Words: 2,683 Time: 10 Minutes
- Econ 101: Why tariffs ultimately don’t work
- Global central banks move to counter expected (Trump) consequences
- S&P 500 pushes into possible zone of resistance
Trump’s favorite word in the dictionary is “tariff”.
In his view, it just needs a little public relations (PR) help.
I don’t know about that…
Personally, I’m not a fan of tariffs. Over the long-run, history has shown they do more harm to the economy vs help.
Better PR won’t change that.
However, in the very near-term (~24-36 months) – they can be seen to add jobs and create benefits for the protected industry(s).
From that lens, people are mistaken to believe they’re working (as that’s what’s visible).
But what about the unseen?
To help explain, I’ll draw on the timeless work of Adam Smith.
The protectionist policies of today are not only reminiscent of those in the seventeenth and eighteenth centuries — but are arguably worse in their complexity and scale.
But first, global markets are reacting sharply to the (incoming) Trump administration.
And whilst it’s another ~5 weeks before Trump officially (re)occupies the White House – global central banks are ‘bracing for impact’.
Navigating a Zero-Sum Global Economy
As a preface, earlier this week I caught up with my post-graduate university professor – John.
It’s been ~30 years since I completed my Masters of Science Engineering degree (where does the time go?) – but we make a point of connecting every 6 months.
It’s fabulous.
John has a Ph.D in economics and is one of the most knowledgeable and well-read people I know. Every time we connect I learn something new.
This week he asked my thoughts on what we see given political recent events…
Where does one start?
I said to John the global economy is increasingly operating in a zero-sum framework, where gains for one nation will arguably come at another’s expense.
Obviously zero-sum game has major implications for how economies attempt to take their share of a pie which is likely to stagnate (vs expand)
This dynamic has been exacerbated by the return of “inward looking” policies.
For example, I talked about the actions of various global central banks on monetary policy – reflecting varying domestic economic conditions.
However, these actions are not priced into markets…
For example, we saw Brazil raised its Selic rate by a surprising 1%, responding to rising inflation fueled by a depreciating currency (i.e., a stronger US dollar)
The weaker Real exacerbates import prices, reversing the country’s previous narrative about “currency wars.”
Though Brazil now confronts inflation, such monetary policy is a direct response to managing local economic conditions in an increasingly complex global context.
Conversely, Switzerland took the opposite approach, cutting its policy rate by 0.5% to weaken a Franc deemed too strong.
Switzerland’s central bank faces geopolitical uncertainties, leaving the door open for a return to sub-zero rates, although current policies aim to control upward pressure on its currency amid euro zone turbulence.
Closer to home for John and I, Canada, like Switzerland, implemented a 50-basis-point rate cut to counter its slowing economy.
This reduction widened the rate differential between Canadian and U.S. rates – sending the Loonie (earning its name from a bird native to Canada) sharply lower.
While these decisions stem from domestic challenges, they underscore how interconnected global dynamics, such as Trump’s trade threats, add complexity and uncertainty.
It also echoes the point I made only yesterday regarding risk (and unknowns).
As a result, markets have responded unpredictably, which says to me that adapting to this landscape will be critical for stakeholders.
European Central Bank and U.S. Divergence
Adding to the above, the European Central Bank (ECB) also reduced its policy rate by 25 basis points, continuing its dovish stance to combat disinflation risks.
ECB President Christine Lagarde signaled more cuts in the pipeline, as inflation in the euro zone remains far below targets.
Now unlike the U.S., which grapples with sticky inflationary pressures (as I highlighted this week) – Europe risks lapsing into a deflationary cycle as producer prices fall.
But this economic divergence underscores the zero-sum reality.
For example, one bloc’s challenges amplify opportunities or obstacles elsewhere.
This is the game being played.
The widening divergence is also leading to sharp reactions in bond markets.
For example, despite rate cuts typically lowering bond yields, European yields saw their largest rise in eight months.
We have also seen something similar in the U.S. – where the 10-year yield has ripped back above 4.40% despite the Fed reducing rates by a cumulative 75 basis points since September.
That was not meant to happen.
Analysts suggest this anomaly reflects shifting market positions and anticipation of limited further easing in the short term (which was my expectation)
This conversation is a good segue to why I’m worried about the protectionist policies to come.
There will be unseen consequences… most of which are not considered.
The Persisting Fallacy of Protectionism
As a preface, I understand why Trump is using tariffs as a negotiating tool.
