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It was an extraordinary first half of the year for markets. After a near 20% drawdown, the S&P 500 staged the fastest-ever rebound from a >15% decline and closed at fresh highs just before June’s end. Investors can be forgiven for feeling some whiplash.

Notably, the primary (though certainly not exclusive) source of volatility, tariffs, are only now beginning to have an impact on real economic data. Does it make sense for equities and credit to ‘look through’ a worsening in inflation and growth outcomes over the coming quarters? Our answer is yes.

The effective US tariff rate has climbed from 2.5 % in early 2025 to roughly 15 % today. Companies are now deciding how much to pass through to consumers vs. absorb in margins. Either choice implies softer consumption as real incomes slip or hiring slows. Slower immigration and still restrictive interest rates add to the drag.

Yet consensus already reflects this step down. Economist consensus pegs 2025 US GDP growth at 1.4%, down from 2.3% in January. The Fed’s June Summary of Economic Projections matches that figure and sees unemployment rising to 4.5%. Near term earnings estimates have been marked lower as well.

But markets don’t just discount cash flows for the next six months. As worst case scenarios are avoided, risk appetite rebounds even before the data does. There is plenty of precedent for markets to ‘move on’ despite worsening economic outcomes. Equities typically bottom when the news is at its worst.

Typically, after a negative catalyst, such as Trump’s dramatic ratcheting up of tariffs, soft data like consumer and business confidence deteriorate along with equity market performance. However, once policy shifts and soft data bottom out, equities start to bottom as well even as the hard data deteriorate (Exhibit 1). This has been precisely the pattern this year, with President Trump backing off worst case scenarios and settling with policies that while painful, are not likely to be cycle-ending.

Exhibit 1: S&P 500 performance after event-driven recessions

Moreover, this ‘pain’ is setting the groundwork for next year’s potential lift. With the labor market softening and services inflation cooling faster than expected, the Fed is likely to cut rates in the second half. Expectations of lower rates, along with a softer USD, are easing financial conditions now, which will support the economy with a lag into 2026.

Meanwhile, the likely summer passage of the ‘Big Beautiful Bill” will add stimulus to the economy via incremental tax cuts and business expensing provisions. As it turns out, tariff revenue is going to offset much of the incremental deficit increase from the bill – in other words, the pain (tax hikes) is coming now, but the economic support (tax cuts) come in early 2026. Markets can anticipate this, along with building deregulatory actions by the administration.

Finally, AI is progressively being incorporated into the operations of numerous companies. This integration is expected to enhance efficiencies, potentially boosting corporate profits. Therefore, it is prudent to overlook short-term challenges, as we may be standing on the brink of significant structural profit gains.

We recognize that this is an optimistic outlook, especially after the swift rebound in markets and valuations once again elevated. As such it’s important to identify risks to our view: of known unknowns, we see one risk that we are comfortable with and another that warrants greater concern. The first risk is that President Trump, now emboldened with stronger stock and bond markets, decides to dramatically raise tariffs again at the deadline on July 9th. While we certainly think the President may raise tariffs on some countries (though below Liberation Day levels) and expect volatility, we are not overly concerned about fresh tariff shocks driving a durable turn lower in the market.

First, markets now have visibility on the process behind tariff increases and what the worst-case outcomes would be. As such we think it is fair for measures of trade policy uncertainty to remain well below their peak. In short, the private sector is more adaptable now that it is familiar with the risks. Second, Trump has shown that he responds to his own constraints, whether market or economy driven (see Macro Monthly: Trump has Constraints). His pattern is fairly straight forward – announce a big tariff, try to extract concessions, and then make a deal, if possible. But Trump has shown he will back down himself if the costs to the economy or market appear too high.

The second risk, which concerns us more, is simply that the labor market doesn’t just bend but breaks. While labor market cooling to date has been gradual, there are plenty of historical examples where weakness reaches a point where it accelerates (i.e., the Sahm rule) and unwinds before the Fed can adjust quickly enough. This speaks to maintaining government bonds as a hedge in a portfolio, despite concerns about sticky inflation and high debt levels. We have confidence that in a recession, bonds will rally despite these concerns, particularly at the front end of the curve.

We upgraded our equity exposure early in June as it became apparent that worst case scenarios would be avoided and equity revisions turned significantly more positive. Despite sharp recent gains, we maintain this overweight as we think over time, markets will continue to look forward to a better 2026 despite weaker near-term data.

In the meantime, a ‘muddle through’ economy is usually positive for pro-carry strategies, including emerging markets and credit. Within emerging market currencies, we like the Brazilian real and Indian rupee – which we think can both benefit from attractive volatility-adjusted carry.

All of these views would be helped by a weaker USD, which we think will remain as a structural theme, driven in part by a narrowing of the growth gap between the US and the rest of the world. Ex-US investors remain incentivized to FX hedge their US asset exposures due to changing correlation dynamics, and expected rate cuts from the Fed will make this a less costly endeavour.

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