The Trump administration announced yesterday a two-tier levy on U.S. imports: a 10% baseline tariff and a reciprocal tariff. The situation remains fluid as the negotiation and retaliation phase begins, but the economic impact is immediate. In this piece, we unpack the key implications for investors, based on the information available today.
Bloomberg reported that the tariff rates were calculated based on trade volume. If a country exports significantly more to the U.S. than it imports from the U.S., its 'reciprocal' tariff could approach 100% - as has happened to some Asian countries dubbed 'the world’s factory.'
This unconventional method of determining tariff rates suggests that the goal may be more about raising revenue or eliminating the trade deficit than 'leveling the playing field.' Why does this distinction matter? If the U.S.'s 'reciprocal' tariff is based on the bilateral trade deficit rather than the tariff rates imposed by the other country, it becomes much harder to unwind. Investors need to consider the risks of a prolonged levy, and/or a significantly reduced trade flow.
Inflation will rise in the short term, by about 0.5%, according to Bloomberg's estimate. In the long term, unless additional tariffs are imposed in either direction or fiscal stimulus is introduced, the effect will be one-time as inflation, by definition, is the CHANGE in price levels.
Inflation also has two components: goods and services. Goods prices will see an immediate increase following the imposed tariff. Service prices, on the other hand, are more "local" and closely tied to demand, which in turn depends on consumer strength and the job market. One effect of the tariffs is a weakening job market in the near term, which could temper spending and potentially lower services inflation, barring any fiscal stimulus.
Tariff's drag on the GDP growth is currently expected to be about -0.8%, according to Bloomberg's estimate. Unlike inflation, the impact on growth will not only be prolonged but also difficult to estimate, as it moves through our complex economy.
Companies adjusting to the new environment and navigating uncertainties will rebalance capital expenditures and their labor needs. Several layoffs have already been announced today.
Treasury yields fell immediately after the tariff announcement for two reasons: a flight to safety and concerns about growth. 10-yr dipped below 4%. Long-term rates will remain capped unless the economic growth outlook improves. The path of the Federal Funds Rate, however, will depend on the relative magnitude in movements for inflation vs. growth.
In 2020, the VIX shot to 80+ intraday and closed above 50. In contrast, both in 2022 and today, the VIX has been more muted, hovering around 30. The story in 2020 was repricing to the new rates, and similarly, today’s story revolves around repricing to the tariffs. So far, there has been no full-blown panic.
Cyclical sectors and stocks with large tariff exposures are sold off in today's trading. The Magnificent Seven have a 75% supply chain exposure overseas, compared to just 40% for the other 493 companies in the S&P 500. A inverting/flattening yield curve will hurt Financials.
Year-to-date, before the tariff announcement, the Magnificent Seven accounted for all of the S&P 500's negative return and more, while the rest of the S&P 500 saw slight gains. Post-tariff, both groups need to experience more drawdowns to account for the tariff shock, which came worse than the market expected and priced in.
Even without the tariff-induced uncertainties, earnings have been challenging to forecast, especially for small-caps. Over the past three years, stocks have constantly failed to meet initial estimates. According to Goldman Sachs, each 100bp change in US GDP growth is worth about 3-4% of S&P 500 EPS growth and each 5pp increase in the average tariff rate reduces the EPS forecast by 1-2%. 2025 started with high expectations that will definitely be adjusted lower.
If the tariffs stay, the long-term winners will likely be companies with large gross profit margins, strong balance sheets, less reliance on physical capital, or more localized supply and market.
At the end of March, valuations have significantly retreated from their peak in November 2024. Current valuations across all market caps are lower than in December 2023. While they could certainly decline further as earnings estimates adjust lower, unless the job market collapses and a recession hits, they may not be far from the trough.
Five years' positive stock-bond correlation reversed today - bonds have finally provided the diversification during the stock market decline. In the near future, Treasury bonds may be the best place to hide from the volatility.
If the economy materially slows down, both public and private equities and credits will be negatively impacted. Investments such as infrastructure will be more insulated.
Active equity managers, long-short and market-neutral managers, derivative income funds and managed futures may emerge as strong players and outperformers in an environment of uncertainty and volatility.