Portfolio Construction

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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