April 03, 2025
The Trump Administration has begun arguably the largest trade reconfiguration strategy in modern American history. Promises made … promises kept. Now questions arise as to what measurable impact the new trade regime will have on our assets? The overnight market reaction has been multifaceted. This morning market pundits are defining the selloff in stock markets as a two-sigma event, which is a statistical measure of an outlier move. But as I measure the move, the data does not support this opinion … yet. What is certain is that trade tensions are shifting investor sentiment away from equities in search of safety. Before we make large shifts to our asset selections it is important to understand the process behind the decisions.
In the world of investing, we consider asset selection as a series of choices. The first choice we make is whether to invest in stocks or in bonds and to what extent we allocate to those two main categories. The most important part of this decision is to understand the macro picture of the overall global economy. We must define the current investing climate – is the global and regional economy expanding, or is it stable, or is it contracting? Luckily this information is readily available, as we are provided with data regarding employment, consumption, and prices monthly. Granted this data is reported with a slight lag and is backwards looking. And when we consider the enormous machine that is our global and US economy, and if we imagine it as a huge oil tanker, one can imagine how difficult it is to suddenly stop or restart such a large vehicle. So … when an economy is growing it takes a lot of effort to suddenly stop it, and vice versa. This is exactly why the Federal Reserve tells us that “monetary policy works with a lag.” And it is also why it is important for the Fed to be forward looking when making major decisions regarding interest rates and balance sheet expansion/contraction. Given recent data, we can be confident that the US economy is expanding on a real inflation adjusted basis at a moderate pace of approximately 2% annually. This is roughly a trend rate of growth. Furthermore, on a nominal basis the US is expanding at a rate of roughly 5% annually.
It would take enormous shock to the economic inputs to abruptly bring this large tanker of a US economy to an abrupt halt and force it into contraction. The US economy is a $28 trillion behemoth comprising nearly 27% of the global economy. It is growing at a nominal rate of nearly $1.4 trillion per year and we would need an enormous shock to derail this rate of growth. For example, Covid was the darkest and most abrupt economic shock of the last 100 years, and the US real GDP went from +2.47% in 2019 to -2.21% in 2020.
Armed with this level of macroeconomic understanding, we can now turn to the data and attempt to make an informed opinion as to the level of economic impact that the Trump tariff proclamation might have on the overall US inflation rate. The US is the largest trading partner in the globe, importing nearly $4 trillion of goods and services and exporting nearly $3 trillion, annually. The size of the US goods trade deficit in 2024 was $1.2 trillion, while the service sector was a net exporter of $0.2 trillion. As the Trump administration announced a baseline 10% tariff on global trade with the US, and at the same time issued country specific tariffs on “bad actors” at somewhat higher rates, we can quantify the amount of taxes that will be collected by US customs because of the tariffs. Assuming there is little change in consumption we expect to raise $912 billion annually in new tax revenue from the tariffs. The passthrough from these tariffs should result in higher overall prices for products that are being levied. The worst-case scenario is a 30% overall passthrough effect and that would raise the price level of imported goods and services by 8.1%. Some goods such as perishable goods will have nearly 100% passthrough as there is little margin in such products and the price increases would be felt immediately. Other goods will have significantly smaller passthrough effect due to higher profit margins and greater competition with US produced goods manufacturers. My educated guess is that US consumers will feel an increase in prices of $273 billion annually on imported goods. This translates to an increase in the overall inflation rate of 0.93% in the US over the next year (formula = $0.273T/$28.000T = 0.93%).
Most of the Trump tariffs will be felt by the companies that manufacture the products that are being imported into the US. To stay competitive with domestic US manufacturers, foreign producers will have to eat upwards of 70% of the loss in the form of margin compression. This translates to $639 billion per year globally. Of this reduced margin I expect that $504 billion of that will be felt by the “bad actors” of the group of trading nations. This group is comprised of China, Vietnam, Mexico, Canada, Japan, Germany, South Korea and India. The “bad actors” account for as much as $720 billion (79%) of the $912 billion tariff burden. That should feed through partially in the form of earnings per share for foreign manufacturers assuming there are no new government subsidies that offset the lost revenues.
So how will all of this affect global equity earnings? Time again for a little simple mathematics. The total market capitalization for global equities is approximately $128 trillion. Assuming gross earnings are $11 trillion (with a global P/E of 12) we can approximate that there will be an earnings reduction of 5.8% per year until the tariffs return to a flat rate of 10% for all global trading partners. As tariffs are renegotiated, we expect the long-term impact to be closer to $300 billion per year. If the passthrough effect is still only 30% on consumers, the inflation impact on US consumers will be 0.32% which can be easily absorbed and offset by tax cuts of $90 billion in the US (I assume that Trump will be asking for tax cuts of as much as $400 billion per year). After the flat 10% tariff is adopted, the earnings hit of $210 billion translates to a reduction in earnings of 1.9% globally.
Finally, if you assume earnings growth globally averages approximately 6%, once subtracting 1.9% due to the new tariff regime, we can expect earnings growth to wind up closer to 4.1% annually for the global stock markets. To put this in perspective, the average recession sees a fall in earnings of -11%. In short, this tariff regime will likely avoid a substantial slowdown in the global economy. With investors reading all the recession warnings from every news source readily available, we may very well benefit from appreciating the math of the entire event before we jump knee deep into the recession bandwagon. In the short run this is clearly a negative event, and the uncertainty has certainly forced investors to lose some risk appetite. After all, we have all fattened up quite a bit over the last four years with large and unusual returns on the stock markets. The time has come to tame our expectations for 20% returns and refamiliarize ourselves with more normal 8% returns over the next few years. The sky has not fallen … but the hammer from Trump’s tariffs has certainly wacked us all in the head.
For the time being, it is wise to look for opportunities in companies with market leadership positions and stellar balance sheets. Recent market movement has begun to present some attractive risk-reward setups for some of the long-term growth companies, especially in the tech space. Defense stocks should continue to perform well as it appears much of the world is moving towards increasing defense budgets. And the AI story is really in the early stage of implementation as many businesses stand to significantly improve productivity over the next few years. This all points to earnings expansion over time and meaningful wage benefits. Imagine, for example, how modern computing algorithms may help solve global health problems and be a harbinger for cures for diseases. We really have only begun to scratch the surface of the new technology of machine learning. It all points to an expansion of sources of earnings for global companies and a higher standard of living globally. For now, absent a protracted slowdown, we should expect this period to be a bump in the road. At some point we will regain confidence and dip our toes back in the markets. My sense is that point will be here sooner rather than later.