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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is co-founder and chief investment strategist at Absolute Strategy Research
Donald Trump sees “tariffs” as the most beautiful word in the dictionary. Investors should not see them so benignly.
US stocks have rallied since the shock of President Trump’s “liberation day” announcement of bigger than expected tariff increases. Initially, this reflected the pause in their implementation. But stocks have continued to rise, even as bilateral deals between the US and its trading partners have confirmed tariff increases. Strong earnings and economic data have lifted sentiment. And investors appear to have reverted to riding the rally led by buoyant tech stocks.
But there are good reasons to be wary of the trend. The headline tariffs emerging out of negotiations might be less than “liberation day” levels but they are still substantially higher than before Trump came to power. Consumers face an overall average effective tariff rate of 18.3 per cent if all the announced increases up to August 1 are brought in, the highest since 1934, according to the running calculations of Yale’s Budget Lab as of last Wednesday. Since then, Trump has announced more tariff increases. Clearly, this is anything but business as usual.
Most economists agree that tariff rises will probably lead to slower US GDP growth and higher inflation. Historically, this combination has seen equity market valuations fall. However, the overall impact on US stocks will depend on the tariff impact on corporate profits.
Current US earnings expectations suggest a sanguine view of that. Upward revisions of earnings forecasts currently dominate cuts to them. And the consensus for projected earnings of the S&P 500 companies over the next 12 months is 11.4 per cent — above the 10 year average of 10.4 per cent.
This optimism on profits appears to reflect three key assumptions, all of which can be questioned: 1) the US is a large domestically driven economy; 2) companies will pass through the tariffs; 3) The Nixon administration raised duties and these had a relatively limited impact on earnings. Let’s look at these in turn.
The US is definitely a more domestically driven economy compared with the OECD average. Exports account for only 11 per cent of US GDP compared with 28 per cent across the OECD. And the US level is much lower than the 31 per cent and 42 per cent respectively in the UK and Germany.
But it also important to remember that the S&P 500 does not represent the US economy, and our estimates suggest that the proportion of revenues of index constituents coming from overseas is now about 41 per cent. Even if US GDP suffers only modestly, growth might be slower outside the country as a result of the new trade regime. And Trump has already made it clear that he expects companies to “eat the tariffs” rather than pass on cost increases.
Some of my clients like to compare the Trump tariffs to what happened in 1971 under Nixon’s tariff regime, when US profits saw no negative impact from the tariffs. However, the Nixon shock saw tariffs of just 10 per cent, and these were removed after four months following an international agreement to end dollar convertibility to gold.
The key risk for investors is that the scale of Trump’s tariffs are, potentially, more akin to the tariff increases seen in the 1920s and 1930s — larger and more open-ended than those under Nixon. Data going back to 1900 collated by Professor Robert Shiller at Yale shows that the only two occasions when earnings fell as much as they did in the Great Financial Crisis were in the early 1920s and 1930s. Whether a coincidence or not, this should certainly be alarming.
The Smoot-Hawley tariffs of 1930 and their role in causing the US depression has been much discussed. Less well known are the 1921 Emergency Tariffs Act (increasing tariffs on farm products), and the 1922 Fordney-McCumber Tariffs (which impacted a broader range of products). As a result of these measures, the average tariff on dutiable goods was 38 per cent. While any causality is hard to prove, S&P earnings fell by 61 per cent in 1921 and US equities dropped by 44 per cent from their peaks of late 1919.
What is also notable from the tariff episodes of the 1920s and 1930s is that global exports as a percentage of global GDP fell sharply — by almost 3 percentage points in the early 1920s and more than 5 per cent in the early 1930s. While the structure of the US economy has clearly changed since the early 20th century, global trade and profit growth are closely linked. Markets today appear to be priced not for “business as usual”, but for perfection.
