Quick View: Trump keeps his “favorite word” on tariffs

For the second consecutive week, US markets opened with a jolt as investors assessed President Trump’s announcement that the US would be implementing wide-ranging tariffs of 25% on Mexico and Canada (with the exception of Canadian energy products, which were hit with the lower rate of 10%), along with additional 10% tariffs on Chinese goods. While markets reacted ferociously, the situation remains fluid, as evidenced by both Mexican President Claudia Scheinbaum and Canadian Prime Minister Justin Trudeau announcing that tariffs would be delayed for at least a month. China, meanwhile, suggested it was taking the situation under review.

Underlying motivations

It should come as little surprise that President Trump has chosen to focus this opening salvo on the three largest sources of imported goods to the US Yet, his motivations are likely different depending upon the region.

Border control and fentanyl supply routes have been given as prominent reasons vis-à-vis Mexico, but trade deficits are also important to the new president. Regardless, the rapid reappraisal on tariffs on Mexico and Canada suggests that there may be a path out of the situation.

China, in contrast, is a strategic rival and, as was illustrated during the first Trump presidency, the country has been singled out by the administration as a key target on trade. While the US trade deficit with China has improved, it remains substantial compared to other countries.

Knock-on effects

When considering tariffs’ effects, the key uncertainty is the time horizon over which they are likely to be enacted. Longer-term or permanent tariff increases could be more damaging in terms of growth and inflation than those that are used as a short-term bargaining chip. It is likely that any tariffs enacted would lift inflation, although that depends on what goods are targeted and what is excluded.

The decision to target Canadian energy imports with a lower 10% rate was likely done with the inflationary impact in mind. Any acceleration in inflation as a result of changes in trade policy could also result in the Federal Reserve (Fed) remaining on pause for longer or potentially considering raising rates if tariffs were to lead to higher consumer prices. An inflation rate starting with a “3” would likely give policymakers a headache.

There would also be potential impacts on American industrial output due to any targeted responses, and higher inflation could put a squeeze on real consumer incomes – although again the magnitude remains to be seen

However, there is also the matter of an offsetting foreign exchange move, with the tariff-target countries having seen significant weakness in their currencies since Trump began gaining momentum in last autumn’s election. Since the end of September, the Mexican peso, Canadian dollar, and euro are 7% to 9% weaker against the US dollar, making their goods slightly cheaper in US dollar terms, excluding the impact of tariffs. If tariff revenue is ultimately used to help support the rationale for the separate issue of tax cuts, there could also be some positive offset from higher growth, although the time frame for tax negotiation is likely much later in the year, creating a gap between these two policy areas.

Initial markets reaction

After sharp losses early Monday, equity markets recovered some ground following the announcement from the Mexican President that same day, while the announcement from Trudeau came after US market close. The suggestion that quick reversals are possible – in exchange for concessions – gave markets hope that this could be a short-lived episode, although perhaps this is only the case with Mexico and Canada.

Losses in US equities were led by technology and consumer discretionary sectors, with the obvious consequences of tariffs resulting in technology hardware and automobiles and components impacted the most. European stocks saw some of the largest losses among major markets. This contrasted with Chinese Hang Seng Index futures, which recovered well into positive territory, indicating the extent to which negative trade outcomes were expected.

The dollar saw broad-based appreciation as would be expected in response to tariffs. Shorter-term US Treasury yields rose as investors worried about the potential for a rebound in inflation and a possible Fed response. In contrast, yields on longer-maturity bonds fell as investors priced in the possible negative impact on growth if more aggressive trade policy is maintained or the current situation escalates.

The announcements saw quick criticism from across the business and political communities, including from within the Republican party. Any pressure due to a market decline and domestic uneasiness may be key in forcing a viable resolution. We cannot, however, rule out the risk of a potential escalation elsewhere, with the European Union likely braced for a renewed trade conflict.

Other countries, such as Japan, Vietnam, Korea, and Taiwan, also have large trade deficits with the US and may yet be singled out if the balance of imports and exports is truly at the core of the matter. The new US administration has signalled repeatedly that trade policy is once again an active tool in forcing its international agenda. Investors appeared to have had their hands over their ears up to this point but are likely listening more carefully now.

 

Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.

Monetary Policy refers to the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.