Are Investors Complacent?

Episode Summary

Executive Summary: Goldman Sachs economists argue markets are underpricing tariff and fiscal risks, but the near-term macro impact is shaping up as a slower-growth, modestly higher-inflation environment rather than an immediate recession. Tariffs are expected to lift inflation one-off, growth is soft but stabilizing, the Fed likely begins cutting in September, and structural forces favor dollar weakness and a steeper yield curve.

Main Topics: Tariff rollout and expected pass-through (Priority: 5/5): Jan Hatsias outlines the tariff increases already in place and expects the average effective rate to rise further by year-end, with gradual pass-through into consumer prices and limited near-term shock because of inventory front-loading and offsetting service-sector disinflation. Inflation outlook and tariff effects (Priority: 5/5): The speakers agree tariffs are starting to show up in prices, but the inflation impact should be gradual and mostly one-off, lifting core PCE into the low threes before dropping out after about a year. Growth slowdown without recession as base case (Priority: 5/5): U.S. growth has slowed meaningfully, with softer employment and weaker first-half GDP, but the baseline remains slow expansion rather than recession. Markets are comfortable looking through temporary weakness. Market complacency and equity resilience (Priority: 4/5): Dominic Wilson explains why equities remain near highs despite tariff headlines: investors expect manageable, non-sustained weakness, believe policy could be adjusted if needed, and are focusing on medium-term growth. Fiscal package and long-run deficits (Priority: 4/5): The new fiscal law is mildly stimulative in the near term, but its effect is likely offset by tariffs. The bigger issue is persistent 6% of GDP federal deficits and rising debt, which could lift term premia over time. Fed outlook, leadership transition, and rates markets (Priority: 4/5): Goldman expects the Fed to start cutting in September, with additional cuts into 2026. Rates markets are adjusting between tariff-driven inflation, decent growth, and the possibility of a future dovish Fed chair. Dollar weakness and structural global themes (Priority: 4/5): The dollar continues to weaken even as U.S. recession fears ease, reinforcing the view that structural forces—valuation, current account deficits, and concerns about institutional credibility—are driving a longer dollar depreciation cycle.

Key Arguments: Tariffs have already raised the average effective U.S. import tariff rate by about 9 percentage points and may rise to around 14 by year-end; the increase is large but has been relatively stable for months. Inflation pass-through is occurring, especially in tariff-sensitive goods categories, but it is gradual due to inventory buffering and offset by softer services and rent inflation. Core PCE inflation is expected to move from the mid-to-high twos into the low threes, likely as a temporary price-level effect rather than a lasting inflation regime change. U.S. growth has slowed materially: first-half 2025 GDP is estimated at only 1.2% on average, with private payroll growth also weakening. Market complacency is not total denial; instead, investors are assuming tariffs create a one-off adjustment rather than a sustained downturn, allowing them to focus on medium-term growth. The new fiscal package supports growth in early 2026, but tariff effects offset much of the stimulus, leaving the broader macro picture largely unchanged. The U.S. fiscal position remains problematic, with deficits around 6% of GDP and rising debt-to-GDP, implying gradual pressure on long-term Treasury term premia. The Fed is likely to begin easing in September, because rates are above the economy’s neutral level and policymakers need confidence that tariff inflation is transitory. A dovish-leaning future Fed chair would matter at the margin, but institutional continuity at the Fed should limit the scope for dramatic policy shifts. Dollar weakness is a structural story tied to valuation, financing needs, and institutional concerns, and the consensus nature of the view does not negate its validity. The main equity risk is not tariffs per se but recession risk—especially signs of a deteriorating labor market and rising unemployment. Investors should think about portfolio diversification, currency hedging for non-U.S. investors, and protection against deeper tail risks such as recession or institutional stress. Data Points: Average effective tariff rate increase: ~9 percentage points so far - Jan Hatsias says implemented tariffs have lifted the average effective tariff rate on U.S. imports by about nine points. Expected average effective tariff rate by year-end: ~14% - Goldman expects further tariff implementation to push the average effective rate to about 14% by end-2025. Baseline tariff assumption: 10% to 15% - The firm expects the general baseline tariff rate to rise from 10% to 15%. Core PCE estimate for June: 25 bps - Goldman’s estimate for June core PCE, based on CPI, PPI, and import price data. 2025 U.S. first-half GDP growth: 1.2% average - Estimate for Q1 and Q2 combined due to front-loading distortions. 2025 full-year U.S. growth forecast: 1% to 1.5% - Goldman’s current expectation for overall 2025 growth. Private sector employment growth: Well below 100,000 - June private payroll growth weakened significantly. ADP payroll growth: Weaker than private payroll figure - Used as a supporting sign of labor market softness. Core PCE inflation outlook: Mid/high 2s to low 3s - Expected tariff-related lift in year-over-year core PCE. Fed funds rate vs. neutral estimate: Low/mid 4s vs. low 3s - Current policy rate is above estimated long-run neutral rate. Expected Fed cuts: 25 bps in Sept, 2 more cuts at next meetings, then 50 bps in 2026 - Goldman’s baseline easing path. Federal deficit outlook: ~6% of GDP - Expected to persist for the foreseeable future. Primary deficit estimate: ~3% of GDP - Implied ex-interest deficit under current fiscal outlook. Euro area growth: ~1% - Baseline view for euro area sequential growth environment. Germany growth with fiscal boost: ~1.5% to close to 2% - Expected lift from expansionary German fiscal policy over the next couple of years. China GDP growth forecast: ~4.5% or slightly above - Reflects resilient industrial sector and weak domestic sector. China exports to U.S.: Down mid-20% range - Exports to the U.S. remain significantly lower, even as overall exports hold up. Tariff deadline: August 1 - A key near-term risk date for additional tariff measures. Fed chair timing: May 2026 - Jan expects a new Fed chair around the end of Powell’s term. Podcast recording date: July 17 - The episode was recorded on Thursday, July 17th.

Pivotal Quotes: "I think people have just got more comfortable that this is going to be a meaningful one-off adjustment, but that you're not going to have a kind of extended period of weakness." — Dominic Wilson: Explaining why equity markets have stayed resilient despite tariff escalation. "I think that what we've seen on inflation expectations, especially longer-term inflation expectations, supports that over the past several months." — Jan Hatsias: Arguing tariffs are more likely to create a temporary price-level effect than persistent inflation. "The biggest source of risk for deeper vulnerability in equities. If the market thinks the unemployment rate is set to rise properly... that is the sort of thing I think we've seen visibly creates a lot of risk aversion." — Dominic Wilson: Identifying recession and labor-market deterioration as the main equity-market tail risk.

Implications: Investors should expect slower growth, somewhat higher inflation, and a likely Fed easing cycle, while staying alert to recession and fiscal/institutional tail risks. Portfolio focus may shift toward diversification, curve-steepening trades, and currency hedging as dollar weakness and term-premia pressure persist.