Donald Trump started his Presidency with a whirlwind of executive orders making good on a number of his campaign promises. Most of them have had limited economic relevance, until President Trump signed an executive order implementing 25% import tariffs on Mexican and Canadian goods and a 10% tariff on Chinese goods. This will have a real and immediate economic impact.
For instance, in 2023, Canada exported goods worth approximately US$439.6 billion to the United States while Canada was the top country the U.S. exported goods to last year, valued at $322 billion, followed by Mexico and China.
Although Trump administration officials said the tariffs were designed to stop the flow of fentanyl and undocumented immigrants, they gave no specific benchmark for the new import taxes to be lifted other than the cessation of the drugs and undocumented immigrants coming into the country.
Canada responded by announcing similar 25% tariffs on a wide range of U.S. goods and agricultural products. As Canada is a major market for U.S. farmers and mid-size manufacturing companies, this will especially hurt the mid-west states. Mexico also announced that it will respond by implementing tariffs, as did China.
However, before the tariffs went into effect both Canada and Mexico agreed to a number of concessions, including sending more troops to the border, which convinced Trump to postpone the tariffs by 30 days. The key question is whether tariffs are a key part of his negotiation tactic or that he truly wants to build a tariff wall around the U.S.
If the tariffs are eventually implemented, fuel, fresh produce, consumer electronics, some of the top goods the U.S. imports from Mexico, China and Canada could get more expensive with blanket tariffs. That means American consumers could pay a lot more for a wide range of goods.
Various estimates of the cost of imposing 25% tariffs generally range from a decline in GDP from its previously projected path by 1-2% in the U.S., about the same in Mexico, and roughly twice as much for Canada. The greater impact on Canada reflects its greater dependence on the U.S. as a purchaser of its exports.
This means it will be hard for Canada to quickly find new export markets. At the same time, it will mean for U.S. consumers that prices of cars and likely fuel will rise.
The fact that Canada and the U.S. are closer in economic standing has resulted in greater integration than with Mexico, which is still largely a source of cheaper labor, in competition with China and others.
On a macro level, the U.S. economy is composed of 90% services and those will not be impacted much by the tariffs. So, initially the impact on U.S. growth will be limited.
The impact of tariffs on inflation is similar to a one-time price shock, so it will not necessarily affect the long-term inflation expectations. If anything, the long-term expectations could come down, as import tariffs on both sides typically simply lead to less trade. This was illustrated by the fact that 10Y Treasury yields came down after the tariff announcement.
Tariffs are typically not leading to more income for the importing country but simply less trade and therefore less economic activity. As the U.S. is still growing at a solid 2.3% pace, tariffs may slow, but not derail, the U.S. economy. Canadian GDP growth has been weaker, which is why Trump feels he has the leverage to gain new concessions from Canada ahead of the review of USMC next year.
Meanwhile, Mexico has already seen a devaluation in the peso over the past year by roughly enough to offset the 25% tariff. In essence, Mexican export firms by largely maintaining dollar prices have been building in fatter peso margins that could be narrowed to maintain sales volume. Meanwhile, the rest of Mexico has already seen peso prices for U.S. imports rise, and some local producers have gained sales as Mexican production prices became cheaper for US consumers.
There is nothing new in devaluation to reset a trade balance. The UK devalued the pound by roughly 25% as it dealt with Brexit. Japan’s yen has fallen significantly in recent years as it deals with competition from China. The Euro has been leading the most recent currency weakness, as it prepares for a 10% tariff which has not yet been levied.
Interestingly, China’s yuan has been among the strongest performing currencies, gaining on most except the dollar. This largely reflects China’s widely diversified export base, which means it has lots of places to go with exports no longer wanted in the U.S. True, China is one of the U.S. largest trade partners with $427 billion in exports headed our way in 2023, but that was just 2.2% of their economy. By comparison, Mexican exports to the US are 25% of their GDP and for Canada, 20%. Germany and Japan both export 3.3% of their GDP to the US. South Korea is 6%, Taiwan 10% and Vietnam 20%. A 10% tariff on China’s exports would cost around 0.5% of their GDP, far less than the impact for Canada and Mexico.
- U.S Growth is Solid… For Now
- Q4 Corporate Earnings
- The AI Gold Rush
- The Fed Enters Wait-And-See Mode
- Treasuries as a Portfolio Hedge
- DOGE Spending Cut Goals
- Japan Runs Hot
- International Equities to Outperform
- Our Portfolio Positioning
U.S Growth is Solid… For Now
U.S. economic activity remained robust in the fourth quarter, with nominal GDP growing by 4.5%, and S&P 500 earnings on track to grow by double digits year-over-year.