In short, my assumption is he wants to try and level the playing field between the U.S.and its major trading partners.
China for example does not play by the rules.
For example, if U.S. companies are seeking reciprocal access (i.e., freer and fairer trade) to Chinese markets – they won’t get it.
Here’s Liza Tobin from the University of Texas (2023)
Cooperative trading relations require a common set of rules or expectations that ensure that economic competition occurs on a level playing field.
Beijing’s rejection of the rule of law as a fundamental operating principle means that the normative commercial structures upon which modern trade depends are at the mercy of a powerful and ideologically motivated political party.
The Chinese Communist Party’s ruthless pursuit of techno-economic dominance in a range of strategic sectors has distorted activities that are usually thought of as positive sum — trade and technology cooperation — into zero-sum games.
But start with history and context…
Since Adam Smith’s The Wealth of Nations over two centuries ago, the case for free (and fair) trade has been compelling.
Smith’s central premise was simple:
Individuals and nations alike benefit from purchasing goods at the cheapest price available.
He likened this to the logic of a prudent household where specialization leads to efficiency.
For example, a tailor buys shoes instead of making them, and vice versa, because it maximizes productivity.
Yet, the fallacies supporting protectionism persist due to short-term thinking and the influence of vested interests.
Smith’s insight that tariffs often harm the broader community in favor of select groups continues to be ignored in contemporary economic policies.
Protectionist policies of today are not only reminiscent of those in the seventeenth and eighteenth centuries but are arguably worse in complexity and scale.
Today’s (modern) tariff systems are steeped in misguided reasoning that prioritizes immediate, visible benefits for certain industries while disregarding the broader, long-term detriments to national and global economies.
What’s needed is long-term (intertemporal) thinking….
Immediate Gains vs. Long-Term Losses
Whether it’s government policy, investing, diet or exercise (it’s a long list) – all too often I see people making the mistake of short-term thinking.
They chase the visible easy win – without a thought toward second (and third) order consequences (which are often more damaging).
Sadly, it’s almost always the way with policy makers.
In the context of tariffs – let me offer a basic example to illustrate:
Consider an American woolen sweater manufacturer lobbying for a $5 tariff on Chinese sweaters.
The rationale is seemingly straightforward:
The tariff keeps the (US) manufacturer in business, preserves jobs, and sustains local economic activity.
These are visible and immediate benefits (where very few would disagree).
However, economics is more about the study of what’s unseen. In this case, the unseen consequences paint a very different picture.
For example, without the tariff, consumers would save $5 per sweater, which could be spent elsewhere, fostering employment in other industries and enhancing overall economic efficiency.
Moreover, the dollars used to purchase Chinese sweaters eventually return to the U.S. economy as demand for American exports.
This reciprocal trade expands productivity in areas where each nation holds a comparative advantage.
However, when protectionist barriers are erected, domestic resources are diverted to less efficient industries, resulting in a net productivity loss for both the protected and broader economies.
Instead of a net gain in employment, the structure of employment merely shifts, often with reduced overall efficiency and real wages.
But because this is unseen – where these impacts evolve over time – it’s not considered.
The Illusion of Tariff Benefits
The imposition of tariffs to foster or protect domestic industries appears logical at first glance.
And I understand why these policies get such widespread support.
By making foreign goods costlier, domestic production becomes viable, creating jobs and boosting specific (protected) sectors.
You might argue that this was one of the key pillars to Trump’s election win; i.e., restoring (manufacturing) jobs to the U.S.
However, this analysis overlooks the crucial reality of opportunity cost and resource allocation.
Again, this is a study of the unseen.
The added cost (e.g., the incremental $5 for a sweater) to consumers reduces their disposable income, curbing their spending across other sectors.
While jobs are created in the protected industry, equivalent jobs are lost elsewhere due to decreased consumer spending. Put another way, the consumer now has $5 less to spend.
Now with 70% of the US GDP a function of consumer spending — this represents a real threat (arguably not something being pricing in).
From mine, a particularly damaging aspect of protectionism is the visibility of benefits versus the invisibility of costs.
For example, a factory’s operation is tangible and noticeable.
The narrative will always be “look at the all the new jobs and factories we have created on-shore. These did not exist before”
It’s very easy to understand why that garners immediate support and enthusiasm.
However, the economic contraction spread across numerous other industries due to higher prices often goes unnoticed.
