Tariff announcements over the weekend and today have significantly impacted the equity market. President Trump’s executive order imposing tariffs on Canada, Mexico, and China sparked volatility and early morning losses. However, the subsequent one-month delay on tariffs against Mexico provided some relief, allowing markets to recover partially. These tariffs, covering a substantial portion of U.S. imports, could moderately impact economic growth and lead to higher prices if fully implemented.
Small-cap and tech stocks underperformed today, while the U.S. dollar rallied. Short-term bond yields rose as market expectations for Fed rate cuts diminished, while long-term yields fell as investors sought the safety of government bonds. The duration of these tariffs remains uncertain, but they are expected to initiate negotiations on border issues and concessions from trade partners. A long-term investment strategy is recommended rather than reacting to daily headlines.
The U.S. economy is relatively insulated compared to its neighbors due to its lower dependence on trade. Consequently, the new tariffs and potential retaliatory actions will likely have a lesser economic impact on the U.S., providing it with leverage in trade negotiations. However, prolonged tariffs could lead to higher domestic inflation as costs are passed to consumers. Several factors could mitigate this impact, including a strengthening U.S. dollar, absorption of costs by foreign exporters and U.S. importers, substitution of products, and potential adjustments to supply chains over time.
Tariffs essentially act as a tax on consumers, potentially causing a moderate, one-time increase in inflation. This gives the Federal Reserve further reason to pause rate cuts while evaluating the effects of tariffs. While rising goods prices could push headline CPI into the 3%-4% range later this year, the likelihood of rate hikes remains low as the Fed is unlikely to consider tariffs a persistent source of inflation. Services, comprising a larger portion of the CPI than goods, will be the primary determinant of inflation.
Economically, higher prices might reduce demand, slightly impacting GDP. Previous research suggests that the 2018-2019 tariffs led to a minor increase in inflation and a slight reduction in economic growth. While the current impact could be more significant due to the broader scope of trade actions, potential tariff revenue could help reduce growing government deficits. Furthermore, tax cuts and deregulation could offset some economic weakness and stimulate domestic growth.
The ongoing trade war creates uncertainty for markets and influences the outlook for growth, inflation, and interest rates. This uncertainty contributed to today’s equity pullback and the surge in the U.S. dollar, echoing the volatility experienced in 2018 due to trade tensions. Conversely, a trade truce in 2019 boosted stock rallies. While similar sensitivity to trade headlines is anticipated, maintaining a long-term investment strategy is crucial amidst potential short-term market fluctuations.
Despite the current uncertainty, strong fundamentals, including rising corporate profits and anticipated economic growth in line with the long-term potential rate of 2%, continue to support the markets. Stable unemployment rates and potential pro-growth policies further bolster this positive outlook. Diversified portfolios are designed to mitigate risk, with certain asset classes responding differently to policy shifts. For instance, U.S. mid-cap companies, primarily deriving revenue domestically, could benefit from stronger domestic growth and lower tax rates. Investment-grade bonds can also provide diversification as investors seek safe-haven assets. Value, defensive, and cyclical sectors remain favorable investment choices within a diversified portfolio. Specific industries, such as U.S. autos, might face challenges due to their reliance on imported parts from Mexico and Canada. However, the broader market index is expected to perform better than trade-sensitive sectors and international equities. Absent a recession or renewed Fed rate hikes, a prolonged tariff-induced market downturn is unlikely. Any short-term pullbacks are likely to occur within the overall bull market.