Why impose tariffs? Judging by the negative response in financial markets, it would appear to be a policy blunder. There are various reasons for doing so. President Trump is fulfilling the pledge he made during his campaign trail to the US industrial heartland. Making imports more expensive by imposing tariffs increases the competitiveness of locally made products. Tariffs also increase government revenue, which can be recycled back into the economy via tax cuts. A third reason is to reduce the size of the trade deficit and current account deficit. Another reason is to gain policy concessions from trading partners.

The motivation behind raising tariffs appears sound, but it is a risky gambit. US households may end up paying more for products, putting pressure on their disposable income and overall consumer spending. Consumer spending accounts for more than two thirds of US GDP, so there will be a negative impact on economic growth. Companies which rely on imported components in their supply chains will be penalised, making them less competitive. Tariffs may also be inflationary, especially in the current environment with the US economy growing beyond its production capacity. Inflation increased unexpectedly in January to a 3% annual pace, well above the Federal Reserve’s 2% target.

The biggest losers will be the US trading partners, even if they retaliate. The US is far less dependent on trade than the rest of the world. Its imports and exports comprise 11% and 7% of GDP, respectively. By contrast, imports and exports in the rest of the world comprise 26% and 28% of global (excluding US) GDP. The 25% tariffs imposed on Canada and Mexico on the 4th of March are likely to tip those economies into recession.

The impact on the US will be comparatively moderate, although consumer sentiment is clouding over. The Conference Board’s US consumer confidence index fell in February by 6.7% from the previous month’s level, its biggest percentage decline since August 2021 in the middle of the Covid pandemic. Respondents cited concerns over trade tariffs and inflation. The survey’s year-ahead inflation expectation increased from 3.3% to 4.3%, the highest reading since 2023. Economic activity data has also been disappointing. Consumer spending dropped in January by 0.2% on the month, the first decline since March 2023 and the biggest in four years.

The Fed should be ready to shore up economic activity with further interest rate cuts. However, the inflationary impact of tariffs has placed a temporary halt on the Fed’s monetary easing cycle. After cutting the fed funds rate by a cumulative 100 basis points in 2024, Fed chair Jay Powell says further rate cuts will have to wait until there is evidence on which direction trade policy drives prices. In theory, tariff increases should only have a temporary effect on prices, which the Fed might be willing to see past if the economy slows. Some fear, however, that once-off tariff price increases will have a second-round impact, making the inflationary increase less transitory.

An underappreciated consequence of US trade tariffs is the impact of an enforced reduction in the trade deficit on foreign investment inflows. Independent macroeconomic research firm, MRB Partners summarises the predicament succinctly: “A trade or current account deficit must have a financial and/or capital account surplus as an offset. Hence, any reduction in the US trade and current account deficit will have as its corollary a decline in foreign investment in US financial and nonfinancial assets.” The US has run a trade deficit in each of the last 49 years and a current account deficit in 43 of the past 44 years. The quid pro quo is that foreign investment inflows into the US have been vast, amounting to $13.1 trillion over the past 10 years, averaging an annual 5% of GDP. The rest of the world now holds $56 trillion of US financial assets, equivalent to 180% of GDP. A forced shrinking of the trade and current account deficits would lead to an exit by foreign investors, potentially leading to a material compression in US asset valuations.

How is US trade policy expected to pan out? In his first presidency, Trump started his term with pro-growth policies, including tax cuts and deregulation. It was only in 2018 that he launched his trade tariff policy, which undermined his earlier efforts at stimulating growth. Financial markets had expected the same sequence in his second term, hence the solid stock market rally which began in October and continued until his inauguration on 20th January. However, his polices are occurring in a different sequence. He has started out with tariff policies, perhaps because this time around the economy and financial markets are a lot stronger than they were in 2017 and better able to cushion any fallout.

The fallout is expected to be significant and likely to repeat the path of Trump’s first term. Sinking equity markets and slowing growth caused Trump to stop lifting tariffs in 2018. It is unclear what his pain threshold is. He may have the stomach for sharply weaker financial markets but will be very unlikely to sacrifice the economy. The economy is on solid ground, and so he may be willing to witness more financial market pain than in his first term, but eventually he will pivot towards his pro-growth policies, encompassing deregulation and tax cuts. At Overberg asset Management, we are prepared for the upcoming period of market uncertainty but see it as a buying opportunity. We expect a growth friendly policy pivot before sentiment has sufficient time to infect the business investment cycle.