Why Markets Remain Murky on Tariff Fallout

Summary

Podcast Summary: "Why Markets Remain Murky on Tariff Fallout"

Episode Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Episode: Why Markets Remain Murky on Tariff Fallout
• Release Date: August 1, 2025

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Introduction

In the August 1, 2025 episode of Thoughts on the Market, hosted by Michael Zezas, Global Head of Fixed Income Research and Public Policy Strategy at Morgan Stanley, the focus is on the ongoing effects of tariffs on the U.S. economy. Joining him is Michael Gapen, Chief U.S. Economist, to delve into recent trade developments and their implications for the market.

Recent Trade Agreements and Tariff Rates

Timestamp [00:00 - 03:07]

The conversation begins with an overview of the latest U.S. trade agreements, particularly with Japan and Europe. Michael Zezas remarks:

"We have an agreement with Japan and an agreement with Europe, two pretty substantial trading partners, where it appears the tariff rate that's going to be applied is something like 15%." ([02:15])

He highlights that these agreements have narrowed the near-term uncertainty around tariff rates, bringing the average effective U.S. tariff rate down to a range of 15-20%, compared to the previously anticipated 25-30%. However, Zezas cautions that long-term uncertainties remain due to the contingent nature of these agreements, which could lead to future escalations if certain conditions, such as Europe's commitment to purchasing U.S. energy, are not met.

Impact on Inflation and Consumer Spending

Timestamp [03:07 - 05:24]

Michael Gapen provides insights into how tariffs are poised to influence inflation and consumer behavior:

"We've long been forecasting that inflation would begin to pick up in June. We saw a little of that, but it would accelerate through the third quarter, kind of peaking around the August, September period." ([04:00])

He explains that tariffs act as a regressive tax, disproportionately affecting low and middle-income consumers who spend a larger portion of their income on non-discretionary goods. Gapen anticipates a slowdown in consumer spending, particularly in these demographic groups, as the higher costs of goods begin to take effect.

Market Perception vs. Actual Impact

Timestamp [05:24 - 06:35]

Zezas addresses the prevailing market sentiment that may have already priced in the effects of tariff escalations:

"We're about to get some real evidence from economic data as to whether or not that view and those assumptions are credible." ([05:24])

He emphasizes that while the market may believe it has absorbed the tariffs, the forthcoming economic data will provide concrete evidence of their true impact on economic activity.

Business Spending and GDP Data Analysis

Timestamp [06:35 - 09:16]

Delving into recent GDP reports, Gapen discusses the volatility in trade and its repercussions on economic growth:

"Final sales to Domestic purchasers, which includes consumption and business spending, was only up 1.1% in the quarter. So the economy's moderating. Things are cooling." ([07:45])

He notes that the second quarter saw subdued capital spending, with equipment spending increasing marginally while investments in structures decreased significantly. This moderation is partly attributed to elevated trade policy uncertainty, which has dampened business confidence and investment.

Future Outlook

Timestamp [09:16 - 10:00]

As the conversation wraps up, Zezas transitions the discussion to the forward-looking perspective:

"As we move into the third quarter... activity data and the Fed will now become much more important over the next several months." ([09:16])

Gapen agrees, highlighting that upcoming inflation and employment reports will be pivotal in shaping Federal Reserve policies and, consequently, the broader economic landscape.

Conclusion

The episode concludes with both hosts acknowledging the complexities surrounding tariff policies and their multifaceted impacts on the economy. While recent agreements have provided some short-term clarity, long-term uncertainties linger, necessitating close monitoring of economic indicators to gauge the true effects of ongoing trade policies.

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For those interested in the intricate dynamics of trade policies and their implications on the market, this episode offers valuable insights from top economists at Morgan Stanley.

Transcript

[Michael Zezas]

Welcome to Thoughts on the Market. I'm Michael Zezas, global head of fixed income research and Public Policy Strategy.

[Michael Gapen]

And I'm Michael Gapen, chief U.S. economist.

[Michael Zezas]

Today, ongoing effects of tariffs on the U.S. economy. It's Friday, August 1st at 8:00am in New York. So Michael, lots of news over the past couple of weeks about the US making trade agreements with other countries. It's certainly dominated client conversations we've had. As I'm assuming it's probably dominated conversations for you as well.

[Michael Gapen]

Yeah, it's certainly a topic that never goes away. It keeps on giving at this point in time. And I guess, Michael, what I would ask you is what do you make of the recent deals? Does it reduce uncertainty in your mind? Does it leave uncertainty elevated? What's kind of your short term outlook for trade policy?

[Michael Zezas]

Yeah, I think it's fair to say that we've reduced the range of potential outcomes in the near term around tariff rates, but we haven't done anything to reduce longer term uncertainties in US trade policy. Consider, for example, over the last couple of weeks we have an agreement with Japan and an agreement with Europe, two pretty substantial trading partners, where it appears the tariff rate that's going to be applied is something like 15%. And when you stack up these deals on one another, it looks like we're going to end up in an average effective tariff rate from the US range of 15 to 20%. If you think back a couple of months, that range was much wider and we were potentially talking about levels in the 25 to 30% range. In that sense, investors might have a bit of a respite from the idea of massive uncertainty around trade policy outcomes. However, longer term these agreements really just are kind of principles that are set out for behavior and there's lots of tripwires that could create future potential escalations. So for example, with the Europe deal, part of the deal is that Europe will commit to purchase a substantial amount of US energy. There's obvious questions as to whether or not the US can actually supply that amidst its own energy needs that are rising substantially over the course of the next year. Could we end up in a situation where six months to a year from now, if those purchases haven't been made, the US sort of presses forward and the administration threatens to re escalate tariffs? Again, really hard to know. But the point is these arrangements have lots of contingencies and other factors that could lead to re escalation. But it is fair to say, at least in the near term, that we're in a landing place that appears to be somewhat smaller in terms of the range of potential outcomes. Now I think a question for investors is going to be how do we assess what the effects of that have been? Right. Because is it fair to say that the economic data we've received so far maybe isn't fully telling the story of the effects that are being felt quite yet?

