Markets Juggle Geopolitical Risk, Tariff Uncertainty, and Stagflation Signals

During the past week, the ongoing conflict and rising oil prices have kept markets cautious, fueling fears of a broader Middle East war and inflationary pressures. The White House said Trump will determine whether the U.S. will become directly involved in the Israel-Iran conflict within two weeks.

Additionally, amid the pending uncertainty of tariffs, while some recent inflation data, such as the May CPI, came in lower than expected, the full impact of tariffs on consumer prices is still anticipated, which continues to create choppy markets.

After the Fed's meeting last Wednesday, interest rates were kept unchanged at 4.25% - 4.5% for the fourth straight meeting. Despite maintaining its forecast for two rate cuts in 2025 (targeting 3.9%), the Fed raised its rate outlook for 2026 and 2027, expecting slower cuts ahead. The Fed also signaled growing concerns about stagflation – a combination of slowing economic growth, rising inflation, and unemployment.

Economically, the housing market, labor market, and manufacturing sector are a bit shaky, with retail sales and industrial production slightly missing expectations:

• Retail Sales for May came in at -0.9%, dipping deeper than the expected -0.5% and the previous month's -0.1%. Core retail sales were also at -0.3%, which fell below the forecasted 0.2%. All these figures pointed to cautious consumer spending.
• Industrial Production for May came in at -0.2%, falling short of the forecasted stability of 0.0% and the previous month's growth of 0.1%, which indicated instability in industrial performance.
• Business Inventories remained steady in the April report. The actual figure matched the forecasted 0.0%, reflecting unchanged consumer demand.
• Housing market: Overall Housing Starts in May were reported at 1.256M, below the forecasted 1.350M and the previous figure of 1.392M. The monthly change was -9.8%, the lowest level in five years. Although economists don't expect an imminent collapse in the housing market, uncertainty will continue to depress construction for the remainder of the year.
• Labor market: The weekly Initial Jobless Claims, reported at 245K, slightly fell from the expected, but the number of Continuing Jobless Claims was 1945K, higher than the expected 1940K, still showing a further loss of labor market momentum.
• Manufacturing sector: Philadelphia Fed Manufacturing Index for June remained steady at -4.0, which defied the forecasted number of -1.7, suggesting manufacturers in the region are still facing challenging business conditions.
• The U.S. Leading Index is an early indicator of significant turning points in the economic and business cycle. May's figure came in at -0.1%, consistent with the forecast and slightly better than last month's dip of -1.4%.

Overall, the markets were in a "tenuous holding pattern," balancing concerns about geopolitical risks and the unknown impact of tariffs with the Fed's consistent message of expected rate cuts and underlying healthy fundamentals in the U.S. economy. The S&P 500 finished the week modestly lower, experiencing a fractional weekly decline (-0.12%). Treasury yields continued their modest decrease – the 10-year yield is now at 4.38%, and the 30-year yield is at 4.89%.

Week Ahead

As a new week is coming, markets will closely watch a packed economic calendar for fresh clues on inflation, consumer strength, and housing trends. Key highlights include the PCE and Core PCE Price Index on Friday – closely tracked by the Fed as a preferred inflation gauge. Also due are updates on personal income and spending, durable goods orders, and the final Q1 GDP estimate, all of which will help shape expectations around economic momentum and outlook. On the housing front, Existing and New Home Sales, along with the Case-Shiller Home Price Index, will offer more insight into a cooling real estate market. Consumer sentiment and confidence readings from the Conference Board and the University of Michigan will provide insight into household resilience. Meanwhile, Fed Chair Powell's testimony before Congress on Tuesday will be closely watched for any shifts in the Fed's tone amid lingering concerns about stagflation.

When Will Clues to Tariff Impact Show Up in the Data?

"It's tempting to draw sweeping conclusions from the first few months of data, but history and economics both call for patience. Tariffs have a way of creeping into the numbers with a lag, and we haven't seen policy like this in almost 100 years."

