The global trade war is here. U.S. President Donald Trump, in an attempt to solve the issues which he promised to solve in his 2016 campaign (immigration, stolen IP and unfair trade practices), has issued a variety of tariffs on imported goods from all over the world. In response, the stock market’s early 2019 rally has turned into a May sell-off. Ever since Trump fired off a May 5 tweet about raising tariffs on China, the S&P 500 has shed more than 6%.
But, let’s take a step back here and understand what’s really going on. What are tariffs exactly? How do they impact the economy? U.S. businesses? The consumer? And why is there this idea running around that if Trump keeps hiking tariffs, the stock market will tumble, much more than it already has?
These are questions that every investor should know the answers to as trade tensions globally continue to escalate over the next several months, since those trade tensions will be the driving force of financial markets.
Without further ado, then, let’s dive into a deep talk about tariffs and what they mean for the economy and the stock market.
What ARE Tariffs?
Broadly, tariffs are a tax on imported goods. The world economy is made up of countries exporting and importing things to and from one another all the time, and often in great volumes. A tariff disrupts that free trade flow, and taxes certain imports from one country to another.
Why would a country do this? There are two potential reasons. Tariffs are a tax, so they raise revenue. Thus, if a country needs or wants to make more money, they could institute tariffs to raise that money from imports. Tariffs also increase the price of imported goods, so they make domestic goods and production relatively cheaper. Thus, if a country needs or wants its citizens to buy domestic goods and products (or wants its businesses to produce more domestically), the government could institute tariffs to accomplish that goal.
Trump is slapping tariffs on imported goods for the second reason. The U.S. economy doesn’t need to raise revenue. It’s one of the biggest economies in the world, and is growing at a healthy rate. Instead, Trump ran his campaign on the “Make America Great Again” slogan, and part of that slogan includes bringing jobs, manufacturing and products back to the United States.
In order to accomplish that goal, Trump is imposing or threatening tariffs on America’s biggest trade partners, in hopes that they will incentivize U.S. businesses to bring production back into the U.S. and U.S. consumers to buy American-made goods. Additionally, he hopes that doing so will accomplish country specific goals, like solving the immigration problem with Mexico and the stolen IP problem with China.
So in summary, tariffs are a tax on imported goods that countries use to either raise revenue, or promote more domestic production and consumption. Trump is mostly instituting tariffs for the latter reason.
Why Tariffs Matter
What’s the impact of tariffs to U.S. businesses, consumers and the economy?
For businesses that rely on imported goods, it means higher input prices. In the near term, either those businesses absorb those higher prices, or they pass them along to consumers. If they absorb those higher prices, it means the cost base goes up, margins go down, and profits take a hit. If they pass the tariff hikes onto consumers, the cost base remains relatively constant, but the price of their products moves higher, and consumers end up fronting the cost of the tariffs.
On the consumer front, the impact really depends on what businesses do. Again, if businesses absorb the tariff hike, consumers won’t feel much of a pinch. But, most businesses pass at least some of the tariff hike onto consumers. In that case, prices on goods imported from the impacted countries will go up, and everything will become slightly more expensive for the consumer.
As for the stock market and economy, tariffs broadly mean lower corporate margins and higher prices. Lower corporate margins mean lower corporate profits, which will lead to a lower stock market. Meanwhile, higher prices mean more inflation, which will lead to higher rates, less favorable borrowing conditions, and a slower economy.
Overall, the near term impact of tariffs to U.S. businesses, consumers, and the economy isn’t favorable. That’s why stocks are in sell-off mode right now.
Why The Tariffs Could Spell Trouble For Stocks
There is a doomsday scenario for the stock market lurking around the corner that could materialize if the current global trade war continues to escalate.
The worst-case scenario here is that no country backs down. China doesn’t wiggle on IP and trade disputes. Mexico doesn’t help stop the immigration flow. The U.S. follows through on its promise to hike tariffs across the board to 25%. That would result in a 25% tariff on almost $1 trillion worth of imports, which accounts for about 35% of America’s total imports.
That’s not immaterial. A 25% tax on nearly $1 trillion worth of goods (or 35% of all imported goods) would impact multiple U.S. businesses, who would inevitably pass some (if not all) of that price increase onto consumers, implying higher prices across the U.S. consumer economy. That means inflation, which currently sits well under 2%, would rapidly climb higher.
If inflation climbs higher, the Federal Reserve has to come off the sidelines, since it is their job to fight that inflation. Thus, the Fed will go from sitting on the sidelines and potentially cutting rates to raising rates to combat inflation. That would lead to a surge in borrowing costs, after a decade-long run of record-low interest rates.
The big problem here? Because interest rates have been so low, U.S. companies have used that to their advantage to lever up their balance sheets more than ever before. Thus, corporate-debt-to-GDP levels are at record highs. These levels are only sustainable with low interest rates. If interest rates climb significantly higher, that could cause a debt crisis and trigger a recession.
Bottom Line on Tariffs
Tariffs are no good for the U.S. economy, consumers, business or the stock market. Thus, so long as tariffs persist, stocks will struggle to head materially higher. Indeed, there is a doomsday scenario lurking around the corner where, if the trade war escalates, it could trigger a U.S. economic recession.
But, that probably won’t happen. In all likelihood, because the global economy is so connected, everyone here wants to get a deal done. Trump is just using tariffs as a negotiation tactic to get a deal more quickly, and do so on more favorable terms for the U.S. Thus, the base case scenario with respect to tariffs is that they do eventually disappear, giving runway for stocks to head higher once they do.
Until that happens, though, investors should proceed with caution in the stock market.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.