Much of the news in the recent headlines has been on the topic of the tariffs imposed by President Trump on the imports from foreign nations which has caused a good degree of market volatility.

A tariff is simply a tax imposed by a government on goods and services imported from other countries, essentially increasing the price of those imported goods and services.   As a result, the concern is that additional tariffs will add to inflation.   Whether or not this is true remains to be seen.   Historically inflation has been more of a function of the money supply.   As we saw in 2021, the M2 money supply grew by a staggering 40% in just 18 months as a result of the policies of the Covid response, and inflation accelerated quickly.

Remember that in 2018 we saw similar tariffs imposed during the 1^st Trump administration, and no such inflation occurred.   The reason for this is likely because the motivation of the President’s position was not consistent with what occurred in 1930 with the Smoot-Hawley Tariff Act.

At that time, during the early stages of the Great Depression, the motivation was to limit free trade in an attempt to protect American industries.  The thought was this would boost domestic production and employment.  However, limiting free trade does not in fact protect American industry, but rather harms it.   The reason is every nation has something it does better than others.   The best way to grow both domestic and global commerce is to have goods and services produced in the most efficient way possible, which may mean that in some cases they are produced in the USA, and in some cases not.

However, what is free trade?  Free trade is a policy position that does not restrict imports or exports.   The question is whether or not the USA has been engaging in free trade with its global trading partners.    Looking at the chart above which shows the average tariff rate imposed by each nation, we can see that it is tough to argue that we have had a level playing field in terms of global trade for quite some time.   While the USA has historically imposed 3.3% on average, the European Union has imposed a 50% higher tariff rate.   India has been the worst offender among our global trade partners at 17%, which is more than 5 times the rate the USA has imposed.  This begs the question, is this actually free trade?

This has contributed to a perpetually growing US trade deficit with most of the world.  A trade deficit occurs when a nation imports more than it exports.  The fundamental cause of a trade deficit is an imbalance between a country’s savings and investment rates.  The reason for the deficit is the United States as a whole spending more money than it makes, which results in a current account deficit.  That additional spending must, by definition, go towards foreign goods and services.  Financing that spending happens in the form of either borrowing from foreign lenders (which adds to the U.S. national debt) or foreign investing in U.S. assets and businesses—the capital account.

However, in a true free market economy, trade deficits should swing back and forth between nations rather than moving consistently in one direction.   There are many things that lead to a trade deficit.   Some of the other causes that contribute to a trade deficit beyond tariffs are as an example:

More government spending, if it leads to a larger federal budget deficit, reduces the national savings rate and raises the trade deficit.

The exchange rate of the dollar is important, as a stronger dollar makes foreign products cheaper for American consumers while making U.S. exports more expensive for foreign buyers.

A growing U.S. economy also often leads to a larger deficit, since consumers have more income to buy more goods from abroad.

The data in the above chart is what the current administration seeks to change.  What is important to point out is that the stated intent is not to create a protectionist economic environment similar to 1930, but rather to level the playing field.  The question is…will the current administration be successful in any meaningful way?  That remains to be seen.

Perhaps they will be successful with some nations and not others.   At this early stage, that can’t be known.    However, what we can see below is that the same nations are generally much more dependent on exports as a share of their GDP than the United States, which is why the current administration believes they are negotiating from a position of strength.

As a result, the current administration believes that they can get other nations to lower their barriers to entry for USA exports.    Time will tell if that happens.  We have already seen some nations respond with a willingness to renegotiate, while others have imposed retaliatory tariffs.

If you put yourself in the position of an opposing politician, it can be difficult to immediately cut a deal with the administration because it may make you look weak, and harm you politically.   It’s likely that many of the opposing hardline positions will soften in the coming weeks as the story leaves the headlines.

What does all this mean for markets?  Not surprisingly, this has led to a quick decline in stocks as markets digest the possible impact to corporate earnings, and companies consider possible changes to their business strategy.   However, at this point the decline, while unpleasant, is well within the range of historical market corrections and nothing unusual to date.

More importantly, other assets classes, such as fixed income are serving to buffer the volatility quite well, as the Barclays Aggregate Bond Index is positive approximately 3.50% year to date as of this moment.    That is a bright spot in the recent volatility which suggests that while market declines are not fun, markets are functioning quite normally.   In contrast, during the 2008 Financial Crisis, and the beginning of the Pandemic of 2020 the bond market declined rapidly along with stocks as the market experienced a liquidity crisis, leaving investors nowhere to hide.   That is not happening at the moment, and the conservative arm of investor portfolios is doing exactly what it is supposed to do.

While we can’t tell you where the bottom of this particular downturn will be, we can say that there will be a bottom, and trying to time such events is as always, an exercise in futility.   Eventually other nations will come to terms with the United States on aggregable tariffs rates for both sides, and we will see how much the terms change in favor of the USA, if at all.

In the meantime, the best answer is the same answer as in any other downturn, and that is to stick to your financial plan, as this period will also pass.

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