Markets and Tariffs

Estimated reading time: 5 minutes

Trading Places

This week saw the first big trade policy announcements from the White House and drove whiplash in markets. Although most investors expected tariffs to be a policy move early in the Trump administration, the size of the tariffs announced still rattled markets. The announcement was to impose a 25% tariff on both Canada and Mexico, and to increase the tariff on China by 10% – those three countries are our top three trading partners. 

This came on the heels of the trade policy uncertainty index having peaked in November, falling a bit in December, then rebounding in January. All in all, uncertainty remains above the highs we saw in 2018-2019 when the last trade war was underway. Markets were already on edge.

But just before the tariffs went into effect, negotiations with Canada and Mexico led to them being delayed for one month. Chinese tariffs took effect as planned at midnight on Tuesday morning. 

Despite the relief many are feeling in reaction to the one month delay, we do not think this story is over and investors should remain vigilant and prudent about taking risk in the industries most exposed to the rhetoric.

Given the U.S.’s reliance on imports from these three countries, it’s no wonder markets were rattled by the news. Imports make up 16% of U.S. GDP, and Canada, Mexico, and China account for over 40% of those imports. If we were to impose the proposed tariffs on all three countries, the cost of imported goods would likely rise, resulting in price increases on certain goods.

Markets then have to ask, how will those price increases be absorbed? Will consumers continue buying the same amount of goods & services, or will they adjust their behavior and make trade-offs? Likewise, will businesses try to reduce costs elsewhere to offset the increased input costs, or pass them through to consumers?

The market action on Monday, February 3, and Tuesday, February 4, suggests that investors saw the tariff threat as a threat to U.S. growth, meaning consumers and businesses would likely have to cut back in some areas in order to absorb the possible price hikes.

Trading Stocks

After a volatile Monday, the major stock indices recovered on Tuesday, but not before investors felt like they’d been put through a pinball machine. The swings that took place across sectors from Monday to Tuesday were dramatic, and can be seen in the chart below.

The biggest sighs of relief came from the Energy, Communications, Tech, and Consumer Discretionary sectors. This gives us a first-look at which areas of the market are likely to be most sensitive to trade conflict with Canada and Mexico, and is something investors should keep in mind as the story unfolds.

Another way to read this chart more broadly is to say that Monday was a mostly risk-off environment with defensive sectors such as Utilities and Staples leading the way, while Tuesday was mostly risk-on and pro-growth with those same defensive sectors performing the worst.

That said, it’s important not to make long-term investment decisions based on what could be very short-term moves in markets. 

Trading Carefully

Sometimes the best thing to do on days like Monday or Tuesday is not to trade at all. Case in point, the S&P 500 closed at 6,040 last Friday, January 31; despite all of the action during the first two trading days of this week, the index closed at 6,037 on Tuesday — a change of three points, which basically amounts to 0%.

Markets are still working through the digestion process, along with mega-cap tech earnings and other economic data. We are also coming up on the next jobs report this Friday, February 7, which will be closely watched.

Volatility will probably persist in these early weeks of the new administration as investors react to headlines and macro developments. The events of this week have not changed our conviction in our longer-term themes that can help markets look through short-term bumps: Liquidity is supportive, labor churn and wage pressure is low, inflation is in a better place than last year at this time, and sentiment is intact – albeit slightly bruised and sensitive. There are certainly risks that remain, but until or unless we have hard evidence of one of them materializing, we are optimistic that solid fundamentals can still support stocks. 

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