Insights

I’d like to discuss a presentation delivered by Austan Goolsbee, President of the Federal Reserve Bank of Chicago, to the Economic Club of New York on 10 April. Austan Goolsbee, gave a remarkably animated talk about tariffs and their impact on the U.S. economy.

Goolsbee is a current member of the Federal Reserve’s Open Market Committee, alongside representatives from Washington, D.C., and Fed bank Presidents from Chicago, Boston, St. Louis, and Kansas City.  

Having previously served as Chairman of the Council of Economic Advisers in the Obama White House, Goolsbee’s presentation style in New York was notably different from his more reserved demeanour I had previously seen when I had attended a talk of his in Chicago.

During his hour-long, fast-paced talk, Goolsbee addressed the economic implications of tariffs. He recounted an interview where he argued that raising interest rates was not the appropriate response to tariffs, a stance that led some to label him a “Dove.” He humorously dismissed the bird analogy, instead likening himself to a “Data Dog,” tasked with sniffing out the data to guide decision-making.

Goolsbee explained that tariffs typically drive inflation higher, which might ordinarily prompt rate hikes. However, they also tend to reduce economic growth, suggesting a need to cut rates. This creates a dilemma where rates might not need adjustment at all. He described tariffs as a “stagflation event” but emphasised that their impact is minor compared to the severe stagflation of the 1970s.

When asked if the U.S. was heading towards a recession, Goolsbee said that the "hard data" was surprisingly strong.

Let us now look at our model of US GDP based on the Chicago Fed National Activity Index. This Index   incorporates 85 variables across production, sales, employment, and personal consumption.  In the final quarter of last year, this index indicated the GDP growth was slightly below the long-term average, suggesting a US GDP growth rate of 1.9% to 2%.

However, data from the first quarter of this year showed stronger growth, just fractionally below the long-term trend.

Using Our Chicago Fed model, we find that US GDP growth had risen from about 2% growth to a growth rate of around 2.6%, indicating a robust U.S. economy far from recessionary conditions.

We think that   increased government revenue from Tariffs might temper domestic demand, potentially guiding growth down towards 1.9% or 2% by year’s end. Despite concerns about tariffs triggering a downturn, this highlights the economy’s resilience and suggests   a “soft landing,” which could allow interest rates to ease, weaken the U.S. dollar, and boost demand for equities.

We will provide monthly reviews of these indicators. We note that, for now, the outlook for the U.S. economy remains very positive.

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I want to discuss a simplified explanation of the US business cycle, prompted by the International Monetary Fund's forecast released yesterday, which, for the first time, assessed the impact of tariffs on the US economy. Unlike last year's 2.8% growth, the IMF predicts a drop to 1.8% in 2025. This is slightly below my forecast of 1.9 to 2%. They further anticipate growth will decline to 1.7% in 2026, lower than my previous estimate of 2%. Growth then returns to 2% by 2027.

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This suggests that increased tariffs will soften demand, but the mechanism is intriguing. Tariffs are expected to reduce the US budget deficit from about 7% of GDP to around 5%, stabilizing government debt, though more spending cuts are needed.  This reduction in US deficit reduces US GDP growth. This leads to a slow down.

The revenue from tariffs is clearly beneficial for the US budget deficit, but the outlook for the US economy now points to an extended soft landing. This is the best environment for equities and commodities over a two-year view. With below-trend growth this year and even softer growth next year, interest rates are expected to fall, leading the fed funds rate to drift downward in response to slower growth trends. Additionally, the US dollar is likely to weaken as the Fed funds rate declines, following a traditional US trade cycle model: falling interest rates lead to a weaker currency, which in turn boosts commodity prices.

This is particularly significant because the US is a major exporter of agricultural commodities, has rebuilt its oil industry, and is exporting LNG gas. The rising value of these commodities stimulates the economy, boosting corporate profits and setting the stage for the next surge in growth in a couple of years.

This outlook includes weakening US interest rates and rising commodity prices, continuing through the end of next year. This will be combined with corporate tax cuts, likely to be passed in a major bill in July, reducing US corporate taxes from 21% to 15%.  This outlook is very positive for both commodities and equities. Our model of commodity prices shows an upward movement, driven by an increase in international liquidity within the international monetary system.

