US Economic Outlook 2025: Navigating the Tariff Tightrope

Executive Summary

• Tariff volatility triggered a Q1 GDP contraction (-0.3%) and supply-chain disruptions, but a temporary U.S.-China truce has eased near-term stagflation fears.

• Recession odds remain elevated (30–60%) despite cooling inflation (2.3% YoY) and resilient consumer spending, reflecting deep uncertainty in business sentiment and policy outcomes.

• Credit markets face bifurcation: Defensive sectors (utilities, healthcare) outperform cyclical industries (automotive, manufacturing), while Treasury yields reflect a "wait-and-see" Fed.

Introduction

The U.S. economy entered 2025 on shaky ground after President Trump’s “Liberation Day” tariffs ignited a trade policy shockwave. While a temporary U.S.-China tariff truce in May 2025 has softened immediate recession risks, structural vulnerabilities linger. This analysis dissects Q1’s GDP contraction, conflicting inflation-unemployment dynamics, and divergent recession forecasts to map scenarios for credit markets.

The Tariff Pendulum: From Escalation to Temporary Truce

April’s blanket 145% tariffs on Chinese goods and 10% global levies triggered a historic import surge (+41% in Q1) as firms stockpiled inventory. This front-running distorted trade balances, contributing to the Q1 GDP decline (-0.3%). The May 13 truce reduced tariffs to 30% (U.S.) and 10% (China), but unresolved negotiations and retaliatory risks keep supply chains on edge.

Key Impacts:

• GDP distortion: Net exports subtracted 1.2% from Q1 growth, masking underlying demand (final domestic sales +3.0%).

• Inflation bifurcation: April’s CPI cooled to 2.3% YoY, but tariffs are projected to add 1% to inflation by 2026.

• Business confidence: The Conference Board’s Leading Economic Index (LEI) fell 0.7% in March, driven by plunging stock prices and weak manufacturing orders.

Economic Vital Signs: Contradictory Signals Emerge

The economy sends mixed messages: cooling inflation clashes with rising unemployment (4.2%) and slowing job growth. Consumer spending remains resilient (+3.6% Q1), but tariffs have dented durable goods orders (-2.1% April).

Critical Metrics:

• Labor market: Unemployment up 0.3 pp YoY, but layoffs concentrate in trade-sensitive sectors (manufacturing, logistics).

• Inflation: Core PCE eased to 3.5% in Q1, yet shelter costs (+5.1%) and auto insurance (+18%) remain sticky.

• Financial conditions: The Atlanta Fed’s GDPNow model flipped from -0.4% to +1.2% post-truce, highlighting volatility.

• Line 1: Core CPI (peaked at 4.1% in Dec 2024, now 2.3%).

• Line 2: Unemployment (3.9% in Dec 2024, now 4.2%).

Recession Risk Assessment: A House Divided

Models and institutions disagree sharply, reflecting uncertainty over tariff permanence and consumer resilience.

Trigger Points:

• July 2025: If truce talks fail, tariffs revert to 145%, risking a -1.4% GDP hit.

• Labor market: Unemployment surpassing 4.5% could signal consumer retrenchment.

Forward-Looking Scenarios: Stagflation, Soft Landing, or Stumble

Scenario 1: Orderly Slowdown (40% Probability)

• Drivers: Truce extended, Fed cuts rates by 75 bps starting September.

• GDP: 1.6–2.2% growth in 2025; inflation stabilizes near 2.5%.

• Credit Impact: Cyclicals rebound; high-yield spreads tighten.

Scenario 2: Stagflation (35% Probability)

• Drivers: Tariffs reimposed, oil prices spike.

• GDP: 0.5% growth; inflation surges to 4.0%.

• Credit Impact: Defensives outperform; Treasuries sell off.

Scenario 3: Recession (25% Probability)

• Drivers: Auto loan defaults spike, manufacturing PMI <45.

• GDP: -1.2% contraction in Q3 2025.

• Credit Impact: CCC spreads widen to 1,200 bps; defaults double.

Implications for Credit Markets: Pricing Uncertainty

Sector Vulnerabilities:

• High Risk: Auto suppliers, retailers, semiconductors (tariff exposure >20% revenue).

• Low Risk: Utilities, healthcare, cloud infrastructure (domestic demand-driven).

Investor Playbook:

• Overweight: Short-duration IG bonds, renewable energy infrastructure.

• Underweight: Cyclical HY bonds, China-exposed industrials.

• Hedge: Long gold (stagflation hedge), short Russell 2000

Conclusion

The U.S. economy remains on a knife’s edge, balancing temporary tariff relief against structural inflation and policy unpredictability. While near-term recession risks have receded, credit markets must brace for volatility through 2025’s “tariff cliff” deadlines. Defensive positioning and scenario-based triggers are critical to navigating this uncharted terrain.