The Tariff Man Cometh…and Go-eth?

Are these levies just a negotiating tool, or an unorthodox revenue-raising scheme? The answer could determine how seriously investors should view them.

Last Monday, the U.S. was on the brink of imposing 1930s-scale tariffs on its two closest neighbors, both of which are allies and partners in a comprehensive trade agreement. Hours later, it delayed the plan for Mexico and Canada but left in place a modest 10% tariff on goods from China, a longstanding target for trade sanctions.

The markets let out a sigh of relief. While there is still much to be negotiated and uncertainty remains, the biggest trade war in 90 years might be over before the first shots were even fired.

A big question remains unanswered, in our view. Does President Donald Trump view tariffs (“the most beautiful word to me in the dictionary,” in his own words) as leverage to achieve specific objectives in unilateral negotiations? Or do he and his economic team envisage a major policy shift in which tariff income partially replaces traditional tax revenues? Or do they think they can achieve both?

A Hit to Growth and Inflation

The speed and scope of the President’s actions are what surprised the markets. The original order applied a 25% tariff on goods coming from Mexico; a 25% tariff on Canadian goods aside from energy products, which would be taxed at 10%; and a 10% tariff on goods from China. President Trump also closed a loophole that exempted packages from China valued at under $800 from tariffs, a quite meaningful carve-out from the 2018 China tariffs.

These measures would have affected approximately $1.3 trillion in goods, representing more than 40% of all U.S. imports and almost 5% of U.S. GDP. They would have raised the average U.S. tariff from around 3% to over 10%.

Estimates of the hit to growth and the increase in inflation vary widely, but we believe these tariffs could cut U.S. GDP by 0.5 – 1.0 percentage points and raise core inflation by 0.5 percentage points, annually. Analysts’ estimates put the hit to S&P 500 Index earnings in 2025 at 2 – 3%, potentially rising further in the event of retaliation, with the auto and agriculture sectors particularly exposed. Canada and Mexico would likely enter a recession.

Another eye-catching number is that this level of tariffs would be likely to generate $150 billion or more for the Treasury. That would be a significant haul, and it is one of the reasons why some have speculated that tariffs are now seen as just another source of tax revenue.

If that is the case, investors should not assume that the threat of high tariffs has dissipated, nor that they will be short-lived when imposed. This would lead us to reconsider our longer-term economic outlook. Inflation expectations would rise. More importantly for an equity market that appears highly sensitive to growth expectations, GDP forecasts would have to be lowered.

Are there any clues as to how to read the U.S. government’s intentions?

Leverage

One argument in favor of seeing this as a revenue-raising effort is the fact that Canada and Mexico were targeted with such huge and broad-based tariffs. This was at the most bearish end of most analysts’ expectations, and it would be a belligerent thing to do against one’s closest trading partners and allies—but it would raise a lot of money. This is particularly important given the level of fiscal deficits the U.S. is generating.

The more likely assumption, however, given how quickly the levies on Canada and Mexico were delayed pending further talks, is that this is a negotiating tactic. Border protection, drug enforcement and agricultural product purchases are all things that may be on the table in those negotiations. President Trump also warned that tariffs were “definitely” on the way for the European Union “pretty soon,” and we might anticipate higher defense spending and looser regulation of the U.S. tech sector to be on that negotiating agenda.

The tactical-leverage theory seems the most likely explanation for the China policy, too, but there are more complex geopolitical undercurrents. At first glance, the decision to punish Canada and Mexico more severely than China looks strange. But the objective here is to press China to honor its promise, under the trade agreement negotiated during Trump’s first term, to purchase more U.S. goods and agricultural products. The administration may feel that the short, sharp negotiating shock applied to Canada and Mexico would be less effective in achieving this aim than a ratcheting approach. Ten percent is likely a starting point ahead of higher tariffs in April, after two separate U.S. Trade Representative reviews of trade with China are due to report.

Long-Term Bullish

Overall, our base case remains what it was two weeks ago: Tariffs are a negotiating tool rather than a revenue-raising effort. However, there is more than enough uncertainty around this to give investors pause.

U.S. economic fundamentals remain robust, underpinned by the strength of the consumer and the potential benefits of other administration policies, particularly deregulation. We remain long-term constructive on U.S. nominal growth and equity markets.

But this uncertainty will likely generate more market volatility—in the U.S. market but especially in the non-U.S. markets that emerge as targets for such aggressive negotiating tactics—and high-stakes games have the potential to cause accidents. The next few quarters could be choppy.