With US dollar debt as the largest component in International reserves , as US interest rates fall, the creation of US government debt accelerates, increasing demand for commodities.  The recent down cycle in commodities is now transitioning to an extended upcycle through 2026 and 2027, fueled by this increased liquidity due to weaker interest rates.

Furthermore, the rate of growth in international reserves is accelerating, having reached a long-term average of about 7% and soon expected to rise to around 9%. Remarkably, the tariffs are generating a weaker US dollar, which drives the upward movement in commodity prices. This improvement in commodity prices is expected to last for at least the next two years, and potentially up to four years.

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Today I’ll be covering a range of topics, including the U.S. economy, tariffs and their impact on inflation, and what this means for the Federal Reserve.

I’ll also discuss how the funds raised through tariffs and employment influence job creation and why this is crucial for stock market performance over the next year.

Contrary to some concerns, the U.S. economy is not heading into a recession. Treasury Secretary Scott Bessent has highlighted the strong employment figures for March, with 228,000 new jobs created. However, a closer look reveals that nearly all of these jobs were in the services sector, particularly in private service providing (197,000 jobs), healthcare (77,000 jobs), and leisure and hospitality (43,000 jobs), with very few jobs  in manufacturing.

This underscores the need for a Reciprocal Trade Act to revitalise U.S. manufacturing.

On the tariff front, Kevin Hassett, Director of the National Economic Council, announced that the U.S. is negotiating with 130 countries to establish individual tariff agreements. Most of these countries will face a 10% tariff, though exemptions are being considered for American firms operating in China, particularly those exporting smartphones, computers, and computer chips to the U.S.

With this 10% tariff applied across these nations, it’s worth examining its effect on U.S. inflation. The latest core CPI inflation rate in the U.S. was 2.8%, which is close to the target of 2.5%. However, as imports account for roughly 13% of domestic demand, a 10% tariff could increase inflation by 1.3%, pushing the total inflation  to 4.1%.

Using my Fed funds rate model, I factored in this higher inflation rate. The current Fed funds rate stands at 435 basis points, and with the next meeting scheduled for 5–6 May. My model suggests an equilibrium inflation rate of around 4.07%. This gives the Fed room to cut rates, not by three cuts as speculated last week, but by one, equating to a 25-basis-point reduction. Last week, I estimated the fair value for the S&P 500 at 5,324 and the ASX 200 at 5767 for the year. Markets have since approached these levels, but unlike the past few years, where markets surged and kept climbing, I believe they will now stabilise closer to fair value. The corporate bond market is less bubbly than before, which supports this more sombre outlook.

Scott Bessent also noted that the previous stock market run-up was driven by the ‘Magnificent Seven’ tech stocks. This was fuelled by America’s dominance in artificial intelligence. However, as China has demonstrated its own AI capabilities, the market then peaked and is now likely to align more closely with global fair value.    

Looking ahead, Peter Navarro, Senior Counsel for Trade and Manufacturing in the White House, provided key insights yesterday. He estimates that the 10% revenue tariff will generate approximately $US650 billion, which will significantly boost corporate tax revenue. This cash flow will support a major bill, expected to pass mid-year, that will lower U.S. corporate taxes from 21% to 15%. This reduction will substantially increase after-tax earnings, even without changes to current operations, and lead to a sustained rise in operating earnings per share in the U.S. market next year.

While this bodes well for 2026, the market will likely need to consolidate in the near term. It will need to do more at the current level before experiencing a significant run-up, particularly next year.

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The first page discusses the outlook for the world economy. I wrote this about six weeks ago, and since then, the U.S. economy seems to have softened a bit. This softness aligns with my model of the U.S. economy. Initially, I expected 2.3% growth this year, but now I'm thinking it might be closer to 2%. Looking ahead to 2026, I believe next year will see slower growth. With US growth closer to 1.9%.

