Managing uncertainty in a rapidly changing economic landscape

As we distill the first quarter's volatility and confusion, we see further economic moderation ahead with sizable risks to the downside. Not surprisingly, the tails of our distribution have thickened as the global trading order gets turned on its head.

Rising recession risks

There were always going to be challenges with maintaining - not to mention boosting - the exceptional growth rate of the US economy in 2024. The 2.7% annual GDP growth figure was underpinned by significant improvement in labor market participation, investment, and energy production. Of course, fiscal support has also been exceptional. But it is unlikely this trick can be repeated.

Indeed, the relentless uncertainty due to major policy shifts, particularly with tariffs, increases the probability on the left tail of our distribution for the US. Following the reciprocal tariff announcement in early April, the aggregate effect across countries and industries lifted the effective tariff rate from about 2.5% at the beginning of the year to more than 20%. Significant uncertainty regarding further tariff increases remains amidst ongoing negotiations and the potential for a retaliatory cycle. At this point, our general assessment assigns a 0.1 percentage point hit to growth for every 1 percentage point increase in effective tariff rates.

Uncertainty is consequently driving U.S. sentiment weaker. Weak sentiment, even in the absence of tails risks around the crystallization of negative policy outcomes, can weigh on growth via delayed investment. Delayed investment weighs on growth in the here and now, and worse, it reduces the future productive capacity of the economy, other things being equal.

That said, the prospect of Fed rate cuts is a key potential mitigant to recession risks, and ample space to provide policy accommodation remains. This space has been reflected in the market pricing for more than three rate cuts through the remainder of the year, which would bring the Fed funds rate closer to 3.5% by year end.

Deflationary narrative persists in China

China continues to grapple with the consequences of bursting asset bubbles in the form of excess capacity, weak growth, and deflation. But there are silver linings. The property sector in leading cities is stabilizing. DeepSeek is lifting private sector sentiment and hopes for a productivity revival. Stimulus announced in late 2024, alongside a temporary boost to exports in an aim to front run rising US trade barriers, puts the near-term growth outlook on better footing.

The impact of tariffs will likely feed into the data from May, and the full impact may take a couple of quarters to play out. New support programs will continue to be ramped up through 2025. China's more measured and calibrated approach to both fiscal and monetary policy - as well as a tolerance for lower growth targets around 5% - is expected to cushion the adjustment, but unlikely to create an inflationary impulse.

The spillover implications of China's weakly moderating outlook, particular around the prospects for inflation, is potentially significant. Whilst tariff uncertainty is arguably already weighing on global growth, the risk is that, if implemented, these tariffs would push prices up and thus pose a risk to the global inflation outlook. China, and its excess manufacturing capacity, forms a key part of this assessment.

The impact of US tariffs levied on China risks exacerbating the underlying excess capacity issues and the global deflationary consequences. And whilst Europe and Asia's markets are particularly exposed to Chinese goods, their exports are also increasingly in direct competition with Chinese goods. China's domination of global supply chains coupled with compositional differences in the trade basket and the underlying shift in Chinese consumption patterns suggests that retaliatory tariffs from China are unlikely to hurt Chinese consumers or change the deflationary narrative. This moderating effect on global inflationary trends acts as an offset to trade barriers and is a key contributing factor to our overarching view of global moderation.

BOJ's path towards policy normalisation

Growth in Japan has improved and inflation has continued to sustainably converge to the 2% target after years of deflation. On our convergence theme, Japan's GDP growth and inflation exceeded that of the US in Q4 2024. As a result, Japan continues on the path towards policy normalization - tariff uncertainty notwithstanding. Even more so following the reciprocal announcement, we expect the Bank of Japan to follow a measured and predictable approach to normalization. This is to ensure that further rate increases stay orderly, without triggering excessive volatility in either the foreign exchange market or long-term yields.

Our base case is for a further rise in policy rates above the current, psychologically important level of 0.5%, with the possibility of a slight acceleration in balance sheet run off sometime in the summer.