Trump’s Tariffs Upend Global Markets: Here’s What Investors Should Know

Margaret Giles: Hi, I’m Margaret Giles with Morningstar. President Trump has announced a series of reciprocal tariffs with specific country rates based off the US trade imbalance with the given country. The higher-than-anticipated tariffs have sparked market selloffs and growing economic concerns around recession and inflation risk. Joining me to discuss the fallout and what it means for investors is Preston Caldwell. He’s a senior US economist for Morningstar Investment Management. Preston, thanks for being here.

Preston Caldwell: Thanks for having me.

Why Global Markets Were Rattled by Trump’s Tariffs Announcement

Giles: The Trump administration has repeatedly signaled that tariffs would be coming. What about the announcement has caused this strong global response?

Caldwell: Words have never aligned perfectly with actions during the first or second Trump administration, and this is not any kind of disparagement. I mean, there’s a credible strategy where the threat of tariffs is used to achieve various geopolitical goals. And that’s kind of the script that played out in the first Trump administration and also in the early months of the second Trump administration. We saw tariffs implemented on Canada and Mexico for a couple of days and then rescinded after coming to an agreement around border enforcement and some other issues. So, I think Wall Street expected, again, these tariffs to be just a means to an end in negotiations. But that’s really not what seems to be the case now. I think now everyone is coming around to a different thesis, which is that these tariffs are going to be implemented for an indefinite period in order to, in the goals of the Trump administration, reduce the US trade deficit.

Now, these tariffs that have been announced, depending on how all the exemptions stack up and everything else, could increase the average US tariff rate by over 25 percentage points. That’s just looking at total tariff revenue divided by total goods imports. That would be the highest level in over a century. It’s hard to make a perfect apples-to-apples comparison, but we can say definitely it’d be the most restrictive trade regime in over a hundred years for the US. And, of course, a hundred years ago, the global economy wasn’t nearly as interconnected as it is now, so there’s really no precedent for this whatsoever. And so it’s an interesting time for the economy and markets.

Why Tariffs May Be Here to Stay

Giles: Absolutely. It feels like we’ve gone from bargaining chip to outright protectionism.

Caldwell: I think so. I listened very closely to the rhetoric yesterday and as Trump reminded us, he’s been talking about the trade deficit since the 1980s, and I think he has now for the first time he has personnel around him in the White House that shares that vision and that aren’t going to talk him out of it like they did in the first Trump administration. So, I see no quick path to alleviating the bulk of these tariffs. I think they’re going to remain in place for an extended period until if and when inflation crops up again and we risk a recession and other ill effects start to manifest themselves, then maybe only then will we see any kind of relief. But for now, I think we’re in it for the long haul.

Short-Term Economic Impact of Tariffs

Giles: Before we start talking about the long term, what are the short-term effects of these tariffs? I want to start with the economic impacts before we talk about the market.

Caldwell: It’s interesting because the short run is actually a little more complicated than the long run, so I’m just going to preview the long run by saying that tariffs represent a decrease in the economic efficiency of an economy because the free market is for everybody to trade with each other unimpeded, and any curtailment of that represents a reduction in the long-term productive potential of the economy. So, that’s kind of the long-run baseline, which I’ll elaborate on.

But in terms of how the short-run transition navigates to that long-term outcome, it’s complicated because there’s a lot of other shocks that are going on in the short run, and there’s a lot of unknowns here. We don’t know what the tariff revenue is going to be used for. Is it going to be recycled into tax cuts, which will ameliorate the demand-side shock from tariffs because households will have more cash coming into their pockets to compensate for the fact that goods prices are going up. It won’t do anything about the long-term supply-side impact, but it will cushion the short-term demand-side impact if that tariff revenue is recycled as tax cuts, so that’s a big uncertainty. To the extent that we do have the tax cuts, then the tariff impact is a little more on the inflationary side. Whereas if we don’t have the tax cuts, then we’ve got a huge increase in federal revenue, so that’s a negative fiscal shock, the deficit going down, and that represents a negative demand shock. That’s a little more on the recessionary deflationary side.

That’s a big uncertainty right now. I would lean toward thinking that it’ll probably be more on the side of doling out a lot of tax cuts. I think that’ll be very politically popular or reduce the unpopularity of the tariffs at least. And so it’s going to be a little bit more on the inflationary side for that reason. But the one thing that’s hard to quantify is the uncertainty effect, which is to say businesses and consumers have uncertainty about what exactly is going to happen with tariffs. Are they going to stick around for five to 10 years? Are they just going to be around for one or two years, or even one or two months? They have uncertainty about how other businesses are going to be reacting to the tariffs. And all of this means that it’s hard to make plans right now, and that sheer uncertainty itself is going to weigh on economic activity. Businesses may cut back on investment spending to a great degree.

We just don’t really have the ability to model what’s going to happen because we don’t have something like this in the historical data. So, who knows what the impact will be on that front, but that uncertainty factor is really what’s creating the recession risk right now because that has the potential to, in the short run, be much more drastic than the actual supply-side impact of the tariffs themselves.

