Dark days before the trade negotiation and likely policy support for economies

These are dark days, but nothing remains static. For every action, there is an equal and opposite reaction. The global economy and financial markets are now absorbing the barrage of bad news from the past 48 hours. But a response is inevitable. There will almost certainly be further tariffs as the world reacts to the U.S.'s opening salvo. At the same time, negotiations will begin. Policymakers will be forced to act—supporting their economies and labour markets. Central banks will face the difficult balancing act between containing inflation and sustaining growth, which should allow room for at least some interest rate cuts. Meanwhile, governments may need to loosen the purse strings and consider fiscal stimulus to bolster their economies.

1. Largest effective tax increase since 1968

The US administration's newly announced tariffs represent a seismic shift in economic policy, with implications that stretch far beyond immediate fiscal gains. At face value, the new tariffs are estimated to generate nearly $400 billion in revenue—equivalent to approximately 1.3% of US GDP. If fully implemented, this would mark the largest effective tax increase since the Revenue and Expenditure Control Act of 1968.

2. Fundamental change in US trade regime

The average tariff rate in the US is expected to rise from just 2.4% in 2024 to 24%. That would represent a fundamental reshaping of the US trade regime, not seen in decades.

3. More inflation

According to JP Morgan, the tariffs could push the PCE price index up by between 1.0% and 1.5% over the course of the year, with inflationary effects most pronounced in the second and third quarters. Such a spike in consumer prices could materially erode real disposable incomes, potentially leading to a contraction in real consumer spending. In an economy where consumption drives nearly 70% of GDP, this raises the spectre of a shallow recession, particularly if business investment and export activity also come under pressure.

4. Escalation risk

We have yet to hear detailed responses from US trading partners, but history suggests that retaliatory measures are likely. These could range from targeted tariffs to broader non-tariff barriers, further dampening global trade flows and increasing costs for businesses reliant on cross-border supply chains. The escalation risk is real and could usher in a period of prolonged trade uncertainty.

5. Potential US tax cuts may be a sweetener but may compound the structural budget deficit and government indebtedness

Politically, the administration appears to be pairing this protectionist stance with a push to extend and potentially expand the existing tax cuts. However, any such fiscal sweetener would come at the cost of a larger budget deficit and higher aggregate government debt—compounding the long-term structural imbalances in the US fiscal position.

6. Erratic and dogmatic policy making is unnerving corporates and consumers alike

From a market perspective, the tariff plan has come as a significant negative surprise—more aggressive and broad-based than anticipated. Beyond the direct inflationary and economic impacts, the broader uncertainty it creates could paralyze corporate decision-making. Many companies may be forced to reconfigure their supply chains—shifting sourcing from China or other tariff-targeted countries to alternative suppliers in regions with less-developed infrastructure and weaker business ecosystems. This kind of realignment takes time—quarters, not weeks—and brings with it meaningful transition costs and operational risks.

7. First the shock – maybe now the negotiation and rollback?

There are, however, a few potential moderating factors. Some market participants believe that there remains scope for re-negotiation, especially as the details and timeline of implementation remain fluid. While some tariff measures are immediate, others are less defined, leaving open the possibility of revisions or rollbacks under political or legal pressure. Moreover, questions remain over whether the President can enact such sweeping tariff measures through executive action without Congressional approval—an issue that may yet face legal challenge.

In conclusion, while headlines will focus on the revenue raised or the inflation uptick, the broader implication is a re-framing of US trade policy in a way that could prove both disruptive and persistent. Investors and corporates alike must now factor in a higher baseline of policy uncertainty, supply chain disruption, and geopolitical tension as they reassess their outlooks for the second half of the year.

8. Bonds challenged by inflation

The risk of higher US inflation by say 1-1.5% has to impact bond yields. That in essence would increase PCE inflation to around the 4.0-4.5% level without even considering some potential second round effects. The last time we saw such elevated inflation was around COVID. If we just consider a few scenarios:

I. The 10-year government bond yield stays at the same real rates with a 1-1.5% increase in the PCE inflation. 10-year yield moves to a range of 4.5%-5.0% based on an average historical real yield of 0.6%.

II. If we assume that the market discounts the inflation rise as transitory, then as we had during COVID 10-year yields could be anchored at much lower levels. However, COVID was a huge constraint on growth and the central bank anchored yields at low levels vis open market operations. Transitory inflation = yields largely unchanged from where they are today.

Chart 1: Real 10-year yield and the level of PCE inflation

The slide in the dollar will worry policymakers. Each percentage drop in the dollar will only add to potential inflation pressures in the future. It also makes US assets less attractive if a new weaker dollar regime takes hold.

Chart 2: US Dollar Spot Index

Equities – unravelling the excesses

The story in the equity world is quite simple. The US equity market has virtually unwound all of its exceptional outperformance of 2024. The MAG 7 now matches the performance of the Chinese equity market! Future performance will be about the ability of policymakers to provide support for their economies and navigate the trade crisis with some deft negotiation.

Chart 3. Absolute performance of major markets rebased to Jan 2024=100

Source: The Global CIO Office