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Meanwhile, the Euro area’s economy is also growing, but at a slower pace. What’s critical here are the relative growth rates. I expect the Euro area economy to grow by 1.4% next year, which suggests that European bond yields will rise relative to U.S. bond yields. This shift means Europeans will keep more of their savings at home, which will likely cause the Euro to rise against the U.S. dollar over the next two years.

Despite recent fluctuations, including last week’s movements, the trade of the year has been the decline of the U.S. dollar and the rise of the Euro and Sterling. This is significant because understanding the commodity cycle hinges on the movements of the U.S. dollar. In short, the U.S. dollar seems to be headed structurally down over the next two years.

China, on the other hand, is experiencing a gradual slowdown, with growth expected to be 4.5% next year, down from 5% this year. India remains strong, growing slightly faster than last year, and its economy is expanding at around 1.5times the rate of China’s.

The Australian economy is also lifting relative to the U.S. due to increased government spending, though this has led to high government debt, which younger Australians will have to pay off in the coming decades.

In terms of inflation, Australia is facing a bit of a paradox. While the U.S. is seeing inflation at a higher level, Australia’s inflation remains lower than expected, even with low unemployment. This is due to the influx of cheap goods from China, where inflation is incredibly low, almost bordering on deflation. This overcapacity in China’s manufacturing sector is driving prices down, essentially exporting deflation to the rest of the world, including Australia. However, because of this, inflation in Australia has not spiked as much as might be expected. Inflation in China has remained under 1%, and its domestic prices are very low due to the volume of exports, further pushing down global prices.

Looking ahead, the global commodity cycle may shift upwards. Commodity prices will likely rise, partly due to a weaker U.S. dollar. This signals the beginning of a new upward cycle. This pattern has happened before, with a recovery in commodity prices and stock markets following periods of slump. The future should follow a similar trajectory, with international reserves rising and commodity prices increasing monthly. After experiencing a negative rate of change in international reserves in the past, we’re now seeing a gradual recovery, potentially reaching the levels seen in earlier decades. This suggests a positive outlook for the global economy in the coming years.

Finally, I use the Chicago benchmark commercial activity indicator in my model to track the performance of the U.S. economy, alongside similar indicators for other regions like China, to assess global economic trends.

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The U.S. economy is facing a series of challenges, particularly concerning US GDP growth. The three-month moving average of Chicago Fed National Activity Index stands at -.20, indicating that the economy is trending below average. The latest monthly number recorded is -0.19, suggesting that the economy is running at around 2% growth.

Six weeks ago, there was a presentation that discussed the current state of the U.S. economy, and one of the major concerns was the unsustainable level of US Federal debt-to-GDP, as highlighted by Jay Powell. This issue largely stems from decisions made by the Biden administration to run deficits, with the deficit peaking at about 6.8% of GDP after the pandemic, far exceeding the sustainable 3% threshold.

This deficit has led to an unsustainable level US Debt to GDP. This has prompted discussions about cutting spending. Notably, Elon Musk and his team at DOGE are attempting to reduce spending and the deficit. The US deficit currently stands at around $2 trillion per year.

The U.S. government is also looking at ways to raise more revenue through a general revenue tariff of 10%. This is estimated to raise a $650 billion revenue increase.

In terms of economic indicators, the typical relationship between unemployment and inflation is showing that when Australian unemployment hovers around 4%, inflation is expected to be around 3.7%. Inflation is now lower than that because deflation is being imported from China

The U.S. dollar index has dropped significantly, losing around 8% from its January peak, which shows a broader trend to a weaker US dollar. This has been tied to forecasts for recovery in commodities, including predictions that oil Brent oil prices will rise to around $US88 a barrel, with long-term projections closer to $US87. LNG price projects are projected at around $US12 per million metric BTU.

Additionally, there's an ongoing moderate shortage of nickel, which has been tied to the global demand for stainless steel. This demand is particularly strong in Europe, where there's been an increase in the use of stainless steel. Zinc is more in demand in China for structural steel. The Zinc price is close to fair value. This reflects the changing dynamics of global manufacturing.

Gold prices, on the other hand, have been rising, and we think will begin to build a top over several years. This is attributed to an aggressive increase in the U.S. budget deficit, which has had a significant impact on the price of gold.

