“The only thing we have to fear is fear itself…” Franklin D. Roosevelt
Tariff Man, as Trump has referred to himself, has struck! In January solar panels and washing machines from China were hit with 30-50% tariffs. Steel and aluminum followed in March with 10-25% tariffs. Additional tariffs increased from 10-25%. China hit back with $60 billion of tariffs. The year was 2018.
The financial markets were volatile as this unfolded: at its worst point the US stock market, as measured by SP500, had fallen almost 17% in 2018. It ended the year down roughly 5%.
However, in the following year there was a (partial) trade de-escalation with a US-China through a trade deal. Along the way, deals were also made with Canada and Mexico. The US stock market ended up over 20% in 2019. The below chart, which I created for my previous commentary (Q4 2024), reports all 4 years of both effective tariffs and stock market return, as well as inflation.
The below chart also appeared in our Q4 2024 commentary.
Note how both the statuary and effective tariff rate varied over time as the trade war escalated and de-escalated. Also note the effective rate is lower due to certain exclusions of items. Often dramatic headline tariffs are announced on a country; however, when considering there are often exclusions on certain products or at least lower rates on certain products, the actual overall rate (i.e., effective rate) is lower.
While tariffs drifted down over the balance of Trump’s term, they were largely kept intact during Biden’s term. In fact, Biden even pursued additional tariffs: 25-100% on EVs, semiconductors, steel, and aluminum, among other items. In the end, both the US economy and financial markets somehow made it through this time, even with a tragic pandemic thrown in.
This all brings us to the Tariff Man striking again. His announced plans have changed more often than New Zealand1 weather, with effective rates expected from 15-20%+, from the past 12.5% effective rates. Financial markets have again been volatile. So far this year, from the peak to the trough, the US stock market fell about 19%. Although I can see an argument for targeted tariffs at a country like China that has systematically traded unfairly with us and regularly stolen our intellectual property, broadly hitting all countries with a tariff, especially our best trading partners, could do more harm than good. In its extreme this could bring a recession, for which the possibility has made markets jittery. However, the adventure has continued with a sudden 90-day pause on these very broad Liberation-Day tariffs, which caused a partial snapback in equity prices. Although the “pause” apparently left in place all prior tariffs and the 10% minimum portion of the reciprocal tariff, there will likely be some additional sector tariffs added, though I think the original announced Liberation-Day tariffs in their entirety are unlikely. Below is a reasonable forecast for the composition of likely final effective tariff rates2:
Travelling along this tariff road has turned out to be quite the Wild Toad’s Adventure. Why?
How can tariffs have so much impact on the financial markets?
The short answer is their potential impact on the economy.
For those not familiar with the various constituents of the US economy, I created the pie chart below using data from the US Bureau of Economic Analysis. It illustrates the 2024 estimated composition of our economy (final numbers usually arrive in the Summer following a year).
In terms of direct impact, trade, on net, actually tends to shrink our US economy. The above pie chart is a bit erroneous because net trade contributes -3% of our economy, whereas this pie chart treats it as if it’s a positive 3%, since a pie chart can only consist of positive components. In contrast to trade, the lion’s share of our economy comes from you and me: our personal consumption represents close to a whopping 70% of our entire economy.
Net trade is made up of both exports—what we are selling to other counties—and imports—what we are buying from other countries. The waterfall chart below shows these trade pieces separately, using the same data as used for the above pie chart, revealing that just exports or just imports taken alone are a meaningful part of the overall economy as measured my Gross Domestic Product (GDP), though still considerably less so than US consumers:
How do tariffs impact the economy?
Tariffs primarily impact the economy by their potential inflationary and growth impacts. As far as inflation is concerned, consider how a 5% additional effective tariff on imports impacts the cost of goods: this would represent .7% of the economy (i.e., 5% X 14%)3. Based on the current expected tariffs, a simple ballpark would suggest the proposed additional effective amounts might add about 1% to inflation this next year. Notice this is also a one-time increase in inflation. A sophisticated analysis by Goldman Sachs forecasts as follows (based on Trump’s highest Liberation-Day proposed tariff rates, which are partially on pause):
Consumer inflation, as measured by headline CPI, is forecasted to go from 2.3% to 3.3%, or a 1% additional rate for 2025. Recall that a short time ago we were at a peak CPI rate of 10+%, as seen below. So, in our current context, CPI of 3.3% should be reasonably absorbed by our current economy.
In summary, at the most likely implemented tariff rate levels, 1% seems a safe estimate of an additional one-time increase in inflation, which by itself should not be a reason to jump out of a Wall Street window (or even a first-floor window). So, there must be something more going on here.
Indeed, the other crucial potential impact is on economic growth, which then affects profits, which then affects the value of stocks.
Goldman Sachs also did a careful analysis of the most likely economic growth impact from the currently expected Trump Tariffs. Accounting for the likely additional tariffs, they
currently estimate an average 2025 economic growth rate, as measured by GDP, of 1.3%, which is about a 1% reduction in economic growth compared to no increased tariffs (i.e., ~2.3% GDP growth is the pre-tariff estimated growth rate). If this estimate proves correct, we will not fall into a recession this year4, though it provides a smaller margin of growth from which to avoid one, which is why markets became spooked.
The below panel delineates the different channels through which tariffs can impact an economy and what were used to estimate the roughly 1% economic hit from the additional expected tariffs:
The left-side panel in the above chart reports via the red line the net sum effect of all four tariff effects across time. On the one hand, tariffs likely add to the economy through reducing the trade deficit as Americans likely spend less on foreign goods (i.e., the gray bar). However, this modest positive effect is more than likely overcome by negative impacts from consumers paying more for their foreign goods, market uncertainty (which can also adversely impact consumption) and business investment.