— Ernie Tedeschi, Director of Economics at Yale Budget Lab, writing for Bloomberg Opinion

For investors taking a behavioral perspective, the ebb and flow of stock prices reflect the day-to-day interplay between sentiment and fundamentals. It's hard to deny that there have been big changes in sentiment in recent months. The S&P 500 slid by over 17% in the wake of trade turmoil from mid-February to early April, then climbed back to near-record highs as tariff fears attenuated and the so-called "TACO" trade ("Trump Always Chickens Out") took over. What's been harder to pin down is how fundamentals are changing.

While we don't doubt the moderation in Washington's tariff tone is a net positive for stocks, even in the relatively optimistic scenarios for how trade policy plays out, levies come in higher than they've been since the late 1930s. Surely, there's going to be some fundamental impact! When it comes to measuring that impact, however, investors sifting through a stream of macro data for clues on the magnitude and timing of real economic effects from trade shocks have found those inferences to be, unfortunately, especially elusive.

Part of the issue is the evident lag, as newly announced policies take some time to take effect, followed by additional time for post-implementation activity to be surveyed and reported. In the case of data that might show an inflationary effect from tariffs—monthly released indicators like the usual CPI gauge or the Fed's preferred PCE Index—that means we're looking at a lag of roughly 30 days from the time a policy officially kicks in. It's the reason neither the CPI nor the PCE inflation reports showed a spike in April, in line with forecasts. Most economists expect a surge in prices to build throughout the second half as previously paused or deferred tariffs gradually take full effect.

While investors might read these so-far muted inflation prints as good news for the economy and markets, other data points suggest a less rosy outlook. Survey data, in particular—which, importantly, can embed forward-looking expectations—have painted a gloomier picture, with consumer confidence, as tracked by the University of Michigan's monthly poll, down sharply in 2025. Similarly, American businesses surveyed in May by the Institute for Supply Management expressed frustration with forecasting and decision-making amid tariff uncertainty.

Concern that businesses will respond to such risk by scaling back puts even more focus on data from the U.S. labor market, but indications here have also muddied the waters. While a May report on private payrolls from ADP showed more loosening than expected, the official Bureau of Labor Statistics (BLS) May jobs data featured surprisingly strong job and wage growth.

Setting aside the fact that evidence on tariff effects so far has been a fairly mixed bag, another problem for data-oriented investors is that the observations streaming in for any given statistic reflect not only the direct impact of tariffs but also the indirect effects of changes in trade policy on the behavior of consumers and businesses, which in turn flow through to the data. This is reflected in registers of import/export activity—one of the first places changes in trade policy are likely to be evident—which is plotted below for a period spanning the last three and a half decades.

April's Record Fall in Imports Follows Months of Front-Running Tariffs

At the far right of the graph, we observe a record 20% decline in U.S. goods imports from March to April 2025: the kind of drop we might not expect to see outside a recession. On the face of it, that is very bad news. Taking into account prior few data points, on the other hand, it seems pretty apparent that April's pullback in trade is primarily a result of importers—who had been front-running Trump's "Liberation Day" announcement for months with above-average orders—finally taking a breather. All of this complexity in the way government policy, along with the behavior of companies and consumers, jointly creates the data makes it that much harder to extrapolate trends from a few initial readings of typically low-frequency monthly or quarterly indicators.

All of this suggests that investors would be well-advised to exercise patience as they attempt to make sense of tariff effects through the lens of incoming macroeconomic data. That's certainly been the Fed's approach—perhaps unsurprising given their admittedly "data-driven" orientation in setting policy. Indeed, minutes from May's FOMC showed a central bank determined to proceed with caution in the absence of much clearer evidence as to how high prices might climb and how much trade chaos will drag on growth. Given how challenging such measurements have proven to be, traders pricing in two rate cuts for 2025 may also need to have some patience.

Disclosure: This material is for informational purposes only and should not be considered investment advice. The opinions contained herein are subject to change without notice. Indices cannot be invested in directly and are unmanaged.