President Trump’s “Liberation Day” tariff announcements on Wednesday, April 4, sent stocks plunging as concerns about the economic consequences rose. The announced tariffs were significantly more sizable than anticipated. While the possible benefits from trading on fairer terms, reducing the US trade deficit, and bringing more production back home are attractive, it remains unclear if tariffs will accomplish that goal, and there are short-term economic headwinds from the strategy.
Liberation Day Tariffs Explained
The easiest way to think about President Trump’s tariff regime is in five parts: reciprocal, USMCA, China, Sectoral, and Commodities. The reciprocal portion comprises a 10% tariff on all goods imported into the US, and about sixty countries are subject to tariffs above 10%. For example, Vietnam was hit with a 46% reciprocal tariff rate. The universal 10% tariff rate became effective on Saturday, but the higher rate for those specific countries will be implemented on April 9.
Canada and Mexico, who are part of the USMCA trading pact, were subjected to no further tariffs beyond the previously announced 25% tariff on all non-USMCA-compliant products.
As expected, China was treated as a special case. Tariffs on Chinese goods will be at least 79% and could reach over 100% if the US enforces the announced additional tariffs on countries buying Venezuelan oil.
Lastly, specific commodities and economic sectors will be subject to a specified tariff rate rather than a country-specific levy. The commodities and sectors include steel, aluminum, lumber, copper, pharmaceuticals, semiconductors, and autos. For example, pharmaceuticals are currently exempt from any tariffs, which helps Ireland as a large exporter in that sector.
Tariffs As A Tax Increase
Tariffs are paid on goods flowing into the country; some portion of that cost is almost certain to be passed along to the end consumer. Most expect companies to absorb some of the additional cost, but the split between the two groups is unclear. Since tariffs add to the costs, they can be considered a tax increase for economic purposes. Strategas Research Partners states these tariffs will be the most significant single tax increase as a percentage of GDP since 1968. This tax increase is almost sure to reduce consumer spending and thus negatively impact US economic growth. Furthermore, corporate earnings could be reduced if companies are unable or unwilling to pass along the full price increase.
To put it into context, Strategas estimates that the revenue generated from the tariffs will be larger than all the tax revenue paid by companies!
These estimates are subject to significant uncertainty since the duration or further changes to tariff rates are impossible to estimate. Furthermore, possible retaliation or other second-order effects add to the difficulty in forecasting the likely impact with precision. The vast scale of the tariffs caused the J.P. Morgan economic team to raise the risk of recession this year to 60%, and it was stated that “these policies, if sustained, would likely push the US and global economy into recession this year.”
Market Reaction
The increased risk of recession and lower earnings sent stocks 9.1% lower last week. The S&P 500 sits 17.4% below its mid-February high, close to the 20% decline from the peak that defines a bear market. The Magnificent 7, consisting of Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), has faired worse deep into a bear market at 28.5% below its mid-December summit.
The Baa credit rating is the lowest level of investment-grade bonds. The spread is the yield investors demand beyond US Treasury bond rates to compensate for the default risk from buying corporate bonds. These spreads expand when investors worry about more bond defaults, typically driven by deteriorating economic conditions. The spreads on Baa corporate debt increased last week reflecting the increasing fear of an impending economic downturn.
US Treasury yields moved lower last week despite concerns that increased tariffs could cause a spike in inflation. The lower yields were caused by the combination of a flight to safety, reduced economic growth forecasts, and increased expectations for Federal Reserve short-term interest rate cuts.
The more economically sensitive cyclical stocks underperformed the less economically sensitive defensive stocks by a wide margin last week. This suggests that economic fears are a primary cause of the stock plunge.
What Happens To Stocks If There Is a Recession?
Looking at stock declines around recessions, the average decline in the S&P 500 is almost 30%. The average is dragged lower by the three most recent economic contractions, which were all atypical. Since stocks are already 17.4% below their peak, assuming we enter a recession, the decline would already be worse than three out of the last twelve recessions.