The right-hand panel reports the additional economic impacts of President Trump’s policies in addition to tariffs, though the tariff effect by far has the greatest impact. On the positive side, some extended tax benefits expected later this year will likely add to the economy (the gray bar). However, these benefits will likely just offset the impact of immigration and DOGE spending reductions, meaning the net economic impact of all of Trump’s policies will likely just be from the final added tariffs. In summary, all told, perhaps the economy will have about 1% of growth shaved off it for about a year. Although this is substantial on a $29 trillion economy, it doesn’t seem to justify the recent financial market selloff, so there must be something more.
The Only Thing we Have to Fear is…
The something more is fear. Although we are not even in the same economic universe as when FDR coined his famous quote on the danger of fearing fear (e.g., 25% unemployment vs. ~4.2% currently), the idea is as relevant as ever in terms of how fear can create a self- fulfilling prophecy: as consumers become fearful, they reduce spending, which can thencause the very recessionary economy they feared. Recall that most of our economy (~70%) is simply how much money we spend in the US. So fear of consumer fear is certainly something to fear.
One way to track the level of consumer economic fear is through US consumer sentiment, which is shaped by consumer’s fear of an adverse economic future, whether it be job losses or outsized inflation.
Arguably one of the most respected and long-running consumer sentiment surveys is the University of Michigan Consumer Sentiment survey. Over the past forty years, the survey has ranged from about 50 to 110, where a larger reading suggests less economically fearful consumers, as tracked in the below graph.
Since the 40-year low hit during the pandemic, consumers have become increasingly optimistic, albeit still below the long-run average. The trend has been up, although there has been a dip in February as the reality of additional tariffs settled in.
It is also interesting to separate consumer sentiment as a function of political ideology. The chart below does just that.
While Democrats have grown very pessimistic—sentiment of around 30—Republicans have grown fairly optimistic (over 80). Meanwhile, the much smaller category of Independents has largely followed democrats in sentiment, as they do in their voting patterns. Based on this, we’d be worried about Democrats’ and Independents’ future spending patterns, and hopeful about Republican ones. In addition, if we only spend time with people similar to ourselves, we will think the outlook is really terrible or pretty darn good.
All said, it is impossible to predict what might ultimately happen, as it depends a lot on what we all do. However, one of the most frequently voiced economic concerns I’ve heard lately is the fear of a stagflation outcome: a contracting economy with high inflation. The mutual fund company DFA generated a startling chart that calculates this kind of environment is actually the best period for after-inflation stock performance:
During such time, stocks had their highest average annual return of 16.4%. I’m sorry to report the most likely scenario is inflationary growth and not stagflation, where stocks averaged 7.58% return. This is also the most common environment historically (i.e., 76/95=80% of years).
So what should we do now?
Overall, our thesis is pretty similar to what it was in December: smaller, more private, domestic US companies will likely fare better in a world of protectionism and reduced regulation. Something I would add now is that I believe the Tariff Man is pushing much of the developed world together, which bodes well for its future growth. As such, I am also more optimistic about international investments going forward. In fact, I think in a decade when we look back, we will be very happy to have owned a material amount of international investments. This view is already built into our current models.
Meanwhile, there are a few things that you can do. First, to find some peace during these loud and tumultuous times, it is helpful to look to the cash flow of your portfolio. A typical scenario today is to be earning 3-4.5% of the value of your portfolio in cash depending on allocations, just from portfolio interest and dividends. Although there is certainly drift in these amounts over time, you can now have the peace of mind that if market prices are going up, down, or are flat, even if tariffs are increasing, decreasing, or paused, you are still enjoying this foundation of cash flow. In other words, you are being paid to wait for capital markets to average out over time, to bring about the balance of your portfolio growth and income.
While we seek peace, we can also help make peace. I was amazed to find the current disparity in economic outlook as a function of our political identity. And yet it is impossible to have a rapidly growing and shrinking economy at the same time. My view is that the actual economy is likely somewhere in between these two views. As such, it can be helpful to spend some time with others that think differently from us (family is usually a sure-fire place to find them), to help those or ourselves be more optimistic about the state of things, and to help others or ourselves to be more realistic about things. Meeting in the middle will help us all be more grounded where we can find a balance of peace, hope, and realism.
Finally, do not be afraid of continuing with your spending plan. We have built out your plans based on a 1,000 different economic environments. We are in just one of them. And, ironically, our spending patterns will most likely be the determinant of our economy’s future.
Looking forward, we will likely also have some positive fiscal changes later this year, for which we are watching to take advantage. Meanwhile, we stay attentive to your financial and investment master plan, and we look forward to sharing more about this with you the next time we visit. Until then, we hope for you to find some peace, make some peace, and go have some fun!
- My wife and I just enjoyed our 33rd wedding anniversary in New Zealand and greatly benefited from Paul Kuhn’s advice: be prepared for every season in the same day!
- This has been an exceptionally difficult commentary to write because the story has changed so often.
- For simplicity I am assuming the consumer bears the entire cost of the tariff, whereas in practice it is some combination of the foreign company, US import company, and consumer.
- Recessions occur about every six and half years, on average, in the US business cycle. Our last recession was in early 2020 during the pandemic. Thus, we are due for a recession at some point. On average, we would have our next one the Fall of 2026. They tend to last 10-12 months.
