As a financial advisor, you may be wondering what to tell your clients about Trump-era tariffs on steel and aluminum – which impact almost every U.S. industry – in addition to solar panels, washing machines, newsprint, and billions of dollars’ worth of goods from China. These tariffs are predicted to impact domestic stocks, domestic bonds, and foreign stocks. As a financial advisor, you should be prepared to answer your clients' questions about how the greater economy will be impacted by these tariffs, and how these changes could trickle down and influence their investment portfolios. 

Background on the New Tariffs

President Trump decided to implement tariffs on a wide range of goods imported from countries like China, South Korea, Mexico, Canada, Russia, the European Union, and other countries. One of the most notable tariffs is the 25% tariff on $34 billion in Chinese imports, which has resulted in an equal amount of retaliatory tariffs from China. Other countries have retaliated as well by introducing tariffs on U.S. imports like bourbon, coffee, orange juice, pork, stainless steel, jeans, motorcycles, toilet paper, cheese and cranberries. Many tariffs have already taken effect; others are threatened. 

The stated purpose of Trump’s tariffs is to protect U.S. jobs, fix unfair trade agreements and reduce the $568 billion U.S. trade deficit, of which $375.6 billion is with China. Economists, however, say imposing tariffs is not a good way to narrow a trade deficit, and could even widen it; more importantly, economists say the trade deficit isn’t something we need to be concerned about any more than we worry about the fact that we buy goods from our local grocery store, but the grocery store doesn’t buy anything from us.

Beyond the tariffs’ stated purpose, true motivations might include dealing with longstanding economic and national security issues resulting from China’s requirement that foreign companies doing business there share their intellectual property, and energizing Trump’s political base as part of a strategy to maintain Republican control after November’s mid-term elections. 

How Will the U.S. Stock Market React to Tariffs?

Anyone who recently retired or is about to retire might be concerned about the decline in the S&P 500 index (SPX) since its record high of 2,872.87 on January 26. On July 6, it closed at 2,759.84, a 4% decline. The Dow Jones Industrial Average (DJIA) peaked at 26,616.71 on January 26 but closed at 24,455.16 on July 6, a decline of about 8%, while the Nasdaq Composite Index has fared much better, with a close of 7,688.75 on July 5, about 1% off its high of 7,781.52 on June 20.

Cyclical U.S. stocks such as those in the consumer discretionary sector, which consists of goods and services consumers only buy when they have enough discretionary income, will likely suffer the most from tariffs because tariffs will increase prices and reduce how much consumers can purchase. But even companies that produce consumer staples, the essential products consumers always buy regardless of their financial situation or the economy’s performance, have seen their stock prices drop since they each earn about half their revenue from overseas. Examples of such companies are such as Procter & Gamble and Johnson & Johnson. The stocks of companies that do most of their business in the United States, like tech stocks, bank stocks and healthcare stocks, have fared better because they aren’t impacted by the retaliatory tariffs other countries have placed on numerous U.S. goods. They have fared better because it is difficult to place tariffs on software and tech services; banks may benefit from higher interest rates; and health care is mostly a domestic industry.

Companies may hesitate to make new investments and new hires. The optimism many businesses felt after the tax reform has turned into pessimism over the tariffs. Tariffs can increase prices of inputs, which can increase the price of final goods. When consumers have to pay more for the same goods, their incomes don’t stretch as far. With lower returns from working and investing, people tend to do less of these activities, and economic output decreases. Further, companies impacted by tariffs may have to lay off workers; some already have. But buy-and-hold investors with a long-term outlook should not stray from their current plans, especially if they hold a diversified portfolio that includes both stocks and bonds.

How will the U.S. Bond Market React to Tariffs?