The analysis was widened to all the bear market-like stock declines, defined as a greater than 19% fall in prices, and since 1946, half of those plunges were associated with a recession. Not surprisingly, the declines related to recession tended to be more severe, including the deepest stock plunge during the 2007-2008 global financial crisis.
It’s Always Darkest Before The Dawn
As sure as the sun always rises, stocks eventually reward the optimist. Unfortunately, timing the rebound is impossible since waiting for good news rarely works. Stocks typically rebound sharply before the data or headlines begin to improve. On average, stocks bottom five months before the end of a recession and have generally risen by over 27% from the bottom before the recession even ends.
Just as stocks tend to fall more sharply around recessionary periods, the rebound is typically more robust.
What Could Go Right?
So far, the focus has been on the downside risk. With markets quickly pricing in a poor outcome and coming closer to assuming a recession, it is worth considering how things could turn around.
There is always the possibility that President Trump’s gambit succeeds in gathering quick concessions from other countries. Since the US is a massive consumer market, one should not underestimate the economic pressure these tariffs will put on different countries. He could also decide that the economic pain was too great and reduce the tariffs unilaterally. The US courts could also strike down the tariffs.
While the tariffs seem sure to depress the economy indefinitely, economic activity could see a soft patch rather than a significant contraction aided by quick Federal Reserve rate cuts.
As noted previously, the tariffs, if retained, are likely to produce significant tax revenue. This revenue should help the US budget deficit. Furthermore, it opens the door to maintaining and lowering the current tax rates to offset this massive tax increase.
What To Watch This Week
The primary focus will likely remain on the fallout from the tariffs, with markets watching for any changes in US policy and retaliation or concessions from other countries.
Thursday’s consumer inflation (CPI) will be notable, though it will not reflect the impact of last week’s tariff announcements. Still, the underlying pace of inflation will be noteworthy for Federal Reserve policy decisions, and some of the earlier tariffs were in pace, so clues as to the passthrough could be gleaned.
Though last Friday’s March jobs release was better than expected, with an increase in 228,000 jobs according to the nonfarm payroll report, it was widely ignored as old news due to the tariff implementation.
Markets moved quickly in reaction to the likely economic drag from the tariffs, with four expected rate cuts for 2025 and an over 100% probability of a rate on or before the mid-June Federal Reserve meeting.
First quarter earnings season begins this week, with some large banks reporting on Friday. While current earnings always take a back seat to future guidance, this season’s situation will be even more extreme, with investors trying to determine the upcoming earnings bite from the tariffs and any retaliation. Good companies typically have better pricing power and operational excellence, so they should be able to pass along or mitigate the increased costs compared to weaker businesses.
Conclusion
While the data does not yet indicate a high likelihood of recession, the massive scale of effectively a tax increase from the expanded tariffs raises the risk. Notably, economic activity may see a brief improvement as companies and consumers move in advance of the tariffs. Still, that pull-forward of activity and the tariff-impacted higher prices for goods will weigh on future growth.
The market is getting all vegetables from the tariffs, which have driven stock prices near bear market territory. Stocks have probably not fully priced in a recession, but quite a bit of bad news is priced into the outlook. There is room for optimism that investors could eventually get some dessert by way of tax cuts and deregulation, offsetting the drag from tariffs. History tells us that stocks almost always move higher before the headlines improve, so timing the rebound is nearly impossible.
The short-term movements of stocks and the ultimate impact of the tariffs are impossible to predict, so investors should keep enough high-quality bonds and cash to cover upcoming expenses or liabilities. As a positive, bonds have returned to their status of providing a hedge to stocks during this downturn. While predicting the short-term price action of stocks is a fool’s errand, last Friday’s indiscriminate and panic selling does provide some optimism that stocks could find some footing this week. The real opportunity in any challenging period is in finding good companies where the stock market has allowed short-term hurdles or forced selling to send the valuation and expectations low enough to provide attractive long-term expected returns.