Tariffs are not inflationary, rather a one-off shift in price level. Tariffs are in fact a tax hike1, which are not inflationary but anti-growth. Investors seem to think that Trump’s tariffs are largely a negotiating ploy. We believe President Trump will do what he said that he’d do. We expect tariffs at levels in line with previous public statements and likely higher than what most investors expect. His goal is to seemingly source new tax revenue to finance further individual and corporate tax cuts. It is an added bonus that he can also extract leverage from trade partners on specific issues like defense spending, immigration, and fentanyl crisis at the same time.
While we think tariffs will be higher than expected, we do believe that the economy will adjust to the new tax hikes. Tariffs did not affect economic growth in 2018 when the last trade war was unleashed, nor did tariffs impact inflation. GDP Growth and inflation remained consistently in the 2% range during the first year+ of the tariff campaign. We believe the impact of tariffs this time around will result in a stronger USD, a goods mix shift (as supply chains adjust), some margin loss by both importers and exporters and lastly a one-off increase in the price level for consumers (but not inflation). The net result of tariffs will likely be effectively neutral to GDP growth and simply change the composition of tax receipts.
We do expect higher market volatility in the short to medium term. Policy uncertainty is the primary risk to economic growth during the Trump admin. How does a CEO know where to invest with this administration? How can you build a four-year investment plan when the rules are not clear or constantly changing? There will be disruption with this administration as executive orders are released, deciphered, then retracted or blocked by judges. Tariffs are a tax on growth and a negative supply shock akin to a natural disaster, geopolitical event and commodity price spike. Negative supply shocks are particularly bad for bonds as investors demand a higher term premium for receiving interest payments further out in an uncertain future.
However, we believe the negative supply shock disruption will be largely offset by new policy drivers – namely deregulation and a smaller federal government (DOGE). These changes are a positive supply shock and have the potential to swamp any negative byproducts of Trade War 2.0. Trump’s tax plan is still being formulated.
The plan is likely to be stimulative as the expiring tax cuts are likely to be extended and some new (smaller) tax cuts are enacted. These new tax cuts will of course be financed with the tariff receipts.
Today’s economic setup seems to most mirror that of the mid-1990’s. Chairman Greenspan cut rates 75 bps over several months in 1995 to get back to a neutral monetary policy. The 1995 rate cutting cycle was a canonical, mid-course correction.
Heading into 2025, the US economy seems to be picking up steam and has renewed upward momentum heading into 2025. The US economy has consistently defied expectations for the last two years as productivity growth has surprised to the upside. Corporate and consumer balance sheets are healthy and remain low relative to history after a decade+ of deleveraging following the Great Financial Crisis. Banks are poised to lend more once the yield curve flips to a positive spread. The banking system is still bloated with too many deposits, but we expect liquidity balances to shift into the real economy this year. Inflation is still above target but now under control. The Fed is likely on pause for now as they digest Trump 2.0. The good news for equity investors is that the hurdle for rate hikes is high but the bar much lower for rate cuts (aka The Fed Put is back).
While most investors are focused on big US policy decisions, the Trump disruption could catalyze significant policy change in both China and the EU. China is due to announce new stimulus measures in March and policy has pivoted rapidly beginning in September 2024. Social unrest – the most important macroeconomic indicator in China – has trended upwards as economic growth has stalled following a property bubble. In Europe, 2024 headwinds are likely to turn into 2025 tailwinds as hike and fiscal tightening turn into rate cuts and Eurozone fiscal coordination. Fiscal transfers to the EA periphery are accelerating this year. EU diplomats are discussing a $0.5T EU defense fund (3% GDP) while the Germans are considering releasing the Schuldenbremse (“debt brake”) a fiscal policy tool designed to limit structural government deficits.
1Per TrendMacro (a macroeconomic firm), a 10% tariff is roughly equivalent to a 1.3% increase in personal income tax rates
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