Key Points:
• Policy chaos continues in the US, with greater than expected tariffs announced on Liberation Day which were shortly followed by a 90-day delay to facilitate negotiations.
• While the final impact of tariffs is highly uncertain, business and consumer confidence are starting to weaken in the US.
• Prolonging this uncertain policy environment risks magnifying the impact on the US economy.
• The market is reacting poorly to the uncertainty, we expect this to continue, and as a result our portfolios are underweight global equities.
The policy chaos which has become characteristic of the Trump Administration escalated over the past month. The much-anticipated Liberation Day tariff announcement was significantly worse than expected, sparking the fifth largest two-day fall in the US market since 1965 (~-10%). The market then partially recovered on news that reciprocal tariffs on all countries except China would be delayed for 90 days, though this gain hasn’t been maintained. Importantly, while bonds were initially rallying (yields falling) this has subsequently reversed with US bonds now selling off in sync with equity markets. This may reflect investors calling into question the inviolability of US government debt with Trump at the helm. Australian bonds have been better supported, a positive for our portfolios.
It wasn’t just the size of the proposed tariffs which spooked markets. The icing on the cake was the realisation that the Administration seems to have no idea what it is doing. If it wasn’t so serious, it would be comical.
Trump’s team has been lampooned for applying tariffs to Heard Island and McDonald Islands which are solely inhabited by penguins. Almost immediately after their announcement, analysts determined that the process by which reciprocal tariffs were calculated made little economic sense. After this news circulated, the US Trade Representative (USTR) released a lengthy paper with a complicated formula. Then, the academic economists who had been referenced in the USTR paper noted that if the formula had been parameterised correctly, the actual tariffs rates levied would be substantially lower than those announced. Regardless, as has become the policy announcement pattern, shortly after Liberation Day, reciprocal tariffs on all countries but China were paused for 90 days to allow time for trade negotiations.
Where Do We Stand?
Accepting as a given that there will be a continued escalation in general business uncertainty due to the unpredictable nature of the Trump Administration, we must also try and estimate the impact of the proposed tariff policy on economic activity and inflation in the period ahead. Is the combination of this uncertainty and now very high tariff rates sufficient to derail the US economy and global markets? The reality is, there are too many uncertainties to be confident of any outcome. The final tariff rate to be levied on all countries is subject to ongoing trade negotiations and could be higher (China’s tariff rate has risen since then because they retaliated with their own tariffs) or lower than what was announced on “Liberation Day.” Several electronics goods have also been excluded from the reciprocal tariffs, lowering their bite. Though apparently additional tariffs on semiconductors and pharmaceuticals are in the works.
Even if we knew what the final tariff rate was going to be, the impact of that number on the economy is uncertain, though is universally expected to be negative. Most economic forecasters expect some weakness in the year ahead, with the consensus expecting a year of below trend growth. Roughly 25% expect a contraction in the economy in the third quarter of this year and around 10% expect a contraction in the second and fourth quarters. Although most still expect a weak, but growing, economy, this seems relatively benign. However, forecasters aren’t generally known for making big, out of consensus, calls about the economy well ahead of time.
Source: Refinitiv, Drummond Capital Partners
A key reason why the impact of the tariffs is so uncertain is differing tariff rates across countries allow for substitution, lessening their impact. While the average tariff rate applied to goods at the current import composition is around 25%, high tariffs against certain countries will encourage importers to seek supply from lower tariffed countries. For example, China’s tariff rate is now between 145% and 245% depending on the good. Australia and the UK are only 10% and the European Union is 20%. While some goods are made exclusively in China, most are built across many locations. Thus, the tariff rate which is most representative of the economic damage is one which tries to account for this substitution. Substitution could take the effective rate to something around 15% rather than 25%, which is still material by historic standards.
Where To From Here?
Our growth barometer is showing signs of weakness in the US economy. Growth has been weakening driven by soft data in the consumer and labour market sectors in particular. Weakness in the consumer would be needed for a recession to occur. Higher tariffs represent a large implied tax increase across the consumer base. Around 10% of US household consumption comprises goods sourced from overseas. An effective 15% tariff on this would be the equivalent of a 1.5% tax across the consumer base.
Most models put the overall drag on the US economy from tariffs at around 1% of gross domestic product. If these models are correct, that shouldn’t cause a recession in isolation, but would lead to a period of quite weak economic growth. However, we think there is a high chance that the tariff impact is compounded by broad based elevated business uncertainty due to the chaotic policy environment. Event studies analysing the economic impact of the 2018 Trade War produce higher economic impact estimates than above, between 0.3% and 0.7% of GDP for a much lower tariff increase than now. If these studies are correct, the tariffs would almost certainly lead to a recession.
We have started to see this impact soft economic data in a more meaningful way recently and expect another step down once the full impact of the “Liberation Day” tariffs are evident in the survey responses. The chart below shows the new orders component has fallen sharply back towards late 2022 lows. This suggests that businesses are pulling back on forward orders because of concerns about demand in the period ahead. The chart also shows the relationship between new orders and forward earnings (EPS) which suggests downgrades to equity earnings should be expected.
We are still early in this attempt to restructure the global trading system and we doubt the final tariff regime we end up with looks much like what was proposed in early April. Some tariffs are yet to be announced and trade negotiations around the winding back of reciprocal tariffs are ongoing.
Portfolio Positioning
Even if the final tariff levels end up being less than what is currently proposed, there is a shock coming to the US economy and in turn this will pressure the global economy. It may not be sufficient to cause a deep recession, but there is a risk that it does if business and consumer confidence are sufficiently weakened by the chaos emanating from the White House. In line with this, our portfolios are currently significantly underweight equity exposure, with the largest underweight to global equities. Though markets are a good way from their highs, they are not that close to fully pricing a recession, which we see as a greater likelihood than an immediate stop to the trade war and a resumption of business as usual in the US economy.
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