Trade War, or Will Cooler Heads Prevail?

Negotiation or retaliation—the world’s response to the surprisingly aggressive U.S. tariff announcements will be critical.

Last Wednesday’s tariff announcements from the U.S. were close to the worst-case scenario and, at the time of writing, have caused a major sell-off in equity markets and a sharp decline in bond yields.

We now know that the U.S. will impose a minimum tariff of 10% on goods from all countries, with higher charges for other trading partners: 20% for the European Union and 24% for Japan, for example, ranging up to 46% and 49% for Vietnam and Cambodia, respectively; goods from China incur a tariff of 34% on top of existing charges of 20%. Wow.

Interestingly, Canada and Mexico are exempted from the new tariffs announced last week. Separate charges on individual goods and commodities are also being levied or investigated. Economists estimate the new average tariff on U.S. imports to be around 20%—the highest level since the 1930s.

What are the likely economic effects, and how long might they last? And, most importantly, is there a method to this madness?

Growth Impact

Coming into the year, our outlook for 2025 U.S. GDP growth was 2.3%. In anticipation of higher tariffs, our core scenario had moved to 1.7% over recent weeks. Our Fixed Income team estimates that the announced tariffs could muffle growth to below 1%, and that further charges and retaliatory measures could potentially take the U.S. into recession.

If the situation does not worsen, history suggests that most of the growth impact will be felt within two or three quarters before businesses make adjustments. But those adjustments could be costly, potentially reducing long-term economic growth by a quarter or half percentage point.

At the same time, we think U.S. core inflation could climb back to 3.5%, and that creates a dilemma for the U.S. Federal Reserve. On balance, we believe the Fed will consider the inflationary effects to be temporary and focus more on growth and jobs data. The market has swiftly moved to price for four rate cuts this year, but unless we see some very poor employment data over the coming weeks, or severe market liquidity issues, we continue to think that two or three is more likely.

Negotiations

We think more tariffs may be coming on specific goods and commodities, but, for a few reasons, we consider this to be an opening position in a set of negotiations.

The first is the sheer level of the tariffs, which would cause material damage to the global economy if sustained—the U.S. Treasury Secretary indicated that they should be considered a “cap,” and invited negotiations, shortly after the announcement. The second is the apparently blunt, simplistic method used to calculate those levels. The third is the exemption of Canada and Mexico, suggesting an opening for other countries to negotiate in the same way they have done over recent weeks. And the fourth is the absence, outside of China at the time of writing, of aggressive retaliatory rhetoric and/or actions from most major trading partners.

European negotiators, in particular, appear ready to come to the table; as we write, the focus there has been on internal fiscal responses rather than retaliation. China announced additional tariffs on U.S. goods on Friday, and state media has said it will join South Korea and Japan with a response. That may be hard to sustain, however, if the U.S. begins talks with the latter two nations or the other Asian countries that now bear some of the highest tariffs.

Cooler heads need to prevail and, in the end, we think they will. A move to negotiations could help the market to shift its focus from trade policy to the tax-cut extensions and deregulation that constitute the next stages of this administration’s economic program, as well as the effects of Germany’s fiscal spending package. This potential shift of focus is a key theme in our forthcoming quarterly Asset Allocation Outlook—previewed here—which sees the Asset Allocation Committee (AAC) upgrade its view on global equities and retain its overweight view on U.S. small-cap equities. The main driver of the view on global equities is an upgrade to its view on non-U.S. developed market equities to overweight. Valuations after the sell-off support these longer-term views.

All that said, we do recognize that the range of outcomes is quite wide. Cooler heads may not prevail, and China’s retaliation could be followed by others. Even if we get negotiations, as expected, they could drag on for months. Since President Trump won the election, we have been saying that we are optimistic about growth over the longer term, but that the transition from an era of globalization to a potentially “zero-sum game” of “mercantilism and protectionism” was likely to be volatile. That is what we are now experiencing, and it is appropriate for risk premia to rise.

