investments conveniently in ONE place

• US tariffs are expected to remain elevated post-negotiations, as the Trump administration intends to rely on tariff revenue to partially fund tax cuts and remain focus on reducing the US trade deficit.

• While tariffs are theoretically a one-time price adjustment, prices could keep rising if inflation expectations become unanchored.

• Given that consumer spending accounts for nearly 70% of US GDP, a drop in consumption due to higher prices would likely lead to a contraction in economic growth.

• Overall, we anticipate the US will enter a stagflationary recession in 2025 unless the Trump administration significantly rolls back its aggressive tariff policies.

• We continue to favour high quality companies, particularly in the digital economy and semiconductor sectors.

• For investors seeking diversification beyond the US, markets in China, Europe, and Japan offer attractive opportunities.

US President Donald Trump triggered a global trade war on April 2, “Liberation Day”, after announcing major tariffs on all imports. In this article, we discuss the implications of Trump’s aggressive trade policy on both the US economy and corporate earnings, as well as how investors can navigate weakness in the US stock market.

US tariffs could stay elevated for the foreseeable future

Although the 90-day pause on US reciprocal tariffs triggered a sharp 9.5% rally in the S&P 500 on April 9, it had little impact on the country’s overall effective tariff rate. According to latest estimates from the Budget Lab, the US effective tariff rate fell a mere 1% from 29% on Liberation Day to 28% following the tariff pause (Figure 1). This small decline is due to the continued enforcement of the 10% universal tariffs on all US imports, as well as a steep increase in tariffs on Chinese exports, which surged to a staggering 145% following China’s retaliation.

Figure 1: US average effective rate is at its highest since 1901

While the tariff rate will likely moderate following negotiations, a return to the pre-trade war range of 2-3% appears unlikely. Instead, we expect the effective rate to settle somewhere between 10% and 20% by the end of the year, for the following reasons:

Firstly, if the Trump administration is serious about reindustrialising the US and reducing the nation’s trade deficit with its trading partners, it will need to maintain high tariffs for an extended period in order for trade and investment patterns to change.

Secondly, Trump sees tariffs as a revenue source to help fund tax cuts and pay down the national debt, although the viability of this approach remains questionable. According to the Tax Foundation, a 10% universal tariff would raise approximately USD 1.7 trillion USD in revenue between 2025-2034, after accounting for changes in consumption patterns and economic output. This falls short of the USD 4.1 trillion needed to fund the extensions of several provisions from the 2017 Tax Cuts and Jobs Act (TCJA) that are set to expire at the end of 2025.

Thirdly, while the goal of trade negotiations is to lower or even remove tariffs, trade wars tend to result in higher long-term tariffs, as demonstrated by the US-China trade war in 2018. Given the ongoing tensions between the two countries, we expect tariffs on Chinese imports to remain well above the baseline 10% even after bilateral trade talks conclude.

With elevated tariffs likely to remain in place, what are the consequences for the US economy and corporate earnings?

Rising inflation and slower growth ahead

Inflation to pick up

US inflation cooled to a six-month low in March, with the Consumer Price Index (CPI) falling from 2.8% in February to 2.4%. However, we do not expect this decline to persist, as current inflation figures have yet to reflect tariff hikes. Historically, it takes a few months for tariff increases to pass through to consumer prices. As such, we should see inflation beginning to pick up by May as the effects of Trump’s trade policy begin to be felt more broadly across the economy.

Reindustrialisation is a costly endeavour for both businesses and consumers. Given that wages in the US are significantly higher than in other manufacturing hubs like China and Vietnam, made-in-US products will naturally be more expensive than their foreign counterparts. At the same time, tariffs raise the cost of importing parts and raw materials needed for local production, further driving up manufacturing costs. These additional expenses are likely to be passed on to consumers in the form of higher prices. Moreover, since the US currently lacks the capacity to fully meet domestic demand, Americans will need to continue relying on imported goods, many of which remain subject to elevated tariffs.

US Treasury Secretary Scott Bessent argues that “Tariffs are a one-time price adjustment” and will not lead to continued inflation. While this may hold true in theory, the reality is more complex. Escalating trade tensions, uncertainty surrounding future tariff policy, and the public’s recent experience with elevated inflation in 2021 and 2022 could unanchor inflation expectations and drive actual inflation higher. After several years of living with high inflation, consumers and businesses may now exhibit a heightened sensitivity to inflation, making them more likely to react strongly to any perceived inflationary pressures.

