Tariff Tuesday: into the unknown

Good morning. Yesterday was rough. It began with the ISM manufacturing survey for February, which showed new orders falling into contraction after three months of expansion. This was “likely . . . the beginning of the end of the recent mini renaissance” in US manufacturing, Thomas Ryan of Capital Economics summed up. Later in the day, President Donald Trump confirmed the country will, as threatened, put heavy tariffs on Mexico and Canada today, with “no room” for negotiation. Stock indices turned down immediately; both short and long Treasuries rallied. At Unhedged, we try not to get too consumed by a single month’s data. But this month has, we must admit, been a doozy. Email us some good news: [email protected] and [email protected].

Tariffs

The market had been hoping Trump was bluffing about tariffs on Mexico and Canada. It appears he was not. Yesterday, he insisted the 25 per cent tariffs will start today, alongside a 10 per cent jump in tariffs on China. The S&P 500 fell 1.8 per cent, and the Russell 2000 small-cap index fell 2.8 per cent. Gold rose sharply.

What is it about tariffs the market so dislikes? Where exactly will the damage be? It is surprisingly difficult to say precisely.

Part of it is simply the belief that tariffs will reduce overall economic growth. The Tax Foundation estimates US tariffs on Mexico and Canada could lower long-run real GDP growth by as much as 0.4 per cent. According to the Brookings Institution, that number could be higher, depending on how Mexico and Canada retaliate.

The reality, we expect, is worse than this. Though forecasting Trump’s behaviour is a mug’s game — he seems to equate unpredictability with power and leverage — it is difficult to imagine he would put 25 per cent tariffs on Canada and Mexico and not do the same to the EU, which he really hates. And together, the EU, Mexico, and Canada made up nearly two-thirds of all US goods imports, which came to about $3tn in 2024. The changes coming to import-heavy sectors such as cars and chemicals could be significant:

Moving beyond the general impact on aggregate growth, it is hard to say exactly what the impact on corporate earnings will be. Some of the variables to estimate: how much do other countries respond? For each product, how much of the tariff are exporters to the US prepared to absorb, and how much will they pass on? How price elastic will demand for the products prove to be? How readily available are domestic substitutes? Even the companies involved struggle to estimate what the net impact on revenues and margins will be.

This uncertainty was reflected in yesterday’s stock sell-off. At the sector level, it did not look like investors were fleeing importers in particular; instead, they were fleeing risk in general.

Defensives rose, as did real estate (which is helped by falling rates) and cyclicals fell. Meanwhile the biggest loser was tech. Yes, the Big Tech companies such as Nvidia are global. But more so than, say, big industrials or materials companies? A more plausible explanation is that tech has had a great run and looks expensive, so selling was a good way for portfolio managers to bring down risk (the energy sell-off likely has more to do with Opec production increases than tariffs).

There were some tariff-driven winners and losers, of course: heavy importers including Dollar Tree fell hard. Weyerhaeuser, the timber producer that will now be competing against tariffed Canadian logs, rose sharply. But for the most part the biggest gainers are classic defensives, such as Hershey and Campbell’s and the big losers (outside of energy) were tech companies.

One of the standard clichés about the Trump administration is that it will be restrained by markets. As tariffs policy finally moves from rhetoric to reality, that idea will be put to the test.

Earnings growth: the last best news

This newsletter has in recent days turned into a dreary litany of market and economic data series that are turning south. But there is one series that has turned up recently, and decisively: S&P 500 earnings. With almost every company reporting, earnings for the index has risen by a fat 18 per cent year over year — much more than analysts had expected — the biggest gain since the post-Covid bounce of 2021.

A benign economic backdrop surely helped, but the big gain is largely a margin story. Revenues for the index expanded by a much more normal 5 per cent, about as expected, according to FactSet. Net margins expanded by 1.3 percentage points over the same quarter last year, to 12.6 per cent.

As the economy slows worries set in, strong earnings growth is good and important news. Earnings support stock prices, stock prices support sentiment, and sentiment supports the economy.

There is however, one wrinkle to the story: as earnings for the fourth quarter of 2024 have come in stronger than expected, estimates for 2025 earnings have edged down. Scott Chronert of Citi published this excellent table showing the change since the start of the year in fourth quarter ‘24 and full-year ‘25 estimates:

Notice how the cyclical stocks, particularly materials, are leading the expectations cuts for ‘25 — and the fact that financials is the only sector that has seen expectations improve, and only by a bit. These estimates will have been informed largely by the expectations set by company leadership in earnings calls with analysts. The tone of those calls has been understandably cautious, given the policy unknowns and the slowing economy, and the fact that companies like to under-promise and over-deliver. This contrast between strong performance and a worried outlook neatly sums up where markets are right now.

One Good Read

The UK in the lurch.

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