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In the silver market, there's an interesting trend where silver tends to move alongside gold prices. Silver is moderately undervalued.

As the budget deficit continues to be a major concern, there will likely be a lot of focus on its impact on stock markets and the general economy. For now, commodities like copper, nickel, and zinc are in the spotlight, with their prices closely tied to global recovery trends.

Meanwhile, in the cattle industry, there’s cautious optimism.

The Fed Funds rate

The Fed is on track to lower rates. I expect three 25basis point rate cuts, with a 50 basis point rate cut the first time, followed by a 25 basis point cut.

The Equities Market

US corporate profit tax is expected to fall from 21%now to 15% next year, so earnings growth will remain strong, and the fundamentals are unlikely to change. The S&P 500 model updated this morning showed that the fair value was 5320 points, while the actual level was 5074 points, leaving 250 points of potential upside. We also see similar growth prospects in the ASX 200, with a fair value currently sitting at 7667.

Tariffs

The US government is also addressing issues with tariffs, and negotiations are ongoing with countries that want to avoid being cut off from the US market. Countries like Vietnam have already agreed to reduce tariffs in exchange for long-term deals with the US.

Between now and the 21st of June, countries are expected to make proposals to improve their deals with the US. These discussions will continue with US Treasury officials, aiming to meet US conditions. The result will be significant tariff reductions

The legislation surrounding these negotiations is expected to pass by the 21st of June, signalling positive movement in the global market landscape.

We see, for example, in Australia, where we're just playing the 10% revenue tariff, which is equal the lowest across the board. The Brits, surprisingly, have their own situation where Donald Trump’s connection to the UK, particularly with his Scottish mother, had an impact. Peter Navarro, however, has pointed out that tariffs must be at least as high as the national value-added tax.

Trump's approach to the economy has been about boosting manufacturing, particularly by bringing back jobs that were lost, mainly to China. The loss of 7 million American manufacturing jobs over a 12-year period due to China’s entry into the World Trade Organisation at the beginning of this century. This has caused a social crisis, which only worsened over time. This situation partly fuelled Trump's rise.

Looking at the global situation, there is also the looming issue with China, whose rearming could pose significant risks. Some believe this may lead to a larger conflict, as the U.S. tries to rebuild its manufacturing strength, reminiscent of the industrial effort during World War II. Experts, including Admiral John Aquilino, have highlighted the importance of maintaining a strong manufacturing capacity for national security reasons, especially in the event of war with China.

In the context of the Aukus deal, while the submarines themselves might not be the most critical aspect, the importance lies in allowing Australian facilities to service and repair American submarines. This would effectively make Australia a key logistical hub for U.S. military operations, much like it was during World War II. The country’s strategic position and facilities are vital for maintaining security in the Pacific. Given the rearming efforts by China, this could become even more crucial soon.

This Chinese rearming process and its military buildup in the Pacific, puts significant pressure on the region’s stability, and should there be a war, Australia will again find itself at the heart of crucial military operations, providing vital support to the U.S. and its allies. The global situation, especially in the Pacific, is a reminder of the strategic importance of maintaining strong alliances and ensuring that the U.S. and its partners are prepared for any potential conflicts.

Are Tariffs Inflationary?

A panel discussion in January, featuring notable economists like Ben Bernanke and John Cochrane, raised this very question. Bernanke, who is known for his work on inflation and monetary policy, alongside Cochrane, who is renowned for his textbooks on economics, examined the impact of historical tariff changes on U.S. inflation. They noted that two periods of significant tariff changes, one in the 1890s under President McKinley and another in the 1930s with the Smoot-Hawley tariffs, did not lead to sustained inflation. This suggests that tariff adjustments, when paired with appropriate monetary policy, do not necessarily lead to inflationary pressure.

For example, the U.S. imports only about 13% of what it consumes, meaning the maximum inflation impact from a 10% tariff increase could be as little as 1.3% in the first year. However, this inflation effect would likely be short-lived, disappearing after a year. As a result, such inflation would be considered "transitory," like the effects seen in the past when tariffs or other price shocks led to temporary increases in prices.

