Is the stock market overreacting to tariffs?

Tariff announcements are moving at breakneck speed. President Trump implemented them on China (twice!) and levied several on Canada and Mexico that he later adjusted. He also announced reciprocal tariffs on the rest of the world, beginning in April. Meanwhile, several countries have implemented retaliatory actions of their own. The amounts seem daunting, and markets have responded with Fear, Uncertainty and Dread. Since its all-time high on February 19, the S&P 500 has fallen more than 6%. Furthermore, the Nasdaq 100 and Russell 2000 indices have both fallen nearly 10%. Bonds have rallied in a risk-off trade, with the 10-year Treasury yield dropping more than 30 basis points and expectations for interest-rate cuts in 2025 jumping from as few as one to more than three. All told, we see the volatility as a sign of overreaction. The level of tariffs sound scary, but they are small compared to the size of the US economy.

I was told there wouldn’t be math On March 4, Trump doubled his February tariff on China from 10% to 20%. He also imposed a 25% tariff on all goods from Canada and Mexico, though over the next few days he exempted their auto industries and delayed action on goods covered by the United States-Mexico-Canada Agreement (USMCA) until April. These three countries are the largest trading partners for the US, collectively accounting for $1.35 trillion in goods—33% of the $4.1 trillion of imports. That sounds terrifying; however, the US economy is huge. In 2024, GDP was roughly $29.7 trillion, meaning just 13% was spent on goods coming into the country. Running through the numbers, we would expect these tariffs to total just above $300 billion, only 1.1% of GDP. The math, however, gets trickier when we turn to reciprocal tariffs in April, as countries charge different rates. An average rate of, say, 10%, would amount to approximately $2.7 trillion, or only another 0.9% of US GDP. That would put the total at something like 2%. Not a crushing amount, though it would have more impact, percentwise, on the targeted sectors.

Consumers will shop around As economists know, calculations must consider more than these first-order effects. If consumers were faced with a 10% increase in the price of a good, they will likely shop around for a lower price. Trump has said this is one of the goals of the tariffs; he wants to incentivize Americans to buy domestic substitutes. He argues this would, in turn, create domestic jobs and help the economy. The impact of these factors is hard to predict, and prices will not rise in exact step with the tariffs. A 2% impact—a worst-case scenario—assumes no substitutes, and it's possible real inflation could be much less than feared. We saw this in early 2018, when Trump announced the first series of tariffs on China. Most economists predicted this would lead to rampant inflation in the US. But Core CPI actually slipped from 2.4% in July 2018 to 2.2% just a year later.

Markets don’t like unknowns, and those abound The real impact to the domestic economy will be determined by several unknown factors, most importantly the length of the tariffs and what the federal government does with the revenue. Only Trump knows the answer to the former, but the latter could take many paths. Tantalizingly, he has repeatedly referred to them as the “External Revenue Service” and believes the importers will pay the taxes. But critics argue that companies will push the cost of tariffs to the consumer. Therefore, the key question becomes what the government does with the money. One option floated is that it could pass it on to taxpayers as a stimulus payment, potentially warding off the impact of rising prices. Alternatively, the government could use the revenue to reduce the colossal federal deficit, potentially lowering longer-term interest rates. There are simply too many unknowns to gauge how this will play out. One thing is worrisome: without any form of government offset, a rise in prices could reduce consumer spending. That could lead to the combination of high inflation and slow GDP growth known as stagflation, which terrifies markets. However, the numbers assumed above suggest that the effect might be less than anticipated as, again, our GDP is mammoth.

In any case, these are longer-term considerations. In the near-term, the furious pace of cuts to federal agencies/programs and the slow progress on a new tax cut bill, increase the likelihood of an economic slowdown—but we don’t think that would extend into a recession. There is even a scenario in which tariffs could support riskier assets. For example, companies might be able to maintain earnings if they raise prices to offset higher costs. Couple that with the aforementioned stimulus and you are left with unchanged EPS and lower rates—a positive situation for stocks! At the end of the day, there are a lot of variables, including ongoing negotiations, which make analysis difficult. However, we think the volatility in the stock market will eventually give way to positive movement.