Potential impact of tariffs weighing on markets, corporations

Raymond James CIO Larry Adam looks at how the proposed tariffs may impact the economy and financial markets.

To view the full article in PDF format, see the Thoughts on the Market publication linked below.

The United States proposed sweeping tariffs on imports from America’s top three trading partners – Mexico, Canada and China – and the equity markets likely will experience volatility until their impacts are known.

The U.S. announced plans to place 25% tariffs on imports from Mexico and Canada, with the exception of energy commodities from Canada at 10%, and a 10% tariff for imports from China. The measures were set to take effect on February 4, but the tariff on Mexico was delayed by one month after Mexico agreed to reinforce the border against drug trafficking with 10,000 National Guard members.

Combined, the three countries account for $1.4 trillion in U.S. imports, equating to 45% of all U.S. imports.

As markets and corporations digest the impacts of tariffs Raymond James Chief Investment Officer Larry Adam anticipates volatility will be elevated in the coming months.

“As we noted coming into the new year, the market was priced to perfection, with elevated valuations and overly optimistic investor sentiment making it vulnerable to any disappointing news on the economic, earnings or policy front,” Adam said. “The swift and sweeping actions taken by the new administration over the weekend highlight that volatility will remain elevated, particularly in the near term.”

Despite tariffs, Adam expects economic and corporate fundamentals to remain solid and remains confident in his committee’s year-end S&P 500 target of 6,375, though the path may not be a straight line.

To enact the tariffs, President Donald Trump invoked the International Economic Emergency Powers Act (IEEPA), a 1977 federal statute granting the president extensive powers to address national emergencies. While the act has not been used to enact tariffs before, President Donald Trump sees it as within his legal authority to address a national emergency, fulfilling his campaign promises to stop illegal immigration and the flow of narcotics across borders.

Looking at our economic and market views

Volatility

Overoptimism among investors has been previously pinpointed by Adam's team as the biggest market risk, with many overlooking potential threats, particularly those originating from Washington. Specifically, they highlighted the market's underestimation of the potential impact of tariffs. Investors perceived these tariffs as a mere negotiation tactic rather than considering the significant economic ramifications of their implementation. As the market and corporations begin to digest these impacts, they anticipate that volatility will remain elevated over the coming months. This period of adjustment will be crucial as the true effects and magnitude of these policies become clearer, influencing their economic and asset class outlook.

Economy

The economic impact of tariffs will depend on their extent, duration and potential escalation into a trade war. If they are implemented for the entire year, Adam anticipates they could generate $150 billion in revenues, cost the average household around $1,000 and reduce GDP growth by 0.5 percentage points, though some estimates are higher for all three figures.

The proposed tariffs will affect prices for a wide range of products, especially autos, fuel, food and consumer electronics. The U.S. imports heavily from its neighbors, with machinery and automotive products being significant categories. The integrated supply chain in North America makes it challenging to disentangle cross-border relationships.

While tariffs negatively affect all economies involved, the U.S.'s diversified economy and strong dollar may help cushion some impacts. Canada and Mexico might face significant challenges sooner, potentially leading them to negotiate earlier.

Fixed income

This weekend’s tariff announcements have triggered a flight to quality in the bond market, with Treasuries benefiting as riskier assets come under pressure. Further weakness in equities could drive Treasury yields lower and reverse the recent steepening trend.

While it is still early to determine the full impact, the initial moves in Treasury yields appear rational. The policy-sensitive 2-year Treasury yield jumped to 4.28% as the potential inflationary impact from tariffs could see the Fed remain on hold longer than expected. Market expectations for the first Fed rate cut in 2025 have been pushed back to July, with fewer than two rate cuts now priced in by year-end. However, longer-maturity yields have modestly declined to ~4.5% as tariffs are likely to lead to tighter financial conditions (e.g., a stronger US dollar, softer equity prices, wider credit spreads) and weaker growth.

With the news still unfolding, Adam is reluctant to change his team's year-end views on the 10-year Treasury and expect it to remain rangebound between 4% and 5%, ending the year at 4.5%. They will closely watch the duration of the tariffs and their impact on consumers, as this will significantly affect growth and inflation dynamics. The Fed’s reaction will also be key.

While assessing the impacts is challenging due to many unknowns, the recent tariff announcement should keep volatility elevated, particularly given the current macro backdrop, debt ceiling negotiations, and the upcoming quarterly refunding announcement. From a technical perspective, we are watching the crucial 4.5% threshold. A break below this level on the 10-year could see yields fall back towards 4.25%, closer to the 200-day moving average.

Equity market

In the U.S equity market, corporate fundamentals remain solid, as evidenced by the 4Q24 earnings season, and overall revenue exposure to tariffs is fairly limited. The S&P 500 receives only 1%, 1%, and 7% of total revenues from Mexico, Canada, and China, respectively. No sector derives more than 5% of revenues from Mexico and Canada, though consumer staples, energy and materials have the most exposure.

The biggest impact could be on input costs and earnings. With valuations already stretched, earnings growth needs to drive the market higher over the next 12 months. If businesses cannot pass tariff costs onto consumers, it could pressure earnings through weaker margins.

Volatility is a natural part of the market. Historically, the S&P 500 experiences three or four pullbacks of 5% or more annually. With only two pullbacks in 2024, an uptick in volatility would not be unusual.

Bottom line: No changes to our forecast as of now

Given the fluid situation, it is too early to change assessments on the economy and different asset classes noted Adam. His team will remain alert to the potential fallout on growth, inflation, earnings, and the interest rate outlook from a wider or extended trade war if that is where the situation is heading.

During periods of heightened uncertainty, it is important for investors to maintain perspective and realize that volatility is part of the market's fabric. Investors should stay focused on their long-term objectives and avoid making decisions based on every twist and turn in the market.

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