Tariffs: Bark Worse Than Bite?

Last week, President Trump made the threat to impose tariffs at the start of next month on the U.S.'s biggest three trading partners (Mexico, Canada, and China)—yet the market response was positive. Global stocks, represented by the MSCI World Index, rose every day last week, even the stock markets of Canada and Mexico are up solidly for this year (MSCI Canada and MSCI Mexico, respectively). China's stock markets, represented by the MSCI China Index, did decline slightly mid-week but that followed six days of gains. Moreover, the currencies of Canada and Mexico are up slightly versus the dollar so far this year—the opposite of what would be expected from tariffs. The market seems to have decided that the bark is worse than the bite regarding the tariff threats—as we wrote was likely to be the case in our commentaries "Five Investing Impacts of a Trade War" and "2024 Elections: Big Bark, Little Bite." The market might be right—but it's still early. Let's explore the potential reasons why the market may be unconcerned about the impact of any new tariffs.

1. No Day One tariffs enacted as had been pledged.
2. U.S. energy exports offered as a way for Europe and China to avoid tariffs.
3. The new political leadership in Europe and Canada are more like Trump, easing the path to cutting a deal.
4. Global trade survived Trump 1.0.

President Trump's inaugural address did not discuss import tariffs. Markets reacted positively to the lack of immediate action on tariffs. However, later in the day, President Trump told reporters from the Oval Office that he was considering a 25% tariff on imports from Canada and Mexico on February 1. Later in the week, he suggested new China tariffs could be enacted on the same day. Stocks in major markets around the world continued to climb each day last week, excepting Mexico's stock market which registered a dip of just -0.06% on Tuesday (measured by the MSCI Mexico Index).

Perhaps market participants remember that Trump pledged to enact tariffs on Mexico on Day One and did not do so. They likely also recall the Trump administration vowing to levy tariffs of up to 25% on imports from Mexico within 10 days back in May 2019, but never enacted them. Could the market be interpreting the February 1 date as an empty threat? Will Mexico, Canada, and China find ways to delay or avert the tariffs by agreeing to other actions? Might any tariffs enacted be far less draconian than those proposed on the campaign trail? Will the threat of a universal, or blanket, tariff on all imports be changed to tariffs on a more limited set of targeted industries?

There are reasons to believe that there is a good chance this may be the case. But there are still risks the market may be ignoring. Notably, President Trump's comments and the presidential memorandum on trade policy note that several federal agencies were instructed to review a broad range of trade issues and to report back with recommendations by April 1. According to White House releases, the Secretary of Commerce is directed to investigate "our country's large and persistent annual trade deficits in goods, as well as the economic and national security implications and risks resulting from such deficits, and recommend appropriate measures, such as a global supplemental tariff." The investigation into the feasibility of an External Revenue Service to collect revenue suggests the administration intends for at least some tariffs to be enacted and to be permanent. That could mean the enactment of broad tariffs are merely delayed rather than curtailed and the markets could reconsider its optimism as the first quarter matures.

President Trump and his staff have suggested that Europe and China could avert import tariffs by buying more U.S. energy (specifically natural gas and oil) in order to reduce the bilateral trade deficits the U.S. is running. Trump's pick for Treasury Secretary, Scott Bessent, has suggested three million barrels per day of additional U.S. oil production as part of his economic plan. If that additional supply were used for export to Europe and China, it might narrow their trade gaps with the U.S. by nearly 20%, at current prices. Given the need for more U.S. imports in these markets, the stock markets may be assuming that energy seems like an easy solution to avert tariffs.

But how easy is it to produce another three million barrels of oil per day or widely expand natural gas production and transport? The Kansas City Federal Reserve's fourth quarter survey of US exploration and production companies published on January 10 indicates that drilling new wells is profitable at an oil price of $62/barrel or a natural gas price of $3.69/MMBtu. That means drilling for oil is currently modestly profitable with U.S. crude oil currently at $75 and monthly oil futures prices over the next two years averaging $69, per Bloomberg data. The same for natural gas at $4.03 (and futures averaging $4.04 over the next two years). More importantly, the survey also asked firms what prices they would need to pursue a substantial increase in drilling across active fields, the numbers were significantly higher. The average oil price needed was $84, and the average natural gas price needed was $4.66. Producing enough energy to narrow the trade gaps may take substantial energy price inflation in the U.S., something the administration may be wary of facilitating.

Political leaders more aligned with Trump's views and policies are on the rise in Canada and Europe, which could herald a more friendly relationship with the U.S. on trade. Europe's right wing populist parties have moved into the lead. The Brothers of Italy (FDI) have led Italy's government for the last two years, the National Rally, formerly the National Front, (RN) is the biggest party in France's National Assembly, and the right-wing populist Alternative for Germany (AfD) party is polling in second place ahead of Germany's February 23 federal election. In Canada, Prime Minister Trudeau has resigned, and his party appears likely to lose this year's election to the Conservative Party candidate, Pierre Poilievre, whom The Economist has called "Canada's Trump." Markets may be taking comfort in the rising potential for warmer cross-border relationships. Accommodative personalities may make trade talks go more smoothly but doesn't guarantee resolution to the focus around Trump's trade policies—the massive U.S. trade gap.

There are also historical reasons to believe President Trump's tariff proposals won't be implemented in full on February 1. Despite the president's threats of implementing across-the-board tariffs on China and ending a trade agreement with Mexico and Canada during his first term, Trump not only forged a Phase One trade deal with China but also successfully renegotiated the United States-Mexico-Canada Agreement (USMCA), formerly the North American Free Trade Agreement (NAFTA). He also renegotiated existing free trade agreements with South Korea and Japan. The volume and value of global trade climbed during Trump's first term and has increased by double-digit percentage rates since his first term began in 2017, as you can see in the chart below.

If history is any indication, the current tariff proposals may simply be negotiation tools leading toward agreements with China and other countries, and potentially much less disruptive to economic growth, inflation, sales, and operations of multi-national corporations. The market seems to believe that Trump will continue to use dramatic tariff announcements as a tool of statecraft to extract actions or concessions, rather than tools of economic policy. The risk?  Trump 2.0 may differ significantly from Trump 1.0.

Of course, the market's steady gains last week could be attributed to more than the outlook for tariffs: early positive results during earnings season, solid economic data (including better-than-expected preliminary purchasing managers indexes for January), talk of deregulation, and next week's Federal Reserve meeting to name a few. However, there are reasons to have caution. U.S. tariffs could raise prices and reduce U.S. consumer demand for goods produced by foreign producers. Retaliatory tariffs can negatively impact corporate earnings for U.S. companies with a sizable share of sales overseas (over 40% of S&P 500 revenues are from outside the U.S. according to FactSet data). Domestic importers may be forced to pay the high U.S. tariffs on goods produced overseas and could have limited opportunity to pass those costs onto consumers, impacting their bottom line. A continuation of the market's steady climb as it seemingly dismisses trade risks above may become increasingly challenging.

Michelle Gibley, CFA^®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.