For the first time in almost a century, aggressive tariffs are being used as a policy tool. With minimal experience navigating a global economy that may be on the verge of a trade war, market participants are understandably anxious about the impact longer-term tariffs will have on both the U.S. and global economies. 

Rationale for Tariffs 

Investors are uncertain about the Administration’s ultimate strategy when introducing or increasing tariffs on the goods of its trading partners. Treasury Secretary Bessent listed three prospective goals of a tariff policy: 

  • Bring manufacturing back to the U.S. While many base manufacturing jobs left the U.S. this century to take advantage of the cheaper labor available in emerging international economies, the COVID-19 pandemic revealed the danger of having widely dispersed supply chains. President Trump has often requested that our trading partners strongly consider opening manufacturing facilities in the U.S.  
  • Raise revenue to help pay for tax cuts and the Administration’s planned extension of the 2017 Tax Cuts and Jobs Act (TCJA). The bond market will be watching carefully to see if tariffs generate sufficient revenue to offset the prospective tax cuts. If they don’t, higher deficits and more extensive offerings of treasury debt will pressure bond yields higher. 
  • Provide the Administration with leverage to negotiate with other countries. We know from the first Trump administration that the preference is for negotiating bilateral agreements. The President wants to collect and play as many chips as possible for these upcoming discussions. 

To the extent tariffs are used primarily to gain greater negotiating leverage for other administration objectives, such as stopping mass illegal immigration and fentanyl traffic into the country, the markets will likely view tariffs as temporary and minimally damaging to economies both in the U.S. and abroad. After the announcement of tariffs on Mexico and Canada, both countries received a thirty-day reprieve in exchange for placing more troops on their respective borders and, in Canada’s case, appointing a “fentanyl czar.” 

Recent History of Tariffs 

However, if the Administration views tariffs as an ideological tool to right past wrongs or is reliant on them to raise revenues to fill budget holes, there would be more of an impact on the global economy. The last time we broadly applied tariffs was via the Smoot-Hawley Tariff Act of 1930, which arguably helped turn a recession into a global depression that lasted until the advent of World War II in 1940. Tariffs on over 20,000 products imported into the U.S. and the retaliatory measures imposed almost immediately by trading partners started a global trade war. Imports and exports declined dramatically in economies already contracting after the 1929 stock market crash. 

The economic theory around global free trade is quite elegant. According to the comparative advantage theory, the production of goods and services occurs in places with the lowest cost of production. Therefore, the ultimate result of genuinely free trade is enlarging the global economic pie for all participants, including developing countries that get a slice of that pie by taking advantage of their lower relative input costs. In 2001, China’s entry into the World Trade Organization was met with great excitement by the developed and developing world. Developed countries understood there would be some job loss in the manufacturing sector. Still, countries transitioning from government-controlled command economies would open a vast new market for goods and services. 

Tariffs in the 21st Century 

While the benefits of free trade are clear, unfair trading practices make them challenging to realize. In addition to tariffs, trading partners sometimes resort to excessive regulation, VAT taxes, strategic currency depreciation, and “dumping” products below cost to gain market share.   

To combat what he’s termed “unfair” practices, President Trump plans to announce reciprocal tariffs on many countries over the next few weeks with an effective imposition date of April 2nd. The tariffs will be imposed country-by-country, starting with the countries where the U.S. has the largest trade deficits. This approach may leave room to negotiate the bilateral deals with these countries the President sought in his first term. The tariffs on China and, inevitably, Europe may be implemented over a longer term to correct trade imbalances. 

Economic Consequences of Tariffs and a Global Trade War 

Should tariffs become a longer-term strategy to raise revenue and boost U.S. competitiveness, investors will need to assess their potential inflationary and growth consequences. With retaliatory tariffs already announced or promised, the global economy seems to be on the precipice of a trade war. The initial impact will likely be increased prices on goods subject to tariffs. Some companies may forego or delay price increases to protect hard-earned market share, but historical evidence suggests that tariffs will increase inflation rates at some level.  

However, it is important to distinguish between inflation caused by increased aggregate demand in an economy and price increases caused by supply constraints or government edicts such as sales taxes. As tariffs are effectively taxes on certain products, the best analogy would be assuming broad-based tariffs have the same effect as a tax increase. If incomes do not keep up with the price increases, the impact is likely contractionary to the economy. While the U.S. may be more insulated in a trade war as a large percentage of its consumption is domestically produced, it is difficult to see any “winners” of a prolonged trade war. 

Potential offsets to the contractionary impact of tariffs are prospective easings of both fiscal and monetary policy. From the fiscal policy perspective, we may be seeing some of the more economically painful aspects of the new administration’s policies before the benefits expected from further tax relief, less regulatory pressure on businesses, and increased reshoring of manufacturing. The policies that can be implemented more quickly through executive orders are getting all the current headlines. In addition to the potentially contractionary tariff policies, the crackdown on illegal immigration with threatened deportations, as well as the expected cuts in federal government payrolls, may also further slow what has been a surprisingly strong U.S. economy. The policies that should provide the growth offsets generally need congressional approval. The upcoming budget negotiations in Congress will center on extending the 2017 Tax Cut and Jobs Act, which will expire at the end of the year, along with some additional proposed tax breaks. The debates will be acrimonious, but the key tax measures should pass as Republicans have slim majorities in both Houses. 

Monetary policy began to loosen in the second half of last year as the Federal Reserve began to reduce the fed funds rate as the inflation rate declined closer to its 2% target. A recent stall in the disinflationary progress has caused the Fed to pause its rate-cutting program. Still, the central bank is expected to resume easing monetary conditions by the middle of the year. However, the initial inflationary impact of tariffs may further delay the resumption of rate cuts.   

Investment Implications 

We have experienced the first equity market correction in the U.S. in over two years. The uncertainty around the timing and magnitude of tariffs and the ultimate effect on the economy is arguably the largest driver of declining prices. Cogent arguments can be made for a pickup in inflation or an economic recession. Stagflation, economic stagnation with above-trend inflation, could be the ultimate outcome, limiting the monetary policy response. 

The strength of the U.S. economy going into this period of greater political uncertainty will help cushion any blows from a global trade war. The expected resumption of progress in bringing inflation down to targets should allow monetary policy to provide additional support to avoid recession. Equities should continue to be volatile until investors receive greater clarity about the magnitude of tariffs and their duration. Bond investors will likely see some yield declines at the shorter end of the maturity spectrum as the Fed resumes its easing policy. However, intermediate- to longer-term yields may stay around current levels and rise as the yield curve fully disinverts into an environment of continued but slow economic growth and tariff-induced inflation. 

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