I feel scared.
I feel scared about last week’s tariff-driven plunge in global stock markets; about a US recession, which I now think very likely; and about a general collapse of the global economy, perhaps comparable with 2008.
If this third – and worst – disaster is to be avoided, Europe and China will have to become much bolder about stimulating their domestic economies. There is a decent chance they will do this, since Donald Trump has shaken policymakers in Berlin, Brussels and Beijing out of their decade-long torpor.
But relying on the wisdom of European and Chinese politicians has been a losing bet for a long time. That is why I feel scared, and why markets were right to feel panicky Monday morning.
The big worries
Let me start with the least of these three worries: the exceptional speed and violence of last week’s equity ‘correction.’ The 10.5% fall in the S&P 500 in just two days was a symptom of unusual investor panic. Before last week, declines of -10% over two consecutive days had only happened on three occasions since 1952.
Each of those two-day plunges – in October 1987, November 2008 and March 2020 – occurred in the early or middle stages of major bear markets.
This could be just a statistical oddity, and history need not repeat itself. But if the violent sell-off last Thursday and Friday does turn out to be a symptom of a major bear market, then US equity prices still have a long way to fall.
The S&P closed on Friday only 17% off its all-time high. That compares with a peak-to-trough decline of 33% in the 1987 bear market, 56% in 2008-09, and of 34% in 2020.
Whether last week’s market ‘correction’ does prove to be a staging post in a major bear market will depend mainly on what happens to the US and global economies in the months ahead. So, let’s turn to the demand-management implications of Trump’s tariffs, which still seem to be very underestimated by investors and global leaders.
A nailed-on US recession
I think a US recession is now almost inevitable, starting in the third quarter. This is not because of the dreaded ‘tit-for-tat’ retaliation or the unpredictability of Trump’s tariff numbers, although these are certainly big headaches for corporate investment and consumer confidence.
It is because of a much bigger – and much simpler – worry: Trump’s enormous tariffs will represent the biggest US tax increase since the 1960s, and possibly even since the second world war. This enormous fiscal tightening, estimated at $300-800bn annually – equivalent to between 1-3% of US GDP – will hit US economic activity and employment very hard from the third quarter onwards.
Since there is almost no prospect of immediate tax relief to offset this huge fiscal tightening, I now think a US recession is more likely than the 60% probability JP Morgan estimated after Trump’s announcement or the 35% suggested by Goldman Sachs earlier in the week. And I say this as someone who steadfastly resisted the false alarms about a US recession in 2022, 2023 and 2024.
To make matters even worse, misguided policy responses in Europe and China could cause a US recession to metastasize into a worldwide slump, snuffing out hopes that global diversification might protect equity investors and threatening bond investors with a vast increase in government deficits and debts.
And now for some good news
After this catalogue of woe, some good news: three possible policy changes that could avert a major bear market, US recession and global slump:
One: The Federal Reserve could come to the market’s rescue by cutting interest rates aggressively to offset the fiscal tightening. I think this very unlikely. The tariffs will push US inflation up from its present 2.5-3% plateau to at least 4% and will eliminate any hope of a return to 2%, even in the long term.
If I’m wrong and the Fed does cut aggressively, or even hints strongly at rate cuts, it will probably trigger a market rally. But any such Fed-driven rally could be a mixed blessing for investors. If the Fed turns unequivocally dovish while inflation rises to 4% or above, much higher inflation will become permanently embedded as the US economy’s new normal. This in turn will unleash wage-price spirals, ultimately pushing bond yields much higher and equity valuations lower.
Two: The US Congress could agree very rapidly on a budget bill with huge tax cuts that would be paid immediately, not delayed until 2026. This seems even less likely than a rescue by the Fed.
The Republican majorities in both houses are so narrow that the highly expansionary Senate bill, with scope for up to US$500bn of annual tax cuts (which may still not be sufficient to compensate for Trump’s tariffs) has been declared dead on arrival by fiscal hardliners in the House.
Meanwhile the much tighter House version (with almost no scope for fiscal stimulus beyond a permanent extension of Trump’s 2017 tax cuts), has no chance of majority support in the Senate.
This doesn’t mean that the US Congress will be unable eventually to pass a tax-cutting budget. But it does suggest that a much greater sense of urgency will be needed, as in the 2008 crisis, to pass and quickly pay out the huge tax cuts required to offset the new and sudden tariff-related fiscal drag.
Three: Europe and China could respond to Trump by urgently increasing and accelerating their domestic fiscal expansions. Fiscal stimulus, combining tax cuts, government investment and selective industrial subsidies, would be the surest and most effective way of counteracting the contractionary effects of Trump’s tariffs on global economic activity and of maintaining world trade outside the US.
Big plan needed
Until recently I felt confident that the Trump shock had jolted Europe and China into fiscal activism. But the initial response to Trump’s tariffs has been disappointing, especially from Europe. European Union leaders have boasted of their ‘strong plan for retaliation’ when what they need is a plan to offset the loss of US exports by boosting domestic demand.
I still think that a strong fiscal stimulus from Europe and China is likely as policymakers around the world come to understand that the most immediate danger posed by US tariffs is not disruption of global trade relations, but simply a possible collapse of global demand (demand deflation was also the main reason why the Smoot-Hawley tariffs of 1930 aggravated the Great Depression).
In a rational world, Europe and China would enthusiastically embrace demand stimulus as the best response to Trump’s tariffs and would understand that the surest way to refute US protectionism is to strengthen growth in the rest of the world. I am optimistic enough to hope for such an outcome.
But I am not brave enough to put much money on it just yet.
Anatole Kaletsky is co-founder, chairman and chief economist of Gavekal. This column was originally published on Monday at Gavekal Research and is published here with permission.
