It is not surprising to see a negative stock market response to the White House’s imposition of new, aggressive tariffs on imports from many of the America’s largest trading partners. President Trump has admitted as much, even as he has unevenly but insistently forged ahead with his expansive tariff policy.
Tariffs are costly, but…
Tariffs are broadly understood by economists to cause disruptions to both the target country and the country imposing the tariff, as costs are passed on to consumers, exacerbating inflation, supply chains are disrupted in a manner that cannot be resolved quickly, and even domestic manufacturing is potentially harmed, with small employment gains in the production of raw materials such as steel and aluminum more than offset by the damage done to industries that use these factors of production in the creation of goods.
Yet despite these risks, and despite the (to many observers) surprising magnitude of the president’s tariff plan, it is worth questioning just how large the impact will be. After all, despite the U.S. being the world’s largest importer and second-largest participant in global trade, the total dollar amount of all imports into the country is perennially well below 20% of U.S. Gross Domestic Product (GDP), which in turn is only about a quarter of global GDP. And because the U.S. is the also the world’s second-largest exporter, the total U.S. trade deficit is a mere 3% or so of the country’s GDP. (Or rather, negative 3%; it is still a deficit.)
These figures are significant, but they constitute a small minority of overall economic activity in the U.S. and globally. As evidence, when the OECD incorporated the new tariff regime into its economic projections, their predicted global GDP growth for 2025 fell from 3.3% to 3.1%. Reflecting the fact that the one country negatively affected by all the new tariffs is the country imposing them, the United States’s GDP growth projections fell further, from 2.8% to 2.2% in the latest OECD report. These are non-negligible changes, but they are still a far cry from the negative GDP growth associated with a recessionary backdrop.
Moreover, rather than putting the rate of inflation on a permanently higher path, tariffs are only likely to result in a one-time jump in consumer prices, reflecting the need to pass at least a portion of the new taxation on to consumers. This jump could also be reversed if the tariffs are removed in the future. The overall inflationary impact of tariffs is also complicated by the potentially dampening effect of reduced economic activity. All this perhaps explains why the market’s own long-run inflation expectations have actually declined slightly since the administration began imposing new tariffs.
So, why the tariff tantrum?
The financial media seems quite satisfied that tariffs are the primary driver of the stock market’s recent stumble. There have been enough instances where tariff news is mirrored by an instant market response to lend plausibility to that conclusion. But does the magnitude of the expected economic disruption justify the magnitude of the market’s response?
To answer this, it is well to review some basic investment theory. A simple (but powerful) model of a stock’s price is that it represents all of a company’s future earnings, discounted back to present value at some expected rate of return. (Simplistically, this is the projected average return demanded by the market in exchange for bearing the risk that the company’s earnings may wind up underperforming the average.)
One reason for a stock market decline, then, is a reduction in the market’s expectations for future earnings. But it is sensible to question whether the projected decline in economic activity due to tariffs is sufficient to explain the decline in aggregate stock prices. If it isn’t, then what else might explain the drop?
Since stock prices, in the model above, are a combination of earnings projections and discount rates, a decline in prices not fully explained by a drop in expected earnings may also imply an increase in the discount rate. We might think of this portion of a price decline as market participants in sum expressing their distaste for political and economic uncertainty by demanding greater compensation for accepting the increased “risk”. However, this also implies that investors who are willing to bear these newly perceived risks may be able to purchase stocks at a higher expected return in exchange for doing so. (But don’t miss all the “mays” and “mights” in this model! Stock market movements aren’t served up with little fortune cookies to explain their causes. While we think there are credible reasons to believe stock market corrections may imply higher expected return, as compensation for elevated risk, our opinions on market timing, be it defensive or aggressive, are as dim as ever.)
What tariff tantrum?
Besides, there are distinct question marks about the assumption that tariffs are driving the stock market’s recent reversal. For example, given the broad application of tariffs, one may wonder why the pullback has fallen so disproportionately on the technology sector, with the tech-heavy NASDAQ Composite Index (as of 3/18/2025) having fallen more than 12% from its peak in February, while, for example, the tech-light Russell 1000 Value Index has dropped less than 5%.
Moreover, given that tariff impacts are global, one may wonder why non-U.S. stocks are having a banner quarter! Were financial media required to report on only the broadest, global measures of stock market performance, there would be no news at all. For example, the MSCI All-Country World Index (ACWI) is up slightly for the year, pulled into positive territory by the +10% performance of international developed stocks and the +6% performance of emerging markets stocks. The outperformance of international stocks accelerated even as the VIX volatility index spiked from 14 to 27 in the space of three weeks beginning in mid-February.
Sources: Torren Management (chart); Black Diamond Wealth Platform (data).
Relatedly, contrary to the canonical currency reaction to the introduction of tariffs, the U.S. dollar index has declined by more than 4% year-to-date. Following an extended period of outperformance by U.S. stocks, the first quarter of 2025 would seem to represent a significant rotation of capital into international markets, with superior local-currency returns to international stocks further bolstered (for U.S.-based investors) by the weakening of the U.S. dollar.
This illustrates the benefits of international diversification. The timing, duration, and magnitude of international equity market performance relative to that of U.S. stocks is unpredictable, but extended periods of substantial divergence in either direction have occurred historically. Thus, a globally diversified portfolio can help smooth out this inter-region volatility.
Back to basics
Two basic principles of stock market investing are the same now as always:
- The stock market is always priced for positive expected return, indeed for higher return than expected of less-risky investments.
- The stock market is always risky, such that it may underperform less-risky investments instead, or even decline.
Political machinations, economic uncertainty, and stock market risk are ever-present realities, even if their presence is perhaps more obvious in times like these. So too, however, are the rewards investors can expect on average if they stay the course.
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