Fed Could Be in Stagflation Bind as Immigration Policy Adds Inflation Risk

The biggest risk to the US economy is stagflation, creating a tough dilemma for the Federal Reserve (Fed). As its Chair Jay Powell emphasised in last week’s press conference, tackling inflation and sluggish growth demands opposing policy responses.

Markets expected the Fed to sit on its hands at last week’s meeting, so the decision to keep rates on hold was no surprise. However, Powell’s hawkish tone – despite the lack of action – was notable. He used some version of the word “wait” 22 times during his remarks. The message is clear: the Fed will not act pre-emptively.

Powell seems to assume tariffs will once again have only transitory inflationary impacts, as they did during the first Trump administration, and that is probably correct. But there’s a caveat: these measures are far more extensive this time and could remain in place for far longer. Also, while it’s trade policy that dominates the headlines, the more significant risk to inflation lies in US immigration policies. If immigration policy is aggressive enough, it could result in a shrinking labour pool in certain industries that could create inflationary pressures that are far more sustainable than those caused by tariffs.

Inflation expectations soar

US consumer inflation expectations are already flashing red. The latest University of Michigan Survey of Consumers shows year-ahead inflation expectations surging to 6.5%, up from 5.0% – the highest reading since 1981. This marks four consecutive months of unusually large increases. Longer-term expectations are also climbing, with five-year inflation expectations rising from 3.2% in January to 4.4% in April, a very significant jump in a short period of time. 

Figure 1. Inflation expectations have jumped since the start of the year

Source: University of Michigan, as of 1 April 2025.

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The Fed is typically dismissive of short-term inflation expectations and focuses instead on whether longer-term expectations are “well-anchored”. But arguably longer-term expectations are becoming far less anchored – even though other surveys, such as the New York Fed’s, have yet to confirm this rise.

And while this inflation threat looms large, we shouldn’t ignore the risk to growth either. The impact of tariffs, DOGE spending cuts, and other US policies has yet to show up in the economic data, but they are likely to negatively impact economic growth. And if the US were to enter into a stagflationary environment, it would be difficult for the Fed to manage – inflation and slowing growth require fundamentally different responses.

July cut?

The Fed is unlikely to cut rates before July unless the May jobs report is terrible – and even then, most Federal Open Market Committee (FOMC) members might argue one weak report isn’t enough evidence of material economic weakness. Current market probabilities reflect this hesitancy, with the CME FedWatch Tool showing only a 20% chance of a 25-basis-point rate cut at the June meeting, down sharply from 55% just a week ago.

Right now, the Fed feels relatively irrelevant to markets; the focus has shifted to Trump Administration policy, especially tariffs. But ongoing uncertainty and volatility may end up forcing their hand. 

Europe’s battle-hardened stocks that thrive, not just survive

Periods of heightened volatility often bring changes in market leadership, driven more by shifts in investor sentiment than by underlying company fundamentals.

Up until April’s ‘Liberation Day’, European equities had been buoyed by a rally in the region’s cheapest stocks, as investors sought to exploit the valuation gap between Europe and the US. Defence stocks also gained traction, with Germany’s announcement of increased military spending sparking interest across the sector and prompting similar commitments from other EU members. So overall, Europe’s first-quarter winners were shaped more by external factors than by company specific improvements.

While the initial rally was style driven, today’s more uncertain environment demands a more selective approach. In our view, investors must focus on companies that can thrive and not just survive in the new geopolitical order. These companies have pricing power, are highly profitable, agile and don’t depend on buoyant global tailwinds to prosper. 

Forged by crisis

The region’s experience of geopolitical and macroeconomic turmoil in recent decades has forged a cohort of battle-hardened, world-leading firms from Copenhagen to Paris. Importantly these companies are not concentrated in a single industry but operate across a broad spectrum of sectors, including fashion, pharmaceuticals, autos, and airlines.

Unlike regions that benefit from dynamic economic growth, Europe’s companies have had to compensate for a lack of growth close to home by excelling in global markets. The eurozone provides a vast and integrated foundation, while Europe’s open relationship with Asia and the US further diversifies its reach.

This history has shaped the companies we favour. They stand out for their robust profitability, strong cash flow, and balance sheet fortitude. Many operate with zero net debt, deliberately maintaining contingency buffers that allow them to not only weather shocks but take advantage of the opportunities they create. For example, Europe’s largest airline by passenger numbers has the balance sheet strength to lock in today’s low oil price for much longer than its weaker balance sheet competitors. 

Pricing power in a tariff-hit world

Pricing power is another defining feature, particularly in the face of rising US import tariffs. Duties are applied to the transfer value of goods imported into the US. Companies with high gross margins – typically those with low costs-of-goods-sold relative to their final selling prices – can defend their profits more effectively. Firms with pricing power need only modest price increases to offset tariffs, especially when demand is inelastic. 

Take one of Europe’s most successful luxury goods brands: with a gross margin exceeding 70%, their cost of goods sold is below 30%. This results in a proportionately smaller tariff-driven price increase compared to its wider peers. This ability to absorb external shocks without alienating demand is crucial in today’s environment. 

Global reach and agility

In an unpredictable world, companies need global breadth and balance to succeed. Many of Europe’s leading firms avoid overreliance on any single region, instead drawing revenues from a broad geographic base. This global reach reflects the structural advantages underpinning their competitiveness. This global scale is not just a defensive attribute but a reflection of their competitive strengths. Flexible supply chains and a nimble approach to advertising further bolster their ability to adapt to volatile conditions. For example, one European beauty company allocates 32% of revenues to advertising and promotion and as the bulk of this spend is now digital, it has the ability to quickly pivot its focus to new, more profitable markets.  

The lesson from recent months is clear: uncertainty is here to stay. For investors seeking to diversify from the US, Europe remains a strategic bet, provided there’s a disciplined approach to picking the winners. 

All data sourced from Bloomberg unless otherwise stated.

With contributions from Kristina Hooper, Chief Market Strategist at Man Group, Nick Wilcox, Managing Director, Discretionary Equities at Man Group and Rory Powe, Portfolio Manager at Man Group.