How Market Volatility Could Lead to Higher Recession Risk

Giles: I want to pivot a little bit, what’s happening in the markets because that uncertainty is certainly being felt on that side as well.

Caldwell: Honestly, even with the S&P 500 down 4%, that’s not really pricing in a lot of recession risk at this stage. So, there’s more downside ahead if that recession risk materializes or becomes priced into the market at any stage as far as US equities go. And it’s a bit odd, though, because at the same time, expectations for the number of Fed rate cuts has creeped up. So, the market as of today is expecting now four rate cuts this year and two rate cuts next year, which is definitely a step up compared to what they were expecting a couple of months ago. That implies that the effects of the tariffs are going to be more on the deflationary side in having a lot more recession risk, which is not really consistent with what’s going on with equity prices. I think markets are dislocated right now. People are still trying to figure out what the new equilibrium is going to be, where is the trajectory to which we’re headed. This is not a settled matter by any means. The market impact is going to play out in coming months, and the story is yet to be written.

Long-Term Economic Impact of Tariff Fallout

Giles: You’ve already talked about a little of the long-term story. I want to talk about that a little bit more. What can we expect moving forward?

Caldwell: The long-run impact is actually fairly unambiguous. We can quibble about the magnitudes, but we know that tariffs reduce real GDP. What is real GDP? It represents the aggregate real well-being, economic well-being in a country. We know that the tariffs are going to permanently reduce the long-run path of the US real GDP. Probably, a 20% tariff hike, if it’s sustained, would represent a hit to around 1% to 2% to long-run real GDP. That is significant. If we look back at the pandemic recession, as bad as that was in the short run, it does seem now today that there wasn’t a long-run impact on GDP. So recessions can be very severe in the short run, but sometimes they’re temporary. But a long-run impact means that it doesn’t go away in 10, 20, 30, 50 years; it’s permanent, and that impact compounds over time. That is a serious deal.

In my prior remark, I didn’t talk about the medium-term impact on inflation. I would say, as a base case right now, there’s probably a short-run bump to inflation that we’d expect to be of the same order of magnitude as the hit to GDP. And so we think that real GDP in 2025 and ’26 now will be probably around half a percentage point lower than we previously expected. And likewise, inflation will be bumping up by at least several tenths of a percentage point for 2025 and 2026. So, the question is to what extent that could persist for a few years, which is something the Fed will be thinking about in terms of their decision-making.

Right now, there’s definitely concern that the inflation process is somewhat unanchored, which means that basically, there’s inertia built up into the inflation rate. So, whereas normally a shock like tariffs, it comes, it pushes up prices once, and then that’s it; there’s no further impact on inflation. When you’re in an unanchored inflation regime, a shock like that has a reverberating impact. It continues to push up the rate of inflation because the rate of inflation itself is looking back in the immediate rearview mirror. And so, any shock tends to have echoing consequences. And so if that’s the dynamics behind inflation right now, then the Fed is going to have to keep policy a little bit tighter than it otherwise would have for a two- to three-year period to offset an inflationary impact. But eventually, we’ll get back to 2% inflation, and that’s all well and good, but the impact of real GDP if the tariffs remain in place will be permanent and negative.

Key Takeaways for Investors During Market Uncertainty

Giles: Lastly, what is a takeaway you have for investors who are trying to navigate all of this uncertainty?

Caldwell: There are no easy takeaways here. We don’t want to panic. And even though I said that there’s more downside risk if markets start to price in more recession risk, that’s very much true, even that is a somewhat of a shorter-run phenomenon. Why? Because look, any asset pricing model is going to have cash flows in the numerator and the discount rate and the denominator. And so what we’re really talking about recession risk is the discount rate going up, and that’s causing stock prices to fall. Well, that’s always a temporary phenomenon. Discount rates don’t just permanently go up. So, no matter how bad corporate cash flows are affected in the short run, you can never really explain the degree to which equity prices fall. For example, 60% during the Great Recession, you can never explain that through cash flows. It’s a discount-rate effect, and that discount-rate effect is temporary.

And the thing is, you can’t really time that discount-rate effect. So, it’s very, very hard to figure out where the bottom is going to be reached and when stocks will start rebounding after a severe bear market. All that’s to say is that, even though I do think there’s a good chance in the short run that US equities could push lower as more recession risk is priced in, it’s going to be very hard to time that, and so it’s still important to stay the course.

Giles: It feels like despite talking about some heavy topics here, there’s potentially a little silver lining of, we don’t feel like we have to completely change course on how we’re investing, right?

Caldwell: Absolutely.

Giles: All right, so we’ll continue to cover the tariff fallout and market volatility on Morningstar.com to help you stay informed. Our analysts have published several great notes covering the impacts on companies like Nike and sectors like autos and banks. Make sure to check back to see our latest coverage. Thanks, Preston, for your time today.

Caldwell: Thanks, Margaret.

Giles: I’m Margaret Giles with Morningstar. Thanks for watching.

Watch How Slower Economic Growth and High Inflation Could Affect Interest Rates for more from Preston Caldwell.