Turning to the Federal Reserve, it's expected that the central bank will continue to respond to economic conditions, potentially cutting rates in the short term if necessary. Predictions for the Fed’s next moves suggest a 50-basis point cut followed by a smaller one, but the ultimate decisions will depend on future economic data and conditions.

On another note, in terms of global geopolitics, the issue of Taiwan and China continues to pose a significant risk. While some suggest the U.S. could work to establish a strong semiconductor industry domestically to avoid being dependent on Taiwan, the future of Taiwan will ultimately be determined by the Taiwanese people themselves. If Taiwan decides to remain independent, the U.S. and Japan might step in to defend it, leading to potential conflict. However, the likelihood of China simply letting Taiwan make its own decision is considered low.

In light of these risks, the U.S. has been taking steps to bolster its semiconductor manufacturing capacity through initiatives like the CHIPS Act, in case Taiwan falls under Chinese control. Such strategic planning aims to safeguard the U.S. against a potential semiconductor crisis. Nonetheless, the ability to forecast such geopolitical events remains beyond the reach of even the most experienced economists.

Despite these uncertainties, the actions taken by key players like Navarro, who has a strong background in international trade and economics, play a pivotal role in shaping future policy decisions. His expertise in China’s economic dynamics has made him an influential figure in the Trump administration's trade strategies, with his books on the subject continuing to inform policy debates.

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After weeks of wild market swings, the US administration has finally paused its most aggressive reciprocal tariffs for at least 90 days. This pause led to the Nasdaq soaring over 12% in a single session, marking its best day since 2001. However, the question remains: is this a relief rally, or is it something more sustainable? The 90-day tariff pause gives countries and companies some breathing room to negotiate their strategies moving forward. However, China still faces 145% tariffs, and negotiations are expected to drag on, with Beijing vowing to fight until the end while the White House seeks to rewrite the global trade order. This creates a high-stakes environment.

For investors, it’s important to focus on upgrading portfolio quality. Stocks that are well-placed, class-leading companies with pricing power are best equipped to weather potential cost inflation and market volatility. Companies like Goodman Group, Pinnacle, Macquarie Group, and Y State are examples of those that can absorb price shocks and remain strong despite recent volatility. Additionally, investors should use volatility wisely. The 12% rise in the Nasdaq is a reminder that panic can create opportunities. High-conviction names in the growth space, such as Hub24, Guzman Gomez in the quick-service restaurant sector, and Pro Medicus in healthcare IT, are all businesses built for long-term growth.

In conclusion, the next 90 days could be critical in determining the outcome of both the tariff situation and this rally. Investors are reminded to stick to the fundamentals, focus on quality, and avoid letting tariff headlines dictate their strategies.

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Investment Watch is a quarterly publication produced by Morgans that delves into key insights for equity and economic strategy.

This publication covers

Economics - Tariffs and uncertainty: Charting a course in global trade
Asset Allocation - Look beyond the usual places for alpha
Equity Strategy - Broadening our portfolio exposure
Fixed Interest - A step forward for corporate bond reform
Banks - Post results season volatility
Industrials - Volatility creates opportunities
Resources and Energy - Trade war blunts near term sentiment
Technology - Opportunities emerging
Consumer discretionary - Encouraging medium-term signs
Telco - A cautious eye on competitive intensity
Travel - Demand trends still solid
Property - An improving Cycle

US President Donald Trump’s “liberation day” tariffs have rattled global markets. Since the pronouncement, most global indices have been down by over 10%. The scope and magnitude of the tariffs are more severe than we, and the market, expected. These are emotional times for investors, but for those with a long-term perspective, we believe short-term market volatility is a distraction that is better off ignored.

While the market could be in for a bumpy ride over the next few months, patience, a well-thought-out strategy, and the ability to look through market turbulence are key to unlocking performance during such unusual times. This quarter, we cover the economic implications of the announced tariffs and how this shapes our asset allocation decisions. We also provide an outlook for the key sectors of the Australian market and where we see the best tactical opportunities.

Morgans clients receive exclusive insights such as access to our latest Investment Watch publication. Contact us today to begin your journey with Morgans.