Assessing the impact of escalating trade tensions

The U.S. has paused newly announced tariffs for most countries for 90 days, just hours after they took effect and unleashed volatility almost on par with the biggest market shocks of the past few decades. President Donald Trump suspended the extra “reciprocal” tariffs on all countries except China, now facing tariffs of at least 145%. The 10% universal tariff remains. Trade tensions with China are deepening, and significant uncertainty remains. Yet the pause suggests that the U.S. administration is taking some account of financial risks and costs as well as a country’s willingness to engage, putting a check on a maximal stance during the negotiations. As a result, we extend our tactical horizon back to six to 12 months from three months to dial up risk.

This is a major development, particularly in easing the near-term risk of a financial accident. Yet we need to brace for unpredictable negotiations, and the U.S. is still likely to end up with much higher tariffs than we expected a few weeks ago. We estimate the average effective tariff rate is now around 20%, even with the pause. We see three primary types of U.S. tariffs. First, tariffs on strategic sectors to support reshoring of activity — so far, 25% levies on autos and parts, and on steel and aluminum, with sectors like lumber, semiconductors, pharmaceuticals and copper likely next. Second, a universal 10% tariff on most imports to generate revenue and aid domestic production. Third, country-specific tariffs on roughly 60 nations with goods trade surpluses with the U.S., intended to provide negotiating leverage to reduce imbalances.

U.S. tariffs add to inflation, and ongoing uncertainty is raising the risk of a recession. Prolonged policy uncertainty may weigh on corporate capital spending and delay longer-term commitments. Consumer spending could be hurt by any erosion of wealth and real incomes. The dented confidence of foreign investors in the U.S. could curb their appetite for U.S. assets. For China, we see tariffs lowering growth – and potential policy stimulus only partly offsetting that drag.

We cautiously lean into risk and shift our tactical horizon back to six to 12 months from three months. We up equity exposure, including to U.S. and Japanese stocks. Yet we expect ongoing volatility and potentially sharp reversals. Selectivity across sectors and securities will be key, and we are wary of chasing momentum. We see opportunities in U.S. technology and global banks, especially European, hurt by the broad-based selloff. Long-term U.S. Treasuries have failed to offer ballast during the stock selloff against a backdrop of persistent budget deficits and sticky inflation. We favor gold as a portfolio diversifier.

The significant escalation in trade tensions this week and extreme trade policy uncertainty has triggered a broad risk asset selloff. The S&P 500 is down 10% in just two days and U.S. high yield credit spreads – that had been resilient to the initial equity pullback – have widened sharply this week. Both have seen their largest moves since the 2020 pandemic shock. These losses are happening even as U.S. economic fundamentals remain solid, underscored by today’s strong U.S. jobs report.

We expected risk assets would remain under pressure until uncertainty starts to dissipate. But this week’s developments suggest pressure could grow – and it is now less clear over how long or short a period policy uncertainty could cloud the outlook. We now expect a bigger growth drag and inflation boost. Many countries are preparing responses to U.S. tariffs. China has kicked off with 34% tariffs and other measures, including export controls. Yet the full set of international responses and country-by-country negotiations with the U.S. will take time, making it hard to have visibility on when and how this will settle. Major wealth destruction could hurt sentiment and spending. Contrary to markets, we do not see the Federal Reserve being able to offer much of a response.

We still believe U.S. equities will eventually reclaim global leadership. But for now, this week’s developments lead us to reduce risk and shorten our tactical horizon to three months. If clarity comes quickly, we would up risk-taking again. Shortening the horizon means giving more weight to our early view that risk assets could face more near-term pressure, so we reduce equity exposure and allocate more to short-term U.S. Treasuries that could benefit as investors seek refuge from volatility. We stay underweight long-term Treasuries given persistent U.S. deficits and sticky core inflation – even before the impact of tariffs. Federal Reserve Chair Jerome Powell today stressed the importance of price stability, reinforcing our view that market pricing of four to five Fed rate cuts this year is overdone. We think gold can serve as a better return diversifier in this environment.

While we are more cautious about broad benchmarks, sharp selloffs and market dislocations are already creating opportunities for security selection. We still see mega forces such as artificial intelligence driving returns. U.S. policy shifts are spurring fiscal spending globally. In Europe, Germany’s €1 trillion package for defence and infrastructure investment is creating opportunities in the defence sector. We don’t think the growth and earnings outlook yet supports sustained European equity outperformance but a broader macro opportunity could emerge if the EU finds a way to jointly issue bonds to fund investment across the bloc, as it did in the pandemic.

The U.S. has sharply escalated its trade protectionism. A new 10% tariff has been announced for most U.S. imports, alongside higher duties across dozens of countries including China and the European Union – due to come into effect over the next week. Canada and Mexico have been spared new levies for now. The key? How long these elevated tariffs last, any retaliation and the impact on growth, inflation and companies.

The dust is still settling on the details, with various interpretations on the amounts involved. We think they add up to a U.S. average effective tariff rate of 20-25% – a level not seen for at least a century. That is the ceiling for where it will ultimately settle, in our view. But we think negotiations between the U.S. and other countries will eventually bring it down. We had expected a 10%landing zonebut now think it could be higher. If much higher, the drag on growth and boost to inflation over the next two years could be sizeable. If tariffs stay fixed at the rates announced, we think U.S. stagflation and a global recession cannot be ruled out.

Also key is how long historically high U.S. policy uncertainty persists – the longer it does, the greater the potential damage to economic activity. We think trade policy uncertainty will peak in the next couple of months, with retaliation, legal challenges or selective rollbacks potentially ahead – and market adjustments to incoming news.

That points to more volatility to come – and ongoing near-term pressure on U.S. equities and risk assets. Yet we see a path for U.S. equities to resume their global leadership over our six-to-12-month tactical horizon. We think trade policy uncertainty will dissipate and other potential policy positives could come to the fore, including a continuation of the 2017 tax cuts and deregulation. Even if sentiment is weakening, we still see solid U.S. corporate and economic fundamentals, though the odds of hard-landing scenarios have risen. Our base case? Slower growth and sticky inflation, not recession. We will be watching the Q1 corporate earnings season to see how companies plan to adapt to tariffs. Assessing the sector impact will be key and highlights why this environment favors taking an active and dynamic approach with portfolios, in our view.

We stay neutral emerging market equities and think the U.S. tariff impact will differ by region: we see Latin America holding up better than Asia. We lean against market pricing of nearly four Federal Reserve quarter-point rate cuts this year: U.S. core inflation is tracking well above the Fed’s 2% target, even before this round of tariffs. We stay underweight long-term U.S. Treasuries given the challenging fiscal and inflation outlook and like quality credit for income. We prefer gold as a portfolio diversifier.