[Michael Gapen]

I think that's completely right. We've always had the view that it would take several months or more just for tariffs to show up in inflation. And if tariffs primarily act as a tax on the consumer, you have to apply that tax first before economic activity would moderate. So we've long been forecasting that inflation would begin to pick up in June. We saw a little of that, but it would accelerate through the third quarter, kind of peaking around the August, September period. So I'd say we've seen the first signs of that Michael, but we need obviously follow through evidence that it's happening. So we do expect that in the July, August and September inflation reports you'll see a lot more evidence of tariffs pushing goods prices higher. So we'll be dissecting all the details of the CPI looking for evidence of direct effects of tariffs, primarily on goods prices, but also some services prices. So I'd put that down as the first marker and we've seen some early evidence on that. The second then obviously is the economy's 70% consumption tariff act is a regressive tax on low and middle income consumers because non discretionary purchases are a larger portion of their consumption bundle and a lot of goods prices are as well. Upper income households tend to spend relatively more money on leisure and recreation services. So we would then expect growth in private consumption primarily led by lower and middle income spending softening. We think the consumer would slow down, but into the end of the year those are the two main markers that I would point to.

[Michael Zezas]

Got it. I think this is really important because there's certainly this narrative amongst clients that we talk to that markets may have already moved on from this or investors may have already priced in the the effects or lack thereof of some of this tariff escalation. Now we're about to get some real evidence from economic data as to whether or not that view and those assumptions are credible.

[Michael Gapen]

That's right. Where we were initially on April 2 after Liberation Day was largely embargo level tariffs. And if those stayed in place, trade volumes and activity and financial market asset values would have collapsed precipitously. And they were for a few weeks, as you know. But then we dialed it back and got out of that. So yeah, we would say it's wrong to conclude that the economy has absorbed these tariffs already and that they won't have a negative effect on economic activity. We think they will. Just in the base case where tariffs are high but not too high, it just takes a while for that to happen.

[Michael Zezas]

And of course all of that's kind of core to our multiasset outlook right now where a slowing economy, even with higher recession probabilities still support risk assets. But of course that piece of it is going to be very complicated if the economic data ends up being worse than you suspect. Now, any evidence you've seen so far? For example, we had a GDP report earlier this week. Any evidence from that data as to where things might go over the next few months?

[Michael Gapen]

Well, another data point on trade policy and trade policy uncertainty really causing a lot of volatility in trade flows. So if you recall, there's big front running of tariffs in the first quarter, imports were up about 37%. On the quarter that ended in the second quarter, imports were down 30%. So net trade was a big drag on growth in the first quarter. It was a big boost to growth in the second. But we think that's largely noise. So what I would say is we've, we've probably level set import and export volumes now. So do trade volumes from here begin to slow? That's an unresolved question. But certainly the large volatility in the trade and Inventory data in Q1 and Q2 GDP numbers are reflective of everything that you're saying about the risks around trade policy and elevated trade policy uncertainty. Second, though, I would say because we started out the quarter with Liberation Day tariffs, the business sector clearly in our mind anyway clearly responded by delaying activity. Equipment spending was only up 4 to 5% on the quarter. IP was up about 6%, structures was down 10%. So for all the narrative around AI related spending, there wasn't a whole lot of spending on data centers and power generation in the second quarter. So what you speak to about the need to reduce some trade policy uncertainty, but also your long run trade policy uncertainty remains elevated. I would say we saw evidence in the second quarter that all of that slowed down capital spending activity. Let's see if the one big Beautiful Bill act can be a catalyst on that front, whether animal spirits can come back. But that's the other thing I would point to is that business spending was weak. And even though the headline GDP number was 3%, that's mainly a trade volatility number. Final sales to Domestic purchasers, which includes consumption and business spending, was only up 1.1% in the quarter. So the economy's moderating. Things are cooling. I think trade policy and trade policy uncertainty is a big part of that story.

[Michael Zezas]

Got it. Maybe this is something of a handoff here where my team had been really, really focused. Investors have been really, really focused on the decision making process of the US Administration around tariffs. And now your team's going to lead us through understanding the actual impacts. And the headline numbers around economic data are important, but probably even more important is the underlying. Is that fair?

[Michael Gapen]

I think that's fair. I think as we move into the third quarter, like between now and when the Fed meets in September again, they'll have a few more inflation reports, a few more employment reports. We're going to learn a lot more then about what the Fed might do. So I think the activity data and the Fed will now become much more important over the next several months than where we've been the past several months, which has been about announcements around trade.

[Michael Zezas]

All right, well, then we look forward to hearing more from you and your team in the coming months. Well, Michael, thanks for taking the time to talk to me.

[Michael Gapen]

Thanks for having me on and to our audience.

[Michael Zezas]

Thanks for listening. If you enjoy thoughts on the market, please leave us a review and tell your friends about the podcast. We want everyone to listen.

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