Amid all the earnings news and the tariff announcements last week, two economic reports stood out. First came the Q2 GDP report which, on the surface, pointed to a resurgence of economic growth in the U.S. Then on Friday came an employment report that showed modestly lower than expected growth for August but also included material downward revisions for both June and July. So, let’s start out this morning by unpacking the significance of those two releases because what you see on the surface doesn’t match what’s happening in real terms.
First, the GDP report. Let me start by reminding all that GDP stands for Gross Domestic Production. Domestic obviously means made in the USA. When we substitute goods that are imported for goods that could be made here, that has a negative impact on GDP. Therefore, when imports surged in Q1 as importers tried to beat the institution of tariffs, that bump subtracted over four percentage points to GDP. Conversely, a buildup of inventory in any one quarter will add to GDP. Remember the last word in GDP is production, not consumption. Thus, in Q1 GDP took a big hit from the surge in imports softened by rising inventories. Conversely, in the second quarter reported last week, imports plunged while there was a modest depletion of inventories. Putting that in perspective embedded within a reported 3% overall GDP growth rate in Q2 was a five-percentage point boost due to a sharp reduction in post-tariff imports.
To get a clearer picture, one should look at the first six months together. If you do that, the impact of fluctuating imports and inventory changes were muted. The real focus would be on final sales which grew slightly over 1% for the period.
Besides consumption, it is also worth looking at capital spending. Over the first half, we know there was a surge in capital spending related to AI and data centers. The combined spending of Microsoft, Amazon, Meta Platforms and Alphabet alone was close to $90 billion in Q2, up high double digits from the prior year. To put that into perspective, $90 billion is a bit over 1% of GDP. If one looks at non-residential capital spending for the second quarter and first six months, and adjusts for the AI-related boom, capex barely grew.
Thus, the bottom line from the GDP report is that over the first six months of 2025, our economy continued to grow and the consumer remained resilient. But the pace of growth was well below normal and target rates. This all makes perfect sense. Monthly tariff receipts now exceed $25 billion. Annualized that is over $300 billion. And that doesn’t include any additional impact from announced tariffs that will be imposed in August. $300 billion is 1% of GDP. It is a tax pure and simple. It is paid by the importer who shares some of the costs with its customers. The White House’s goal is for tariffs to stimulate more domestic production. Maybe it will in time. But history, both from Trump’s first term and so far this term suggests if that happens, it will be slow. For example, early tariffs this cycle of 50% on imported steel and aluminum have had minimal positive impact to date on the domestic production of steel and aluminum.
Let’s now turn to Friday’s employment report. It was weaker than expected but the shocking numbers were the outsized revision of June and July data. For months, economists have been concerned about the size of prior month revisions. But these were shocking. Whatever, the key point is that our labor force is growing but at a pace that won’t sustain more than nominal growth. Economists generally believe that monthly gains of 150,000 jobs are a baseline to achieve growth of about 2% annualized. The numbers for the past three months are consistent with growth of half that pace. 1% is consistent with the final sales numbers contained within the GDP report.
Again, the bottom line, looking backwards through the data, is that over the first six months of 2025, our economy remains resilient but growing at a pace that is well below both trendline and goal. I think it is safe to assume that if both the GDP and labor data was available to the FOMC earlier in the week, the chances that it would have lowered the Fed Funds rate by 25-basis points rather than hold rates steady would have been much greater. There will be an additional employment report and several inflation reports before the September meeting. If that data reinforces what we learned last week, look for two or even three rate cuts before the end of the year.
I don’t want to leave the impression that our economy is structurally weak. In fact, the opposite is true. Household debt to net worth is close to 50% below levels seen just prior to the Great Recession. Average mortgage rates for outstanding mortgages are just over 4%, versus the 7% rate for new mortgages. Stock markets are near record highs. Bonds yield significantly more than the pace of inflation. In simple terms, it is the fortress balance sheet of American consumers that makes our economy so resilient, defying forecasts over the past several years that a recession was imminent. One may also note that our economy is roughly 70% services and 30% goods. Tariffs, at least so far, only apply to goods. Can corporations thrive against a backdrop of rising tariffs? Record high profit margins suggest they can, recognizing that the tariff impact on some companies may be tougher to overcome.
Finally, let me turn to markets. Longer term, the picture still looks bright. But policy changes force changes everywhere. It isn’t just tariffs. Immigration restrictions hurt growth rates. Embedded in the employment data, labor force participation rates are declining once again after rebounding post the pandemic. Aging population is the primary cause. AI also forces changes displacing some jobs and creating others. Hopefully, productivity will improve over time although AI’s impact to date has been minimal, certainly not enough to offset both the short-term effect of tariffs and tighter immigration control.
We have seen change flow through earnings reports thus far. The Mag 7 (excluding Tesla which is basically unrelated to AI growth at least for now) are reporting accelerating growth. Stocks have rebounded sharply since Liberation Day lows as it has been apparent that Washington noise only has a muted impact on their businesses. On the other hand, government attempts to cut costs have had outsized impacts elsewhere. Domestic auto manufacturers, supposed beneficiaries of tariffs on foreign car imports are seeing surging costs both in labor and tariffed materials like steel and aluminum. If Mercedes makes a car in Germany and ships it here for sale, there is a proposed 15% tariff. Ford may pay no such duties, but it must pay a secular tariff of 50% on imported steel and aluminum in addition to tariffs on certain imported components. No wonder Ford and GM had to absorb combined tariffs of close to $4 billion.
Another sector getting belted from multiple directions is healthcare. Government is going to cover less costs, and seeks to lower drug prices, while hollowing out the FDA and other agencies causing mass confusion particularly for early-stage drug development.
As for “drill baby drill”, lower oil prices are leading to less new drilling and less production.
Again, all this suggests changes are happening and corporations (as well as all of us) need to adjust. Some of the changes will have to be adjusted, mid-course corrections if you will. Tariffs weren’t meant to disadvantage the auto industry further, for instance. Whether the new world economic order will accelerate growth overall is still a very open question. For that to happen, productivity growth will have to offset declines in the growth of our workforce. For investors, change means we have to adapt as well. We have been doing that for decades. Iconic names of the past like Sears and Eastman Kodak are gone, precisely because they couldn’t adjust. None of today’s Dow Industrial components were in the original Dow Jones averages. Right before our eyes we are witnessing the decline of newspapers and over-the-air television. Movie theatres are empty. Malls are being displaced by online shopping. Tennis players are switching to pickleball.
Great companies adapt to change. Tired companies living in the past head for the corporate graveyard. We all overstay our welcome with some of our investments. How do you sell the stock that went from $10 to $100, even if it backs off to $90? Almost never will we pick the exact top or bottom. But we can’t ignore the tea leaves forever. The good news is that a resilient economy, vibrant innovation, less regulatory restraint, and thriving capital markets mean there will be a long-term tailwind, an economic jet stream. That doesn’t preclude bumps necessitated by bad policy decisions that require near-term correction or excessive enthusiasm that creates short-term speculative bubbles. The seeds for some of that froth are evident today. But the long-term future remains bright and that should be the focus of long-term investors.
Today, Tom Brady turns 48. Martha Stewart is 84 while Martin Sheen is 85.
James M. Meyer, CFA 610-260-2220