Our view is that some of the offsetting factors that helped soften the impact of the 2018 tariffs are unlikely to be as effective this time round.
The US announcement of broad tariffs on imports from Canada, China, and Mexico and the subsequent market reaction show that President Trump's tariff policy has the potential to disrupt both the world economy and global financial markets. However, the suspension of tariffs against Mexico and Canada a few days after the announcement are also testament to the high level of uncertainty around the future path and scale of US trade policy. We examine the scope of US imports at risk from tariffs and why differences between 2025 and 2018 have increased the inflation risks from import duties.
The duration of tariffs and retaliation of trading partners will be key variables to watch to evaluate the overall growth and inflation impact. Investors should be mindful of the risk that several US import duties, and retaliatory tariffs from trading partners, remain in place in the medium term.
Finally, we lay out three different tariff scenarios and their implications for different asset classes. Given the high level of uncertainty we view diversification into quality bonds and alternatives as key to mitigating US trade policy risk.
What trade is at risk from US tariffs?
Trade is of vital importance to the US. According to the latest US Customs and Border Protection Agency data, the US imported USD 3 trillion’s worth of goods in the first 11 months of 2024. The latest World Bank data showed that Canada, China, and Mexico accounted for 44% of US goods imports in 2022. Including the European Union would take the share of US goods imports at risk from tariffs to 60%. Consumer and capital goods are the key sectors, accounting for two thirds of all imported goods, but intermediary goods – those going into final products manufactured in the US – account for 17% of imports. This suggests that broad based tariffs could not only directly impact prices for both corporations and consumers, but also cause significant supply chain issues for the very domestic manufacturers they are designed to support.
Campaign promises
On the campaign trail President Trump spoke of a 60% tariff on all Chinese imports and a 10-20% universal tariff on all other imports. However, there is considerable uncertainty about what the final policy mix will be. The initial round of tariffs announced at the beginning of February applied a 25% tariff to Canadian non-energy and Mexican imports, and a 10% tariff to Canadian energy and Chinese imports. Combined these policies would quadruple the US effective tariff rate from 2.4% to 10%, although the Canadian and Mexican tariffs have subsequently been delayed.
This is still below what President Trump promised on the campaign trail. If those policies were implemented, they would further raise the effective tariff rate on US imports to 17%. Our view is that the different economic reality this time round will eventually constrain the President, however the larger than expected size and scope of February’s initial announcement increases the risk that politics overrule economics and high tariffs remain a more permanent feature of US trade policy.
Economic consensus is that tariffs are a net negative. However, President Trump and his team view tariffs as the solution to three main problems, first, as a way to redress what they see as unfair global trade imbalances, which left the US with a current account deficit of USD 818 billion in 2023 and have led to the destruction of US manufacturing jobs over the last 20 years; second, as a revenue raising tool to fund domestic tax cuts; and third, as a negotiation tool to enforce the Trump administration’s political goals.
The requirement to raise revenue would be particularly pressing if President Trump decided to cut corporation tax again. Extending the expiring provisions of the Tax Cuts and Jobs Act (TCJA) is already likely to put pressure on federal finances. Cutting corporation tax from its current rate of 21% to 15% would imply additional lost revenues of close to USD 700 billion over the next 10 years. An average effective tariff rate somewhere in the region of 12% would be required if tariffs were used to offset these losses. While we think it is unlikely the final rate is this high, the requirement for revenue could bias the Trump administration in favour of tariffs over other potential solutions, further escalating trade tensions.
Investors should consider the implications of trade tensions for their portfolios, as even the targeted 2018 tariffs led to significant market volatility, and some of the prior offsetting factors are likely to be less effective this time round. The result is that a similar increase in tariff rates, unless they are cleverly targeted, risks being more inflationary than before.
What is different this time compared to the 2018 tariffs?
During his first term President Trump introduced targeted tariffs on a range of Chinese imports in response to what he deemed unfair trading practices. A combination of the limited scope of the duties, the devaluation of the renminbi, and importers absorbing some of the costs, meant the initial inflationary impact was limited. In the longer run there is also evidence that indirect exports of transhipped goods helped maintain US consumer access to cheap Chinese manufacturing. These factors are likely to be less potent a second time round, meaning that significant increases in tariff rates risk reigniting inflationary pressures in the US.
While overall inflation remained contained in 2018, sectors that were exposed to tariffs did see upward pressure on prices. However, the limited nature of the 2018 duties confined price increases to just a few sectors, and in the generally benign environment of the time, these price rises were offset by price falls elsewhere. The scale and scope of the proposed tariffs this time round mean that far more sectors are likely to see price rises, leaving less room for offsetting elsewhere and potentially leading to upward pressure on overall inflation.
