Are tariffs to blame for US inflation heating up?

Last week, US inflation came in higher than expected, with tariff-related items showing a pick-up in prices. The headline rate rose 0.3% in June compared to May, bringing the annual rate to 2.7% from 2.4%. US Treasury yields rose as the data failed to ease investor concerns that inflation will pick up in the coming few months. From this perspective, the direction and level of tariffs are both important. The direction is one of improvement, with tariffs settling at a lower level than threatened initially. But President Trump’s tariffs on many countries will likely settle at a higher level than prior to the trade tensions, possibly close to 20%. For example, last week, the US announced a trade deal with Indonesia (after the UK and Vietnam), which includes a 19% tariff rate, down from the 32% rate previously levied. 

If tariffs settle around 20%, this will imply some price increases, which could be reflected in the inflation data for the following few months. For now, Trump’s tariffs have only partially impacted inflation. This is primarily down to businesses loading up on inventories at the start of the year to stay ahead of anticipated tariffs. At the same time, retailers temporarily held off on adjusting selling prices. However, they can’t hold back price hikes indefinitely, despite operating at margins above pre-pandemic levels. Pre-tariff imports will eventually run out, and firms will need to raise prices. The good news is that tariffs, once implemented, should only represent a one-time price increase. In addition, US tariffs are typically applied to the customs value of imported goods, rather than to the higher final retail prices. We think US inflation could rise above 3% in the second half of 2025. 

As most of the impacts of the new tariffs are still ahead, the US Federal Reserve (Fed) may not be at ease with the latest inflation data. With risks that inflation will continue to rise, only a weakening labour market could seal the deal for an interest rate cut from the Fed in September. A July cut by the Fed is already off the table, given the solid employment data in June. Nonetheless, as prices start to rise, growth could slow. This has been our baseline scenario in 2025. A slowing economy could support some rate cuts by the Fed, in our view. 

We expect three US rate cuts in 2025 and 2026. However, the markets are pricing between four and five cuts, so readjusting their expectations to fewer cuts would likely lift US Treasury yields. Furthermore, the US Administration’s increase of the debt ceiling to fund its budget will exert upward pressure on yields. For these reasons, given our concerns around the US debt trajectory, we’ve recently sold some of our US Treasuries.  

Overall, given fiscal and trade risks, as well as our belief that the US dollar will continue to weaken, we’ve diversified away from US sovereign assets in 2025. As such, we’ve added exposure to European and emerging market equities, Japanese equities and government bonds. In sterling portfolios, we added to UK equities, too. That said, we recently purchased US equities, as the new US budget is likely to cushion growth, albeit at the expense of rising debt, as noted above. Deregulation is the next phase of Trump’s economic agenda, which is likely to be a tailwind for the economy and equities. 

Broadly speaking, our allocation remains highly diversified across regions and asset classes and includes a range of strategic and tactical risk mitigators (such as a gold overweight), given lingering uncertainty. In essence, a well-diversified portfolio can absorb shocks in one part while benefiting from strength in another.  

Over the weekend, Japan's ruling coalition lost control of the upper house in an election, weakening somewhat the position of Prime Minister Ishiba. That said, the coalition remains by far the largest political bloc in parliament, and the opposition landscape is quite fragmented. Ishiba has vowed to remain party leader and prime minister, given the upcoming tariff deadline with the US and ongoing trade negotiations. The election result adds some uncertainty as the opposition may try to push for some fiscal support, adding to budget pressures. But Japan often relies on supplementary budgets without spooking markets. In addition, we think the Japanese sovereign markets (government bonds and currency) had anticipated such a result, so the impact of the result could be limited. We recently bought Japanese government bonds (and yen) and, as such, are monitoring any developments. We think risks are limited for now and still find value in Japanese assets, including equities, with prospects of moderate yen appreciation. 

The European Central Bank (ECB) reconvenes on Thursday, one week before the Fed and the Bank of Japan. In contrast to its recent meetings, we think the ECB will likely hold the key policy rate at the current level of 2%, as indicated by several officials. Our view is further underpinned by the uncertain outcome of US-European Union (EU) tariff negotiations, given Trump’s recent threat to raise tariffs on imported European goods to 30% from 1 August. Whether this will happen and, if so, when, remains to be seen, as the US and the EU are engaged in negotiations. Over the past few days, Trump signalled that, in a trade deal, tariffs would still rise to 15-20%, with no exceptions for the car industry. The majority of commentators appear to see this as a negotiation tactic and market expectations are for a trade deal over the summer encompassing a minimum 10% tariff, some extra duties on specific sectors (raising the overall tax rate to, say, 15%) and some carveouts and exceptions at the sector level. 

In Europe, we expect that the preliminary purchasing managers’ indices (PMIs) for July (Thursday) may lack direction, highlighting the ongoing uncertainty from tariff discussions, as we’ve seen in the recent US and Japanese PMIs. The Ifo business climate release in Germany (Friday), a large exporter, will add further colour to the economic picture. Lastly, the European earnings season starts this week while in the US some of the Magnificent-7, big tech-driven firms such as Alphabet and Tesla, will report their results.