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• Tariffs usher in and accelerate longer-term trends across the global economy.
• The era of sound money—the persistence of positive real interest rates—remains well supported by short- and long-term forces.
• The case for global diversification is strengthening, even with the prospect of transformative artificial intelligence (AI).

Three themes are worth emphasizing as we reach the midpoint of 2025: 1) tariffs are likely to produce both an unmistakable signal and unremitting noise for the global economy, 2) interest rates above the rate of inflation are here to stay, and 3) the case for global diversification is strengthening. We emphasize these themes even amid recent heightened geopolitical tensions.

1. Tariff developments could muddy the waters and hasten trends

Tariffs have been tapped to a much larger extent as a policy tool than we had anticipated at the start of the year. Our 2025 economic outlook put supply-side forces and their potential stagflationary effects —downward pressure on growth and upward pressure on prices—at the center of our short-term economic assessments. Meanwhile, high policy uncertainty and the anticipation of slowing global trade have accelerated imports and fostered inventory buildup ahead of tariff announcements. This dynamic adaptation is clouding macroeconomic data, necessitating care in distinguishing signal from noise. Thanks to the substantial frontloading of imports in the U.S. during the first quarter, the realized effective tariff rate, which is the average-weighted tariff actually paid by importers, has remained well under 10% so far. However, tariff frontloading and policy uncertainty will eventually subside, and we do expect the effective tariff rate to climb to around 13% by the end of 2025.

Tariff rates hold the key for our economic outlook 

_{Notes: The figure shows the estimated impact of effective tariff rates on our 2025 year-end forecasts for U.S. GDP growth and inflation as of three different points in time: at the beginning of 2025, currently, and when tariffs were announced in early April. These estimates hold all other drivers constant and assume that the effective tariff rate will remain in effect throughout 2025.}

_{Source: Vanguard calculations, as of June 13, 2025.}

Yet tariffs and related global policy discussions may prove to be a catalyst for longer-term trends. For example, the European Union’s commitment to increase defense spending could boost the region’s economy for the next few years and become a kernel of homegrown productivity in the longer term. In China, efforts to shift from an export- and investment-driven economy to a consumer-driven economy will be crucial. And in the U.S., a spotlight is being shined anew on the importance of fiscal discipline. Whether via tariffs, growth, or any other means, the U.S. needs to put its fiscal deficit back on a sustainable path.

2. Higher interest rates are here to stay

As we discussed in our 2025 outlook, the era of sound money continues. This means the neutral rate—the theoretical rate that keeps the supply and demand of capital in balance—is far higher than it was pre-pandemic. Inflation is expected to remain above the Federal Reserve’s 2% target in the short term. However, of more enduring relevance is the U.S. fiscal deficit. At 6%–7% of GDP, it is historically high for a peacetime and nonrecessionary environment. Worse yet, the deficit picture is likely to deteriorate over time given aging demographics. If left unchecked, those persistent deficits become a source of excess demand and inflationary pressures. However, if the Federal Reserve is to remain committed to its price stability goal, then we’re likely entering a period of persistently higher real interest rates. The bond market has taken note of this tension, demanding greater compensation for risk. The term “bond vigilantes” may become more commonplace going forward.

With yields on corporate bonds within the 5%–6% range—a level not seen since before the 2008 global financial crisis—two significant observations are worth highlighting for investors. First, spreads have remained surprisingly compressed through the policy turmoil, and they’ll likely stay rangebound absent an unforeseen event, or tail risk. Second, bond investors may need to adjust their mindset from the pre-COVID-19 era, when bond holdings appreciated due to declining rates. In the years ahead, the source of return is more likely to be collecting a healthy level of interest income and reinvesting it at a high rate.

3. The case for global diversification is strengthening

Our 2025 outlook noted a continued equity market dichotomy: A handful of firms (representing the “new economy”) that grow earnings around 20% year-over-year and whose valuations are stretched, while the rest (representing the “old economy”), in the U.S. and abroad, have less impressive earnings growth and more reasonable valuations. This tension has persisted even following a volatility spike in the first half of the year that 1) exposed the vulnerability of high valuations and 2) demonstrated U.S.-based tech firms’ continuing ability to generate earnings growth against this backdrop.

Beyond valuations, two additional considerations strengthen the case for a globally diversified portfolio. First, even if AI transforms the economy (and this is the essence of current valuations), the history of technology-based transformations suggests that the benefits of such advancement accrue beyond those companies that lay down the infrastructure. The next winners in the AI race could be those value companies that benefit from the technology breakthroughs, as opposed to the growth companies that created the technology in the first place. From a historical perspective, railroads in the 19^th century and technology, media, and telecommunications companies in the 1990s provide some of the most salient examples of this concept.

Second, in the last 15 years, U.S. equities and the U.S. dollar have moved in lockstep, with both outpacing their international counterparts—a double whammy for global diversification. But that has left both U.S. equities and the U.S. dollar overvalued relative to a broad range of fair-value estimates. In addition to the enduring strategic case for global portfolio diversification, the expected weakening of the home currency paired with higher expected returns on international investments make the case for global rebalancing of portfolios even more compelling now.

_Notes:

• _{All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.}
• _{Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.}
• _{Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates.}