U.S. policy in motion
The great bulk of the world’s economy-, policy- and politics-relevant developments continue to emanate from the U.S., and specifically the White House.
High uncertainty
As vast numbers of unconventional policy balloons are floated, modified mid-flight, and occasionally even implemented, policy uncertainty is high (see next chart). Trade policy uncertainty is at unprecedented heights (see subsequent chart).
U.S. economic policy uncertainty surges further after 2024 election
U.S. trade policy uncertainty surges to record high after 2024 elections
Uncertainty interacts in a number of ways with the economy and decision-making. In general, high uncertainty threatens to temporarily reduce economic activity as businesses and households hold back on their investments and purchases.
But uncertainty can also induce other actions. In the present context, American businesses are notably stockpiling foreign inputs so as not to be caught flat-footed as major tariffs now arrive. That’s a temporary economic boost for foreign suppliers, but it doesn’t last.
On the other hand, to the extent some major business decisions are nevertheless going forward in this time of uncertainty, the U.S. is more likely to be the beneficiary of new factories and new hiring. If tariffs are applied, companies will still have access to the U.S. market; if tariffs are not applied, no great harm is done by expanding in the U.S., especially given the isolationist instincts of the present White House.
Maximum boldness
While President Trump was nothing if not bold and unconventional in his first term, the ante has been raised considerably in these early stages of his second term. The ideas are bigger and even more unconventional, they are coming faster than in his first term, and the scope for action is greater given an improved understanding of how to use the executive pulpit, more support within the Trump cabinet, more Congressional support, and greater ideological alignment with the judicial system as well.
Certain moderating factors do still exist:
Some of what President Trump proposes is bluster designed to secure a strong bargaining position and to normalize less extreme outcomes.
The rougher edges of many plans will be reined in by political, economic, practical and legal constraints.
President Trump wants a strong economy and strong financial markets, which are incompatible with some of the more extreme policy ideas – though this idea is currently being put to the test.
There is reason to think the White House is pursuing a shock-and-awe approach that frontloads policy initiatives. This means there may be fewer big policy moves and less uncertainty later. Furthermore, if history holds and the midterm elections in late 2026 tilt away from the ruling party, the scope for major policy moves thereafter becomes significantly more limited.
But for all of that, the sheer scale of proposals being made to refashion tariffs and trade, the civil service, border control, the regulatory environment, government spending and taxation, the global order, and possibly even what constitutes U.S. territory is striking. This is not a scene-for-scene remake of the 2017—2020 period. In turn, one cannot automatically assume that the economy grows happily and markets thrive.
As the tariff discussion below will elaborate, certain growth-damaging policies are beginning to be pursued beyond our base-case expectation, flagging the potential for worse economic growth and higher inflation. Already, high uncertainty is proving a bigger factor than initially expected, albeit with the mixed implications discussed earlier. An unanswered question is the extent to which the governance capacity and societal norms within the U.S. might diminish, and similarly the extent to which international trust in the U.S. falls. These may all bring potentially diminishing effects on the U.S. economy and financial markets.
Here come the tariffs
The immediate future
It is a big week for U.S. trade policy, with additional Chinese, Canadian and Mexican tariffs implemented.
The U.S. is applying a further 10% tariff on China as of March 4. This comes on top of the 10% tariff already implemented on February 4 and pre-existing tariffs dating back to prior administrations. The U.S. is also musing charging Chinese-made ships US$1 million or more per visit to U.S. ports beyond ordinary fees in an effort to diversify the production of oceangoing vessels.
With no reprieve seemingly this time, Canada and Mexico must brace for the immediate impact of 25% blanket U.S. tariffs. The two countries are certain to respond with tariffs of their own, and in Canada’s case, potentially also with non-tariff barriers.
Concerningly, U.S. negotiators have seemingly acted in bad faith thus far, with a refusal to articulate coherent grievances, clear demands, to acknowledge appeasement efforts, or even to hold serious discussions. In turn, going forward, U.S. trading partners cannot count on fair or coherent negotiations, nor that the U.S. will honour any agreements reached. All of this flags the increased likelihood that tariffs may be large and may persist for some time – unless the U.S. economy is bloodied enough for Trump to lose his nerve. The protests may be loudest out of the highly integrated North American auto sector.