Inflation is often a self-fulfilling prophecy—when people expect prices to keep rising, they tend to bring forward purchases, which in turn push actual prices up. At the same time, workers may seek higher wages to make up for the loss in purchasing power. Businesses will also raise prices to offset rising labour costs, ultimately resulting in a wage-price spiral that drives inflation even higher.

According to preliminary results from the University of Michigan consumer sentiment survey, year-ahead inflation expectations surged from 5.0% in March to 6.7% in April, the highest reading since 1981 (Figure 2). The five-year expectations gauge also climbed to 4.4% from 4.1%. This suggests that inflation expectations are at risk of being unanchored.

Figure 2: Both 1-year and 5-year inflation expectations have risen sharply since the start of the year

Stagnant to negative GDP growth

Needless to say, higher prices will result in lower consumption. Furthermore, the recent weakening of the US dollar could exacerbate this issue (Figure 3).

Traditionally, investors tend to flock to haven assets like US treasuries during periods of market uncertainty. However, Trump’s unpredictability and hostility towards the current economic order have eroded confidence in US assets, resulting in treasury yields spiking and the dollar declining. A weak USD will erode consumer purchasing power, resulting in lower consumption. As consumer spending accounts for nearly 70% of US GDP, a fall in consumption will lead to a contraction in GDP.

Figure 3: The US dollar has weakened considerably in recent months

Businesses are also likely to delay investments and hiring due to the uncertainty surrounding the extent and duration of the tariffs. Businesses rely on stable and predictable conditions for long-term planning, which stands in stark contrast to the unpredictability of Trump’s policymaking. His erratic announcements, sometimes made on social media and occasionally surprising even his own advisers, undermine the sense of stability businesses need. This lack of clarity discourages investment and could ultimately weigh on GDP growth.

Investors hoping for a boost to the economy from potential rate cuts will likely be disappointed. While the market currently expects 3-4 cuts in 2025, we believe that the Fed is likely to adopt a prudent wait-and-see approach as long-term inflation expectations are at risk of being unanchored.

Recession and stagflation are likely

Overall, we expect the US economy to enter a recession in 2025 if Trump does not significantly roll back his tariffs. We also believe that stagflation is likely, driven by the supply shock these tariffs would impose on the US economy.

Typically, during a recession, declining consumer demand leads to lower prices. However, with tariffs in place, companies face higher production costs and tighter margins, limiting their ability to cut prices. This creates a scenario where inflation remains elevated even as economic growth slows. Such a combination poses a major challenge for the Fed, as it complicates the usual policy response of cutting interest rates to stimulate growth.

Earnings set to decline but bright spots remain

Companies that deal with goods and manufacturing will bear the brunt of tariffs as the cost of production rises. This leads to lower profit margins, lower consumer demand, and ultimately lower earnings.

Apple, for instance, could experience negative earnings growth this year, as the electronics it ships from China to the US remain subject to a 20% tariff, despite the recent tariff exemption on electronics. While the company has increasingly shifted manufacturing to India, over 80% of iPhones are still manufactured in China.

Non-goods and service-oriented sectors such as Financials, Communication Services, and Information Technology, though less directly affected, will also feel the ripple effects of an economic downturn.

Banks could suffer from negative loan growth due to reduced consumer and business spending, while investment banking and private equity activity are also likely to be significantly reduced due to subdued market confidence.

Digital advertising companies like Meta and Alphabet are likely to see lower ad revenues as businesses scale back their marketing budgets. Trump’s aggressive reciprocal tariffs on China, along with the elimination of the “de minimis” tariff exemption, have already prompted Chinese e-commerce giants Temu and Shein to slash their spending on US advertising platforms, as higher import costs are expected to make their products less appealing to American consumers.

That said, we still expect the tech sector to be resilient in the face of tariffs and expect earnings growth in the tech sector to remain robust with double digit increases. Software companies such as Microsoft, Adobe, Oracle, and Salesforce are largely insulated from tariffs due to their minimal reliance on physical goods or manufacturing. Even in the event of a recession that dampens IT spending we believe the impact on these firms will be relatively limited, thanks to their strong balance sheets and substantial order backlogs. Industry leaders like Microsoft are particularly well-positioned to navigate these evolving conditions, underpinned by their strong competitive moat and a highly sticky customer base — particularly among large enterprises.

