Commentary: Slowdown delayed, not denied

Through the incessant noise of wars in the Middle East, on-again, off-again tariffs, and highly disruptive immigration tightening measures, both the US economy and the markets have proven to be resilient, occasional bouts of volatility notwithstanding. With respect to the US economy, Nowcasting estimates from Atlanta Federal Reserve point to real GDP tracking 3%+ growth in 2Q, which would put 1H25 growth in the 1.5%+ territory, after a virtually flat 1Q. As for the financial markets, they have made up the losses incurred after the April 2 Reciprocal Tariff announcements, with both Nasdaq and S&P500 in positive ytd territory.

Survey-based data reflected acute uncertainty and stagflation fears initially, but they have begun to ease lately. St Louis Fed’s economic policy uncertainty index remains highly elevated, but it is down from the panic-induced peak reached a couple of months ago. University of Michigan’s survey of consumer sentiment and inflation expectations also show that peak fear is behind.

The risk of this feel-good moment being a temporary one is high. From an oil shock emanating out of the Middle East to belated but inevitable inflation passthrough from tariffs, several developments are on the cards that could undo the marginal improvement in sentiments. At the other end of the risk spectrum, putting aside the funding implications, the forthcoming Big Beautiful Bill would inject fiscal impulse to the US economy, in the form of a series of tax cuts. This would be a potential offset to the potential negatives in play. The tax cut may end up being largely oriented toward the wealthy, who tend to have lower marginal propensity of consume, but it would still support domestic consumption.   

Should we then upgrade our 1.5% real GDP growth forecast for 2025? There is a decent chance that growth is a tad higher this year, we concede, but it is too early to consider such a change. As Chair Powell pointed out during his June FOMC press conference, there are too many uncertainties out there to make a decisive call on economic momentum and the path of inflation, especially as the trade and fiscal policy environment is beset with frequent escalations and about-turns.  

There are other reasons to be cautious. Immigration measures and public sector employee firings offer a multitude of risks. On immigration, the ongoing crackdowns will hurt labour supply/cost in farming, fishing, shipping, construction, transportation, and recreation. Coming during the summer months when both farming and construction reach their high seasons, this may play out sooner than later. On the public sector, the DOGE-related firings are beginning to show up in the data, with public sector’s contribution to payrolls at its weakest in a decade. This is particularly in contrast to the Biden years, when public sector hiring was particularly buoyant. Interestingly, similar trend is being seen in the private sector payroll figures as well, for separate reasons. 

If public sector job cuts meant meaningful improvement in the fiscal position, then at least there would be one upside, given the federal government’s high deficit and debt position. However, despite all the noise around defunding foreign aid, public broadcasting, research, and education, it turns out that fiscal needle is not moving at all. Burdened by ever rising interest payment costs, defence spending, as well as social security and entitlement spending, public expenditure remains on an upswing. Through the third week of June, federal government spending was up 7.2%yoy, compared to less than 1% growth during the same period last year. Adjusted for inflation, public spending was falling in real terms last year, it is rising robustly this year.

We see three key drivers of economic slowdown ahead: (i) labour supply crunch due to mass deportation, (ii) rising cost of production due to labour crunch and tariffs, and (iv) slowdown in non-AI investment due to uncertainty around trade and investment policy. A moderation of company margin and profitability is on the cards, and while legal blue-collar workers may see their wages go up, the outlook for a wide range of white-collar job is becoming gloomy.

We are marking down our 2026 GDP growth forecast to 1.5%, which puts us in the non-recession, but below-trend growth, camp. This will provide the Fed with room to cut rates modestly even as inflation remains above-trend. We see 50bps of cuts this year and 50bps more next year.


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