Markets hate uncertainty.
Since President Trump’s April 2 “reciprocal” tariff announcement, the news has been moving fast.
Although tariffs have been wide ranging, U.S. – China trade restrictions have been in the forefront. Recently, both countries have escalated their tariffs, with U.S. imports of Chinese goods reaching a 145% increase and Chinese imports of U.S. goods rising to 125%. The headlines have been concerning. How will businesses handle this disruption? Will China tariffs mean empty shelves as trade dries up and supplies dwindle? Will we experience a recession this year? Will we have a return of high inflation due to these added tariff costs?
The financial markets have reacted. Between April 3-4, the S&P 500 sold off more than 10% as markets priced in the increased economic uncertainty. At its lowest point, the S&P 500 sold off more than 18% and the international EAFE index declined more than 14% from its highs.[1]
The market has since had a strong recovery, rallying on each positive announcement as uncertainty decreased.
On April 9, the S&P 500 advanced 9.5% as a 90-day pause on “reciprocal” tariffs was announced for all countries except China.[2] Sometimes “less bad” can be good for the market.
Despite trade tensions cooling elsewhere, the U.S.- China trade war continued unabated. U.S. tariffs peaked at 145% on April 10 followed by China’s tariffs reaching 125% on April 11.
On May 12, tensions eased when the U.S. and China reached a major trade agreement after successful negotiations in Geneva, Switzerland over the preceding weekend. The two countries have agreed to suspend and pause various tariffs, effectively reducing them by 115% each. The deal has the U.S. retaining a 30% tariff on Chinese goods, and China keeping a 10% tariff on U.S. imports. Improved communication and the release of a joint statement by the countries have fueled optimism that better cooperation and mutually beneficial long-term resolutions can be enacted.
This cooling of trade tensions has brought with it a recovery in the stock market. As of its May 13 close, the S&P 500 returned to positive territory and the international EAFE index delivered a strong 14% return year-to-date.
Source: YCharts
Although considerable uncertainty remains, the market has applauded potentially taking the “worst case scenarios” off the table. Reducing tariffs on Chinese goods from 145% to 30% ends what was effectively an embargo on China that had companies scrambling for alternatives. The likelihood of a recession over the near term is similarly reduced, though a slowdown of economic activity is still possible.
Although these tariff pauses are only for 90 days, this buys the U.S. and foreign governments time to meet and negotiate longer-term deals. It also gives businesses much needed time to add flexibility to their supply chains and find lower cost options for imported goods.
What does this mean for inflation?
An inflation “tug-of-war” has been raging behind the scenes.
Tariffs directly raise inflation by increasing the cost of importing goods. Some of the direct impact of tariffs could be mitigated by sourcing products locally or from lower cost regions. Retailers would likely absorb some of these price increases, but ultimately, consumers will end up paying higher prices for tariff-affected goods. Lowering the tariff rates eases some of the direct impact.
The likelihood of an economic slowdown or recession caused by the increase in tariffs has overshadowed their direct impacts. Because recessions tend to reduce inflation by reducing demand in the economy and thus reduces prices, lower tariffs lessen the risk of an economic slowdown, dampening this disinflationary impact.
One way to measure the market’s inflation expectations is to look at the breakeven inflation rate, which is the difference in yield between Treasurys and Treasury Inflation-Protected Securities (TIPS). TIPS pay both income and an inflation adjustment, whereas a Treasury only pays interest. The breakeven inflation rate reflects the level of future inflation at which the returns of Treasurys and TIP would be the same, indicating where the market sees inflation over the period.
When the “reciprocal” tariffs were announced on April 2, the market priced in lower inflation, as the market anticipated that the impact of an economic slowdown would offset any direct inflation impacts from tariffs. As trade fears eased, both the direct impact of inflation and the deflationary impact of an economic slowdown were reduced. As a result, inflation expectations have normalized.
Source: YCharts
Uncertainty is likely to remain high as 90-day tariff pauses transition into longer-term resolutions. But for long-term investors, uncertainty is nothing new. The economic reality is that recessions are a normal part of the business cycle and inflation is a persistent headwind to a portfolio’s returns. Instead of reacting to every headline, it is better to have a long-term plan – and stick to it. Instead of changing your portfolio with the fluctuations in the market, build it to be resilient and able to withstand all the bumps in the roads you are certain to encounter.
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