Additionally, while a recession or stagflation scenario may dampen AI demand across end-markets, we believe that cloud service providers will continue to invest to stay ahead in the AI race. In fact, Amazon plans to spend $100 billion this year to capture more AI opportunities, while Alphabet has reaffirmed its $75 billion AI investment plan, even as Microsoft scales back its data centre leases in the US and Europe amid market uncertainty. This strong AI capital expenditure from hyperscalers will, in turn, benefit the semiconductor sector. While US tariffs on semiconductors are likely and export restrictions to China have intensified, we expect the largest semiconductor players to remain resilient due to their leading position and technological superiority. Nvidia, for instance, has a strong economic moat that is supported by its three horsemen – CUDA, chips architecture and ethernet & networking.

Managing risk through selectivity and diversification

Taking into consideration the impact of tariffs on earnings (under the assumption that Trump does not roll back on his tariffs), we have downwardly revised our earnings projections for the S&P 500. We expect earnings growth in 2025 to turn negative, before gradually recovering in 2026 and 2027. Applying a fair PE of 22x to estimated 2027 earnings, we arrive at a new target price of 5,935 for the S&P 500 index, representing an upside potential of 13%.

Table 1: Projections for the S&P 500 Index

S&P 500 Index	2024	2025E	2026E	2027E
Earnings Per Share (EPS)	237.07	225.30	243.14	269.76
Earnings Growth YoY	7.0%	-5.0%	7.9%	10.9%
PE Ratio (X)	22.25	23.42	21.70	19.56
Target Price (based on a fair PE of 22X)				5,935
Upside Potential				12.5%
Source: Bloomberg Finance L.P., iFAST Compilations. Data as of 16 April 2025

Figure 4: Share prices are driven by earnings growth in the long run

We continue to recommend that investors adopt a selective approach when investing in the US stock market, focusing on high quality companies that are better positioned to navigate a stagflation environment. We also maintain our preference for digital economy and semiconductor stocks, as their earnings are well-supported by long-term structural demand for AI and digitalisation solutions.

Table 2: Recommended products for US equities

Sector/Style	Recommended Products
Quality Stocks	• JPMorgan U.S. Quality Factor ETF (NYSE: JQUA)
Technology	• Fidelity Global Technology A-ACC-USD • Eastspring Investments Unit Trusts – Global Technology SGD • Invesco NASDAQ Internet ETF (NASDAQ: PNQI)
Semiconductors	• VanEck Semiconductor ETF (NASDAQ: SMH)

While a recession in the US has traditionally had far-reaching global consequences, this common notion may no longer hold true if the US continues to alienate its trading partners and prompt other nations to deepen collaboration without the US. Against this backdrop, we see strong diversification benefits in investing beyond the US.

China’s government is taking decisive steps to revive its economy and support the private sector after past regulatory crackdowns, while Europe’s defence industry stands to benefit from Trump’s retreat from the transatlantic alliance which pushes European nations to ramp up defence spending. Japan also remains a compelling market with structural tailwinds such as economic normalisation, corporate governance reforms, and a semiconductor industry revival.

China is on track to be a Dark Horse, as we said!

European defence stocks rally amid growing transatlantic divide: A paradigm shift?

Invest in Japan: A structural opportunity with promising earnings prospects

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Stagflation and recession: A double threat looms over the US economy

Joel Phua

Published on 18 Apr 2025

US tariffs could stay elevated for the foreseeable future

Figure 1: US average effective rate is at its highest since 1901

Rising inflation and slower growth ahead

Figure 2: Both 1-year and 5-year inflation expectations have risen sharply since the start of the year

Figure 3: The US dollar has weakened considerably in recent months

Earnings set to decline but bright spots remain

Managing risk through selectivity and diversification

Table 1: Projections for the S&P 500 Index

Figure 4: Share prices are driven by earnings growth in the long run

Table 2: Recommended products for US equities

Ways to Invest with FSM Global

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Stagflation and recession: A double threat looms over the US economy

Joel Phua

Published on 18 Apr 2025

US tariffs could stay elevated for the foreseeable future

Figure 1: US average effective rate is at its highest since 1901

Rising inflation and slower growth ahead

Figure 2: Both 1-year and 5-year inflation expectations have risen sharply since the start of the year

Figure 3: The US dollar has weakened considerably in recent months

Earnings set to decline but bright spots remain

Managing risk through selectivity and diversification

Table 1: Projections for the S&P 500 Index

Figure 4: Share prices are driven by earnings growth in the long run

Table 2: Recommended products for US equities

Ways to Invest with FSM Global

Don't have an account with us?

Need Financial Advice?

Latest Articles More

more.articles More

Live Chat 8:30am to 10:30pm, (Mondays to Fridays excluding PH) and 8:30am to 12:30pm, (Saturdays excluding PH)

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