Tariff damage is set to be considerable for Canada and Mexico, likely to the point of inducing an economic contraction in the coming months if the tariff rate is indeed the full 25%. Whether that broadens into a deep recession will depend on how long the tariffs last.
The Department of Commerce has also announced its intention to nearly triple anti-dumping duties against Canadian softwood lumber, taking the rate from 7.66% to 20.07%. The rate will be even higher for a handful of companies. This is distinct from countervailing duties on Canadian lumber, which are also expected to rise in May.
Steel and aluminum tariffs are scheduled to be applied on March 12. These are set to be slightly more intense than those implemented in 2018, in part because the aluminum tariff was just 10% the last time, and in part because a broader set of downstream products have been included in the tariffs. We assume these sector tariffs are indeed implemented on schedule, though there may be room for reductions or exceptions later.
Canada is the largest exporter of both steel and aluminum to the U.S. (see the next two charts). In theory, these tariffs will be applied on top of the pre-existing 25% tariff. From a sector-specific standpoint, copper has recently come into focus as a potential tariff target, though this is a less clearly formed thought at the moment.
Canada leads iron and steel exports to U.S. in 2024
Canada also leads in aluminum exports to U.S. in 2024
Reciprocal tariffs
Looking beyond North America, the main Trump tariff act will likely be the “reciprocal tariffs” that were recently proposed. President Trump himself has called them “the big one.”
The basic idea behind reciprocal tariffs is to impose tariffs on countries that already levy tariffs on the U.S. In a best-case scenario, this might even persuade those countries to tear down their own trade barriers, resulting in a net improvement in international trade. The oft-cited example is that Europe charges a 10% tariff on U.S. cars, while the U.S. merely charges a 2.5% tariff on European cars (though, inevitably, the situation is more nuanced than that, as the U.S. presently imposes a 25% tariff on European light trucks, while the European Union (EU) imposes a smaller 10% tariff on U.S. light trucks).
The idea of reciprocal tariffs has now received so much focus and broadened so significantly in concept that it is set to be a key tariff lever used by the Trump administration. The White House has indicated that these tariffs are set to be applied on April 2.
Some simple analysis argues that countries such as China, India and South Korea have some of the biggest positive tariff differentials in terms of how they treat U.S. products versus how the U.S. treats their products (see next chart). The EU also tilts slightly in this direction.
Weighted average effective tariff rate shows China, India and South Korea have greatest advantage over the U.S.
If the specific numbers used in that chart look wrong – didn’t the U.S. have a 19% effective tariff rate on Chinese goods before recent actions, not the mere 2.5% shown here? – the answer is that there are two ways to calculate the average tariff rate. The 2.5% figure examines the actual imports into the U.S. from China and simply calculates a weighted average of the various tariff rates applied to the goods actually imported.
Conversely, the 19% effective tariff rate looks at the full sweep of Chinese exports – not just to the U.S. but to the world – and uses those weights paired with U.S. tariff rates to calculate a weighted average U.S. tariff rate on Chinese products.
If it sounds absurd to factor in products that aren’t even exported to the country levying the tariff, the reason for this is that tariffs discourage trade. If one country applies a 1000% tariff on another, imports will probably converge to zero. The first calculation approach would therefore conclude that the average tariff applied against the other country is 0%, since there is no flow of goods. The second approach tries to get around that by getting a sense for what the composition of trade might have been absent the tariffs. Both approaches have their logic, and both have their flaws.
What do we mean by the idea of reciprocal tariffs broadening? The concept is no longer just about fighting tariffs with tariffs.
The idea of reciprocal tariffs has now received so much focus and broadened so significantly in concept that it is set to be a key tariff lever used by the Trump administration. The White House has indicated that these tariffs are set to be applied on April 2, even if technically there is supposed to be a second round of studies after April 1 before tariffs are implemented.
What do we mean by the idea of reciprocal tariffs broadening? The concept is no longer just about fighting tariffs with tariffs. The size of the reciprocal tariff applied against a country will now factor in the scale of non-tariff (regulatory) barriers that limit access for U.S. firms, the degree of currency undervaluation, and even whether a country imposes a sales tax on foreign goods.
