Budding Trade War Sparks Fears of Stagflation

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Hopes that the unveiling of the Trump administration’s tariff policies would bring some clarity to the markets and tamp down recent volatility were dashed when the levies, rolled out last week, proved to be much higher than the markets expected. The president announced that he will enact 10 percent levies on virtually all trading partners and additional reciprocal duties on imports from many countries. If enacted as currently proposed, the tariffs would be the highest levies applied on trade with the U.S. since the early 1900s. The size of the duties sparked fears of a global trade war and the possibility of the type of stagflation last seen in the 1970s. Additionally, comments by President Trump and Federal Reserve Chair Jerome Powell following the initial wave of selling sparked by the tariff announcements dimmed the prospects of a pivot by the administration or a rate cut by the Federal Reserve to cushion the blow of likely higher prices and slower economic growth resulting from the newly announced levies.

It is possible that the administration may strike some deals with individual countries before the reciprocal tariffs are scheduled to take effect on Wednesday (the 10 percent duties went in effect last weekend); however, it appears as of this writing it’s unlikely the president will materially soften his stance. Indeed, after China announced retaliatory tariffs on U.S. goods late last week, Trump took to social media to declare, “My policies will never change.” We have long been skeptical that the president’s approach to trade was purely part of a negotiating strategy. Trump has a long history of embracing the concept of tariffs and appears to be trying to reshape the role of the U.S. in global trade and defense. As such, we believe it is unlikely that he will materially alter his stance in reaction to a market sell-off. In other words, the Trump put that we discussed recently is unlikely to materialize in the near term.

Similarly, the prospects of a so-called Fed put in the form of a preemptive rate cut to boost the economy as tariffs take hold also seems unlikely in the near term. As we’ve noted in the past, while inflation has come down significantly from its peak, it is still running above the Fed’s long-term target of 2 percent, and core prices have ticked higher in recent months. While the risks to both sides of the Fed’s dual mandate of price stability and full employment have risen in recent months given that the job market is still relatively solid as shown in last week’s Bureau of Labor Statistics (BLS) jobs report, we believe the Fed sees inflation as the greater concern. Chair Powell noted in a public appearance late last week the increased likelihood of a full-blown trade war adds to the risk of heightened price pressures. “While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent,” Powell said. “Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.”

With both the administration and the Fed unlikely to intervene in the near term, the economy will need to stand on its own for the time being. Fortunately, as Powell noted in his comments, recent “hard data” shows the economy is continuing to churn along, albeit at a slower pace. However, he went on to note that “soft data,” which includes sentiment surveys of both consumers and businesses, shows growing pessimism about the economy and rising uncertainty/concerns about federal policies. The tension between the hard and soft data is something the Fed is monitoring because an erosion of confidence elevates the risk of recession.

The tariffs are almost certain to be larger than previously expected; so, too, will be the economic effects they bring, including higher inflation and slower growth. Additionally, given the size of the tariffs, the longer they are in place, the greater the likely negative economic impact. While the administration is expected to ease regulations on businesses, which could result in more economic growth, it is unclear how the final policies will look and whether they will take effect quickly enough to offset any headwinds caused by the new tariffs. While there has been much debate on “who pays the tariff,” the reality is that U.S. consumers and corporations are likely to be impacted. All of this comes at a time when, as we have continuously noted, the economy was already unbalanced—with some areas thriving, while others struggle under the weight of higher interest rates. As such, we believe economic risks remain high and expect market volatility will persist in the near term.

While it is impossible to know for certain how the size of impact the new tariffs will ultimately play out, much less how long the effects will last and whether or not they will ultimately prove to achieve the administration’s desired intermediate- to long-term impact of bringing more jobs and production back to the U.S., it is important to remember that economic challenges are a regular part of business and investing cycles. Tariffs are a nearer-term shock and a notable divergence from the current economic operating system that has been in place for years. This means that risks and volatility are likely to remain elevated in the near term. Fortunately, the U.S. economy is dynamic, and as we’ve already seen during prior periods of high uncertainty (such as COVID), economic policies can be adjusted as their impacts (good or bad) become evident. This is the same approach we took during the pandemic, which was ultimately shown to be prudent as the market recovered and rewarded those who stayed the course. As such, we don’t believe investors should make major adjustments to their long-term strategy. If you’ve worked with an advisor to develop your financial plan and investing strategy, your portfolio was likely designed to account for the fact that every economic cycle endures periods of uncertainty. We believe diversification is the best way for investors to deal with uncertainty. The other approach—concentrating in one segment of the market—suggests that the investor knows exactly how things are going to play out. And let’s not lose sight of the fact that an unpredictable future will lead to unpredictable opportunities for investors in the intermediate and long terms.

We believe uncertainty will remain elevated for a while, and economic risks are growing, but we also believe the best way to address it is by focusing on the long term and staying diversified to avoid concentrating too much on any one market segment or asset class.

Wall Street wrap

Last week’s economic reports highlighted the tension between the hard and soft data with the Jobs report and initial jobless claims showing a solid employment picture while soft data pointed to potential weakness. While the economic debate continues the downbeat tone of much of the soft data in recent weeks is likely to begin to show up in hard numbers in the future.

Hiring stronger than expected: Last week’s Nonfarm payroll report from the BLS showed stronger than expected growth, with 228,000 new jobs added in March, including 209,000 positions in private industry. The diffusion index (which measures the portion of the 250 industries covered by the report that added jobs versus those in which employment is unchanged or declining) eased to 54.2 percent versus February’s level of 56 percent.

