It’s Happening Again… (Highest Tariffs Since Great Depression)

The Tax Foundation estimates that the average tariff rate in the U.S. could rise to nearly 17.7% under Donald Trump. He's promised a 10% tax on imports across the board, 25% on Mexico and Canada, and 60% on imports from China. This is what that would look like relative to all of the tariff data going back to the 1930s. After 70 years of seeing the average tariff rate in the U.S. trending lower as globalization and free trade became the norm, we would almost instantly see it get back to the highest level since the Great Depression. In fact, many suspect that the high tariffs from the 1930s were instrumental to triggering the worst downturn in modern financial history. Whether you are a fan of tariffs or not, they are going to happen and the impact they're going to have on the economy and markets could be massive. The first goal of tariff is to strengthen domestic manufacturing by making foreign goods more expensive and so U.S. goods more competitive. This is a chart showing U.S. manufacturing employment and we see that U.S. manufacturing has been on a massive decline over the last 40 years, falling from its peak in 1980 just as we saw imports begin a meteoric rise. Many attribute the exporting of U.S. manufacturing overseas as the root cause for rising inequalities in the United States, explaining why middle class wages have only risen by 73% since 1980, while the upper income wages have grown by 326%. A radical increase in tariffs does have a shot at actually reversing these trends, but just like the drawbacks of globalism were not felt until much later, it's unlikely that any positive impacts from tariffs will be felt anytime soon. The second goal of tariffs is to bring in revenue for the U.S. government and they really need that revenue right now. The U.S. government has been bleeding about 1.5 trillion dollars per quarter over the last few years, a level of deficit that is completely unprecedented, so tariffs would indeed provide a much needed revenue to begin potentially reducing the deficit. Over 200 billion dollars were collected from tariffs during the Trump and Biden administrations. Tariffs under Trump 2.0 are magnitudes larger. Estimates currently suggest they could bring in as much as 3.7 trillion dollars over the next decade, which equates to about 10% of the total current national debt. So tariffs could indeed bring in some relief to the government's budget, but again, government debt is a long-term theme that is unlikely to have much impact on markets or the economy in the short term. What could have a short-term impact, however, is inflation. And that's what has so many economists worried that tariffs could put upwards pressure on consumer prices, with inflation having come back down to more reasonable levels in the last couple of years. Many expect these tariffs could mark a turning point and lead the inflation rate higher again, the famous second wave of inflation. Now, if that happens, it could be dangerous. Looking back a little bit further in history, we see that rising inflation levels in the United States have often been followed by economic recessions, as indicated by these gray recession bars. And if we add the U.S. stock market on top, we see these spikes have also been associated with some of the largest stock market drawdowns, causing a few really big ones in the 1970s and also triggering the 25% decline that we saw in 2022. In fact, inflation going down recently is what's been keeping us optimistic on U.S. stocks over the last 12 months. This has provided the ideal conditions for financial assets to rise. Whether we're talking about stocks, crypto, gold, we, along with our clients at Bravo's Research, have been able to benefit from a major bull market in all of these over the last year by having long exposure to the strongest parts of the market. All of that, in great part, thanks to low inflation. So it is a fair question to ask whether tariffs can be the primary driving force behind a second wave of inflation, which would completely change our trading strategy. On the surface, it's true that tariffs do raise consumer prices. Remember, a tariff is a tax on an imported good, and so they're paid for by the company that imports these goods. So in this case, American firms. The company paying the tariff has a few options. They can absorb the cost, which reduces their profit margin. They can pass the cost on to consumers by raising their price, so causing inflation. Or they can try and rejig their supply chain, find a local manufacturer, which is generally a deeply costly process. So these all constitute a cost for either the consumer or the company. So chances are that at least part of the cost of tariffs is going to be reflected in higher consumer prices. For example, in 2018, Trump imposed a 20% tariff on washing machines that were imported from China and eventually raised these tariffs to 50%. If we look at the price of washing machines in the US, we see they immediately jumped by about 12% when the tariff came into effect. Academic research suggests that for every percentage point increase in the effective US tariff