Outlook for the 2nd quarter: markets under the spell of US tariffs

Bond markets: US tariffs change all forecasts – more significant interest rate cuts by the ECB

In the first quarter of 2025, the European bond markets were characterized by strong movements triggered by the rise in yields on German government bonds. For example, the yield on ten-year German government bonds rose by a total of around 37 basis points over the course of the quarter to 2.73% at the end of the quarter. At the beginning of March, the yield even peaked at over 2.9%. This was caused by a fiscal turnaround in Germany and the associated concerns about a noticeable increase in government debt in the future. Despite this volatility, investment-grade corporate bonds proved to be remarkably stable. Spreads remained largely constant, indicating the solidity of many issuers and lower interest rate sensitivity.

The announcement of surprisingly high tariffs by US President Donald Trump on April 2, which could go down in economic history as Black Wednesday, changes the outlook for 2025. The probability of a US recession has increased. The higher US tariffs in combination with a US recession mean a negative growth impulse for Europe. At the same time, weaker economic growth and a marked fall in commodity prices will have a strong disinflationary effect. Inflation swaps are currently pricing in an average inflation rate of only around 1.38% over the next twelve months. In this environment, we now expect at least four further interest rate cuts by the ECB, not just one, which is roughly in line with the expectations priced into the financial markets. A surprisingly rapid decline in inflation coupled with weak economic data could even prompt the ECB to cut its key interest rate to 1.0% by the end of the year. This means there is a good chance that government bonds in the euro zone will perform well in the second quarter. Corporate bonds are likely to perform less well, as there is a threat of widening spreads due to the increased economic risks. 

Equity markets: Little prospect of a rapid recovery in the second quarter

Global equity markets showed mixed performance in the first quarter of 2025. In the US, the S&P 500 fell as political uncertainty and US tariffs, including against Canada and Mexico, triggered concerns among market participants. The MSCI World index, which is heavily influenced by the US equity market, lost around 2.6% in local currency terms. European equity markets, on the other hand, showed strength: the MSCI Europe rose by around 6.4% (in local currency), supported by solid corporate profits, expected rising defense spending and lower-than-expected burdens from the US tariffs announced by the end of March. Above all, however, Germany’s turnaround decision to increase government spending boosted the European equity markets. Developments in Asia were mixed. While China suffered from weaker economic data, Japan benefited from stable domestic consumption and strong demand for semiconductors. Overall, geopolitical tensions, trade measures and sectoral differences shaped the global markets.

The tariffs imposed by US President Donald Trump on the whole world are likely to hit the US economy itself the hardest. Rising inflation and declining consumption could lead to a recession in the US. It will also likely be difficult for the US Federal Reserve to cut the key interest rate quickly and rapidly. There is therefore much to suggest that the second quarter could be difficult on the equity markets in Europe and the USA and that the risk of price losses will predominate. A rapid price recovery seems rather unlikely. However, much depends on the US government's decisions on trade policy. If there are signs of an easing in the conflict between the US and China, the equity markets could recover quickly. However, if US President Donald Trump were to attack the US Federal Reserve, there would also be a risk that international investors' confidence in the US dollar could be undermined.

Eurozone economy: Despite Trump's tariffs, the European economy should show resilience

US President Donald Trump's announcement at the beginning of April that he would impose a US punitive tariff of 20% on the EU and even higher punitive tariffs on many other countries came as a nasty surprise. Participants on the financial markets had expected significantly lower tariffs. According to experts' calculations, the average US tariff could have risen from around 4% before Donald Trump's election to around 24%, the highest level since 1910. This would undoubtedly have sent shockwaves through the global economy. Fortunately, US President Donald Trump rowed back and lowered the tariff rate for the EU to 10% until at least July 9. This significantly reduces the negative growth impulse for the EU. 

Based on its macroeconomic model, the Kiel Institute for the World Economy has come to the conclusion that the tariffs announced on April 2 could reduce gross domestic product (GDP) in the US by 2.0 percentage points in the coming months and by around 0.5 percentage points in the EU. At the same time, according to the model, inflation could rise by up to 9.0 percentage points in the US, while it could fall by around 1.25 percentage points in the EU. These are purely model results and should therefore be treated with caution. Nevertheless, the model outcomes provide important conclusions.

