Resilience Reigns

Our outlook for the U.S. economy continues to improve following consistently stable “hard” data that contradicts the significant economic weakness predicted by the degradation in the survey, or “soft,” data during Q1 and Q2. The relative (albeit, notably intermittent) de-escalation in the trade war and the passage of the One Big Beautiful Bill Act have, in aggregate, resulted in a greater sense of certainty, increasing our confidence that the U.S. economy can avoid a recession over the next 12 months.

That said, the odds of an economic pothole remain higher than average, and we currently estimate the probability of recession at 40%, against the historical average of 20%. Contributing to this assessment is our view that the Federal Reserve will not preemptively cut rates to support the economy, given the high degree of uncertainty related to tariff-induced inflation, which we explore further below. Increasingly, the stage is being set for a reactive policy response to a meaningful degradation in the economic data, and the Fed will likely be late to respond. 

Inflation has been cooperating so far, but that may prove to be cold comfort, as the U.S. consumer has not yet borne the brunt of the expected changes to trade policy. As a reminder, tariffs are taxes that are collected when goods hit our shores. For context, the average tariff rate in early 2025 was roughly 2.5%, and the expected average tariff rate peaked at roughly 28.5% on Liberation Day. Based on current policies, which continue to evolve, the current average rate is 15% to 16%.

As noted, uncertainty persists, given that many trade deals have yet to be inked. However, we can assume that the average tariff rate will be notably higher at the end of 2025 than it was at the beginning of the year. As policy changes, the impact will also evolve. It is evident that the true impact of the tariffs will be felt with a lag, and we can see this clearly as we measure the actual tariff revenue collected: In May, the revenue collected suggested an average tariff rate of 9%, below the 15% estimated average rate. We can anticipate the impact will continue to increase over time, but with a lag of a few months.

Financial markets continue to show tremendous resilience in the face of continued uncertainty, but we would note that the current degree of uncertainty is relative: The worst case scenarios that were top-of-mind in April are far less likely now. This has led investors back to playing offense and leaning into U.S. equity markets, which are outperforming non-U.S. markets.

The rally in U.S. equities has been aided by strong performance from large-cap tech stocks, but the rally is not being driven exclusively by a technology tailwind. We have seen a revisiting of one of the themes at play earlier this year, a broadening out of participation across sectors in the U.S. market. To date in July, the equal-weighted S&P has outperformed the capitalization-weighted (i.e., size-weighted) benchmark, with strong participation from some value-oriented sectors and strategies. Further, we are seeing an outperformance of small stocks over large, with the Russell 2000 gaining over 3% and outpacing the large-cap S&P by over 2% since the beginning of the month.

Investors are more confident that the tariff impact on revenue and earnings will be manageable: Earnings estimates for 2025 have stabilized at 9% year-over-year. General expectations are that the cost of the increased tariffs will be borne equally among exporters, importers — who will have to absorb higher prices into their margins — and U.S. consumers. We are watching developments carefully and will soon have some additional insight from Q2 earnings reporting season, which gets underway next week.

Signed into law as planned on the Fourth of July and the foundation of President Trump’s agenda, the One Big Beautiful Bill Act brings significant changes to tax law for individuals, businesses, investors and charities, beginning as early as this year.

From a tax perspective, the centerpiece of the bill is the extension of key provisions of the 2017 Tax Cuts and Jobs Act which, barring the legislation, would have sunset at the end of 2025. This includes a permanent increase to the estate, gift and GST tax exemption (raised to $15 million for individuals and $30 million for married couples in 2026), as well as the permanent extension of the TCJA’s lower income tax rates for individuals.

Notably for investors and founders, the bill expanded the definition of “small business” for the treatment of Qualified Small Business Stock from $50 million to $75 million, resulting in significant new opportunities to exclude capital gain from such stock from tax. And, for businesses, 100% bonus depreciation and expensing of domestic research and development costs, phased out since 2022, return for 2025 and beyond.

For a thorough analysis of the bill and associated planning opportunities from the Northern Trust Institute, read Beyond Sunset: Tax Planning for the One Big Beautiful Bill Act.