Tariff Tantrum – What the H*ll is Going On?

Level-set

• At least 10% minimum tariff on imported goods
• Reciprocal tariffs
• Higher interest rates to battle higher inflation, but recently rates are going the other way
• US employment numbers look good
• Higher than average stock valuations combined with solid expected profit growth
• Consumer balance sheets are strong

Let’s take a step back from the headlines, politics, and stock market fears to look objectively at the tariffs being imposed. A tariff is a tax.  As currently presented a $600 billion per year tax on consumers.  At face value, this is the largest tax increase in American history. The president and his advisors have decided to redefine the “tariff” that other countries impose on goods exported from the US to include both tariff and non-tariff barriers to trade.  Non-tariff barriers include things like the EU not importing genetically modified (GMO) corn, or China artificially lowering the value of its currency to make their exports cheaper.  The administration’s theory is that absent all trade barriers, imports and exports between any two countries would be equal and the extent to which they are unequal is solely attributable to government-imposed barriers.  The “reciprocal tariffs” are therefore calculated based on the percentage difference between imports and exports between each country.  There is ample academic research, and real-world experience, taking an opposing view, but it’s important to understand the thought process of our current policymakers. 

An American industrial renaissance has been a bipartisan dream for decades. Ross Perot, Dick Gephardt, Joe Biden, JD Vance and Nancy Pelosi have all, at one time or another, pushed protectionism, or industrial policy, or opposition to NAFTA and its “giant sucking sound” of job destruction, or providing financial incentives for foreign companies to build factories in the hollowed out American heartland.  Anyone who has travelled through Youngstown, Ohio; Gary, Indiana; or Flint, Michigan knows that they have a point.  Something needs to be done.  There are legitimate concerns about the American ability to independently manufacture indispensable goods.  Imagine entering a conflict with a country that is the sole source of the high blood pressure medication used in our country.  If our grandparents’ health is hostage to a foreign adversary, such a conflict wouldn’t last long.  The Biden administration passed the Chips and Science Act, the Infrastructure Act and the Inflation Reduction Act all with the express purpose of revitalizing American manufacturing.  The impact of these “carrots” takes time to be felt, the current administration believes that the “sticks” of tariff will act faster.

Another of the administration’s concerns is the rising cost of interest on government debt.  The deficit for the year ending October 2025 will be at least $2 trillion.  The federal government’s total budget in the last year before the pandemic (FYE 2019) was $4.4 trillion with a deficit of $980 billion.  For 2025 the budget is $7 trillion with a deficit of $2 trillion.  The budget is up 60% and the deficit up 104% over the last six years.  The total accumulated government debt has gone from $23 trillion to $36 trillion and interest payments from $375 billion to $1trillion – up 167%.  The growth in debt and deficits since the pandemic is clearly unsustainable. The administration’s plan is to reduce the deficit by $1trilion through cost cutting (DOGE), collect $500 billion from tariffs, and decrease interest costs by $200 billion by refinancing at lower interest rates.  If successful, the deficit would be back to pre-pandemic levels.   

A contributor to rising government debt is the burden of maintaining the world’s reserve currency.  You may hear about the “Triffin dilemma” in the news.  Named for an economist writing in the 1960s, the dilemma is that maintaining the reserve currency is great in the short-term when the value of our currency is artificially high and consumers become rich relative to rest of the world, however over the long-term we run structural trade and budget deficits leading to instability which undermines confidence in the currency.

Reducing government spending will reduce economic growth.  Reducing international trade will reduce consumer and business spending, further reducing economic growth.  When economic growth dips below zero, we enter a recession.   We expect economic growth to be about 1.5% on an annualized basis in the first quarter of the year down from 2.4% in the fourth quarter of 2024– before tariffs and before most of the cuts to government spending.

Open questions:

1. Will the administration use tariffs as a negotiating tool or are they to be permanent?
2. Will the tariff actually collect the expected amount of revenue?
3. Can government spending cuts rein in the deficit?
4. When Hanes builds a T-shirt factory in town, whose kids are skipping college for a job behind a sewing machine?

With that as background, what do we do next.

1. We make sure that short-term needs for cash are covered with income and/or liquid investments.
2. Don’t make rash decisions. On average each year, from a high point to a low, the stock market drops 5% three times, one being at least 10%, and every three years one being at least 15%.  This is not a penalty for an investment mistake, it is a normal, natural and expected cost of investing in stocks.  It’s the reason we don’t invest 100% of our client’s assets in stocks.  The attractive long-term average returns that accrue to stock investors include these drawdowns.  The best market days often closely follow the worst. A balance of investments provides for dampened volatility.
3. Active managers have the ability to take advantage of drops like this while passive index funds are forced sellers of stocks that drop in value.  Index funds make up a large portion of total investment dollars which exaggerates price swings.
4. Bonds have performed well in periods like this and over the last couple of weeks bond funds are by-and-large up in value – in the 3-5% range.
5. For many clients, we’ve added to the category of alternative investments – private credit, private real estate, infrastructure and/or private equity.  Historically these categories have not moved in the same direction as stocks.  Some, over the last two years when stocks were gaining well more than their annual average, performed modestly or even poorly.  Many performed well in previous stock declines.
6. When investing in stocks we can ask, “are this company’s prospects 10, 15, 20% worse than they were a few weeks ago?”  The answer could be “yes”, but if it is “no”, this could be an opportunity to buy more.
7. Valuations in stocks are still historically high even with the recent decline.  But, US companies continue to grow with solid expectations for profit growth this year. 
8. You don’t need to catch a falling knife.  Looking back to previous market declines greater than 20% – this century that occurred in 2001, 2002, 2008, 2009, 2011, 2018, 2020, 2022.  Buying as the recovery was underway was a solid strategy.

Sources:

https://en.wikipedia.org/wiki/National_debt_of_the_United_States

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