Examples of non-tariff barriers include “buy local” laws, regulations that limit foreign ownership or participation in certain sectors, and even regulations that differ from the U.S. (such as different packaging rules, different safety considerations, chemical restrictions, and so on). It is a complicated subject, as the U.S. engages in many of these practices itself, and it is unclear how that will be handled. The U.S. has a variety of “Buy American” provisions, with the past two administrations increasing their use.
Punishing countries for foreign barriers to entry that bar U.S. firms is arguably more fruitful territory, but the U.S. also erects such barriers. As an example, the U.S. does not allow foreign airlines, ships or trucks to operate domestic routes. There are also restrictions on foreign firms providing military contracting and operating banks, telecommunication firms, radio and TV stations, nuclear power plants, farmland, telecommunications firms, and more.
It is of course not entirely realistic to think that all countries should have the exact same packaging and safety rules. But the present mishmash of rules equally hurts foreign countries seeking access to the U.S. market.
White House comments indicate foreign currency valuation concerns will be focused on countries that have manipulated their currencies to be softer than they would otherwise have been. The question is how this is defined. Helpfully, in November 2024, the Treasury Department declined to designate any major trading partner as a currency manipulator. However, it maintains a monitoring list of countries in the grey zone: China, Japan, South Korea, Taiwan, Singapore, Vietnam and Germany.
Ironically, imposing tariffs on a foreign country due to their exchange rate could exacerbate the issue.
Confusingly, Japan and China have actually been defending their currencies in recent years rather than seeking to weaken them. How is Germany on the list when it lacks an exchange rate? It maintains a sufficiently large trade surplus with the U.S. that the implication is that the country’s exchange rate (via the euro) must be undervalued to have gained such a trade advantage. If that’s the way the U.S. opts to interpret exchange rate mismatches, nearly every country could come under scrutiny as the U.S. dollar is extremely strong right now.
Ironically, imposing tariffs on a foreign country due to their exchange rate could exacerbate the issue. One would normally expect the affected country’s exchange rate to weaken in response to a tariff.
The idea of imposing an additional tariff on countries due to their sales taxes is puzzling. Yes, a sales tax increases the cost of a product sold to customers, much like a tariff. But sales taxes are applied equally to products produced domestically and those produced abroad, rendering the tax irrelevant from a trade fairness perspective.
The only way the argument makes sense is if you observe that because the U.S. does not have a federal sales tax, its businesses and workers theoretically carry a heavier share of the tax burden via income taxes, whereas other countries can afford to tax their businesses and workers less since the sales tax also generates revenue. Thus, an American business selling its product to another country must pay the heavier U.S. income tax and yet its product is still hit with the foreign sales tax. Of course, in practice, U.S. corporate and personal tax rates are quite competitive on the global stage, and the U.S. has every ability to tilt its taxation mix toward sales taxes if it wants.
There is a very real chance that the U.S. opts to cut through all of this complexity simply by concluding that countries that run a trade surplus with the U.S. have gained some sort of competitive advantage, and levying tariffs proportionately to the trade surplus.
One might argue that the digital sales taxes recently implemented in a handful of countries are a different matter given that they target revenue that isn’t explicitly generated in the taxing country, and given that they disproportionately target U.S. tech giants.
There is a very real chance that the U.S. opts to cut through all of this complexity simply by concluding that countries that run a trade surplus with the U.S. have gained some sort of competitive advantage, and levying tariffs proportionately to the trade surplus. This would be full circle of a sort, as this was President Trump’s focus in his first term.
Although not clearly articulated, there is also the growing possibility that the U.S. factors the implicit military protection it is providing to other countries into its tariff bill, with the view that these countries owe the U.S. for the service. This also gets complicated quite quickly as one could equally argue it is in the best interest of the U.S. to be allowed to operate military bases in foreign countries, and that the U.S. may not like it if other countries build strong militaries that could create a more volatile global order.
The takeaway is that if these reciprocal tariffs are indeed interpreted quite broadly, just about every country could come in for a significant hit. Emerging market countries would theoretically be particularly vulnerable given that such countries often impose fairly large tariff barriers.
