Tariff Turmoil and Investment Strategy

One clear advantage of getting older, (and I can attest to many of its disadvantages), is that you learn from experience. The financial market chaos, following the President’s tariff announcement, is different from previous market slumps. Every market selloff is. However, a common thread in all crises is that the best decisions begin with a structured approach to analysis. With that in mind, the tariff turmoil can be examined by considering six issues:

1. The Cause of the Chaos
2. The Problem with the Pretext
3. The Response from the Rest of the World
4. The Effects on the Economy
5. Potential Policy Pivots, and
6. Investment Strategy

The Cause of the Chaos

When the market closed last Wednesday, just before the President unveiled his new tariffs, it had already been a disappointing start to the year, with the S&P500 falling 3.6% year-to-date and growth and small-cap stocks seeing bigger losses. However, international stocks had seen solid gains and some pullback in U.S. growth stocks was to be expected, following two years of excellent returns.

Investors had been nervous about signs of economic deceleration and uncertainty surrounding the extent of the Administration’s tariff ambitions. However, an announcement of reciprocal tariffs shouldn’t logically have been a game changer since the average tariff levied by other countries on U.S. goods (using 2023 data) was just 4.6%. This was certainly higher than the 2.2% levied by the United States in the same year. However, if “reciprocal tariffs” meant adding 2.4% to U.S. tariff rates, the global economy would presumably be able to adjust fairly easily.

In the event, the President announced a combination of a universal 10% tariff and much higher “reciprocal tariffs” which we estimate boost the average tariff rate to 25% - higher even than the roughly 20% rate imposed in the infamous Smoot-Hawley tariffs of 1930. These much higher tariffs, if sustained, will provoke sharp retaliation and have the potential to trigger U.S. and global recessions, boost inflation, increase inequality, slow productivity growth and reduce corporate profits. This, not surprisingly, shocked global financial markets, with the S&P500 falling more than 10% in two days. Thursday and Friday also saw significant declines in international stocks, bond yields and oil prices and a drift down in the dollar.

The Problem with the Pretext

In a trade war, as in a military one, it is important to understand how you got into it. In the second Gulf War, the United States invaded Iraq on the false pretext that Iraqi weapons of mass destruction posed an imminent threat. Forty years earlier, the U.S. Congress authorized more direct involvement in the Vietnam war in response to a fictitious second attack on U.S. naval forces in the Gulf of Tonkin.

The imposition of massive tariffs on our trading partners is also based on a false premise, namely, that these tariffs are only in response to far higher tariffs that other countries levy upon us.

A handout distributed by the Administration last Wednesday has a long list of countries with percentages listed under two headings: Tariffs Charged to the U.S.A and U.S.A. Discounted Reciprocal Tariffs. Under the first heading, there is a subhead in smaller font: Including Currency Manipulation and Trade Barriers.

The problem with this is that the numbers under these headings bear no relationship at all to actual tariffs charged by other countries on the United States. For example, it claims that the European Union charges a 39% tariff on imports from the U.S. while the World Trade Organization estimates that the actual average tariff applied by the E.U. to U.S. goods is roughly 2.7%.

So where did the 39% come from? Bizarrely, all of the estimated “tariffs” published by the Administration are calculated as net exports to the U.S. divided by total exports to the U.S. As such, these numbers do not reflect actual tariffs (or currency manipulation and trade barriers, for that matter).

In reality, the vast majority of our trade deficit can be ascribed to two factors:

First, a very basic macro-economic identity shows that if the government lives beyond its means, (that is to say, government spending exceeds taxes), and the private sector pays its own way, (that is to say private investment equals private savings), then the country as a whole will live beyond its means, (that is to say imports will exceed exports). Our huge budget deficit is a key cause of our huge trade deficit.

The second factor is that, for many years, the U.S. dollar exchange rate has just been too high to achieve trade balance. Put simply, our stuff is expensive so foreigners don’t want to buy it while their stuff is cheap so we consume it with gusto. Nor is this problem getting any better. In the first quarter, the real broad trade-weighted value of the U.S. dollar was at its highest level since the third quarter of 1985.

Clearly, if we want to achieve trade balance, a better approach would be to reduce the budget deficit and try to work with other countries to gradually reduce the exchange rate to a more reasonable level.         

The Response from the Rest of the World

The 10% tariffs took effect at 12:01 AM on Saturday, April 5^th while the “reciprocal” tariffs are scheduled to go into effect at 12:01 AM on Wednesday, April 9^th. China has announced additional 34% tariffs on all U.S. goods along with other measures, while Canada has imposed tariffs on U.S. autos, in response to tariffs imposed upon Canadian-built vehicles.

