First Quarter 2025 Summary and Discussion of Tariffs and Inflation
Although Q1 seems like it was long ago, let’s do a brief summary:
Data compiled via Black Diamond as of March 31, 2025; benchmarks sourced from MSCI, Bloomberg, HFRX, and Lipper. Indices are unmanaged and cannot be invested in directly. Index performance does not reflect the deduction of advisory fees, transaction costs, or other expenses associated with an actual investment. Past performance is not indicative of future results.
US Stocks
U.S. equities declined in the first quarter of 2025, with the S&P 500 falling approximately 4.3%, reflecting a cautious and increasingly risk-averse market environment. The quarter was marked by rising geopolitical uncertainty, renewed trade tensions, and evolving expectations around monetary policy, all of which contributed to elevated volatility and reduced investor appetite for risk assets. While the economy remained resilient by some measures, market participants grew increasingly concerned about the implications of protectionist policy measures and their potential to dampen global trade and corporate earnings.
Performance across sectors was notably uneven. Defensive segments such as consumer staples, energy, and utilities outperformed, as investors favored areas of the market perceived to offer stability and income in uncertain conditions. In contrast, more cyclical and growth-oriented sectors, particularly technology and consumer discretionary, experienced pronounced weakness amid valuation pressures and a more challenging macro backdrop. The quarter underscored the importance of sector rotation and risk management as market dynamics shifted away from the momentum-driven environment of prior quarters.
Emerging Markets
The first quarter of 2025 saw mixed performance across emerging markets (EMs), but generally, the asset class showed resilience amid global economic challenges. Despite various geopolitical tensions, such as the ongoing Russia-Ukraine conflict and concerns over Chinese economic slowdown, EMs posted modest gains. China, the largest EM economy, showed signs of stabilization after a difficult 2024, with growth policies aimed at reviving the domestic consumer sector starting to yield positive results. The government’s stimulus measures, combined with easing regulatory pressures on key industries, provided a much-needed boost. However, the growth trajectory remains uneven, with concerns over debt sustainability, particularly in high-risk economies like Argentina and Turkey, lingering as potential headwinds.
Interest Rates
Central banks continued to maintain a cautious stance on interest rates during Q1 2025. The Federal Reserve kept its benchmark interest rate at 4.25-4.50%, signaling a wait-and-see approach amid improving economic conditions. The decision was based on a mix of solid GDP growth and inflation that, while still above target, showed signs of easing. While inflationary pressures moderated, there was concern about wage growth and housing prices keeping inflation higher than desired.
Globally, other major central banks such as the European Central Bank (ECB) and Bank of England (BoE) also followed similar paths of caution. The ECB, despite facing persistent inflationary challenges, opted to keep rates steady, while the BoE balanced inflation concerns with a desire to support economic growth.
The relatively stable interest rate environment has allowed risk assets, like stocks, to thrive, especially in the US. However, the yield curve remained inverted, signaling investor concern about the potential for future economic slowdowns and recessions, perhaps signaling that all was not well with the possibility for tariffs in Q2.
The Impact of Tariffs and Inflation on Economic Growth
The market is currently worrying about the slowdown in economic growth brought on primarily by the uncertainty around tariffs and the fear of inflation. This has caused volatility in the equity markets and has led to P/E (Price/Earnings) multiples contracting, and earnings estimates being revised downward. After the recent drawdown, markets now seem to be in a wait-and-see mode, moving sideways, as they prepare for the release of new information. Markets most recently retested the lows of the year, setting up the potential for a double bottom, or setting the stage for a leg lower.
Our job as investors during these types of uncertain periods is to analyze whether we are going to fall into a recession. A recession is typically defined as a significant decline in economic activity spread across the economy, lasting more than a few months. It is often identified by two quarters of negative GDP growth, rising unemployment, and reduced consumer and business spending.
Many economic factors contribute to recessions, with inflation and tariffs being two major variables that could play a vital role over the next couple of months. Inflation erodes purchasing power and increases costs for businesses and consumers, while tariffs disrupt trade and increase prices on goods, potentially slowing economic growth. The relationship between inflation, tariffs, and recessions is complex, but there is substantial evidence that high inflation combined with aggressive tariff policies can contribute to an economic downturn.
Our determination as to whether we are going to fall into a recession is important because pullbacks in markets that do not precede a recession have turned out to be buying opportunities historically. On the other hand, growth scares that eventually lead to recessions are not buying opportunities, as markets in that scenario have further price declines before eventually becoming a buying point at lower levels.