Perhaps the U.S. will simply ask that other countries increase their defense budgets, which is the main line of thinking at present. But there is a scenario in which the U.S. insists on other concessions or levies tariffs as a way of charging for the military protection provided.
The takeaway is that if these reciprocal tariffs are indeed interpreted quite broadly, just about every country could come in for a significant hit. Emerging market countries would theoretically be particularly vulnerable given that such countries often impose fairly large tariff barriers. India, Korea, Taiwan and Thailand have sufficiently large trade surpluses, tariff barriers and economies to potentially capture U.S. attention.
To the extent the threat of reciprocal tariffs is meant in significant part to extract concessions from other countries, a big question is how far other countries are willing to be pushed.
Would they intervene to strengthen their exchange rate?
Would they remove their sales taxes?
Would they remove non-tariff barriers on historically shielded sectors?
The answer is likely “no” more than “yes” to this list.
In turn, there is a definite danger that the U.S. is unable to reach an agreement with the countries it targets. The scenario of significant tariffs is mounting, and with it the prospect of serious global economic damage.
Until quite recently, one would argue that markets have been somewhat complacent to this rising risk, though now they appear to be starting to better factor it in. For context, a handy rule of thumb is that every 5-percentage point increase in the U.S. weighted average tariff rate reduces corporate earnings in the U.S. by 1-2%. We have generally worked with the view that the weighted average U.S. tariff rate will increase by about 5 percentage points across the various Trump tariff initiatives. But there are now increasingly conceivable scenarios in which it rises by several times that.
Fiscal policy
March 14 government shutdown deadline
The most urgent item on the U.S. fiscal docket is the approaching March 14 expiry date for government funding. A government shutdown would ensue if a continuing resolution is not secured. The most likely scenario is a short-term continuing resolution that defers the issue by perhaps another month.
But a shutdown is not impossible as Republican fiscal hawks (who desire spending cuts) wage war against Republican defense hawks (who wish to preserve defense spending). A shutdown could also be a blunt force instrument to aid in achieving White House spending cut ambitions.
Of course, for that reason, the Democrats may be more willing to support a continuing resolution despite the Republican majority in Congress. A full-year continuing resolution is also a possibility.
Department of Government Efficiency
The newly formed Department of Government Efficiency (DOGE) has been at work since the January 20 inauguration, seeking to deliver up to US$2 trillion in spending cuts by July 4, 2026.
Significant layoffs have been enacted and numerous federal contracts have been terminated. However, progress in the early going has nevertheless been quite limited in the context of the overarching goal. As of February 17, DOGE reported spending cuts of US$55 billion, but independent analysis argues the true figure may be just US$2.6 billion when double-counting and prior decisions are removed from the calculus.
Either way, this isn’t an enormous change in the context of annual federal government spending worth US$6.75 trillion in fiscal year 2024. It also doesn’t go far in taming a deficit that was approximately US$1.8 trillion for the year.
So far, the effect of DOGE is pretty small, and legal constraints should also limit the department’s accomplishments.
A cursory look at the Treasury Daily Statement also fails to show much net progress: the U.S. government spent more money over the first 27 days of February (US$593.8 billion) than it did a year ago (US$585.0B).
This is certainly not the final word on DOGE. Alongside broader fiscal efforts discussed next, there may still be a palpable effect at the national economy level. But so far, the effect of DOGE is pretty small, and legal constraints should also limit the department’s accomplishments.
From a legal standpoint, Congress is in charge of major fiscal and organizational decisions such as eliminating government departments, and so it is unlikely that DOGE will be the prime driver of the U.S. fiscal trajectory in the coming years. There have also been questions around the legality of recent mass layoffs, both in the context of union agreements and government rules.
While the courts currently sport a conservative tilt, which would superficially seem to align with the Trump White House, there may be more frictions than generally imagined as today’s conservative judges tend to take an “originalist” view of the law, which translates into a more restrictive view of rights. This may limit the White House and its offshoots from doing certain bold, unconventional things.
U.S. budget aspirations
On February 25, the House of Representatives approved a budget resolution that closely aligns with President Trump’s priorities. It calls for US$4.5 trillion in tax cuts, paid for partially by US$2.0 trillion in spending cuts. For clarity, these figures are the cumulative sum of such actions over the next decade, not for a single year. This combination of policies would increase the size of the deficit by a cumulative US$2.5-plus trillion over the decade.