Earnings Downgrades

With all of this going on, some investors may have forgotten that first-quarter earnings season is kicking off this week. As Ashok Bhatia, Rob Dishner and Paul Grainger wrote last week, it will provide an abundant source of hard data about the state of the corporate world as we enter this new period of volatility.

It is notable that tariffs may already have been a factor in Q1 earnings estimates, even before the aggressiveness of the new policy was known, let alone before it takes full effect. This goes beyond a general worsening in sentiment, which we have seen in a slightly worse-than-normal set of downgrades from analysts since the start of the year.

One would expect U.S. tariffs to have the biggest negative effect where imports are a large proportion of total costs. According to Bank of America Global Research, that is the case for industries like Petroleum and Coal Products (at 33%), Motor Vehicles and Parts (at 24%), Computer and Electronic Products (at 24%), Machinery (at 21%) and Chemical Products (at 21%).

This aligns roughly with where we have seen the biggest analyst earnings downgrades over the past three months: the Materials sector (mainly chemicals) and Industrials, where Q1 earnings estimates have declined by 13.7% and 6.8%, respectively. It also matches with earnings expectations for Europe: Setting aside Energy, where earnings are expected to shrink largely due to the base effect from high profits last year, Consumer Durables is the STOXX Europe 600 sector where earnings are expected to shrink the most in Q1, with the Autos sector leading the way.

Looking at these sector exposures in the light of Wednesday’s announcement, we would also suggest that the risk to Retail has picked up, particularly the Apparel sub-sector, due to some of the most punitive tariffs being imposed on goods from Asia.

Hit to Small Caps

Another thing to note is how hard U.S. small caps sold off last week. Bank of America estimates that, in a set of bilateral trade wars, the hit to small-cap earnings could be three times bigger than the hit to large-cap earnings, assuming the same pass-through of additional costs to end consumers.

That raises a question about the AAC’s positive view on small caps and one of our key investment themes for 2025: the broadening of equity market performance beyond U.S. mega-cap tech stocks. Then again, the Nasdaq Composite Index was down heavily last week, too, as were the so-called Magnificent Seven stocks (Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta and Tesla). As of Friday morning, the Russell 2000 Index and the Magnificent Seven were both down by more than 9% since the tariff announcements.

What are earnings telling us?

As a measure of our broadening theme, we keep track of the proportion of the 163 sub-industries in the S&P 500 that are expected to have positive earnings growth over the next 12 months. The long-term median is 75%. In May 2023, it hit a trough of just over 50% and has since been rising back to the long-term average—but the momentum has stalled since the start of this year. Moreover, Information Technology is expected to be the S&P 500’s second-fastest-growing sector in Q1, despite the extraordinary growth of the past two years.

Even so, a convergence of IT earnings growth with that of the rest of the market remains the strong analysts’ consensus, according to FactSet data. A year ago, S&P 493 earnings were shrinking by 9% while the Magnificent Seven’s were growing by 52%. That gap has been steadily closing, and by Q4 this year, the S&P 493 is expected to be growing by 8.7% versus the Magnificent Seven at 13.6%.

It is also worth noting that the Computer and Electronic Products industry depends on a lot of imports, and that U.S. Big Tech is a likely target for European retaliation should negotiations hit a wall in the coming weeks. In a world of higher tariffs, that could ultimately accelerate the anticipated convergence.

Mean Reversion

Of course, we would much rather see our “broadening performance” theme play out due to a cyclical recovery in profits rather than a collapse in mega-cap tech valuations amid a general market sell-off.

Last week’s news undoubtedly reduces the likelihood of that outcome. To get back on track, it is critical that cooler heads prevail in forthcoming negotiations, and that the world steps back from the brink of an all-out trade war.

Joe Amato recently interviewed Admiral James Stavridis, NATO’s 16th Supreme Allied Commander and 15th Commander of the U.S. European Command, on the current geopolitical landscape. A replay of “The End of NATO? A Geopolitical Turning Point” is available here.