Tariff Turmoil Rattles Markets, but Recession Risk Still Low: Wolfe Research

The U.S. economy faces a precarious balancing act in early 2025, as tariff uncertainty and shifting policy landscapes shake investor confidence. While Wolfe Research has raised its recession probability estimate to 30-35%—nearly double the historical average—the firm argues the economic cycle remains intact, buoyed by resilient consumer spending and a labor market that, though cooling, has yet to collapse. The key question now is whether tariff-driven headwinds will tip the scales toward stagnation or if underlying strength can weather the storm.

The Tariff Effect: Growth Slows, Volatility Rises

Wolfe’s revised 2025 GDP forecast now stands at 1.6%, down from 2.2%, as tariff uncertainty disrupts supply chains and consumer behavior. The first quarter offered a stark preview: GDP fell 0.3%, the first contraction since 2020, driven by a surge in imports as businesses and households stockpiled goods ahead of anticipated tariffs. Meanwhile, the April 2 announcement of new tariffs on vehicles, electronics, and apparel amplified fears of rising costs, with economists warning of a 1-1.5% inflation spike by year-end.

Markets have priced in this turmoil. The S&P 500 fell 8.7% from its February peak by late March, with tech-centric sectors bearing the brunt. The “Magnificent Seven” (M7) tech giants—Apple, Microsoft, Amazon, Alphabet, Meta, NVIDIA, and Tesla—saw their collective value plummet 14.6%, underperforming the broader market by a wide margin.

Inflation: A Delicate Dance Between Easing and Rising Pressures

While headline inflation dipped to 2.4% in March—thanks to falling energy and travel costs—the path ahead is clouded. Producer prices fell 0.4% in March, but tariff-driven input costs threaten to reverse this trend. Consumer expectations remain stubbornly elevated: the New York Fed’s survey pegged one-year inflation expectations at 3.6%, while the University of Michigan’s gauge showed a 6% forecast—both exceeding current CPI readings.

The Fed’s dilemma is clear: with unemployment at 4.2% and core inflation still above target, policymakers are reluctant to cut rates further. The federal funds rate remains anchored at 4.25%-4.50%, even as the Fed acknowledges tariffs’ drag on growth. This creates a conundrum for markets, where bond yields have decoupled from equity prices—a sign of investors pricing in conflicting signals.

Labor Market: Cooling, but Not Collapsing

The labor market’s resilience has been a key buffer against recession fears. March nonfarm payrolls rose by 228,000, though the three-month average dipped to 152,000. Unemployment inched up to 4.2%, reflecting federal layoffs tied to reorganizations under the newly created Department of Government Efficiency (DOGE). However, average hourly earnings grew 3.8% annually, suggesting wage pressures remain subdued.

The bigger risk lies ahead: corporate profitability faces a squeeze as tariffs raise input costs. Wolfe warns that delayed investments and further layoffs could emerge if businesses cannot pass costs to consumers without stifling demand. Lower-income households, disproportionately affected by price hikes, face the steepest challenges. Budget Lab estimates suggest tariffs could reduce real GDP by 0.9% and boost prices by 2.3% in the short term.

Stagflation Risks: A Shadow, Not a Certainty

While the term “stagflation” has resurfaced, current conditions fall short of the 1970s crisis. Unemployment remains moderate, and consumer spending—though slowing—remains a pillar of growth. Still, the combination of tepid growth, rising inflation, and higher unemployment has raised alarms. Wolfe cautions that tariffs could amplify stagflation risks by simultaneously crimping output and raising prices.

Navigating the Markets: Defensive Plays and Caution

Wolfe’s investment playbook emphasizes resilience:
1. Defensive Sectors: Utilities and healthcare outperformed in Q1, with defensive stocks like Johnson & Johnson and NextEra Energy proving stable amid volatility.
2. Fixed Income: Bonds remain a hedge against equity declines, though yields face pressure if growth falters further.
3. Cyclical Caution: Homebuilders and discretionary stocks have already priced in ~33% recession risk, making them vulnerable to further pessimism.
4. Alternative Income: Real estate and infrastructure investments, along with structured products, offer downside protection in turbulent markets.

The M7’s underperformance underscores the risks of overexposure to tariff-sensitive sectors. Investors are fleeing growth stocks reliant on foreign supply chains, favoring domestically focused firms instead.

Conclusion: A Fragile Equilibrium, but Not Yet a Crisis

Wolfe’s analysis paints a picture of an economy teetering between resilience and vulnerability. While the 30-35% recession risk is elevated, the labor market’s staying power and consumer strength suggest a downturn is far from certain. The critical variables are clear:
- Tariff Resolution: A rollback or negotiation could alleviate uncertainty and stabilize markets.
- Fed Policy: Rate cuts would ease financial conditions but risk reigniting inflation.
- Inflation Trends: A return to 2-3% CPI would ease fears, while a resurgence above 4% would deepen pessimism.

For now, investors should prioritize safety. Defensive stocks, bond diversification, and a focus on firms insulated from trade wars are the safest bets. As Wolfe notes, “volatility is here to stay until clarity emerges.” With the S&P 500 already down 8.7% from its peak, patience—and a cautious portfolio—will be rewarded.

The path forward hinges on whether policy makers can resolve trade disputes or if markets will force their hand. Until then, the old adage holds: in uncertain times, the best offense is a strong defense.