Home Insights Macro views Confronting the risk of a policy-driven recession

Confronting the risk of a policy-driven recession

March 13, 2025 | 9 min read
Seema Shah
Chief Global Strategist
Christian Floro, CFA, CMT
Market Strategist

The past few weeks have delivered several negative surprises to the U.S. economy and markets, with investors struggling to digest the rapidly evolving news flow and policy shifts. Growth forecasts are being revised downward and even Google searches for “recession” have spiked. As market volatility swirls and investors’ nerves are tested, let's revisit the current U.S. economic outlook and appraise the potential for a U.S. recession in 2025.

A disorderly start to the year

At the start of the year, investors were anticipating a growth-friendly administration that would reinforce the narrative of U.S. exceptionalism and enact policies likely to strengthen the U.S. economy relative to the rest of the world.

However, policy has not panned out quite as expected. Not only has the sequencing of economic policies been different, but the tariff policy proposals have been considerably more severe than anticipated. With policy uncertainty extraordinarily elevated, the U.S. economy has already begun to be negatively impacted.

Sequencing: The initial anticipation was that the new U.S. administration would initially focus on shoring up the U.S. economy via deregulation in the first quarter, before introducing tariffs that could modestly hit U.S. growth later in the second or third quarters. However, the government appears to be following the “eat your vegetables before you have dessert” approach, introducing import tariffs and federal employee job cuts in the first few weeks of the presidential term, but no corresponding moves to ease regulatory policy. So far in 2025, the U.S. economy has only faced headwinds and has not yet benefitted from any tailwinds.

More severe policy proposals: Tariffs were not only enacted earlier than expected, but the threatened tariffs have been meaningfully larger than anticipated, with a potential increase in the effective tariff from 3% to 11% - four times the increase seen in President Trump’s first term and almost twice as large as what had been widely expected by analysts.

DOGE disappointment: The changes that have been proposed by the Department of Government Efficiency (DOGE) are also not exactly as expected. Initially, there were high hopes that DOGE would introduce meaningful spending cuts, eradicating inefficiencies that would create the fiscal space necessary for future tax cuts. Instead, the proposed federal employee cuts and policy change recommendations from DOGE are adding to anxiety. While our estimates suggest that the number of federal employees directly impacted reflects a fairly small portion of the U.S. labor force, there are 5-7 million private sector jobs which are dependent on U.S. contract spending and grants, magnifying the potential overall impact of the policies.

Policy uncertainty: Uncertainty around the timing, magnitude, coverage, and duration of tariffs has undermined sentiment. In fact, the uncertainty is already weighing on capex plans as businesses decide to put investment and hiring plans on hold until they have policy clarity, and several large corporates are already sounding alarm bells. For example, Delta Airlines just slashed earnings expectations, citing “the recent reduction in consumer and corporate confidence caused by increasing macro uncertainty.” A lack of clarity around policy plans also makes it more difficult for the Fed to provide the monetary support the U.S. economy will likely need. For now, their hands are essentially tied until policies have been announced and implemented.

A turbulent rest of the year, but with some glimmers of light

With animal spirits giving way to pessimism and fear, investor concerns around recession have spiked. However, while the economy is likely to slow over the coming months as it absorbs the negative growth impact of tariff policy uncertainty and federal employee cuts, a recession is by no means assured, given the multiple supports that are either already in play or likely to come into play over coming months.

Tariff policy: It is unlikely that tariff policy will be quite as severe as threatened. While tariffs are sure to be higher than Trump 1.0, the various exemptions already announced have reduced the likely tariff hit to U.S. growth. Initial proposals had suggested a 25% tariff on all goods from Mexico and Canada, a 10% tariff on China, and a universal 10% tariff on other countries — which altogether could have lowered U.S. growth by 1.6%. Now, taking the USMCA tariff exclusions for Mexico and Canada into account, as well as the energy exemptions for Canada, but adding in the newly announced steel and aluminum tariffs and a doubling of proposed tariffs on China, results in a reduced 1.4% hit to U.S. growth (as well as a smaller impact to the Mexican and Canadian economies, but slightly larger impact to China’s GDP). Reciprocal tariffs would amplify the negative impact on the economy. But, with U.S. growth running at almost 3% last year, tariffs alone would likely not be sufficient to tip the U.S. into recession.

Furthermore, even if tariffs are increased as much as proposed, they may not all be maintained at their new elevated levels for a prolonged period. While it is impossible to predict, as some countries look to rectify U.S. grievances or impose their own tariffs on the U.S., it is possible that some tariffs may be lowered, exempted, or even removed entirely. Such a scenario would provide support to economic growth, but likely not until the second half of 2025.

