Trade policy continued to dominate market conversations this past week as the Trump administration’s full tariffs took effect early Thursday morning. Imports from most countries now face 10 percent levies, and some key trading partners pay much higher taxes on their exports to the U.S.; for example, goods made in China face tariffs of 30 percent. In addition, President Trump announced this week that imports from India and Brazil would be taxed at 50 percent—the former as punishment for India’s ongoing purchases of Russian oil and the latter in response to what the president considers Brazil’s unfair treatment of former Brazilian leader Jair Bolsonaro. The administration also threatened to boost tariffs on the European Union to 35 percent, up from the recently negotiated level of 15 percent, if the bloc fails to meet its commitments for investment in the United States. The overall effective tariff rate stands at 18.6 percent as of August 7, up from between 2 percent and 3 percent at the start of the year, according to the Yale Budget Lab.
To this point it has been difficult to estimate tariffs’ impact on economic growth and inflation, given the complexity of global economics, the Trump administration’s frequently shifting policies, and the effects of other key changes. For example, recently enacted tax cuts and reductions in regulation may help offset the economic headwinds from tariffs. That said, signs started to emerge in June that tariffs were having negative effects on hard economic data. Most notably, the jobs report released Friday, August 1, was much weaker than expected and included major downward revisions to previous months’ job numbers. Despite the controversy over the latest jobs report, other recent economic data has been consistent with a slowing labor market.
One key question has been the extent to which tariffs’ impacts on goods would filter into the services economy, which makes up roughly 70 percent of U.S. gross domestic product (GDP). Data out last week from the Institute for Supply Manufacturing (ISM) Services Purchasing Managers Index (PMI) showed that the services economy weakened in July as price pressures rose, indicating that tariffs may be starting to extend beyond goods and affect the services sector. (More on this release below.)
The Federal Reserve has held off on reducing interest rates out of concerns about stoking higher inflation. After the Fed’s July meeting, Chair Jerome Powell noted that the still solid economy and job market made it possible for the rate-setting committee to take a wait-and-see approach on rates. Policymakers have been divided, however: In July, Fed governors Christopher Waller and Michelle Bowman dissented from the decision to leave rates unchanged, the first time in more than 30 years that two governors cast dissenting votes.
Recent weakness in jobs data has convinced the options markets that the Fed won’t wait much longer. As of Thursday, August 7, the Chicago Mercantile Exchange’s FedWatch Tool estimated a better than 90 percent probability of a rate cut at the Fed’s meeting on September 17. San Francisco Federal Reserve President Mary Daly gave credence to that view in comments Wednesday, saying the Fed may need to cut interest rates soon to support the labor market. Daly expressed the belief that the jobs picture currently presents a greater risk than inflation. She asserted that tariffs may lead to a one-time step-up in prices rather than a persistent inflation increase—echoing some of Powell’s remarks after the last Fed meeting—and said she expects that current monetary policy and weakness in the economy ultimately will drive inflation down. “The labor market has softened,” she said, “and I would see additional slowing as unwelcome, especially since we know that once the labor market stumbles, it tends to fall quickly and hard. All this means that we will likely need to adjust policy in the coming months.”
The U.S. equity market largely shrugged off concerns about tariffs and the economy last week, rebounding from the previous Friday’s sell-off. Gains were powered by rising expectations for a September rate cut and strong earnings, especially from prominent tech companies. The earnings season has been solid overall, with S&P 500 companies’ earnings per share rising 11.8 percent year over year in the second quarter. More than 80 percent of companies posted positive earnings surprises as of August 8, with 90 percent of companies reporting, according to FactSet.
Investors seem to be betting on upcoming interest rate cuts and counting on them to counteract the drag from tariffs. We think it is too early to make that assumption. The degree of tariff impacts and how long they will take to work through the economy remain open questions. In the meantime, high equity valuations may heighten the impact any negative developments have on stock returns.
The economic and market landscape is changing quickly and unpredictably. At times of great change, it is important to remember that the financial markets are always influenced by countless variables that are in constant motion. Uncertainty is a fundamental characteristic of the financial markets, and it is central to the potential for investment growth—it is a feature of investing, not a bug. A diversified portfolio that is tailored to your particular needs, goals and circumstances can capture a wide range of opportunities and guard against a wide variety of risks without requiring you to predict them.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
