Update on Tariffs

Back from the brink? Plus thoughts on interest rates, tax policy, financial markets

Events have moved fast and furiously since my last post (“Why Wall Street Hates Tariffs”). This post is designed just to be a quick update to ground these events within the framework I laid out.

Understanding anti-tariff bias

First, we have to remember that the establishment is highly biased against tariffs and Donald Trump, so we have to ground ourselves in an understanding that whatever is happening is not as bad a portrayed in the media, academic writings, market commentary, economic forecasts, etc. The financial markets, on the other hand, are more rational, but have a rational bias against tariffs that I described in my post. Watch what the markets do and take commentary with a grain of salt.

Strategy vis-a-vis China

The thesis of my piece was that economically the tariffs weren’t the end of the world, as long as there wasn’t escalation. Over the past couple of weeks, the only country against whom the U.S. was engaged in escalation was China. There were reports that exports from China to the US were grinding to a halt. The reason for this would be that the tariffs were too high…but also that because they were too high, they would almost certainly come down. Why pay 145% tariffs now when they would likely be substantially lower in a few weeks?

Then bam!, tariffs on China were lowered to 30%. This seems like quite a comedown and it’s not clear what the strategy is beyond tactical retreat (which is a fine reason, by the way). China remains a bad actor on trade that needs to reform it’s whole economic system to be a constructive participant in the global economy. I expected the new China tariff to be 50-80%, a level where goods would still flow and tax revenue would get collected, but substitution effects would encourage both buying from other countries and reshoring manufacturing to the U.S. Maybe 30% will have the same reforming effect, but certainly the lower level will substantially revive the flow of goods and capital between the U.S. and China and the markets were pleasantly surprised, to put it mildly. I assume Treasury Secretary Bessent’s original idea of ratcheting tariffs up over time to seek concessions is now the operative plan. If the path of tariffs is gradually up from here, economic activity will get pulled forward, rather than being held back as was the case a few days ago.

Recession or no recession?

I’ve been skeptical of the idea we were destined for recession unless there was a complete breakdown in trade between China and the U.S. Now that we should expect trade to resume, the recession risk is likely off the table. While DOGE and the tariffs are fiscally contractionary, now Congress is rolling out fiscal expansion via tax cuts and continued deficit spending. Further deregulation will also be pro-growth. The tariffs create improved terms of trade for the U.S. and will create pro-U.S. substitution effects at the margin, and now we can pivot back to focusing on the great AI infrastructure and energy buildout.

What about interest rates?

Key to my investing framework is that the Kondratiev Wave that began with the last trough just after World War II troughed during the Covid Era in 2020-2021 and the long term low for interest rates is in. The Covid Era stimulus (giant deficits monetized by the Federal Reserve) reflated the economy the same way the WWII spending ended the depression and started the new upwave. As a result, both economic growth and inflation should retain more upward pressure than expected, and interest rates will remain in “higher for longer” mode.

I do not think tariffs are “inflationary” in the monetary policy sense. Tariffs are deflationary in that they are a tax on demand and they slow the supply of overseas credit to the U.S. The Federal Reserve seems to understand this, but they are waiting to see how economic growth plays out before taking any action. They’ve gotten away with remaining restrictive on policy for longer than expected because of the continued strong economic growth momentum. Inflation risks are now more persistent than they were pre-pandemic because of the Covid reflation, not because of tariffs. Either way, we end up in the same place…fewer cuts than expected over the next 12-24 months.

Tax cuts to the rescue?

The House revealed the first look at the GOP tax blueprint and it extends current individual tax rates, adds narrowly-tailored tax breaks on tips, overtime, state and local taxes and auto loan interest for the duration of Trump’s term, and curtails some green energy tax breaks among other offsets. Overall, beyond keeping the status quo in place on individual and corporate taxes the new stimulus shifts money from rewarding green energy to rewarding hard work (especially the breaks on tips and overtime). It’s a bit complicated and messy for my taste, but overall stimulates the economy and has substantial benefits for the working class. Not a game changer, but net positive for GDP.

The big remaining debate appears to be over the allowance for the SALT deduction. An obvious solution to finding more room for tax cuts would be to write the 10% baseline tariff into law and / or to formalize the DOGE cuts. Why these aren’t in the law is beyond me.

Net effect for the financial markets

Clearly the next 90 days will continue to be uncertain on trade and tax policy. Tax policy is likely to be net positive, but pretty much as expected. Trade policy will be uncertain as negotiations play out, but at this point, tariffs are highly unlikely to be higher than those imposed on Liberation Day and its immediate aftermath, and the market reaction that level is now known. Most announced deals will be viewed as a positive and most countries will likely want to cut deals.

If the dollar weakens, that is generally positive for nominal corporate earnings, although the friction caused by tariffs within multinationals’ income statements is not yet quantified. Buoyant earnings combined with solid GDP growth should be constructive for equities near term, but upside is capped by high valuations.

If interest rates are “higher for longer”, then the value in the markets is more in the fixed income arena: short and intermediate term treasuries and munis, TIPS, high grade mortgages and ABS, floating rate debt…not for price appreciation but for income and principal preservation. Credit and commercial mortgages may be ok for now, but are likely to be particularly vulnerable in the next downturn.

Note I am not providing financial advice, please consult your own advisors before making investment decisions.