If the tariffs slow economic growth, bond yields could decrease and bond prices could increase. But if tariffs do slow economic growth, the Federal Reserve may decide not to continue hiking interest rates. This decision could increase bond yields and decrease bond prices. The reason bond prices fall when interest rates rise is because older bonds that have lower interest rates become less valuable. To convince a seller to buy an existing lower-rate bond instead of a new higher-rate bond, the bond holder has to give the seller a discount on the bond’s price. (For more, see: Why do interest rates have an inverse relationship with bond prices?)

When the Federal Reserve met in June 2018, the target federal funds rate was set at 1.75% to 2.00%. During that meeting, the Federal Reserve stated that it anticipated two more rate increases this year. The bond market reacted with the flattest yield curve in a decade, with two-year Treasury notes at 2.59% and 10-year Treasury notes at 2.99%, a difference of 0.40%. On July 6, when the United States implemented a major round of tariffs on $34 billion in Chinese goods, we saw a difference of just 0.29% between two-year (2.53%) and 10-year (2.82%) Treasury notes. The bond market reacted to the imposition of the tariffs with lower rates and a flatter yield curve for U.S. government bonds because investors think the tariffs will hurt economic growth, but they also think the Federal Reserve will continue to hike interest rates in the short run. Investors have increased their demand for safe bond investments. And analysts have been quick to point out that a flattening yield curve could be a warning sign of a recession.

How will the Global Stock Market React to Tariffs?

The foreign stocks of countries affected by the tariffs, such as China, Mexico, India, South Korea and EU nations, could lose value. For example, China’s stock market declined substantially after the tariffs that were applied in July 2018. The Shanghai Composite Index (SHCOMP), which provides a broad overview of the Chinese economy, reached a year-to-date high of $3,559.47 on January 24, 2018. By July 2018, it stood at just $2,733.88, a 23% decline, and one not seen since March 2016. The yuan’s value has fallen as well relative to the U.S. dollar.

However, the stocks of some countries impacted by the tariffs showed no signs of being disrupted. By contrast, Britain’s FTSE 100 (UKX) stood at a high of 7,877.45 in May 2018 and declined only slightly to 7,603.22 on July 5, 2018, despite Trump’s tariffs on U.S. steel and aluminum imports that are in part sourced from the U.K. Increased market volatility is likely as the impacted countries make further threats, and ultimately decide what tariffs to impose or lift. 

How Tariffs May Affect Economic Growth

Tariffs tend to reduce supply and raise prices. A full-on trade war could cut U.S. GDP by 1 percentage point, according to estimates from Deutsche Bank economists. This is a significant amount since U.S. GDP has averaged about 2% per year since the Great Recession ended. Cutting GDP growth in half wouldn’t cause a recession, but it would increase the risk of one, the economists predicted. 

The Tax Foundation predicts a long-run decline of 0.44%, or $110 billion, in U.S. GDP, if all the tariffs the United States and other countries have announced go into full effect. Also, around 342,000 workers could lose their jobs, and wages could fall by 0.31%. The impact could be less severe if fewer tariffs are enacted. 

Bank of America Merrill Lynch economists created a model assuming a 10% global tariff on all goods and services and found that U.S. GDP would grow 0.4 percentage points less in the first year and 0.6 percentage points less in the second year as a result. Tariffs have already led to layoffs and we can expect them to lead to more. 

The Bottom Line

The extent of the tariffs' impact on your clients' investments will depend on how long the tariffs remain in place, and whether the leaders of China, South Korea, India, Mexico, Canada, and the European Union escalate the trade war by introducing tariffs on additional goods such as seafood, eggs, produce, pet food, leather, flooring and many other items. At their current level, the tariffs only represent 0.4% of the U.S.'s total GDP, but the longer this situation lasts, the more serious the consequences could be, as the threat of a recession grows. In the short run, the fiscal stimulus from Trump’s tax cuts, which represent 1.4% of GDP, are projected to have a stronger impact on the U.S. economy. If political leaders can reach a quick resolution, a full-on trade war can be avoided and we can continue the current business cycle of the U.S. economy, in an expansion since June 2009.