To deal with this, alongside the country’s existing deficit, the debt ceiling would be lifted by $4.0 trillion, conveniently dealing with an issue that has already forced the Treasury to begin taking extraordinary measures when the prior debt ceiling was hit in late January.
If this proposed budget were enacted into law, it would of course increase the U.S. debt by several additional trillion dollars. It would also provide a measure of fiscal stimulus (though a significant part of the “stimulus” would actually be the avoidance of restraint as prior tax cuts failed to expire). But there are still several hurdles to be cleared.
A budget resolution is a non-binding framework that sets revenue and expenditure targets without enacting them into law. Nor does it specify where precisely the revenue and expenditures will come from. What it does do is lay out that framework, and enable the reconciliation process. This amounts to the fast-tracking of fiscal initiatives with a simple Senate majority rather than the 60-vote supermajority that would otherwise be necessary.
As it happens, the Senate had previously passed its own budget resolution, and the two resolutions have substantial differences that will have to be addressed. The Senate version focused on funding additional initiatives such as border security, the military and energy projects, amounting to about US$340 billion in new spending. It also inserted the provision that the additional spending be paid for via unnamed spending cuts elsewhere. The proposed Trump tax cuts were left for a later day.
There is some urgency to the process given the aforementioned March 14 government shutdown deadline plus the fact that the debt ceiling has already been struck. A more realistic timeline – if a single omnibus bill even proves possible – is the April 15 deadline.
The two chambers now need to reach an agreement over these significant differences. It will not be an easy task, as the Republican majority in each chamber is razor thin. From that point, the reconciliation process can begin. Both chambers will need to pass a much more detailed bill that lays out precisely where tax hikes, spending cuts and spending increases will come from. This will also be hard, as spending cuts are never easy, and finding scope for US$2 trillion of them is even harder.
Practically speaking, entitlements may have to be cut to achieve that scope of reduction, with Medicaid (which is the medical program for low-income individuals) increasingly in the spotlight. It may be that this amounts to a downloading of Medicaid costs to the state level, with states potentially picking up some of the slack. Or it could be that benefits are simply reduced.
There is some urgency to the process given the aforementioned March 14 government shutdown deadline plus the fact that the debt ceiling has already been struck. A more realistic timeline – if a single omnibus bill even proves possible – is the April 15 deadline under federal law when a unified budget resolution is supposed to be achieved. We flag that it may prove quite difficult to achieve everything that the White House aspires in the near term given so many competing factions in Congress and thin margins.
Inequality lens
As an aside, it is striking that several of the proposed government policies would theoretically increase inequality within the U.S. The proposed tax cuts provide a disproportionate benefit to the wealthy given the greater sums of income that benefit and the potential ancillary effect on the stock market. The imposition of tariffs – while unwelcome from a stock market perspective and wealthy shareholders – serves as something loosely akin to a sales tax since a significant fraction of the tariff cost is passed onto consumers. Sales taxes are regressive because lower income households spend a larger fraction of their income on purchases, meaning that tariffs affect them to a greater extent via this channel.
Aside from simply redistributing income, which naturally benefits some parties and hurts others, higher inequality is a condition that is tentatively associated with slower overall economic growth.
Foreign policy
As the U.S. seeks to disentangle itself from Ukraine, the rest of Europe is being forced to step up its own contributions to Ukraine.
A starting observation is that European nations have already been contributing by more than is generally appreciated.
U.S. military aid now totals approximately US$65.9 billion.
EU aid totals about US$138 billion plus another US$10.5 billion from the U.K., $US3.3 billion from Canada, and more from others.
Nevertheless, the EU and others will have to increase their support if Ukraine is to continue defending itself against Russia. This tentatively appears to be coming together as countries announce additional pledges to Ukraine and as military budgets are now set to grow. Realistically, though, the U.S. hole cannot be completely filled in short order, and so Ukraine finds itself in a more vulnerable position.
While the long-term aspiration of EU nations is no doubt to gain a greater degree of self-sufficiency in their military procurement (and European defense stocks have rallied), a significant part of any increase in such spending will for the immediate future significantly benefit U.S. defense contractors.
