By: Reed C. Fraasa, CFP®, RLP®, AIF®
Tariffs have long been a tool used by governments to influence international trade and protect domestic industries. While they might seem like a topic best left to economists and policymakers, tariffs can have real-world economic and market implications. Understanding how tariffs work and how they might affect our financial plans is essential for making informed financial decisions.
What Are Tariffs?
Regardless of what politicians may say about tariffs, a tariff is essentially a tax imposed by a government on imported goods. There are two main types of tariffs:
Ad Valorem Tariffs: These are calculated as a percentage of the value of the imported goods. For example, a 10% tariff on $100 worth of goods would add $10 to the cost.
Specific Tariffs: These are fixed fees based on the quantity of goods imported, such as $5 per ton of steel.
Governments impose tariffs for various reasons, including protecting domestic industries, generating revenue, and as leverage in trade negotiations.
How Do Tariffs Work?
When a country imposes a tariff, the cost of the imported goods increases for businesses and consumers. This can lead to several potential outcomes:
Higher Prices for Consumers: Companies that import goods typically pass the additional cost of tariffs onto consumers, resulting in higher prices.
Reduced Competition: Tariffs can make imported goods more expensive than domestic products, potentially reducing competition for local businesses. However, this may also be an opportunity for local companies in the same industry to raise their prices and remain competitive, resulting in higher consumer prices.
Impact on Trade Balance: Tariffs can reduce the volume of imports, potentially improving the trade balance. However, if other countries retaliate with their tariffs, it can lead to declining exports. The current tariff war started by President Trump has triggered retaliatory tariffs against many US exports from our trading partners so that losses may offset any gains on the trade balance.
The Economic Impact of Tariffs
The economic effects of tariffs can be complex and far-reaching. Here are some key considerations:
Inflationary Pressures: By increasing the cost of imported goods, tariffs can contribute to inflation, as businesses often pass on higher costs to consumers. After two years of tightening to bring inflation down, the Federal Reserve recently began cutting rates. However, given the uncertainty of President Trump's tariff policy, the Fed's Chairman Powell recently indicated that they are holding steady with rates until the President commits to any policy. Uncertainty around tariffs impacts markets and long-term economic and monetary policy.
Supply Chain Disruptions: Tariffs can impact global supply chains, primarily if raw materials or components are sourced internationally. Many products imported from Mexico into the United States contain components manufactured initially in the US. This phenomenon, known as "production sharing," reflects the deeply integrated supply chains between the two countries, particularly within the United States-Mexico-Canada Agreement (USMCA) framework. It is estimated that approximately 40% of the value of US imports from Mexico is attributed to content produced in the United States. This means that for every dollar's worth of goods imported from Mexico, about 40 cents represent U.S.-sourced materials or components. A tariff on Mexico can impact US small and mid-sized companies and jobs.
Corporate Profitability: Companies that rely heavily on imported goods may experience squeezed profit margins, impacting their stock performance.
Retaliatory Measures: Trade partners may impose tariffs, affecting industries reliant on exports. The "Chicken Tax," a 25% tariff imposed by the United States in 1963 on light trucks, potato starch, dextrin, and brandy, was a retaliatory measure against European tariffs on American poultry during the "Chicken War." While most tariffs were eventually lifted, the light truck tariff remained and profoundly impacted the US automotive market. It effectively protected American truck manufacturers from foreign competition, leading to higher prices and limited consumer choices. The tariff also influenced the strategies of foreign automakers, prompting companies like Toyota and Nissan to focus on producing trucks domestically to avoid the high import costs. Decades later, the "Chicken Tax" continues to shape the US market by maintaining high prices and reducing competition in the light truck segment, demonstrating the long-lasting economic consequences of trade disputes. The EU dropped the tariffs on US poultry and replaced it with a quota limiting the amount of US poultry imports.
Jobs: Some argue that tariffs on foreign-made goods create employment in the US; however, nothing is quite as simple as it may seem. In "The Globalization Myth: Why Regions Matter," the author, Shannon K. O'Neil, discusses the unintended consequences of the 2018 US tariffs on steel. The tariffs were intended to bolster the domestic steel industry by making imported steel more expensive, incentivizing US manufacturers to buy locally produced steel, and creating US steel jobs. While the tariffs led to approximately 4,600 additional jobs in the US steel production sector, about 75,000 jobs were estimated to be lost in steel-consuming sectors, such as automotive and construction, due to increased production costs and reduced competitiveness. This data illustrates that for every job gained in steel production, approximately 18 jobs were lost in downstream industries. This outcome underscores the complex and often unintended consequences of protectionist trade policies on the broader economy.
Impact on Investment Portfolios
Tariffs can influence investment portfolios in several ways:
Equities: Companies in industries directly affected by tariffs, such as manufacturing or agriculture, may see stock volatility. Additionally, consumer-facing businesses could struggle if tariffs lead to higher prices and reduced consumer spending.
Bonds: Tariff-induced inflation can affect interest rates, potentially leading to volatility in bond markets. Rising inflation could prompt central banks to increase interest rates, which typically hurts bond prices.
Commodities: Tariffs on raw materials can affect commodity prices. For example, tariffs on steel or aluminum can influence the construction and automotive industries, impacting commodity investments.
International Investments: Tariffs can affect currency exchange rates and the economic stability of trade partners, influencing international equities and bonds.
Increased Uncertainty: The current market volatility results from the uncertainty around the talk of tariffs. By announcing tariffs one day and lifting or changing tariffs a few days later, businesses and monetary policymakers cannot plan. Also, traders make quick decisions on buying and selling based on the most current information available, and that information has been very chaotic. The result will be continued market volatility until a consistent, clear tariff policy is implemented, if any.
How to Navigate Tariff-Related Market Volatility
Investors can take several steps to manage potential risks related to tariffs:
Diversification: A well-diversified portfolio can help mitigate risks associated with specific sectors or regions affected by tariffs.
Focus on Quality Investments: Companies with strong balance sheets and diversified supply chains may be better positioned to weather tariff impacts.
Monitor Policy Changes: Staying informed about potential tariff changes can help investors anticipate market reactions.
Conclusion
While tariffs are often a political and economic tool, their impact on investment portfolios can be significant. By understanding how tariffs work and taking proactive steps to manage potential risks, investors can better navigate market volatility and maintain a balanced investment strategy. If you have questions about how current or potential tariffs might affect your portfolio, please reach out for a personalized review of your investment strategy.
Arnold J. Toynbee said, "The greatest lesson of history is that we do not learn from history."
As always, a thoughtful and well-informed approach to investing can help you achieve your financial goals, regardless of market conditions.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.