The trouble with tariffs

The US election is over, and investors are beginning to assess who will be the winners and losers during Trump’s second term in office. Will President-elect Trump do all that he said he would do? Or was a lot of what he proposed just campaign rhetoric? We can be fairly certain that tariffs are going up at least somewhat and that more tariffs are going to be imposed. On the campaign trail Trump promoted a 60% tariff on Chinese goods and a 20% tariff on all other imported goods. We find it unlikely that the blanket 20% tariff will be initiated, but we feel sure that there will be higher and more widespread tariffs on Chinese goods.

International markets initially sold off after Trump’s victory, with investors responding to the negative effect higher tariffs can have on GDP growth and company earnings. Strategists have lowered their GDP growth forecasts for next year for Europe, China and the UK. Some have also raised their inflation forecasts. There is a lot of money at stake. In 2023 the US imported goods worth $3.1 trillion, with 29% coming from Mexico and Canada, 18.7% from the European Union and 13.9% from China.

Back in the eighteenth century, a group of thinkers called the mercantilists argued that the wealth of nations was a sort of zero-sum game and that tariffs should be used to defend one’s own industries and hurt those of rival countries. Economic theory has long been hostile to the mercantilist assumptions behind tariffs. Indeed, the very study of economics in the modern sense began with Adam Smith and David Ricardo making the case for the benefits of trade against the mercantilists.

The current policy debate, then, is an old one. Put me down on the side of Smith and Ricardo. For all the rhetoric, the incoming administration may wind up there as well. Some of the tariffs are evidently meant as bargaining chips or, in the words of a Trump adviser, “escalate to de-escalate.”

Tariffs are a tax on consumers. Countries don’t pay tariffs directly—consumers do. Any “optimum tariff” advantage vanishes if trade partners retaliate, which they invariably do. There is, in fact, a kind of futility to tariffs. The US trade deficit with China has increased under both the Trump and Biden administrations in spite of higher tariffs on Chinese exports. But they can be gravely serious—the Smoot-Hawley tariffs of 1930 were one of the causes of the Great Depression.

When tariffs are enacted, importing companies will look to either shift production to countries that will not be impacted by tariffs or else raise prices. Companies that make everything from microwaves, to shoes, to cat litter have all said they will raise prices in response to a 60% tariff being imposed on Chinese exports.

Accordingly, tariffs can lead to higher inflation. UBS economists estimate a 35-40 basis point increase in US core PCE from a 60% tariff on Chinese goods. China will look to devalue the renminbi to make its exports more attractive. Higher tariffs will also cause the dollar to rise, a headwind for both developed and emerging international markets.

But it is too early to make any firm forecasts around the impact of Trump’s tariffs because we don’t know for certain what they will be. As indicated above, they may in large part be intended as leverage to encourage companies to relocate factories to the US. What we do know is that increased trade tensions aren’t good for anyone. Global trade has created immense wealth, raising living standards for billions of people around the world.

Post-Covid, we see supply chains being reconfigured. We think this trend continues, regardless of additional tariffs being imposed, so the potential range of outcomes is wide. Should new tariffs create a disruption in global trade, however, that would impact growth and put a lid on equity market returns.