•Stock markets correct on average each year more than 10%.
•The extent of further downside typically depends on whether a recession occurs.
•During non-recession sell-offs since WWII, markets decline ~23% on average vs. ~35% when there is a recession.
•The current sell-off since February 19 of -14% is roughly in line with its annual average since WWII.
* For the average recession and non-recession corrections, sell-offs must decline -20% or more to be included in the sample. Calendar year means the average max drawdown during each individual calendar year. Data through 4/4/2025.
** Calculated using decline from February 19, 2025 peak through April 4. Source: chart via BNY Mellon, based on S&P 500 data, post-WWII corrections through February 19, 2025. For illustrative purposes only.
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management.
Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2024, over which the average annual return was 10.6%.
Guide to the Markets – U.S. Data are as of April 8, 2025.
Inflation
Inflation reduces the real income of consumers, meaning they can afford fewer goods and services with the same amount of money. This leads to lower consumer spending, which is a critical driver of economic growth, as it provides the fuel for roughly 70% of economic growth in the United States, the world’s largest economy. When inflation is high, businesses face higher costs for raw materials, labor, and transportation, which may force them to raise prices and pass that along to consumers or cut costs elsewhere, including reducing their workforce to maintain stable profitability If wages do not keep up with inflation, workers experience a decline in real earnings, leading to lower overall demand in the economy.
In recent years, inflation has been a major concern, especially following the COVID-19 pandemic. Supply chain disruptions, labor shortages, and increased government spending all contributed to rising prices. While inflation has fallen from higher levels and now sits in the 2.5-3.0% year over year range by most measures, reducing it to the Federal Reserve’s target of 2% has proven difficult.
Tariffs
Tariffs are taxes imposed on imported goods, making them, in many circumstances, more expensive for consumers and businesses. Governments have used tariffs historically for various purposes, such as protecting domestic industries, reducing trade deficits, or retaliating against unfair trade practices. While tariffs can help certain domestic industries in the short term, they often lead to higher prices and economic inefficiencies in the long run because they distort the economic law of comparative advantage, which describes one country’s advantage over others in producing a particular good at a lower opportunity cost than a trading partner. the Economic principle theorizes that countries should focus on producing goods and services for which they are best at, while trading for goods they are not as productive at producing.
This economic distortion brought on by tariffs increases the cost of imported goods, leading to higher prices for consumers. When consumers pay more for imported goods, they have less disposable income to spend on other goods and services thus resulting in a slowing of overall economic activity. Additionally, businesses that rely on imported materials may face higher production costs, leading to reduced profitability, lower wages, and even layoffs of their employees.
One recent example of tariffs impacting economic growth was the U.S.-China trade war, which began in 2018 under the Trump administration. The U.S. imposed tariffs on hundreds of billions of dollars worth of Chinese goods, and China retaliated with its own tariffs. The result was increased costs for American businesses and consumers, supply chain disruptions, and uncertainty in financial markets. (Fajgelbaum et al., 2021)
The modern economy relies on global supply chains, meaning that tariffs can disrupt business operations worldwide. For example, U.S. tariffs on Chinese steel and aluminum have led to higher costs for American manufacturers, particularly in industries such as automotive and construction. When tariffs lead to higher production costs, companies may pass these costs on to consumers, contributing to inflation and reducing overall demand.
This may already be happening. The blunt tariffs that President Trump has put into place in early February are having a chilling effect on economic activity. Foreign governments have cautioned their citizens to be careful when traveling to the US. Consumer spending has already stalled in 2025 with real personal consumption expenditures down -0.6% (month/month) in January and then bouncing back only 0.1% in February. (FRED, Real Personal Consumption Expenditures, April 2025)
The Potential for a Recession
Both inflation and tariffs can slow economic growth, but their combined effects can be even more damaging. High inflation reduces purchasing power, while tariffs increase the cost of goods, exacerbating inflationary pressures. If businesses face both rising costs from inflation and additional expenses due to tariffs, they may cut jobs or reduce investment, further weakening economic activity.
Historically, periods of high inflation combined with trade restrictions have often led to economic downturns. For example, during the 1970s, the U.S. experienced stagflation—a period of high inflation and slow economic growth—partially due to oil price shocks and restrictive trade policies. Similarly, during the Great Depression, the Smoot-Hawley Tariff Act of 1930 imposed high tariffs on imported goods, leading to a sharp decline in international trade and worsening the economic crisis.