Federal Reserve: The Federal Reserve is likely to provide a policy boost in the second half of 2025, if not earlier, as the economy weakens and as labor market cracks widen. Currently, the Fed is being held back from providing additional policy rate cuts because there is still limited evidence that the economy really needs immediate additional support, inflation remains above target, and because elevated government policy uncertainty raises the risk of a wrong monetary policy move. The Fed would likely prefer to wait until they have policy clarity and a clear line of vision into the economic outlook, suggesting that policy easing will be delayed until late Q2 or even early Q3. Tariffs will put some upward pressure on inflation, but provided inflation expectations remain anchored, the Fed will likely look through the price increase.

We only expect two or three rate cuts this year given the continued focus on sticky inflation, but note that in the event of a more significant labor market deterioration the Fed would likely prioritize the full employment side of their dual mandate — introducing a more aggressive pace of easing.

Growth supportive initiatives: Although deregulation was not an early-year tailwind, the policy agenda is likely still in the pipeline, even if it has been somewhat deprioritized. Several sectors, from energy to financials, stand to enjoy a powerful return to capital and earnings environment, which could spur economic growth. From a fiscal side, extending the Tax Cuts and Jobs Act of 2017 will likely happen at the end of the year. While doing so is not stimulative, because it is simply extending a fiscal act that is already in place the Trump administration may look to introduce modest new household tax cuts, potentially funded via tariff revenues. A pivot to more growth-friendly policies of deregulation and tax cuts later this year could offset the drags from tariffs and other policies.

Balance sheet strength: Both household and corporate balance sheets are in their strongest shape in several decades. Household leverage, measured as liabilities as a percentage of net worth, is at its lowest level since 1975. Similarly for corporates, cash holdings as a percentage of liabilities are elevated, especially relative to history, suggesting ample buffers in the event of a revenue or cash flow squeeze. These dynamics suggest that households and corporates are well-placed to withstand headwinds, a resilience that meaningfully reduces the risk of recession.

AI development continues: The U.S. remains at the helm of technological advancement and innovation, with growing numbers of sectors and companies looking to benefit from the productivity gains that AI can bring. As a result, although the Magnificent Seven has borne the brunt of the turn in investor sentiment, earnings growth potential from key U.S. tech players remains strong and likely to continue contributing significantly to overall earnings growth and the broad economy.

After a weak first half of 2025—where quarterly economic growth is set to slow sharply from 3% to a below-trend 1.4%—policy relief in the second half should help stabilize momentum, keeping the U.S. economy from outright recession. However, the risks remain high. Policy uncertainty is unusually elevated, and without the expected support, growth could falter, pushing the economy onto a much weaker trajectory. While the odds of recession have risen, investors should not treat it as the base case—but neither should they dismiss the possibility outright.

Investor considerations

For investors, compounding the challenges of a deteriorating economic outlook is the backdrop of elevated market vulnerabilities, with stretched valuations in both equity and credit markets. U.S. markets have responded negatively to recent events, with the S&P 500 down almost 10% from its January record high and credit spreads widening recently. Yet, there are a few key considerations for investors:

  1. Historically, investors experience several large pullbacks each year, with very few exceptions. The average year sees a U.S. stock market drop of -13.5%, yet most years still end in positive territory, averaging 9% gains. Indeed, volatility is a normal part of investing, and investors are often rewarded for staying disciplined through short-term volatility.
  2. Beyond the volatility, U.S. markets can still deliver decent equity returns in a modest growth year because different types of companies perform well in differing economic environments. Companies with balance sheet strength, impressive margins, and strong cash flow can likely continue to prosper. Active management is essential for investors trying to identify potential outperformers in a weaker economic environment.
  1. As the global economy adjusts to swift changes in U.S. policies, global diversification remains crucial for managing portfolio risk and capturing opportunities. Indeed, global economies, which are more cheaply valued than the U.S., have been looking to shore up their economic resilience to U.S. policies. Their improved fundamental outlooks, coupled with the more attractive valuations, have been driving an impressive outperformance against the U.S. that is likely to continue.
  2. The benefits of cross-asset class diversification have been on full display in recent weeks as bonds have rallied and equity markets have struggled. With this negative correlation, fixed income is once again performing its ballast role, helping portfolios weather the economic slowdown and market pullback. Moreover, the higher rate environment means investors can now lock in attractive yields without taking excessive credit risk. Credit quality, duration exposure, and liquidity should remain top of mind as well. In addition, with inflation threatening signs of persistence amidst the tariff threats, investors should also prioritize real assets that can provide inflation mitigation in this environment of geo-economic and political uncertainty.
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