Unpacking the potential impact of tariffs

Markets are under pressure following sweeping tariffs:

President Trump unveiled yesterday a sweeping new set of tariffs imposing a minimum 10% tariff on all imports coming to the U.S. that will go into effect on April 5. In addition, the new administration will impose higher reciprocal tariffs on the countries with which the U.S. has the largest trade deficits.

For example, China will face a 34% rate (on top of the existing 20%), Japan a 24% levy, Vietnam a 46% rate, and European goods will be subject to a 20% duty. The individual higher tariffs will go into effect April 9.

Canada and Mexico were exempt from the new reciprocal tariffs for the goods that are compliant with the USMCA (U.S.-Mexico-Canada) agreement, but duties on several goods, including aluminum, steel and autos, will remain in place. 

The new actions are estimated to raise the effective rate on all imports from 2.3% last year to around 25%, the highest in at least 100 years. The new announced tariffs rates are higher than most expected and thus are triggering a broad sell-off in global equity markets. Government bonds are seeing a flight to safety, with the 10-year yield falling toward 4%, the lowest in six months1.   

A trade war poses downside risks to growth that may outweigh impacts on inflation

The U.S. is less dependent on trade compared with many of its largest trading partners. However, trade uncertainty has already led to a drop in consumer confidence, and the new tariffs, which act as a tax on the consumer, will likely weigh on spending and business investment.

With demand weakening, the rise in inflation will likely be smaller than the potential decrease in economic activity. Estimates based on a 2018 Federal Reserve model suggest a potential 2.4% hit to U.S. growth and a 1.4% rise in prices1. This growth-negative and inflation-positive effect is fueling investor concerns around stagflation and could possibly lead to downward revisions to corporate profits. However, that assumes that the additional revenue raised will not be recycled in the economy to support growth, and we know that pro-growth policies are also part of the administration's agenda. 

In addition, we believe the Federal Reserve is more likely to step in to support softening economic growth and a potentially weaker labor market. Given the higher-than-expected magnitude of the tariff announcement, we could see the Fed cut rates potentially more than the two times outlined in its March meeting this year. While the potential for higher inflation from the proposed tariffs may give the Federal Reserve pause, we believe policymakers are likely to view tariffs as a one-off increase in prices, as opposed to an ongoing source of inflation that would de-anchor inflation expectations, though they will closely monitor the latter. Additionally, tariffs would most directly impact goods inflation, which carries a smaller weight in the consumer price index (CPI) basket compared with services inflation.   

Uncertainty will linger, but negotiations may provide an off ramp:

Yesterday's announcement provides some clarity on the administration’s trade framework, but it does not answer all of investors’ questions. In response to the reciprocal tariffs, some countries may choose to retaliate, while others may try to negotiate, and this process may play out over time.

The announcement mentioned that the new tariffs will remain in effect until the threat posed by the trade deficit is satisfied, resolved or mitigated, which potentially opens the door to country-specific negotiations that can provide some relief. Perhaps the higher-than-feared levies represent a high point and may be negotiated down, softening the blow to global growth.

If the end result is a reduction in tariffs and trade barriers that other countries impose on the U.S., it will be a long-term positive for trade. But in the near term, high uncertainty will keep market volatility elevated.   

Portfolio diversification remains critical:

The potential risks to economic growth and corporate profits suggest that after falling into correction (10% decline from highs), the recovery in stocks will take a while to materialize. Patience and investment discipline will be key for investors to navigate the trade headlines, which no doubt will continue to dominate the market narrative.

Despite the headwinds, the fundamental drivers of market performance remain more supportive than harmful: 1) unemployment is low; 2) the Fed remains in a rate-cutting cycle; 3) corporate profits are still likely to rise this year, though potentially less than the 10% expected before tariffs; and 4) the policy agenda may soon shift to pro-growth measures, such as tax cuts and deregulation.

The good news for investors with balanced and diversified portfolios is that those portfolios have weathered the pullback better than those with concentrated positions in U.S. large-cap stocks. International stocks are up for the year, U.S. mid-cap stocks have outperformed, and bond prices have rallied, helping smooth out the equity-market volatility.

At a sector level, industrials, technology and consumer discretionary could be more exposed to tariffs based on their heavier reliance on imports, while financials, utilities and real estate are more insulated from a trade war. 

While the immediate drawdown in stock markets may be jarring, we recommend that investors stay with their long-term investment strategy, emphasizing diversification and high-quality investments. Avoid making emotionally charged investment decisions, and remember that time in the market has proven to be a better strategy over time than trying to time yourself in and out of the market. (Our Don't Fear the Bear report is a great reminder of this: https://www.edwardjones.com/sites/default/files/acquiadam/2023-07/RES-4011-A.pdf) 

Read the full Daily Snapshot here: https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/daily-market-recap

Source: *Bloomberg

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