In principle, the general trend of the model shows that the negative impact of tariffs on economic growth in the EU is rather limited. In addition, there will be a noticeable disinflationary impulse, as the euro exchange rate has risen and commodity prices have fallen significantly. We also do not expect the EU to impose any significant counter tariffs on the US, meaning that the disinflationary effect is likely to take full effect. This gives the European Central Bank (ECB) more scope to cut key interest rates. We expect four key interest rate cuts to just 1.5% over the course of the year. Nevertheless, there is a high probability that the key interest rate could even fall to 1.0%. We therefore expect the European economy to remain resilient. The ECB's interest rate cuts, combined with rising government spending in Germany, should enable economic growth of around 1.0% for the euro zone this year and next. Our previous forecast was 1.5 percent. To be honest, however, there is a great deal of uncertainty about the impact of customs policy on the macroeconomy, so the forecasts may well have to be adjusted more often.

US economy: Zero percent growth and recession as the baseline scenario

The scale of the tariff increases announced and implemented by US President Donald Trump is staggering. The average tariff rate could have risen from around 4 percent to around 24 percent – a level last seen in 1910. Interestingly, despite the announcement on April 9 to postpone some tariff increases for many countries for 90 days, the average tariff rate only seems to be reduced to around 20 percent for the time being, which would still be an incredibly high level historically. The tariff increases against almost all countries in the world will hit the USA itself the hardest. The US trade deficit will only be reduced if the USA imports less – and that presupposes lower consumption. However, consumption will only fall if prices rise and real incomes fall. Accordingly, US inflation is likely to rise significantly after the higher tariffs come into force. In addition, US share prices have fallen significantly since the start of the year, meaning that private household wealth has declined. The positive wealth effect, which boosted consumption in previous years, could therefore be reversed this year. Against this backdrop, a US recession has become our base scenario, to which we assign a probability of 60 to 65%. We expect economic growth of 0.0% for 2025.

The US Federal Reserve is in an extremely difficult situation: on the one hand, economic weakness requires interest rate cuts, but on the other hand, rising inflation argues for interest rate hikes. It is true that tariffs act like a consumption tax that has a one-off effect on consumer prices and disappears from inflation data after a year. However, the problem is that tariff effects consumer prices are not transparent for consumers. US consumers could therefore lose confidence in monetary policy if the US Federal Reserve lowers the key interest rate despite rising inflation. We are therefore currently assuming that the US Federal Reserve will adopt a wait-and-see approach for the time being. In reality, however, uncertainty is extremely high, and scenarios in which the US Federal Reserve significantly lowers the key interest rate are certainly conceivable. Key interest rate hikes, on the other hand, are very unlikely. However, there is a risk that the Fed will come under increasing political pressure to lower the key interest rate.

Asian economy: Japan has room for negotiation on punitive tariffs, albeit not in the short term

In Japan, US President Donald Trump's announcement to raise tariffs on Japanese cars to 25% and on all other goods to 24% came as a shock and the Japanese equity market fell significantly as a result. Accordingly, the tariff pause announced by US President Donald Trump on April 9 was greeted with relief. Japan is a key geopolitical building block for the US in the conflict with China and therefore has the best chance of being one of the first countries to make a "deal" with US President Donald Trump within the next 90 days. The growth shock could therefore be smaller than expected. We still see a good chance of economic growth of around 1.0% – assuming a deal is reached between Japan and the US. The Japanese export industry can now cushion the lower tariffs of 10% thanks to the extremely weak yen exchange rate, which has enabled very high profit margins in recent years.

By contrast, the trade conflict between the USA and China has escalated. US President Donald Trump had already imposed 20 percent punitive tariffs and announced additional 34 percent punitive tariffs. China responded by imposing punitive tariffs on US products. Donald Trump subsequently threatened to do the same and imposed tariffs on Chinese goods totaling 145%. China's exports to the US are therefore likely to suffer a severe setback in the coming months. In 2024, China exported goods worth USD 525 billion to the US, which corresponds to around 15% of total Chinese exports. Government infrastructure investments and exports have been the only growth drivers of the Chinese economy in recent years. Chinese exports to the USA will certainly fall significantly over the next few months and thus weigh on China's overall exports. This is likely to hit the Chinese economy hard. Against this backdrop, we see a high probability that the Chinese government will make great efforts to strengthen domestic demand in upcoming weeks. Ideally, it would expand the social security system so that consumers have to save less for their own retirement and thus have more money for consumption again. It remains to be seen what the Chinese government will decide. In principle, however, we expect the government's measures to stimulate growth.