Two Analogies to Explain Tariffs
From a market strategy standpoint, understanding how tariffs could impact growth and inflation is very important, because the market’s perception of those impacts has dramatically impacted performance this year. In March and April, sentiment surveys (how investors perceive the markets and economy) plunged as investors were convinced tariffs would hurt economic growth and spike inflation.
But neither have happened so far and that reality, combined with TACO (the administration reducing the impact of tariffs) has led to a substantial positive swing in sentiment, to the point where now the S&P 500 is not pricing in any chance of an economic slowdown (if it was, it wouldn’t be trading near 23X earnings and positive YTD despite a substantially higher tariff burden).
Point being, investors’ perception of tariffs matters a lot to this market, and if worries that tariffs could hurt growth or boost inflation re-surface, that will pressure stocks.
These two analogies help to explain how tariffs will impact the economy and help explain why we haven’t seen tariffs hurt growth or boost inflation, and why the Fed remains so hesitant to cut rates.
Analogy 1: How tariffs impact the economy. It’s like the economy put on a weighted vest. For those into fitness, one of the recent trends has been to put a weighted vest on to walk, run or workout. The weight of the vest has to be light enough that the person can still complete the exercises, but also heavy enough that it makes those exercises substantially more difficult.
Tariffs are essentially a weight vest on the economy. They are, at current levels, light enough so they aren’t preventing the economy from continuing to hum along. But just like with a real weight vest, the longer it stays on, the more difficult the exercises become. The longer tariffs stay in place, the harder it will be for the economy to maintain the pace of growth. And we’re likely starting to see this “tariff weight vest” begin to tire the economy via a recent dip in most major economic indicators. Again, just like a real weight vest makes simple exercises difficult after it’s been worn for a long time, so too will tariffs make growth harder and harder to achieve the longer it stays on the economy.
Analogy 2: How tariffs impact inflation. Holding a beach ball underwater. Have you ever tried to hold a beach ball underwater in a pool or a stream? It’s easy at first, but the constant pressure of air trying to rise almost always leads to the beach ball slipping out of one’s grip and breaching the surface.
Tariffs have a similar effect on inflation. They are the equivalent of inflating the beach ball. Initially, vendors and retailers are eating price increases, consumers value shopping and statistical offsets (like slowing home price increases) can keep the inflation beach ball under the surface. But the longer the tariffs stay in place, the more inflation has the ability to escape, just like how that beach ball finds the weakest point of resistance to surge to the surface.
The Fed believes we are still early enough in the tariff regime that 1) The tariff weight vest isn’t dramatically weighing on the economy (yet) and that 2) The aforementioned offset of reduced margins, value shopping, and statistical offsets are keeping that inflation beach ball submerged. But the longer the tariffs stay in place, the inevitable will ultimately occur, in that the weight vest will exhaust the economy (slowdown?) and/or the inflation beachball will escape to the surface. That’s why the Fed is warning about an inflation pop in the coming months and why it is still focused on any impacts to growth.
Bottom line, it’s undeniable that the global trade system was due for a fresh look and potential shake up as a lot has changed in the past several decades regarding global trade, and tariffs are one way to address that issue. Whether they are the best way to accomplish goals or reorient global trade is debatable, but what is not debatable is that tariffs will have a cost on growth and inflation, the only question is how much.
But just because that cost hasn’t shown up yet, it’s important not to become complacent to those risks because the longer tariffs stay in place (at current levels or higher) the more inevitable the reality that growth will slow and inflation will get boosted.
As such, we will remain more conservative in our portfolios. The clouds will clear in the next couple of months.