Today, the global economy faces a combination of rising inflation and increasing trade tensions. The COVID-19 pandemic disrupted supply chains, and geopolitical conflicts have led to new trade barriers. If inflation remains high and governments continue implementing protectionist trade policies, global economic growth could slow significantly, increasing the risk of a recession. While our base case is still that a recession will be avoided, the chances of falling into one have increased over the past few weeks. We would estimate the odds of recession in 2025 to be around 40-50%.
Policy Solutions
To avoid a recession caused by inflation and tariffs, policymakers must carefully balance economic strategies. Central banks must manage inflation through interest rate adjustments without slowing economic growth too much. Governments globally should also consider reducing unnecessary tariffs and encouraging free trade to prevent further price increases and improve supply/demand imbalances which contribute to economic imbalances that lead to further inflation pressures. Higher core inflation may potentially tie the Federal Reserve’s ability to cut interest rates if needed to stimulate the economy, as they are forced to combat higher inflation by keeping rates high, thus slowing economic growth and putting downward pressure on aggregate demand and prices.
As of this writing, tariffs are going into effect with China (104%). China is retaliating aggressively, with 84% tariffs on our goods. Markets continue to sell off, as they are looking for both parties to reverse recent escalation.
Businesses can also adapt by diversifying suppliers, improving efficiency, and passing costs onto consumers in ways that minimize demand reduction. Consumers may shift spending habits toward more affordable goods or services. These adaptations can help soften the economic impact of inflation and tariffs. From a long-term perspective, bringing supply chains back to the US may prove to be an effective means to combat tariffs if they remain in place. However, that process takes time and significant investment.
Portfolio Ramifications
Since the unwind of the Yen carry trade in August of 2024, we have taken several steps to de-risk client portfolios in preparation for an increase in volatility:
In Q3 2024, we reduced our allocation in U.S. Large Cap from a slight overweight (2%) to neutral and distributed the 2% we took from equities into fixed income, alternatives, and cash.
In Q1 2025 we optimized our allocations within the fixed income opportunistic, liquid alternatives buckets, and EM equity. We looked to move up in quality within fixed income as recession risk started to rise, while prioritizing allocation to a top-performing manager within the Emerging Market Debt space. We increased our allocation to in-phase long-short equity managers that will shine in a more volatile market environment, while reducing our allocation to trend following systems within managed futures that struggle in a tariff-headlined environment. We diversified our EM equity exposure by adding a value-tilted manager that would pair nicely with our growth manager in the EM equity space.
Within the past 2 weeks as the markets continue to digest tariff news and increasing recession odds, we have eliminated any credit risk that existed in the fixed income segment to prioritize high quality, investment grade bonds. We have reduced our large cap growth allocation and distributed that allocation between large cap value and core. With the continued outperformance of international equity, we added a top-performing manager to help bring portfolios closer to a neutral tilt than a growth tilt. We continue to diversify where we can while maintaining neutrality.
Conclusion
While Q1 of 2025 brought mixed returns and decent economic growth, that all changed dramatically on April 2. Inflation and tariffs each have the potential to slow economic growth, but when combined, they create a particularly challenging environment that increases the risk of a recession. Inflation erodes purchasing power and raises costs for businesses, while tariffs make goods more expensive and disrupt trade. Historical examples, such as the 1970s stagflation and the trade policies of the Great Depression, show that high inflation and restrictive trade policies can lead to economic downturns. While we are not suggesting that either of these two scenarios will play out today, they do serve as warnings that these two variables have the potential to disrupt the economic expansion we have enjoyed since the end of the pandemic.
Policymakers can take steps to mitigate these risks by managing inflation carefully, reducing trade barriers, and investing in domestic production. While inflation and tariffs alone may not necessarily cause a recession, their combined effects, if not managed properly, could push the economy into a downturn. By implementing sound economic policies, governments and businesses can help ensure continued growth and stability. While we have already taken steps in your portfolios to mitigate some of these risks, we will be monitoring this situation closely in the days, weeks and months ahead and will continue to adjust your portfolios accordingly.
Elyxium Wealth LLC (“the FIRM ”) is a registered investment adviser located in Beverly Hills, California. The FIRM may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements.
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