More generally, as the U.S. rejects international bodies such as the World Trade Organization and the World Health Organization, and as it seeks to distance itself from traditional European and North American allies, those countries must begin the process of rethinking their place in the global order.
It is important that these nations not overreact given that the U.S. policy could well swing back in a more conventional direction before the end of the decade. But that is a long time to wait, and any reversal is not certain. These countries will presumably seek to engage economically with China more fully, to strengthen trade ties with one another, and to construct a new working alliance that has Europe rather than the U.S. at its heart. We would presume that NATO remains in place in name, but with diminished relevance. Thus, there could become four distinct spheres of influence – those surrounding each of Europe, the U.S., China and Russia – rather than the current three.
War on drugs?
As the White House prioritizes limiting fentanyl imports from Mexico and Canada, and in the context of very high drug overdose death rates in recent years, it is worth framing this as a public policy issue in and of itself.
The U.S. fought a so-called “war on drugs” that began in the 1970s, escalated in the 1980s and arguably peaked in the 1990s. The 2000s and 2010s then saw a shift toward lighter sentences and decriminalization.
Now, the pendulum may be swinging back in the opposite direction. Given high drug overdose rates in recent years alongside discontent about the level of crime and disorder in the U.S., the current administration may well increase its scrutiny beyond border controls and toward the home-grown contributors to the present drug problem. In synchronization with this, attitudes toward the police have been rebounding from low levels. During the first war on drugs, incarcerations rose – with implications both for those jailed and government budgets. At the same time, crime fell (though possibly for a variety of reasons and not exclusively due to the war on drugs), and civil liberties declined.
Economic developments
U.S. economic concerns, but overblown
The U.S. economy has definitely softened recently. Our focused Economic Surprise Index confirms that this is the sharpest drop in economic surprises since early 2022, when big rate hikes were beginning (see next chart).
RBC GAM U.S.-focused Economic Surprise Index shows sharp drop in economic surprises
Each of the seven variables that go into our focused surprise index is now negative (see next chart). These include everything from a big miss in the latest survey by the National Association of Home Builders (NAHB) to a slight miss in payrolls – which, truthfully, was a pretty solid report once special factors are considered.
Fortunately, periods of negative economic surprises usually do not last for long (though some of that is because expectations adjust to a diminished outlook).
U.S.-focused Economic Surprise Index is negative
The latest Institute for Supply Management (ISM) Manufacturing Index was arguably a little worse than its headline figure suggested. It showed notable weakness in new orders and employment, and a prices paid component that leapt significantly higher. Still, the ISM Manufacturing and ISM Services indices remain above the critical 50 threshold, indicating ongoing growth.
Walmart recently warned of more cautious consumers ahead. Disappointingly, U.S. personal spending shrank by 0.2% in January. But that comes on the heels of an outsized 0.8% gain in the prior month. The massive 0.9% increase in personal income that same month – the largest monthly gain in a year – is also a promising sign. We thus still believe households are fundamentally in adequate shape.
But feelings can differ from fundamentals. For example:
Consumer enthusiasm – which so revived after the U.S. election – has lately been shaken by recent public policy proposals (see next chart). Tariffs worry Americans, inflation fears are again mounting, and the housing market remains soft.
The University of Michigan and the Conference Board measures of U.S. consumer confidence for February have recently retreated back to pre-election levels, fully unwinding the enthusiasm they initially showed for the Trump administration.
Goldman Sachs’ Twitter Economic Sentiment Index has also declined but still remains well ahead of pre-election readings.
Small businesses remain enthused by the election result, but they have also lost some excitement. Subsequent monthly data may see a further decline given the enactment of further tariffs (see subsequent chart).
U.S. consumer sentiment dropped on Trump policy concerns
Small business sentiment supercharged by Trump’s win
With rising inequality, consumer spending growth is increasingly reliant on the top 10% of earners who – amazingly – now conduct approximately half of the economy’s spending (see next chart). They have proven more impervious than other segments to high interest rates and perhaps even the direct effect of tariffs. But they are particularly oriented to the stock market, which has recently been falling. Their support is less certain should that trend persist.
