Bracing for Tariffs

Originally published February 14, 2025

The first weeks of President Donald Trump's second term have seen markets wobble after tariffs were announced, only to have many of them quickly rescinded or delayed—a reminder to be careful about taking these announcements at face value. Nevertheless, tariff issues are likely to cause market volatility in the months ahead as investors try to figure out which countries will be targeted and what impact new tariffs might have on the economy. Uncertainty about tariffs, immigration, regulation and taxes also may keep Federal Reserve policy on hold until at least the middle of the year, leaving fixed income markets searching for clarity.

Global stocks and economy: What's next for tariffs

Since taking office, President Trump announced 25% tariffs on goods from Colombia then subsequently dropped them before they were scheduled to begin. Similarly, 25% tariffs on goods imported from Mexico and Canada were also subsequently delayed. A 10% additional tariff was applied to goods from China. What is next for tariffs, given talk of new metals tariffs, "reciprocal tariffs," the looming end of the 30-day tariff delay on Mexico and Canada in early March and the administration's more comprehensive review of trade due on April 1?

What's next?

Canada and Mexico: The delay in U.S. import tariffs on goods from Canada and Mexico until March may be extended as the countries work to improve border security and U.S.-headquartered companies—whose factories are the source of most of the exported goods from Mexico to the U.S.—seek to have their voices heard in Washington. But more complex negotiations may follow on updates to the U.S.-Mexico-Canada Agreement as Trump seeks to reduce trade imbalances, the erosion of U.S. domestic auto production, and keep Chinese companies out of Mexico.
China: The 10% across-the-board increase in tariffs on goods from China may likely stay in place. China's limited retaliation seems designed to avoid escalation. This may be because China is more focused on domestic economic concerns rather than friction on direct trade with the U.S. which makes up only 3% of its gross domestic product (GDP), based on China's reported exports to the U.S. Yet, Trump did refer to the 10% tariff announcement as an "opening salvo." Note that executive orders on Trump's Day 1included a directive to review the existing China Section 301 investigation (related to its semiconductor industry practices) and the Phase One deal (an agreement Trump signed with Beijing in 2020 to increase China's purchases of U.S. exports) by April 1, signaling further U.S. actions may follow. China may respond with an offer to purchase U.S. goods or concessions on geopolitical issues such as Russia-Ukraine in the negotiations that may follow.
Europe: To try to avoid U.S. tariffs on members' exports, the European Union (EU) has the ability to offer additional purchases of U.S. energy and defense products, an increase in Europe's defense spending, in addition to threatening retaliatory tariffs on U.S. services. At this time, Trump has not specified a timeline for when he might announce tariffs against the EU. It may be that Trump is awaiting the outcome of an election in Germany on February 23, as Germany is Europe's biggest economy and is a major auto exporter to the United States.

United Kingdom: When asked by a reporter on February 3 about potential U.K. tariffs, Trump responded, "I think that one can be worked out. Prime Minister Starmer has been very nice. We've had a couple of meetings, we've had numerous phone calls, we're getting along very well, and we'll see whether or not we can balance out our budget with the European Union." The U.K. is not a member of the E.U. and Trump's response suggests the U.K. is further down Trump's list, indicating that they may have an easier solution to avoiding tariffs than other major countries.
Japan: While Japan's $70 billion trade surplus with the U.S. and the yen's undervaluation could be potential targets, Japan's new Prime Minister Shigeru Ishiba had a friendly meeting with Trump earlier this month. In part, due to Japan's imports of U.S. energy and Japanese manufacturers' considerable investments in their U.S. operations, Japan is the top source of foreign direct investment in the United States, per the latest data from the Bureau of Economic Analysis. However, Japan could still be hit by an across-the-board tariff on all U.S. imports—an idea Trump had floated on the campaign trail.

While the stock and currency markets bounced back after the tariffs on imports from Mexico and Canada were delayed, tariff issues are not yet solved and still hold the potential to drive market volatility in the months ahead. But, just as importantly, these events serve as a reminder that we should be cautious about taking announcements at face value, let alone overhauling economic forecasts or investment portfolios in response to them. The MSCI EAFE Index of developed international stocks has the highest weightings in Japan and the United Kingdom, while not having any exposure to Canada, Mexico, China, or the United States. Stock in these two countries offer a potential safer haven for investors seeking less exposure to the combatants in the Trump 2.0 Trade War.