Hourly pay for non-supervisory production employees grew by 0.16 percent for the month and was up 3.9 percent year over year. The annual pace of wage growth is still above the 3 to 3.5 percent rate the Fed believes is consistent with its goal of inflation sustainably at 2 percent. However, the latest monthly gain suggests that wage growth may be easing.

The BLS’s other jobs report, the Household survey, showed the unemployment rate rose to 4.2 percent from 4.1 percent in February. The labor force participation rate edged higher to 62.5 percent from the prior month’s 62.4 percent. This uptick contributed to the rise in the unemployment rate. In total, the Household report showed 201,000 more people employed in March than during the prior month.

More on the employment picture: Announced job cuts in February totaled 275,240, up 205 percent from the same month a year ago, according to the latest report from Challenger, Gray & Christmas Outplacement Services. This marks the third highest number of announced cuts in the history of the report (since 1989) and the highest monthly total since April 2020 (as the pandemic was beginning to unfold). The vast majority of cuts were from the government sector as the Department of Government Efficiency (DOGE) began to ramp up its efforts to cut federal payrolls. During the past two months DOGE actions have been tied to more than 280,000 announced job cuts. In total, more than 497,000 job cuts have been announced since the beginning of the year, which is the highest first-quarter total since 2009, during the Great Financial Crisis.

While announced cuts to government payrolls surged, signs of hiring in the private sector dwindled; just 13,198 new positions were announced, down from 34,580 new hires the prior month. This brings the total hiring announcements during the first quarter of the year to 53,867, which is a 16 percent decrease from the same period last year—and it’s the lowest first-quarter total since 2012.

Finally, initial jobless claims were 219,000, down 6,000 from last week’s final figure. The four-week rolling average of new jobless claims came in at 223,000, a decrease of 1,250 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.9 million, up 56,000 from the previous week’s revised total and the highest number since November 2021. We view continuing claims as a more reliable indicator of the labor market, as they measure workers who are facing long-term challenges in finding a job and, as such, filter out some of the temporary noise that can be found in initial claims data. The latest report suggests that while employers continue to hold on to workers, those who are laid off have had a hard time finding new work.

Manufacturing dips back into contraction as costs spike: The latest data from the Institute of Supply Management (ISM) shows the manufacturing sector contracted for the first time in three months. This marks the 27th time in the past 29 months the sector declined. The composite reading for the index for March came in at 49, down 1.3 points from the previous month (readings below 50 signal contraction). Readings for new orders dropped to 45.2, down 3.4 points from February. This marks the second consecutive month of shrinking demand. The production index declined by 2.4 points to 48.3, and the employment index fell to 44.7, down 2.9 points from February. Weaker growth was largely attributed to uncertainty about the impacts of proposed trade policies from Washington. “Demand and production retreated and destaffing continued as panelists’ companies responded to demand confusion,” Tim Fiore, chair of the ISM, noted in comments released with the report.

Tariffs also continued to drive an acceleration of price pressures for manufacturers. Prices spiked, with the latest reading coming in at 69.4, up 7 points from February. This marks the sixth consecutive month that manufacturers have faced higher costs for raw materials. For further context, the price index has risen 21.2 points over the past six months and is now at the highest level since June 2022. The recent trend in rising costs comes at a time when the Fed is seeing heightened risks on both sides of its dual mandate of price stability and full employment and adds to the case for the Fed to hold rates at current levels.

Growth in services sector slows: ISM data for the services side of the economy showed a downshift in the pace of expansion, with March’s headline reading coming in at 50.8, down from February’s final reading of 53.5. New orders slowed to 50.4, down from February’s reading of 52.23. Prices continued to climb (albeit at a slower pace), with the latest reading coming in at 60.9, down from 62.6 in February. The latest figure marks the fourth consecutive month that the input price index has been above 60 percent. Increased price pressures were widespread, with 14 of 18 industries reporting higher costs.

The latest results from the survey showed the employment index tumbled to 46.2, down 7.7 points from February’s final reading. Four of 18 industries reported growth in employment, while 10 recorded declines in payrolls; the remaining four saw little or no change in hiring. Among comments from survey respondents was this statement: “Conservative view of the job market and economy; not adding head count or resources.”

The week ahead

Tuesday: The National Federation of Independent Businesses Small Business Optimism Index readings for March will be out before the opening bell. Last month’s report showed companies planning to raise prices as tariff concerns were heating up. At the same time, small business felt less certain about where the economy and business climate were headed. We will watch to see if the fluid nature of tariff discussions continues to sow concerns among business owners.

Wednesday: The day offers a look at the minutes from the most recent meeting of the Federal Reserve Board. We’ll be looking for board members’ thoughts on pockets of sticky inflation as well as how trade policy is playing into their thinking on the economy, jobs and prices.

Thursday: The Consumer Price Index report from the BLS will be the big report for the week. Last month’s data showed core inflation eased, but over the past few months the reading has been stuck above the Fed’s 2 percent target. We will be digging into the data to see if last month’s slower pace continued or was simply statistical noise and not the beginning of an improving trend.

Friday: The latest readings from the BLS on its Producer Price Index will offer a look at changes in costs for buyers of finished goods for March. We will be watching to see if input costs continue to creep higher, which could put pressure on profit margins or slow the pace of disinflation.

The University of Michigan will release its preliminary report on April consumer sentiment and inflation expectations. Consumer sentiment has tumbled in recent months as inflation expectations have turned higher in response to concerns about tariffs. We will be watching to see if the trend continues or if there are signs that those concerns are having an effect on attitudes toward purchases in the months ahead.

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