The general belief in US exceptionalism – the expected outperformance of the US economy and therefore US risk markets – remains strong. While in the short-term, the US economy may be facing a slowdown.
Recent data signaled a shift in the US economy: the Atlanta Fed's GDPNow model swung from a 2.3% reading to -1.5% for the first quarter of 2025. Yet equity markets barely reacted. The S&P500 remains near record highs, bond yields have drifted lower, and the dollar is holding firm. Investors appear to be looking through the macroeconomic weakness, treating it as a temporary blip driven by a surge in imports ahead of upcoming tariffs rather than a sign of deeper fragility; after all, economic recessions are not typically preceded by a surge in imports.
But is this complacency justified? Beneath the surface, multiple indicators suggest the US economy is at an inflection point.
Economic surprise indices, which measure how data is tracking against expectations, have been deteriorating since late last year and turned negative in February. Equity markets, often an early signal of shifting sentiment, have begun to reflect this. Conventional cyclical sectors have underperformed their defensive counterparts, and US homebuilders, typically a bellwether for economic momentum, are down 20% since their post-election peak. European equities, meanwhile, have outperformed US equities year to date – an unusual dynamic that suggests that investors may be positioning for relative weakness in US growth.
Bond markets are also adjusting to a growth slowdown. The US 10-year Treasury yield, which peaked at 4.8% in mid-January, has fallen sharply despite sticky inflation expectations. This suggests that traders see economic momentum fading – an ominous sign for the equity risk premium.
Beyond the data, policy shifts could further reinforce the slowdown. The Trump administration appears willing to tolerate a growth slowdown in order to push through structural reforms, particularly in two areas: immigration and the role of government in the economy. Under Biden, a surge in immigration helped expand the US labour force, easing wage pressure and boosting economic growth. Yet that proved unpopular given the prolonged recession in real median wages, which did not decisively exceed their Q1 2020 peak until Q3 2024, amid much higher asset prices and borrowing costs. That dynamic is now reversing. Stricter border enforcement and large-scale deportations are likely to reduce net migration sharply, cutting potential US GDP growth by 30-40 basis points, and also pushing shelter inflation lower.
At the same time, the administration’s effort to “reprivatise” the economy by curbing government-driven economic support could act as another short-term headwind. A fiscal consolidation strategy that includes withholding funds from certain government programmes and reducing public-sector employment will hurt. Already, Musk's government efficiency drive has led to a spike in initial jobless claims in Washington, DC. These measures could amount to a fiscal drag of 1-2 percentage points of GDP over the coming year, weighing on domestic demand at a time when higher interest rates are still filtering through the economy.
For investors, a recession is not necessarily imminent. But a slowdown might be. Household balance sheets remain healthy, fiscal deficits are still elevated and bank credit growth has not shown signs of outright contraction - all of which underpin underlying demand growth. But the next phase of this cycle likely will feel different to the last few years.
At the same time, the combination of weakening but still positive US growth could prompt investors to look beyond US assets. With signs of relative strength in European equities and the prospect of a weaker dollar, emerging markets may become more attractive after years of underperformance. If the dollar loses steam, it could provide an unlikely twist to earlier certainties of the Trump trade – potentially shifting capital flows in ways that few had expected.
The market’s faith in US exceptionalism remains intact - for now. But with growth signals flashing caution and structural changes underway, the coming months could determine whether that confidence is well-placed or whether investors are underestimating the risks ahead.
