US economy shrugs off trade war and soldiers on

Investors may not think the economy is taking off, but they are probably relieved that the worst-case scenarios feared in recent months haven’t come to pass. Trump’s tariffs, deportations, and cuts to the federal bureaucracy have bent the economy but haven’t broken it.

The S&P 500 plummeted 19% from its previous high in February to its 2025 low on April 8. Behind the drop: fears that Trump’s threatened tariffs of as high as 145% on China and 50% on other major trading partners would send inflation and interest rates up, sap business and consumer confidence, and spark a recession.

Instead, Trump has significantly dialed back the tariffs from what he first proposed. Although tariffs did come into effect starting in February on China, Canada and Mexico, as well as on autos, steel and aluminum, the effect on inflation to date has been milder than feared. Oil prices leapt when Israel attacked Iran and the U.S. joined in, but have since fallen back.

Even after President Trump’s rollbacks, the average tariff in the U.S. is 18.8%, the highest since the 1930s.

Economists at JPMorgan Chase put the probability of recession starting in the next four quarters at about one-third, down from 60% in early April.

In recent months, business confidence fell amid tariff threats. Yet that sentiment never fully translated into behavior: businesses kept investing in equipment, factories and technology. They kept adding jobs, albeit at a slower pace than last year.

“The macro economy is doing decently,” said Jason Furman, a Harvard economics professor who was an adviser to President Barack Obama. Especially when it comes to tariffs, the market is now more confident “that Trump will back off if necessary,” he added. “In April I think the fear was he would just plow ahead no matter what. Now there is a sense that there are realities he won’t try to blow past.”

Consumer confidence has also recovered a bit. The University of Michigan’s consumer sentiment index rose 16% in June from May, though it remains 18% lower than in December.

Wall Street analysts expect earnings at retailers and other S&P 500 consumer discretionary companies to fall in the second quarter from a year earlier.

Earlier this year, “consumers were really on a downward trend, they really were worried that the high levels of tariffs threatened and policy volatility could lead to very dire consequences,” said Joanne Hsu, director of consumer surveys for the University of Michigan. Now, “consumers don’t think we’re out of the woods, but they’re less worried about the worst-case scenario.“

Still, while consumer spending never collapsed, new data shows that it has weakened significantly. The labor market also appears to be softening. Annualized growth in gross domestic product is likely to average 0.8% over the first two quarters of 2025, according to S&P Global Market Intelligence, down sharply from 2.5% in 2024.

The stock market isn’t the economy, but it does capture in real time how investors feel about growth, profits, interest rates, and risk. While companies were cautious about the outlook a few months ago, their recent profit guidance has tended to be better than analysts expected, according to FactSet.

The policy landscape has also become less unpredictable, easing investors’ fears. Republicans’ massive tax and spending bill remains up in the air, but that sort of risk is more familiar than the tariffs and steep cuts to the federal bureaucracy by Elon Musk’s Department of Government Efficiency that regularly emanated from the White House in previous months.

“If you look at the beginning of the year, the main action economically was tariffs and DOGE, and both of those were very dramatic, very fast and of debated lawfulness,” Furman said. “Now the main thing going on is this fiscal bill, which I think is problematic. But it’s sort of normal…things have moved more into the legislative arena, which is weirdly more predictable.”

In a recently released report, the White House Council of Economic Advisers predicted the Senate draft of Trump’s “one big beautiful bill” will significantly boost investment, wages and employment in the next four years relative to a scenario in which the 2017 tax cuts expire this year, as scheduled.

This past week, Fed chairman Jerome Powell acknowledged there has been little evidence of tariffs pushing up inflation broadly thus far, and some Fed officials have said a rate cut should be on the table as soon as next month. That has caused some bond yields to drop, which is also good for the stock market.

Still, tariffs’ full effect could still lie ahead. A 90-day pause on Trump’s steepest tariffs is to end July 9. Officials have said that deadline could slip as the U.S. and some partners close in on deals. But Friday, Trump said he had broken off talks with Canada and would issue new tariffs soon, and the administration is also carrying out probes that could yield new tariffs on semiconductors and pharmaceuticals.

Trump’s tariff threats spurred car sales earlier this year.

Even after Trump’s rollbacks, the average tariff in the U.S. is 18.8%, the highest since the 1930s, versus 2.4% in 2024, according to Preston Caldwell, chief U.S. economist at Morningstar. He thinks that will push inflation based on the index of personal-consumption expenditures to 3.2% in early 2026, versus 2.3% now.

The biggest risk to the outlook appears to be the consumer. This past week, the Commerce Department sharply revised down consumption growth. That softness has persisted in the second quarter, with inflation-adjusted consumption slipping 0.3% in May from April, leaving the level of spending below December’s. Particularly notable was softness in discretionary categories including air travel and hotels, which are especially sensitive to moods about the economy.

Wall Street analysts now expect earnings at S&P 500 consumer discretionary companies, which includes retailers, restaurant chains and carmakers, to slip by 5.1% in the second quarter from a year earlier, according to FactSet, down from a 2.2% gain at the end of March.

Write to Jeanne Whalen at Jeanne.Whalen@wsj.com, Justin Lahart at Justin.Lahart@wsj.com and Te-Ping Chen at Te-ping.Chen@wsj.com