rate, consumer prices will rise by 0.1%. So given Donald Trump is getting ready to raise tariffs by 15%, that would mean around a 1.5% increase in consumer prices in that scenario. But that would be just a one-off price increase. Real inflation is spread out over time. It's when consumer prices rise month after month, and there is simply no evidence that tariffs could cause this kind of prolonged rise in inflation. In fact, we can see this just by looking at what happened to inflation during the trade war under Donald Trump's first term. There was an initial jump in inflation, but it quickly came back down to 2% around the Federal Reserve's target. Of course, the size of Donald Trump's tariffs this time around are shaping up to be much bigger and much more widespread than anything we saw during the first trade war. But when we zoom out to the last 100 years of inflation data and we add the average US tariff rate on top, we see that in the 1930s, tariffs were also exceptionally high, and this was definitely not a period marked by inflation. Quite the opposite, actually. The 1930s saw severe deflation. So we think that this narrative around tariffs potentially fueling another wave of inflation is overblown. While tariffs do mechanically impact consumer prices, they don't necessarily lead to structurally higher inflation. And again, that's pretty good news for stocks. Low inflation is one of the key drivers behind today's stock market bull run, and it does not seem that tariffs are going to reverse that in a big way. There is, however, one way that we think they actually could, and that is through their impact on corporate profit margins. This chart shows us corporate profit margins as a percentage of GDP. You can see they've been on a clear uptrend since the early 1980s, culminating in one of the most profitable periods in stock market history that we're experiencing today. One of the reasons for this growth in corporate profit margins is the expansion of free trade and globalism over the last 40 years. In fact, on this chart, we see a clear correlation between rising exports and U.S. corporate profits. As free trade has opened up, American companies have profited from access to cheap labor and manufacturing overseas and consumers in foreign markets, leading corporate profits higher. Donald Trump's tariffs could put a heavy dent in this trend, as many companies will need to bring back manufacturing to the United States. Of course, this is exactly what tariffs are meant to achieve, but it could come at the cost of lower corporate profits. In aggregate, we believe that tariffs are more likely to lead to shrinking profits for U.S.-based companies, especially those with heavy foreign exposure. But it's hard to say exactly when these tariffs are going to start weighing on corporate profits. Donald Trump has not yet formulated a clear plan for how he's going to implement them. What is certain, however, is that the impact of tariffs have not yet been taken into account by analysts. Wall Street forecasts on S&P 500 earnings are at record highs right now as a result of the U.S. sidestepping a recession and continuing to print strong economic growth. These strong earnings are what have been driving the market higher since 2022. Now, it could be that if Trump does go through with the tariffs over the duration of the next four years, a significant trade war could slow down earnings growth and, in the worst case, completely turn it around. The New York Fed found that firms with ties to China lost $1.7 trillion in market valuation as a result of tariffs during Trump's first term. With tariffs around four times larger during his second term, one could speculate that this cost would amount to as much as $5 trillion in market valuations, which equates to about 10% of the total S&P 500 market cap. That's how we think the real impact of tariffs will be felt. In fact, if we look again at corporate profits as a percentage of GDP, we can clearly see that declines in corporate profits tend to precede economic recessions as companies are forced to cut down costs and so potentially laying off employees given the reduced profits. To be clear, we don't think we'll see the impact of tariffs on the stock market immediately. Fundamental forces are still driving the market higher today, but shrinking corporate profit margins could become a problem in the second half of 2025 if these tariffs are implemented now. Whether or not you think tariffs are a good idea, what's clear is that they're about to put a major dent in globalism. Between 1980 and 2010, the world went through an extended period where trade openness increased, as shown here by this chart that measures the sum of all global trade divided by world GDP. U.S. businesses were able to expand their profits as they exported their supply chains abroad during this period. The 2008 financial crisis slowed globalism. COVID-19 slowed it down as well, but neither of them completely killed it. Trump's tariffs, on the other hand, could mark the beginning of an outright reversal in trade openness. If that's indeed about to happen, both the negative and the positive consequences of globalism would be reversed.