Adjusted for inflation, the U.S. economy grew at an annualized rate of 2.3% in the fourth quarter. Though the pace of growth slowed from 3% to 3.1% in the second and third quarters, real final domestic demand, which excludes inventory adjustments and net exports, grew by 3.2% as the U.S. continued to exceed its estimated 2% long-run potential trend rate by a comfortable margin. The soft-landing consensus is as solidly entrenched as the recession consensus was two years ago.
What could go wrong? Growth is decelerating but robust, despite still-restrictive monetary settings, inflation is receding and will continue to fall, and Fed rate cuts are coming once the inflation genie is back in the bottle. Plus, a more business-friendly administration has moved into the White House.
The trouble may be that things are too good as it is very difficult for an economy to remain at full employment. Too much acceleration risks overheating, forcing central bankers to tighten policy to counteract inflation pressures, slowing economic expansion. Too much deceleration and unemployment will start rising sharply. The problem is that tariffs can weaken growth while strengthening inflation.
While Q4 U.S. GDP slowed down to 2.3% annualized growth from 3.1%. The weakness was mostly driven by inventories. Consumer spending beat estimates and accelerated to 4.2% from 3.7% in Q3, as domestic demand remains strong.
The GDP report confirms recent trends. Consumption is holding up, housing has likely bottomed but has limited upside, and capital investment remains subdued due to policy uncertainty. The U.S. economy is at a pivotal point, where a re-acceleration of growth would likely ignite inflation, yet a deceleration would translate into higher unemployment. The latter scenario is more likely, as the tightening in financial conditions from higher bond yields will weigh on growth and employment, leading to softer consumption. In other words, headwinds loom for the cornerstone of U.S. economic growth.
Despite all these risks, and the inevitable volatility in markets because of the uncertain outcome of all the new Trump policies, we should keep in mind that positive outcome surprises are also possible. The new decision makers are unorthodox and apparently bent on provoking animus but perhaps a different approach will pay dividends. We are open to the idea that the new regime’s bravado, willingness to challenge the status quo and growth orientation could inspire consumers and businesses and spark an upward inflection in economic activity and equity markets.
Q4 Corporate Earnings
The fourth quarter U.S. corporate earnings have been quite strong with 32% of S&P 500 companies having reported, 74% are beating Q4 earnings and 62% are beating revenue estimates.
Roughly 52% of companies have had double beats, i.e. sales and net income, while only 16% have had revenue misses and earnings misses. Notable sector standouts in terms of earnings beats so far include Communication, Technology and Financials.
As it relates to the Magnificent 7, earnings surprise was well ahead of the S&P 493 (5.7% vs. 3.9%) though revenue surprise was underwhelming (0.1% vs. 1.3%). Magnificent 7 companies continued to report far stronger earnings growth (16.0% vs. 8.4%) and revenue growth (8.6% vs. 3.9%) overall compared to S&P 493 companies that have reported so far.
Earning expectations are much higher this year than last year, which could lead to negative surprises later in the year. In addition, tariffs pose downside risk to S&P 500 earnings estimates and return expectations. If company management teams decide to absorb the higher input costs, then profit margins would be squeezed. If companies pass along the higher costs to its end customers, then sales volumes may suffer. Firms may try to push back on their suppliers and ask them to absorb part of the cost of the tariff through lower prices. We estimate that every 5%-points increase in the U.S. tariff rate would reduce S&P 500 earnings-per-share (EPS) by roughly 1-2%. As a result, if sustained, the tariffs would reduce S&P 500 EPS forecasts by roughly 2-3%, not taking into account any additional impact from major financial conditions tightening or a larger-than-expected effect of policy uncertainty on corporate or consumer behavior.
The AI Gold Rush
The generative AI ‘gold rush’ has had a powerful effect on the U.S. equity market over the past two years, and this may continue until either a U.S. recession emerges, major U.S. action on trade occurs, or there is a meaningful shift in the narrative about AI and productivity.
The news that DeepSeek had built a high-quality open-source AI model more cheaply than previously thought possible highlighted how difficult it might be for individual companies to monetize AI even if it eventually drives a step-function move higher in productivity. DeepSeek’s claim that it succeeded without massive capital expenditures on the most advanced chips or training protocols caused investors to reassess the moats around specialized chip designers and AI model builders. Drawing a bead on the stocks of go-go power providers, it also claims that its model requires vastly less power to run than the state-of-the-art US models that inspired the datacentre construction spree. The dust has not yet settled, and it is too soon to say if the DeepSeek news will mark a top for the highest-flying AI-connected companies.
The Fed Enters Wait-And-See Mode
Despite Donald Trump expressing his desire for lower interest rates, the Federal Reserve kept rates on hold in its 4.25%-to-4.5% range, as expected in its January meeting. The main change in the FOMC statement was the removal of the reference to progress towards the Fed’s 2% target, leaving instead a simple mention that inflation “remains somewhat elevated.”
