Sebastian Mullins | US recession fears abate but "safe haven" status under threat

What a difference a month makes. Last month we were concerned that an effective US tariff rate of 20% would cause serious pain and damage to the economy while we wait for Trump to negotiate potential trade deals. However, since the back peddling on China, the effective tariff rate now sits at around 12%, which is more manageable and removes much of the pain while we wait for deals to be signed.

A US recession has therefore moved from a likely outcome to now just a risk. Our global economics team have adjusted their US growth forecast for 2025 down from 2.4% at the start of the year to 1.7%, assuming we roughly end up with a similar level of effective tariff rate post-negotiations. Trump appears to be moving the narrative away from tariffs towards his fiscal plans which will likely take centre stage over the coming months. While this has the chance to hurt equities through higher bond yields, the recession case has mostly been removed.

We are still watching for cracks in the US economy

While fears of a US recession have reduced, we remain focused on the US job market and retail sales. If the US does fall into a recession, the inflationary impact from tariffs (while once-off) will delay the Federal Reserve from cutting rates to save the economy. Our economics team expect US inflation of above 3% over the next two years. It would also hurt the US fiscal position, with deficits widening as the economy slows, potentially limiting further stimulus.

We do believe, however, that the Federal Reserve will ultimately cut rates to preserve growth if push came to shove, but not after the pain had been inflicted in both the US economy and the market. This could result in inflation expectations further out becoming unanchored, again limiting the desire for longer-dated US Treasuries.

Other central banks have wiggle room

In other parts of the world, central banks have the capacity to cut rates and lean on fiscal stimulus to protect their economies given any slowdown. For example, Germany has already discussed 3.5% of extra fiscal spend focusing on defence, infrastructure, and tax cuts. These economies also enjoy cheaper equity markets which may benefit from repatriation of funds as investors reassess their US overweights.

That said, US equity positioning is still very light at almost -1 standard deviation, and so systematic traders could reallocate given strong momentum and falling volatility. We have therefore upgraded our view on US equities from negative to neutral, but have simultaneously upgraded our view on the EU, UK and emerging market equities to positive. We retain a neutral rating for Japan given the potential for higher rates and a stronger currency.

Uncertain US growth prospects could hurt the US Dollar as "safe-haven" status is threatened

Uncertain growth prospects and uncertainty in US capital markets may lead to an unwind of the strong capital inflows into US assets seen over the past 10-15 years. Our view on the US dollar (USD) remains negative. The recent USD reaction during a broad risk-off episode suggests it is losing its safe-haven status.

We believe capital flows back to countries like Europe and Japan, who have been buyers of US Treasuries and US equities on an unhedged basis, will be pulling money back to their home currencies, strengthening the euro (EUR) and Japanese yen (JPY). Rate differentials between the US and Japan, along with the potential rebound in European growth thanks to upcoming fiscal stimulus, could further support the JPY and EUR. Opportunities remain in terms of select emerging market currencies (EM FX), where real yields are high, valuations are cheap, and countries are less exposed to the ongoing trade tensions.

*Sebastian Mullins, Head of Multi-Asset and Fixed Income, Australia