The US economy is heading for recession

Happy Sunday. This week I return to the US economy.

The odds of a recession in America rose this week. Still, it is not most analysts’ base case for this year. So, sticking with Free Lunch on Sunday’s contrarian tradition, here’s why the world’s largest economy will succumb to a downturn in 2025.

The argument has two components. First, even before US President Donald Trump’s inauguration, the US economy was weaker than many appreciated. I outlined why in an opinion column in August and in an earlier edition of this newsletter, “Debunking American exceptionalism”.

Second, “Trumponomics” has damped the outlook further by introducing stagflationary forces and financial market risks. That is the focus of today’s newsletter.

Let’s begin with consumers. A reminder: high spending has been propped up by debt and expenditure on essentials such as food, housing and healthcare. Serious delinquencies on credit card balances hit a 13-year high at the end of last year, with steep interest rates increasingly squeezing households.

The White House’s agenda will add insult to injury by lumping taxes on top. The proposed duties on Mexico and Canada (now on pause), plus those already on China, will raise the US effective tariff rate to its highest since 1943, according to the Budget Lab at Yale. It reckons higher price levels could cost households up to $2,000.

This is only a taster; further tariffs are expected. And though the president has a knack for pushing back deadlines, the impact on sentiment is already stark.

Confidence has plunged. Consumers’ inflation and unemployment expectations have spiked. That is an ominous trifecta. Households are still trying to stomach a 20 per cent, post-pandemic rise in the price level. Notably, real consumption fell in January for the first time in nearly two years. Cautious spending behaviour is now more likely.

Next, business. On-and-off tariff and customs rules, broader capriciousness in policymaking and troubled consumers are a potent mix. Import duties are set to raise costs and retaliatory measures will stifle international sales. But the radical uncertainty also impedes businesses’ ability to plan and adapt.

The effects are already showing up in business activity indicators. The Goldman Sachs Analyst Index pointed to a contraction in sales, new orders, exports and employment across manufacturing and services companies in February. Manufacturing construction spending — which surged under the Inflation Reduction Act and the Chips Act — has also slowed, with the schemes’ statuses unclear under the new administration.

Corporate outlooks have also dimmed. BCA Research’s capex intentions indicator has fallen into contractionary territory. Historically, that has signalled a slowdown.

Small businesses’ hiring plans are thinning too, according to the latest NFIB survey. The Challenger tracker of planned job cuts jumped a staggering 245 per cent in February.

A reminder: before Trump came in, many overestimated the extent to which America’s “strong” labour market was underpinned by private sector dynamism. Government, healthcare and social assistance account for two-thirds of new jobs created since the start of 2023 (and half of the 151,000 non-farm payrolls added in February). Immigration has also bolstered employment growth since the pandemic.

Then comes the new administration’s objectives. Beyond the impact of policy uncertainty on the private sector, Evercore ISI estimates that Elon Musk’s public sector cost-cutting efforts could shave off a total of half a million US jobs this year. In an extreme scenario, that could reach over 1.4mn.

A planned crackdown on undocumented immigrants, who account for at least 5 per cent of the workforce, will add to the job losses.

Next, this administration has pushed stock market risks higher.

Before Trump came in, the S&P 500 was already at both historically high valuation multiples and concentration levels — with the market capitalisation of the largest 10 companies at a multi-decade high.

But markets had also under-priced just how far the president would go with his policy agenda, as exemplified by the recent correction in the US stock market back to pre-election levels.

In the past year, analysts had suggested the stretched valuations of the S&P 500 were not overly concerning, as they reflected higher earnings estimates and the promise of artificial intelligence. But optimism around earnings will now subside. Sales and investment plans have been clouded by uncertainty, in AI and otherwise. Many US companies earn significant sums abroad, in nations Trump might wage trade wars against. In other words, stock prices have room to fall.

If the president is really “just getting started” on his plans, his tolerance for further stock market weakness might be quite high. Yet the threat of a falling market has real economic implications: the equity holdings of households as a proportion of their total assets are at a record.

Finally, broader financial risks appear more probable (even if their probability is still low) and could drive a tightening in financial conditions.

Matt King, Satori Insights founder, points to potential triggers that could reverse America’s “safe haven” status (in which flights-to-safety are associated with a stronger dollar and lower Treasury yields). “A combination of concerns around fiscal irresponsibility, Fed independence and some of the more extreme proposals . . . as part of a Mar-a-Lago accord might just do the trick,” he said.

The administration’s plans to plug the deficit with tariff revenues (particularly if they are stop-start) and the so-called Department of Government Efficiency are highly questionable. US borrowing costs are already high; fiscal laxity adds to yields. US Treasury demand faces other potential headwinds, such as the forthcoming increase in German Bund issuance. It is easier now to imagine the US becoming caught in a vicious cycle of higher yields and larger debt projections.

Then there are the risks that Trump’s plans lean into: the institutionalisation of crypto, haphazard financial deregulation and potential manipulation of the dollar.

Markets don’t know how to price the uncertainty, just like when Trump was last in office. A rapid re-pricing of political risks could drive sell-off dynamics in bond and equity markets. That may then trigger liquidity problems.

How the Fed will react is also unclear. Given the underappreciated signs of a cooling economy last year, interest rates were too restrictive coming into Trump’s second term.

Now, rates are in a holding pattern. The weakening growth outlook is raising expectations for cuts. But with inflation expectations rising and recent memories of sky-high price growth, the Fed might lean to the cautious side and keep rates high. In that case, the growth outlook would dim further. Indeed, the inflation-growth trade-off is harder for the Fed to assess, raising the risk of an error.

The upshot? Many analysts are cutting their GDP forecasts for this quarter, driven by businesses stockpiling imports in anticipation of tariffs. Most expect this to unwind in the second quarter (although Trump’s stop-start tariffs will continue to incentivise stockpiling). Even then, with slowing activity and sentiment, rising financial risks and an already less-than-dynamic economy, it’s hard to see what could lift the mood and spur growth.

Perhaps Trump’s pro-growth tax cut and deregulation measures? First, they are yet to begin. Second, they will be offset by the anti-growth elements of his policy agenda. Tax cuts will boost profits, but companies’ ability to do anything with the gains will be limited by uncertainty and higher import costs. Slashing red tape can support investment, but monitoring various new tariff regimes and carve-outs is itself a huge additional regulatory burden.

It’s possible that a downturn can be avoided. But that would require Trump to significantly pare back his import duty plans and curb his shoot-from-the-hip style. How likely is that?

Rebuttals? Thoughts? Message me at freelunch@ft.com or on X @tejparikh90.

Food for thought

Here’s a reminder of why Free Lunch on Sunday’s counter-consensus analysis is valuable. Recent calls made on European stock markets, the German economy and China appear to be hitting the mark.