Chief Global Strategist
On Saturday, the White House announced the imposition of heavy tariffs on goods exported from Mexico, Canada and China and all three nations announced their intention to retaliate. These tariffs threaten to raise prices and slow economic activity across all four countries. While the end game of this trade war remains very uncertain, it has the potential to impact bonds, stocks and exchange rates. For investors, regardless of the early market reaction, the reality of a trade war suggest the need for broad diversification including allocations to real assets and international assets.
The President’s Actions and Foreign Reactions
The actions taken by the President were in the form of three executive orders. While Congress should normally be involved in setting tariffs, the President claimed the right to do so using emergency authority to combat the flow of illicit drugs. The executive orders specify 25% tariffs on all goods imported from Mexico, 25% on all goods imported from Canada, with the exception of energy products where the tariff rate is 10%, and 10% on all goods imported from China. The tariffs come into effect at midnight on Monday night.
Canada, Mexico and China have all responded
Canadian Prime Minister, Justin Trudeau, announced 25% counter-tariffs on C$155 billion of U.S.-made goods starting with levies on C$30 billion worth of goods starting on Tuesday and ramping up to the full amount after 21 days. Provincial premiers and politicians vying to replace Trudeau as Prime Minister also expressed support for retaliatory action.
Mexican President Claudia Sheinbaum announced that she is readying both counter-tariffs and other measures in retaliation. Meanwhile, the Chinese Commerce Ministry also pledged to take countermeasures.
The Economic Impact of Tariffs
The tariffs announced by the President, along with retaliatory actions by our trading partners, could both raise prices and slow economic growth.
With regard to inflation, the first question is how much might tariffs reduce consumption of goods imported from these three countries and the second is how much of the import tax would end up being paid by consumers.
We estimate that the U.S. imported $1.36 trillion in goods from Canada, Mexico and China last year and that the tariffs announced by the President would have implied an average import tax of 19% on those goods. Under the crude assumption that a 19% increase in prices results in a 19% decline in purchases (either through lower consumption or substitution of other goods or suppliers), the tariffs announced could have raised $206 billion. Last year, total nominal consumer spending was $19.8 trillion, so if all of the price increase were passed on to consumers, it could be expected to increase the consumer price index by just over 1%. This, of course, assumes that foreign manufacturers, importers or retailers don’t absorb some of the cost. However, it also ignores the potential knock-on effects of retailers trying to maintain their percentage margins in the face of lower volumes, compensating wage increases or the impact of tariffs on other countries that the President has threatened.
Tariffs would also lower economic activity. The United States exported roughly $760 billion in goods to Canada, Mexico and China last year and slower economic growth in these countries, combined with the effect of retaliatory tariffs, could significantly reduce those exports. The effects would be more severe for Canada and Mexico than the U.S. however, as exports to the U.S. account for a far larger share of GDP in Canada and Mexico than the other way around. It is also worth noting that both Canada and Mexico had less momentum entering 2025 than the United States, with the most recent GDP readings showing year-over-year growth of 1.5% and 0.6%, respectively, compared to 2.5% in the United States.
Equally seriously, the uncertainty caused by the trade war could stall production and investment – no company will want to pay a tariff this week if it could avoid it by waiting until next week. No company could make a plan on whether to build a plant in Canada, Mexico or the United States without having some idea of the tariffs that could be levied upon it.
It is quite possible that the administration will seek to compensate exporters that will be hurt by the trade war, reducing any net revenue benefit for the federal government. Slower economic growth would also, of course, reduce revenue. Moreover, the prospect of higher inflation from a trade war would probably further delay any further Federal Reserve easing and possibly boost long-term interest rates. In this context it is worth noting that a 1% increase in Treasury interest rates across the board would eventually add $300 billion to the annual interest paid on the federal debt.
Trade War End Game
As this is being written, it is completely unclear what the end game of the trade war could be. It may be that, over the course of negotiation, tariffs on Mexico and Canada are scaled back to 10%. However, tariffs could also be broadened to include Japan, Europe and other trading partners. One small restraining factor is that the President intends to use tariffs as a revenue source in paying for part of the extension of the 2017 tax cuts and other tax cuts that he promised on the campaign trail. It is possible that, as the big tax bill is being negotiated, he will want to settle on an amount to pencil in for tariff revenue and stick to it. However, experience from his first term and the first two weeks of his second suggest that policy uncertainty could persist.
It is also worth considering that other countries will tend to maintain tariffs to match the U.S. levies and could target particular U.S. companies as a way of concentrating their retaliatory fire power, with U.S. technology companies probably the most exposed to trade revenge.
Investment Implications
In the meantime, investors have every reason to be concerned about a trade war. Last week’s GDP report showed that the U.S. economy entered 2025 with plenty of momentum, and this should be further confirmed by this Friday’s jobs report. However, equity markets continue to carry high valuations both overall and particularly among mega-cap technology stocks. A trade war has the potential to impart a stagflationary impulse to this investment environment, boosting inflation and interest rates while dragging on growth and profits.
If this scenario unfolds, U.S. equities with the highest valuations are likely the most vulnerable while non-U.S. assets and real assets could provide ballast to portfolios. Most of all, investors should ensure that they are well diversified and balanced as we head into much stronger and uncertain trade winds.