Top 10% of U.S. households account for nearly half of total spending
It was recently reported with some alarm that the Federal Reserve Bank of Atlanta’s closely watched GDPNow index has suddenly pivoted from forecasting more than 2% annualized gross domestic product (GDP) growth for the first quarter to predicting a startling 1.5% decline. Did the U.S. economy suddenly step off a cliff? We don’t think so.
What happened is that imports surged in January. Mathematically, imports subtract from GDP – hence the model’s pivot to a negative forecast. But surging imports rarely happen when an economy is contracting. Imports would normally also shrink during such a period.
Instead, what we think happened is that many businesses are stockpiling inventories of foreign products, hoping to minimize the pain of tariffs. Thus, they imported more but didn’t sell more. This should show up as additional inventories, which would neutralize the GDP drag from imports. But the inventory data doesn’t yet reflect that.
The bottom line is that the U.S. economy has definitely slowed and is no longer supercharged. High interest rates are weighing, elevated uncertainty may be restricting activity, and tariffs will now do their damage.
Our theory is that the inventory data will eventually catch up. In turn, it is likely that the Atlanta Fed’s GDPNow index will have to be revised upward, and that the U.S. economy is still growing in the first quarter of this year. Also do not forget that most of the data available for forecasting Q1 GDP originates from the first month of the year. The second and third months are still mostly blank slates.
The bottom line is that the U.S. economy has definitely slowed and is no longer supercharged. High interest rates are weighing, elevated uncertainty may be restricting activity, and tariffs will now do their damage. A portion of the tailwind that briefly came from election-induced enthusiasm has also unwound. The U.S. outlook over the coming quarters is now clearly diminished, though not – we think -- recessionary.
Of course, should equity markets and/or the economy remain weak for any period of time, that could motivate a policy pivot in a less damaging direction.
U.S. exceptionalism in retreat
As U.S. growth prospects dim slightly and as the U.S. stock market underperforms, U.S. exceptionalism can be said to be diminishing somewhat. This is doubly true since the rest of the world is simultaneously managing a slight economic acceleration (see next chart).
Interest rates have fallen more profoundly outside of the U.S.
Foreign exchange valuations are more competitive.
Households have more room to boost their spending.
Inflation is lower and some economies have economic slack that renders them less at risk of overheating.
With new commitments for military spending and a smaller fiscal deficit than the U.S. in most markets, there is upside potential here, too.
Economic surprises outside of the U.S. show upside potential
More fundamentally, as the U.S. seemingly endeavours to vacate its role as the global policeman, other countries are making the decision to re-arm. As the U.S. reduces its previously dominant role in such international institutions such as NATO, the World Trade Organization and the World Health Organization, others will take up those mantles or similar ones.
The U.S. status as the world’s reserve currency remains fundamentally unchallenged but is nevertheless eroding slightly. This could be accelerated if tariff negotiations include demands that countries sell their dollars to bolster the value of their own currencies. These developments are examples of U.S. exceptionalism fading in a non-economic structural capacity.
To be clear, the U.S. remains an exceptional nation with enormous wealth, a large military, brilliant people and a disproportionate share of the world’s innovation and great companies. But this exceptionalism is presently being challenged on several fronts. We would still bet on the U.S. economy outgrowing most of its peers in the years ahead. But the growth advantage is set to be somewhat smaller than before.
China optimism
If one can be called a China optimist despite assuming economic growth of just 4-5% this year and a steady-state growth rate of more like 3-4% within a few years’ time, then that is what we are. There are five reasons why.
U.S. tariffs shouldn’t hurt China too badly given that just 2.5% of what it produces is consumed directly by Americans.
The DeepSeek AI story confirms that China is indeed at the technological frontier, not just when it comes to batteries, drones, solar panels, trains and electric cars, but also within sniffing distance for artificial intelligence despite a significant computer chip disadvantage. The key point is that the country is still capable of innovation.
The deep chill imposed by the government on Chinese tech companies – and on the corporate sector more generally – appears to be warming. President Xi met with the Alibaba founder, seemingly giving a green flag to businesses. The stock market has responded accordingly.
