What Is The Worst Case Impact Of Tariffs?
Macro Mechanics
The best information we can ever provide investors is the mechanics of how we think about macro conditions over time, rather than what we think about them at any particular time.
Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.
Thus far in our Macro Mechanics series, we have provided our understanding of the following subjects:
We highly recommend reading these previous notes if you are unfamiliar with our approach. Today, we revisit a subject that has significantly impacted global macro markets: tariffs.
In our last Macro Mechanics note, we outlined our thoughts on the mechanical effects of tariffs and their likely pass-through to the economy. We highly recommend reading that note if you haven’t already, as it will offer vital context for the analysis presented in this note.
How Do Tariffs Impact The Economy?
The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time.
In today’s note, we assess the announced tariffs to determine whether the full slate of tariffs, if implemented, would have a material impact on economic conditions. The objective of this note is to evaluate the reasonable worst-case effects for corporate profits, trade balance, and overall activity.
Our takeaways are as follows:
Tariffs, if implemented, will significantly weigh on gross trade. However, the effects on the trade balance may well be positive. This may result in a cosmetic boost to GDP, while total trade suffers.
The tax effect of tariffs on corporations is insufficient to overcome business cycle forces in determining cyclical outcomes.
While the linear impact of tariffs on corporate profits is modest, the non-linear effects on fixed investment are potentially much more negative. Currently, they imply a material weakening of the economic growth rates, but not a recessionary outcome.
Adding up these drivers, the tariffs’ impact on the trade balance has the potential to add approximately 0.64 % to annualized GDP. In comparison, the fixed investment impacts have the potential to detract approximately 1.3% from annualized GDP Growth. The net effect is a 0.66% drag on GDP growth. Our current systematic projection, based on domestic business cycle conditions, stands at 2.4%, excluding this drag. Accounting for this drag and time series factors, our estimate falls to 1.09 % GDP Growth over the next year.
It is essential to recognize that this projection is based upon the worst-case outcomes of tariff implementation, rather than the baseline projection. We find the confidence effects to be more significant, with both potential negative impacts on consumption and investment. These prospective impacts outweigh the impacts from trade itself. In large part, these confidence effects will be contingent on financial market outcomes across stocks, bonds, and the dollar. In this environment, the best forward-looking reading of the economy will likely come from cross-asset, macro market trends.
Let’s dive into the data driving this assessment. We begin with our evaluation of the tax effects of tariffs, i.e, the prospective drain on corporate profits. As systematic investors, we focus on the predominant cause-and-effect relationships that offer predictability for markets. One of these is whether business cycle conditions provide insights into the future of equity markets. Estimating the trajectory of corporate profits is a crucial component of this approach. Upon the announcement of tariffs, we needed to determine whether the outlier nature of tariffs was sufficient to override traditional business cycle forces and become the dominant driver of corporate profits. Tariffs are a tax paid by businesses, which they pass on to consumers. However, the first burden is paid by companies. As such, we sought to determine whether extremely high tariffs could have a significant impact on the structure of corporate profit growth rates. To create this understanding, we identified what we believed to be a substantial outlier event, namely a 10-fold increase in tariff rates, and estimated the impact on corporate profit growth if this rate had been applied throughout history. We found there to be minimal change to corporate profits even at a 10-fold increase. We visualize this below:
Above, we show corporate profit growth in blue, and corporate profit growth after subtracting a ten-fold increase in tariff rates. As we can see, our stress test indicates that the tax effect of tariffs is likely to be minimal, even in an outlier event such as a tenfold increase.
The announced tariff rates came out in line with this stress test, shocking markets and global policymakers. The weighted average effective import tariff rate, as announced, stands at