U.S. stocks and economy: Recovery disruption?

After a prolonged slump, key areas of the U.S. economy are showing early signs of improving—but there are policy risks potentially standing in the way of a sustained recovery. We have frequently characterized the post-pandemic recovery as being bifurcated, with cyclically oriented sectors like manufacturing and housing bearing the brunt of the weakness while services and labor have been resilient.

Clouds have started to clear of late for manufacturing. As shown in the chart below, the Institute for Supply Management (ISM) Manufacturing Purchasing Managers' Index (PMI) rose in January, climbing into expansion territory for the first time since October 2022 (the 50 level separates expansion from contraction). Housing confidence has not followed suit, though, presumably because of still-elevated mortgage rates and unaffordability for first-time buyers.

Manufacturing pulling out of a slump?

Threatening the recovery in these sectors is the tariff-related uncertainty described above. Regardless of whether the tariffs are implemented, the result is an extremely volatile policy environment. As shown in the chart below, the U.S. Trade Policy Uncertainty Index spiked to the second-highest level on record in January. As long as trade pressures persist, we think uncertainty will remain elevated, potentially acting as a wet blanket on business spending and confidence (an environment similar to the 2018-2019 trade war with China).

Trade uncertainty spiking

Until this point, the U.S. equity market has remained resilient in the face of the spike in uncertainty. However, the recent bounce in breadth metrics has been relatively weak. As shown in the chart below, the share of S&P 500 members trading above their 200-day moving average has deteriorated this year; for the Russell 2000, the trend has been similar, but with a persistently lower share over the past year.

Some minor breadth concerns

That is similar to the backdrop we saw from 2017 heading into 2018. Of course, no two eras are the same, but we think that risks of a bigger pullback will build if policy uncertainty remains elevated in the face of a relatively weak improvement in market breadth. Investors should continue to focus on high-quality segments of the market, especially those that can maintain strong earnings guidance in the face of a more-volatile policy backdrop.

Fixed income: Waiting for clarity

At its most recent meeting, the Federal Reserve signaled that it would keep interest rates on hold for the foreseeable future, leaving the bond market without clear direction. Treasury yields have been trading in a narrow range, buffeted by uncertainty over economic policy. We expect the trend to continue until there is more substantive information or a change in economic conditions.

For now, the economy continues to be on a solid growth path, powered by ongoing robust consumer spending.

Personal consumption expenditures have driven GDP

Although the pace of hiring has slowed, the labor market remains strong with the unemployment rate at 4.0% and average wage growth at 4.1%. Most importantly, inflation has stalled in the 2.5% to 3.0% region, above the Fed's 2% target rate.

Inflation has stalled in the 2.5% to 3% area

In his press conference following the meeting, Fed Chair Jerome Powell indicated that he expected rates to fall later in the year, but for now the Fed is in "no hurry" to cut rates. He also noted that policy uncertainty around tariffs, immigration, regulation, and taxes are reasons to hold off on interest rate cuts. It's too soon to assess the impact of these forces on the economy and inflation.

The Treasury market also appears to be waiting for clarity on these various policies. Yields have held in a relatively narrow range over the past month as markets try to factor in the likely outcomes. Tariffs tend to lift prices, immigration changes will reduce the size of the labor force, regulation could provide a boost to growth and tax cuts could spur consumption and wider deficits.

We expect the Fed to keep policy on hold until at least the middle of the year. Meanwhile, the bond market is likely to remain volatile, but we see the risks for yields tilted to the upside. The potential policies tend to lean toward raising inflation. Moreover, 10-year Treasury yields around 4.5% are near our estimate for fair value if the Fed cuts rates to the 3.75% to 4.0% range by year-end. If that doesn't happen, then the risk is that 10-year yields retest the 5.0% to 5.25% region.

The 10-year Treasury yield is at 4.5%

With so much uncertainty, we are taking a cautious view on duration, suggesting investors target a benchmark level or below. Investors currently can earn yields in the 4.5% to 5.0% in high-credit-quality bonds without taking excessive duration risk.

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