However, for the most part, countries have been cautious in responding to these new tariffs. Part of this reflects some hope that the President might yet change his mind. However, many foreign governments are also cautious about imposing tariffs anyway, prudently recognizing that tariffs generally tend to hurt the economy imposing them just as much as the country upon which they are imposed.

That being said, in time, other countries can be expected to retaliate, although likely not in as dramatic a fashion as the President’s announcement.

The Effects on the Economy

The economic effects of the tariffs, if they stick, will likely be extreme.

In 2024, U.S. goods imports amounted to $3.3 trillion or 11% of nominal GDP. If we assume that only half of the cost of the tariffs are passed on to consumers, (which seems very optimistic), and the average tariff rate rises from 2% at the start of the year to 25% by the end of next week, economywide prices would be boosted by 1.3%. This number could, of course, be boosted further by businesses trying to maintain margins amidst falling demand and higher wage demands.

On the output side, impacts could be at least as severe, partly because of retaliation, partly because of the impact of higher import prices on consumer pocket books but mostly because of uncertainty. Businesses, large and small, will be reluctant to hire or to commit to capital spending ahead of a potential recession. They will also likely hesitate to buy inventory for fear that, as soon as they have paid the higher tariffs, the President will change his mind and the tariffs will revert to lower numbers. Presumably, they will hesitate to invest in building manufacturing facilities in the United States for the same reason.

The Potential for Policy Pivots

It has to be admitted, however, that any economic forecast predicated on the announced tariffs is highly unstable. Part of this instability stems from the possibility that economic and market turmoil could result in policy pivots.

One possibility is monetary stimulus. The President, in a tweet on Friday, urged the Federal Reserve to cut rates now and claimed that the Fed Chairman, Jerome Powell, was playing politics by not doing so. However, Powell in a speech a few hours later, stressed the uncertainty surrounding the impacts of tariffs and other Administration policies on inflation and economic growth saying that it was too soon to judge the appropriate path for monetary policy. That being said, markets are now betting on four 25-basis point rate cuts in the federal funds rate in 2025 with a first reduction likely occurring at the Fed’s next meeting on May 7^th.

It should be stressed, however, that, even if the Fed did acquiesce to the President’s views, accelerated monetary easing could well worsen the situation if it was seen as a sign of panic or a surrender of Fed independence.

An alternative possibility is fiscal stimulus. Last Wednesday, entirely overshadowed by the tariff announcement, the Chairman of the Senate Budget Committee, Lindsay Graham announced that he was going to use “current policy” as the baseline for scoring the reconciliation bill that is currently embarking on its journey to the President’s desk. This would essentially treat the 2017 tax cuts as status quo, allowing Republicans to reduce the reported cost of tax cuts in deficit projections.

It wouldn’t, of course, change any actual levels of spending or taxation. However, it would give the impression of additional room for fiscal stimulus. This stimulus could come in the form of a partial implementation of the President’s proposals to exempt tips, overtime and social security from income tax, to restore the state and local tax deduction, to introduce new corporate tax breaks for domestic production and to allow for the deductibility of auto loan interest. It could also allow for one time checks, such as the so-called DOGE dividend, to stimulate the economy should it fall into recession. The more the economy weakens over the next few weeks and months, the greater is the likely fiscal stimulus, aimed partly at reviving the economy ahead of the 2026 mid-term elections.

And a third potential pivot is on the tariffs themselves. It’s not hard to imagine a scenario by which the President, while retaining the 10% universal tariff, announces that he will suspend the broader reciprocal tariffs for six months while he negotiates with trading partners. While even 10% tariffs would leave the economy vulnerable to higher inflation and slower growth, any pullback from the tariffs announced on Wednesday could trigger a sharp market rally.

Investment Strategy

All of this makes tactical positioning extremely difficult. Going to cash, after a sharp downward move in markets, would be a mistake if some policy pivot, particularly on the issue of tariffs themselves, led to a market bounce. However, buying in at lower prices to catch a market bounce could also go badly wrong if the economy sinks into some form of stagflation followed by outright recession.

However, for investors, the important questions today are the same as they were at the start of the year: Do they have a portfolio that is balanced in terms of risk and expected return for where they are in life or has it drifted away from that balance? Are they, even after the last few days, still too concentrated in over-valued securities? And do they have a truly globally diversified portfolio including allocations to value equities, fixed income, international equities and alternatives. This is no time for bravery when it comes to tactical moves. However, it is a good time for a prudent reassessment of strategic allocations.

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