US tariffs are likely temporary measures intended to extract concessions from trading partners. Unless we see signs of trade policies causing deeper economic damage, staying invested in a portfolio of diversified risk assets remains the right approach.

Since his inauguration, President Trump has reignited trade tensions with a list of new tariff measures. He has imposed 25% tariffs on most goods from Canada and Mexico, while tariffs on Chinese imports have been increased from 10% to 30%. Trump also plans to impose tariffs on specific industrial sectors and has introduced the concept of ‘reciprocal tariffs,’ which aims to match the tariffs imposed by other countries on US goods. While Trump’s tariff playbook is hardly new, its impact on financial markets and the economy is far more nuanced than the splash it generates in news headlines. To better understand the implications of Trump’s latest tariffs, we examine three factors to determine whether Trump’s tariff measures are significant or simply noise.

Larger tariffs, larger impact

Tariffs can impact the economy in several ways. At the micro level, they increase costs for businesses that rely on imported goods, potentially leading to higher prices for consumers. At the macro level, prolonged tariffs battles can slow global trade and dampen economic growth. The severity of these effects depends on how broad the tariffs are, how long they last, and whether other countries retaliate. A brief tariff skirmish may create short-term market volatility but have limited economic disruption. In contrast, a full-scale trade war, with retaliatory tariffs by trading partners could significantly weaken the economy pushing it towards a recession.

Will tariffs push the US into a recession?

For investors, major stock market downtowns have historically stemmed from economic contractions, not political manoeuvres. Since 1928, nine out of ten S&P500 declines of over 15% in a year were linked to recessions or wars, while the 2022 drop followed aggressive Fed tightening. The sharp sell-off in US stocks in Q4 2018, fuelled by fears of a Fed policy mistake and escalating trade tariffs, underscores how economic uncertainty can unsettle markets even without a recession.

The recent softening in economic data, with the Atlanta Fed’s ‘GDPNow’ real-time growth indicator projecting a 2.8% contraction in 1Q 2025, reflects concerns that tariffs could further weaken demand, discourage investments, and slow hiring, even as unemployment at 4.1% remained below the Fed’s long-term rate. The good news is oil prices are declining. It is hard to have a recession when energy prices decline. Long term yields are also moving lower, reducing the cost of debt financing. The Dollar is weakening, a positive sign for global risk appetite. Expectation of rate cuts by the Fed have also risen, which will help mitigate the risks of a slowing economy.

Could a trade war spark a financial crisis?

Financial markets tend to react sharply to uncertainty, but volatility alone does not equate to systemic risk – one having market-wide impact. Financial crises tend to occur when stress in the financial system spills over to the broader economy. The 1997 Asia financial crisis and the 1998 collapse of US hedge fund Long-term Capital Management triggered market selloffs but did not lead to a US recession. The 2011 European debt crisis rattled global markets but was contained before causing widespread damage. In contrast, the 2008 global financial crisis was different – banks were overleveraged, and policymakers were slow to act initially, requiring extraordinary government support to prevent a total collapse.

Today, US banks are in a far stronger position. They are well-capitalised, with solid liquidity buffers and more stringent regulatory oversight. Credit markets remain stable, with no signs of a significant widening in credit spreads.

How will policymakers respond?

Policymakers play a crucial role in determining whether an economic shock turns into a full-blown crisis. Their response can either stabilise or exacerbate downturns. The current situation is unique because Trump’s trade policy itself is the cause of uncertainty. While the administration has no incentive to create a recession, trade policy remains unpredictable and markets dislike uncertainty. If economic data begins to deteriorate, investors will look to the Fed to step in, but so far, the Fed has signalled a wait-and-see approach, rather than a willingness to cut rates pre-emptively.

What should investors watch next?

Markets are forward-looking. What happens next is more important than what has already happened. Key to watch will be the potential for further trade war escalation – will Trump double down on his announced tariffs after US trade partners retaliated against his initial set of tariffs? A second scenario is Trump potentially announcing a scale back of tariffs, in line with our views of tariffs as temporary tools to extract concessions from trade partners. Additionally, energy prices, corporate earnings, and credit markets are also key. If oil prices were to surge above USD 100/bbl, recession risks would increase significantly. Similarly, if companies start cutting earnings estimates due to trade concerns, it will signal a deeper economic slowdown. Finally, if credit spreads begin widening significantly, it could be a red flag that conditions are deteriorating.

What does this mean for asset allocation?

Given our view that tariffs are likely temporary measures intended to extract concessions from trading partners, we remain pro-risk in our asset allocation. While trade tensions may create short-term market fluctuations, the fundamental outlook remains supportive. We continue to favour global equities, with corporate earnings remaining resilient, and a broadening in performance from the US to Europe and China suggests improvements in risk appetite. Within bonds, Developed Market High Yield bonds continue to offer attractive opportunities amid a still-strong US labour market and low corporate default rates. Emerging Market bonds have also performed surprising well amid tariff-related noise. Lastly, gold remains a key portfolio diversifier, serving as a hedge against geopolitical uncertainty and market volatility. Unless we see signs of trade policies causing deeper economic damage, we believe staying invested in a portfolio of diversified risk assets remains the right approach.