Market Brief: Trade War Escalation Rumbles Financial Markets

Financial markets are caught in the grip of a worsening selloff after Donald Trump hit Canada and Mexico with near-universal punitive tariffs and doubled existing levies on China, triggering immediate reprisals and dragging the world into a widening trade war. Ten-year Treasury yields are down another 10 basis points, North American equity markets are barrelling toward a third day of losses. and foreign exchange flows are moving toward safe havens.

After Trump said there was “no room left” to negotiate a deal, 25-percent levies on imports from Canada and Mexico kicked in early this morning, with Canadian energy products coming in for a smaller 10-percent hit. Tariffs on China went up by 10 percent, lifting the total tax burden on most Chinese products to more than 20 percent. As far as we know, there no exceptions contemplated for products—like vehicle components—that cross borders multiple times during the production process, meaning that the move could cripple a major swath of the North American auto industry, and—perversely—boost the appeal of vehicles entirely produced in countries outside the United States.

All three countries are preparing retaliatory measures. In an announcement last night, Canada said it will apply 25-percent levies on roughly $30 billion in US exports immediately, with a second round hitting $125 billion within three weeks. Beijing said it will place additional restrictions on companies operating in China, and hit US agricultural exports with 15-percent import taxes. And Mexico is expected to announce countervailing tariffs at a press conference this morning.

The Canadian and Mexican economies are expected to suffer near-immediate recessions as US demand plunges, exporters cut production and jobs, businesses halt investment, import prices climb, and consumers spend less. A range of models prepared by central banks, academics, and private sector economists suggest that exports from the two countries could be 20-30% lower and gross domestic product could be trimmed by two or three percent in the long run if tariffs remain in place—but there are many unknowable factors involved, and the reality is that investors and policymakers will face deep uncertainty for a long time to come.

Other regions could soon come into scope. If we’re correct in thinking that rhetoric on fentanyl, immigration, and trade imbalances from the president’s advisors has masked Trump’s much simpler objective—that of raising fiscal revenues—the European Union looks like the next domino to fall, given that the bloc collectively sends the largest volume of goods to the United States and therefore represents the biggest denominator for import tariffs.

It is possible that the direct impact on the American economy could be relatively limited. Imports amount to roughly 14 percent of gross domestic product and make up a relatively small share of personal consumption. Tariffs imposed during the first Trump administration—albeit much smaller in scale, executed after decades of low inflation, and timed to coincide with a raft of corporate tax reductions—slowed growth almost imperceptibly and left aggregate price indices only modestly higher.

But there are good reasons to suspect that the US will suffer self-inflicted damage. Recent experience would suggest that American importers will pass along the cost of tariffs to consumers*, meaning the measures just announced could temporarily raise the Federal Reserve’s preferred core inflation benchmark by a full percentage point or more, with a shift in household pricing psychology potentially making the impact last longer. The poorest members of American society will bear the brunt of a highly-regressive tax on consumption, and inequality will rise. Growth will slow over the long run as economic frictions increase, contributing to rising inefficiency and lower overall productivity.

The economic backdrop has changed since 2018. Post-pandemic, inflation expectations have risen, awareness of where tariff burdens will fall has increased, political polarisation has increased, equity valuations are higher, and the impetus provided by tax cuts is no longer available. It is, for lack of a better phrase, different this time.

Markets could suffer serious damage. As has been highlighted on many earnings calls already, corporate earnings could take a hit as profit margins shrink and global demand growth slows. Businesses in the auto, energy, household goods, and energy sectors could suffer a prolonged period of underperformance. Borrowing costs might rise as prices climb and inflation expectations become unanchored. And “wealth effects”—the changes in spending that accompany changes in perceived net worth—could go into reverse as households at the top of the income distribution begin to suffer losses.

Currencies are moving in counterintuitive ways as traders contemplate the second-round effects set out above. The Mexican peso and Canadian dollar are recovering after a brief selloff as expectations for US growth are revised lower, the state-managed Chinese yuan is holding firm, and the euro is still climbing on improved prospects for defence spending and common debt issuance.

This dynamic is unlikely to last if market signals fail to change the administration’s approach, Trump’s rhetorical stance hardens, and it becomes clear that the announced tariffs will remain in place for a prolonged period of time. The Canadian dollar and Mexican peso are exposed to renewed downward pressure as central banks in Ottawa and Mexico City shift in a more decisively-dovish direction, the People’s Bank of China could begin to steer the yuan lower, and the euro’s gains will almost certainly dissipate in the face of tariff threats against the Continent’s biggest exporters.

But the current upheaval could also have profoundly negative long-term consequences for the dollar. The US global security umbrella is in tatters after the administration opened a rift with its NATO allies, voted on Russia’s side at the UN Security Council, withdrew military support for Ukraine, and hit its closest allies with punitive tariffs. At the same time, a series of decisions to roll back money laundering requirements, reduce securities enforcement, and abrogate existing trade deals has diminished the perception that legal protections will prove binding on both parties to financial or trade transactions executed under US law. For better or worse, the appeal of other currencies, payment methods, and legal systems is likely to grow in the years ahead, slowly eroding the dollar’s long-standing dominance in trade deals, debt transactions, and currency reserves.

*As Warren Buffett recently put it, “the tooth fairy doesn’t pay ‘em”.

Please note: The morning Market Brief will be on hiatus between March 10 and March 21 as I take a badly-timed vacation. Try not to do anything that might trigger currency volatility. Thank you for your cooperation : )

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