The market is looking through the tariffs

Good morning. Readers were split on whether yesterday’s letter, which noted signs of worrisome exuberance in the risk markets, was too complacent or too negative. Does not mean it got the picture right? Or that it was a middling, boring take? Either way, we have plenty more to say on the topic, some of which you can find in the second item below. We remain eager to hear your thoughts: unhedged@ft.com. 

Are 15% tariffs . . . fine?

The US-EU trade deal (if we are calling these agreements “trade deals”) further cements the consensus that we are heading to an average US tariff rate of about 15 per cent on goods (plus higher tariffs on macho commodities, such as steel). This is up from just 2 per cent or 3 per cent last year.

The US stock and bond markets seem to think that this a perfectly acceptable outcome. Big-cap stock stocks are at highs, corporate bond spreads are tight, and the Treasury market is calm. Is the market right to be so sanguine?

For context, some very rough math. The US imported $3.3tn in goods last year. Tax that at 15 per cent; that’s about $500bn in revenue. For scale, a half-trillion is about 1.7 per cent of 2024 GDP, 10 per cent of total 2024 federal tax receipts and 27 per cent of the 2024 federal deficit. It’s a lot of money. The questions are what the impact on spending, savings and investment of collecting it will be, and how these impacts will show up in corporate profitability and the US fiscal outlook.

I don’t know how to answer these questions systematically, so I am depending on others’ insights. 

Here is Joseph Wang, the artist formerly known as “Fed Guy”. His numbers are in the same range as the ones on the back of my envelope:

Federal tax revenue was 17 per cent of GDP in 2024 and the new tariffs would marginally increase the tax burden by about 1 per cent of GDP. However, the aggregate numbers may be misleading as the burden will fall particularly hard on a narrow set of sectors . . . the auto and clothing sector are particularly dependent on imported goods and would bear the brunt of tariffs . . . These strains could ultimately lead to a rise in unemployment that leads to lower consumer spending

Lesson one: watch sectors, not the whole economy. Lesson two, Wang says, is that benefits of tariffs for domestic production may appear, but that will take time. Wang thinks the market is “looking through an obvious slowdown to [benefits that] may not even materialise”.

Adam Posen of the Peterson Institute emailed Unhedged to argue that the damage done by tariffs should not be expected to show up in equity prices in the short term: 

One. Tariffs are an inefficient, distortionary tax with regressive impact. Thus, while they may generate a ~$300bn annual revenue to start, they will have more negative impact on investment than a better designed tax would, and they will favour some sectors over others inducing shifts in production/labour to less productive uses, and will hit lower-income people harder.

Two. Over time, tariffs induce corruption and diminish competition. This will slow productivity growth in the US economy.

Three. Even though EU, Japan, UK and others acceded to Trump demands for a quick deal, and can live with 15 per cent across the board tariffs . . . they will change their behaviour to de-emphasise the US as a trading and investment partner.

My colleague Martin Wolf argues that the mis-allocations created by the import tax might not be too bad:

My guess is that if tariffs stay where they are and there is no further retaliation, the growth effects on the US and the rest of the world will be quite modest and difficult to measure. Of course, some inefficient sectors will expand and efficient sectors will contract, but in a large and relatively closed economy, these impacts will be modest. 

The real risks, again, are weighted to the long run:

The economic paradigm has been fundamentally altered. Is this new arrangement stable? Or is much more craziness coming down the road? When it becomes obvious that US trade deficits are not diminishing, what will Trump do?

How are global relations going to be affected? My guess is that there is going to be a global shift towards more reliance on China and less on the US. In the long run, this will reshape the world.

The summary, I believe, is that markets are right to not be too worried about 15 per cent tariffs — in the quite specific sense that markets can be right. Markets weigh the near future heavily relative to the long-term future and only discount things that can be quantified crisply, rather than speculating about the meaning of structural changes and trends. The near-term, quantifiable impact of 15 per cent tariffs seems likely to be manageable, and less important than many other factors. If you want a measurement of the long-term structural damage tariffs will do, you certainly should not look to markets to provide it. 

Two more points on irrational exuberance

Some self-criticism, and some external criticism, of yesterday’s irrational exuberance piece.

Start with self-criticism. It occurred to me when I re-read the piece that the fact that US margin debt in securities accounts has passed $1tn is pretty meaningless without context. The margin debt would, ideally, be divided into some measure of the equity in those accounts. Debt levels can only be high or low relative to equity or income. Finra, which publishes the margin debt totals, does not publish an equivalent equity figure. So what to scale the margin debt figure to? 

As a first stab, I divided it into the total market capitalisation of the US stock market. This is grossly imprecise: not only do US securities accounts hold non-US equities, they hold fixed income securities as well. And much of the market cap of the US market is held by foreigners. But at least this approach compares the margin debt with a measure of the appreciation of risk assets. And on this imperfect measure, margin debt looks low by the standards of the past 25 years — though it has increased notably in the last year and a half, after a long decline that began in late 2021:

So I (provisionally) withdraw margin debt from my inventory of things that make me think the market is becoming feverish. There are still plenty of others.

The external criticism came from the comments section. “Classic FT: we may be in a bubble, but it isn’t over yet, when it starts to come down I’ll tell you I told you so,” wrote Kevin Brooke. Fair enough. Everyone knows that it is very hard to identify a bubble while it is inflating, and impossible to say when it will pop. So it is fair to ask why, given this difficulty, people like me insist on rattling on about bubbles in the first place. 

My answer is that allocation matters. I think that the historical correlation between very high valuations (and other frothy phenomena) and poor long-term returns is about as solid as any relationship in finance. Given this, and the fact that markets are volatile, it makes sense to try to identify extremes of exuberance and shift portfolios towards cash, at least at the margin. The long-term opportunity cost is likely to be pretty low, and you might get a chance to invest at higher returns during a rout (when you will be feeling like hell and looking for something to do).

That said, in my experience, it is never a good time to be all the way out of the US market, or even mostly out of it. Another reader, Strix Technica, quoted Peter Lynch’s great aphorism: “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” Certainly true in my case! I’ve learned the hard way that having more than, say, a fifth of my portfolio in cash creates a psychological trap where I wait for the big crash that takes forever to arrive. 

One good read

The case for people.

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