While Chairman Powell indicated that inflation would not need to be back at 2% to start cutting again, he was very noncommittal towards a possible March rate cut. The focus of a lot of questions surrounded policy changes, especially tariffs. Powell refused to offer specific policy responses, as tariffs would weaken growth while strengthening inflation. Tellingly, Powell reiterated he sees policy as restrictive, and thinks it is currently well-calibrated.
The initial reaction to the statement was a cross-asset selloff, with equity and bond futures plunging. But, as usual, the press conference was more dovish than the statement. Specifically, Powell downplayed the wording changes, which helped stocks and bond rally.
Treasuries as a Portfolio Hedge
In recent weeks Treasury yields came down to 4.5%. We expect yields to stay near current levels in the short-term. And there is still a risk that yields will spike higher on concerns that the Trump administration’s spending cuts may not offset planned tax reductions, which could lead to higher fiscal deficits.
Looking further ahead, we think it is more likely that yields will trend down as economic growth slows. Investors can lock in high yields and benefit from an increase in the market value of bonds as rates gradually decline.
Any further increase in long dated Treasury yields will likely elicit a negative stock market reaction. Yet, it may be the final capitulation moment and a good tactical entry point for Treasuries; especially if the bond market starts anticipating again more Fed rate cuts for 2025 and 2026.
In our view, Treasuries are now regaining their historical role as portfolio diversifiers and can act as a hedge for investors if equities experience volatile episodes in 2025.
DOGE Spending Cut Goals
The fight over a new round of tax cuts in the next budget reconciliation bill will likely happen in May. Trump will push for more tax cuts while promising to pay for that by increasing federal revenue through tariffs and by cutting federal spending significantly.
The problem is tariffs typically generate a lot less revenue than expected as trade flows will change in reaction to tariffs.
In relation to spending cuts by the newly established Department of Government Efficiency (DOGE), Bank of America (BofA) raises the question of whether the US government is in fact too big. It notes that relative to other G7 nations, the US government has by far the lowest expenditure to GDP ratio, which suggests the US does not have a spending problem. At the same time, however, its government revenue is also the smallest relative to GDP. As a result, the US has the second-largest deficit in the G7, just behind Italy.
As to how much DOGE can save, the department’s aim to save $1-2 trillion or 3.5-7% of GDP is unrealistic, according to BofA’s Head of Federal Government Relations. While it is early days, BofA believes $150-300bn is a more reasonable assumption. In any case, spending cuts are likely to arrive no earlier than FY2026 and will go up against interest expense increases of $100bn per year and increases in Social Security and Medicare Outlays due to an aging population. BofA forecasts a significant total fiscal deficit of 6.4%/7.1% of GDP in 2025/2026.
It will be a much harder to significantly reduce government expenses, also because a large part of government spending in the U.S. is not federal but at the state and local level. And DOGE will not have any jurisdiction over that.
Japan Runs Hot
Japan’s economy is running hot for the first time in decades. The BoJ recently hiked its base rate to a 17-year high of 0.50% and signaled that more monetary tightening is coming. The Tokyo CPI, which gives an advanced read of national price pressures, suggests inflation will keep accelerating while remaining above target. The labor market also remains strong, sustaining wage pressures.
We think Japanese equities will continue to perform and we favor Japanese dividend paying stocks with more of a domestic focus to profit from potential yen strength.
International Equities to Outperform
We are still positive on equity markets. Corporate earnings are solid and the economic cycle in the U.S. is still solid. Despite the focus on U.S. policy actions, we think there is a good chance that international equities will outperform the U.S. this year. Equity market valuations are much lower as expectations for European and Chinese markets are subdued. However, we still think the possibility of positive economic surprises is much higher outside the U.S. For example, Europe could get its act together and stimulate its economy to reform its industrial sector and the German federal elections this month could be pivotal for that. China could surprise by unleashing more fiscal support. It is possible that new trading pacts will be formed between countries to counter the threat of U.S. tariffs, which will boost international trade. And potential ceasefires in the Middle East and in Ukraine would be positive for Europe and Asia.
Next to that, we could see a weaker US dollar this year after rising for almost 14 years. Interest rate differentials will become smaller and the U.S. could actually actively try to depreciate the dollar, as that would be a more effective method to bring down the trade deficit than implementing tariffs. A weaker dollar would boost the return on international assets as well.
Our Portfolio Positioning
Despite the uncertainty, we think there could be more upside in equity markets, but we will see volatility, especially in the first half of the year when it becomes more clear what Trump’s key priorities are.
At the same time, an allocation to traditional fixed income and private credit will offer diversification benefits to portfolios.
We favor global diversification to deal with unexpected surprises this year, even though some of them could very well be positive surprises, especially for international equity markets. As such, we think international markets can outperform the U.S. in 2025.
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