In 2018, the major offsetting factor for the competitiveness of Chinese exports was the devaluation of the renminbi. Between April and October 2018, the Chinese currency fell 10% against the US dollar. But currency devaluation is unlikely to be as effective as a countermeasure to US tariffs this time round. First, the real effective exchange rate of the US dollar is at the highest level since 1985. Second, the US administration is explicitly looking at currency manipulators as targets for tariffs, so attempting the same devaluation policy risks compounding the problem.
The longer-term impact of the 2018 tariffs was offset by changing supply chains. China’s share of US imports has fallen by nine percentage points since 2018, with key beneficiaries of this change being countries such as Mexico, Vietnam and Taiwan. However, import data for these countries suggests that a proportion of this increase in trade could be accounted for by transhipped Chinese goods. The administration’s recognition of this phenomenon, as well as the broader range of countries being targeted for tariffs, means that in 2025 there is less scope for this to happen again.
Finally, corporations appear marginally less willing to absorb tariff costs than they were in 2018. Using a large language model to examine the question-and-answer sessions from recent corporate earnings calls shows that, while most firms are still not discussing tariff impacts, those that are show a shift in sentiment around how to deal with tariff costs. Among firms where a clear response to tariffs was mentioned, we found a shift in favour of passing on tariff costs to end consumers.
Investment implications
Given these factors, there is a risk that Trump’s tariff policy in 2025 is more inflationary than in 2018. The scale and duration of both US tariffs and trading partner retaliation will be the key variables that dictate the size of the inflation impulse and hit to growth. We have identified three broad potential scenarios: the deal scenario; the campaign promise scenario; and the Smoot-Hawley Tariff Act 2.0 scenario.
The deal scenario
The deal scenario is closest to the market’s benign base case prior to the start of February. In this scenario a combination of negotiations and economic and market volatility would cause a rethink of tariff policy. The US administration would declare victory on a number of political issues allowing President Trump to reduce tariff rates. Price pressures would be short lived and the overall inflationary impulse from tariffs would likely be moderate and partially offset by existing disinflationary forces. While there could be significant short-term volatility, the medium-term outlook remains largely the same. The path for Federal Reserve (Fed) policy would remain unchanged, and after initial headwinds equity markets could be supported by deregulation and modest fiscal measures.
The campaign promise scenario
The size of February’s initial announcement makes us more nervous that the Trump administration wants to deliver the trade policy they promised on the campaign trail. In this scenario, tariffs would be used not only to achieve political goals but also as a source of government revenue to finance the full extension of the TCJA as well as the promised corporation tax cut. The impact on markets would be more disruptive as permanent tariffs would be implemented broadly and the effective rate rises significantly. The initial economic impact would be stagflationary. The size and scope of tariffs would make it hard for corporates and currency markets to absorb the price shock, while US growth would slow even if the economy would likely avoid recession. Any fiscal offset would not be delivered until 2026. Rising inflation would prevent the Fed from cutting rates to support the outlook. The US dollar would be supported by wider inflation differentials while equity market volatility could rise as margin uncertainty increases and business confidence falls. Alternatives, in particular real assets, should outperform. Within public markets, income and value strategies could benefit from higher inflation. European government bonds would outperform as the European Central Bank would likely cut rates to support growth.
The Smoot-Hawley Tariff Act 2.0 scenario
Our extreme risk scenario is a return of average US tariff rates to a level last seen in the 1930s after the Smoot-Hawley Act was enacted. Although we attach a lower probability to this scenario the market impact could be dramatic. In this scenario, the US administration would use massive tariff increases to finance significant tax cuts for households and corporates, seeking to replace major revenue sources with tariff income. The US tariff rate would rise to the highest level since the Second World War and cause a significant negative volume effect in global trade, as trading partners retaliated. This volume effect would outweigh the price effect, and the overall result would be deflationary. Bond markets would rally as sovereign yields fell. Despite fiscal stimulus, risk markets would underperform as equities fell and credit spreads widened. Long duration and high-quality assets would outperform while European equities would be particularly vulnerable to an escalating trade war given the share of revenues generated overseas (see exhibit 1).
Conclusion
In the coming months we expect higher levels of volatility, particularly if there are further tariff announcements against Europe. However, the new administration inherited a booming stock market and a mandate from the voters to fight inflation, both of which could be at risk if the tariff card is overplayed. If tariffs do prove temporary, then risk taking should still be rewarded in the medium term, but investors need to be aware that an aggressive trade policy with the prospect of higher interest rates and margin pressures, or an outright growth shock, could turn out to be an unpleasant backdrop for the markets. Portfolio diversification will be key to weathering trade policy uncertainty, and the inflation and growth risks. Depending on which scenario unfolds, alternatives can help mitigate some of the upside inflation risks, while European government bonds should provide a buffer in the case of a deflationary shock.