China’s property market has been quietly stabilizing. There are finally whispers that the sector is staging a small recovery. If the risk of bankruptcy by major builders and local governments is off the table, and if rising home prices encourage households to resume spending their (largely housing-oriented) wealth, it marks an important new chapter for the Chinese economy.
China’s most important annual meetings are set to convene shortly, and additional economic stimulus is likely. Already, a plan to recapitalize the country’s banking sector has been fleshed out, with US$55 billion committed. In turn, healthier banks should be in a position to support growth.
Canada’s path forward
Strong economy behind, weak ahead?
The Canadian economy has, like many of its international peers, shown impressive strength in recent months.
As an example, Canadian retail sales rose by a sturdy 2.5% in December. The recently released fourth-quarter GDP number was a well-above-consensus +2.6% annualized. The details of this were also good, with strong consumer spending growth and residential construction, and decent gains from business investment and trade. A happy development was that real GDP per capita rose in the fourth quarter, a rare occurrence after persistent declines across most of 2023 and 2024. Canadian employment was also strong in its January release.
Support for this economic strength comes in particular from interest rates, which have fallen more profoundly in Canada than almost anywhere else.
Of course, this is all fairly stale data. Several worries exist about the immediate outlook ahead. One is that these numbers may flatter the Canadian economy as the U.S. has pulled forward Canadian exports to stock up on its inventory of critical materials (they could continue to flatter January and February numbers as those are released as well).
Another is that high policy uncertainty in the U.S. should theoretically weigh substantially on business and household decision-making within Canada. But the big one is the imposition of large U.S. tariffs on Canada. These threaten to contract the Canadian economy over the next few months and could do worse damage over a period of quarters to years if left in place. At a bare minimum, it is set to be a time of extreme economic choppiness over the coming quarters for Canada.
Canadian election
Liberal race
Canada’s incumbent Liberal government will select its next leader on March 9. There are four candidates, but only two – former central banker Mark Carney and former Finance Minister Chrystia Freeland – are considered serious contenders for the title. But, practically speaking, it may already be down to one. Betting markets assign a 96% chance that Carney becomes the next federal Liberal leader, versus just a 3% chance for Freeland. For those unfamiliar with the ins and outs of parliamentary democracies, the winner becomes Prime Minister even before any election is held.
Election timing
Canadian Parliament is prorogued until March 24. The expectation is then that an election will be called shortly after Parliament again assembles, with betting markets giving a 64% likelihood that an election is called before the month is over. The election race must then last between 36 and 50 days. That points to a probable election in the first half of May.
Election outlook
The opposition Conservative Party and its leader Pierre Poilievre had a gaping 20-plus percentage point lead in the polls as recently as January. But that has now compressed massively, with just a 6-point Conservative (38.6%) lead over the Liberals (32.9%) according to our 10-poll weighted average (see next chart). If anything, this understates the Liberal surge, as the most recent polls show an even closer race. Also, the Liberal Party is historically quite efficient at converting votes into parliamentary seats. Recall that the Conservatives actually won the popular vote in the last two elections but nevertheless captured fewer seats than the Liberals.
The Conservative Party’s lead narrows
Why such a pivot in expectations over the past two months? Feelings of Canadian nationalism have surged as the U.S. has threatened tariffs and proposed to subjugate Canada, to the benefit of the incumbent Liberals. Simultaneously, and in that same context, the Conservative Party platform focusing on the notion that “Canada is broken” is finding a less receptive audience during this time of national pride.
Of course, the Liberal Party honeymoon may not last. Favourable feelings toward Carney or any Liberal leader are not assured of persisting once they are in the big seat. Conversely, the imposition of large tariffs on Canada could further inflame the aforementioned patriotic sentiment.
Betting markets continue to point toward a Conservative win, with a 66% likelihood versus a 34% chance for the Liberals. That’s a lot closer than the 90%-plus probability assigned to the Conservatives at the start of the year but is still a pretty comfortable lead.
From a policy standpoint, the Conservative platform is arguably the more growth-friendly of the two given promises of tax cuts and – more importantly -- deregulation, though the chasm between these ideas and Liberal policy appears set to shrink under the next Liberal leader.
-With contributions from Vivien Lee, Aaron Ma and Ana Ardila
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