This takes a lot longer to unfold.
Consequently, the illusion persists that tariffs generate economic gains without drawbacks when, in reality, they stifle innovation and suppress real wage growth by forcing economies to operate inefficiently.
Tariffs Reduce Real Wages and Productivity
I understand some of you may write in with arguments as to why tariffs can increase real wages.
However, let me offer the counter argument.
From my lens, tariffs merely enable domestic industries to operate at higher cost structures while artificially maintaining “job security” within those (protected) industries.
However, this security comes at a steep (unseen) price.
Consumers face higher prices, reducing their purchasing power across all goods and services.
This inefficiency extends beyond consumers, as protected industries divert resources from sectors where they would yield higher productivity and innovation.
The long-term effect is a reduction in average labor productivity.
And increased labor productivity is the only way you are able to drive (real) wage increases (without driving inflation).
For example, tariffs may enable American workers to compete with lower-wage foreign workers in inefficient industries, but this comes at the cost of stifling competitive, higher-value industries.
From the consumer’s perspective, their reduced ability to afford goods and services directly lowers their overall standard of living.
Thus, while tariffs temporarily preserve jobs in (protected) inefficient industries — they create inefficiencies that harm the overall economy.
And what’s how it should be viewed.
Global Trade Barriers and Broader Consequences
Further to my preface outlining the actions from various central banks – the economic impact of tariffs extends well beyond national borders, often exacerbating inefficiencies in global trade.
High tariff walls reduce mutual gains from trade, forcing nations to employ resources inefficiently.
For instance, prohibitive tariffs effectively diminish demand for foreign imports, leading to reduced export opportunities for domestic producers.
Industries reliant on international markets suffer (which is Trump’s intent in some cases) — undermining the broader economy’s competitive advantage.
Moreover, protectionist policies often breed retaliatory measures, as foreign nations impose counter-tariffs.
This “trade war” dynamic further constrains economic growth and discourages international cooperation.
The analogy of tariffs as economic “barbed-wire entanglements” is apt:
They create artificial obstacles that waste resources by limiting access to efficient markets.
While certain special interests may temporarily benefit, the overall economy suffers.
A balanced approach recognizes that although tariff reductions may harm specific groups in the short term, the long-term gains in productivity, efficiency, and consumer welfare far outweigh these localized losses.
Putting it all together – it’s easy to understand why the enduring appeal of tariffs stems from their visible short-term benefits and the pervasive myths surrounding their efficacy.
I get it.
However, a deeper analysis reveals that protectionism reduces efficiency, lowers real wages, and distorts market dynamics.
It’s the seen vs the unseen.
Over the long-run, it’s my view that economies ultimately squander the potential gains from free trade and specialization. The end result is the size of the total global pie stagnates (or contracts) vs grows.
From mine, Adam Smith’s insights remain as relevant as ever, where policymakers would be well served to heed his wisdom. We should aim to look beyond immediate (short-term) gains to embrace the broader, enduring benefits of free trade.
The path to economic prosperity lies establishing (lasting) bridges that enable the unfettered exchange of goods and ideas.
A Market Ignorant of the Risks
Possible tariff wars are simply one of the many risks facing markets in subsequent years.
Central banks (and governments) are taking immediate action to effectively ‘hedge’ their economies for what’s to come.
For me, it’s difficult to see how the global economy expands.
Inward looking (protectionist) policies have always resulted in retarded growth. Why will this time be different?
However, in the near-term, such policies will give the perception of working.
Jobs will be created in the (protected) industries – however at a cost of other areas of the economy – exasperating ineffeciencies.
For now, equity investors remain largely complacent towards these risks. They see very little (or no) downside risk… which could prove costly.
Let’s see where the market finished with a quick look at the weekly chart:
Dec 14 2024
The S&P 500 has traded per the script the past 13 weeks or so.
That is, once the Index exceeded the July high of 5500 – it rose to challenge the (expected) 61.8% to 76.% zone outside the pullback from Jul 15 to Aug 05.
I pencilled in this zone a while back (see white lines) as the next profit target (for shorter-term traders).
My best guess from there is the probabilities of a pullback towards the 35-week EMA (or ~5600) are quite high.
However, in the very near-term, there are few catalysts to drive it lower.
For example, if the Fed decides not to cut rates next week (a surprise) or issue more hawkish language – this could rattle the bulls.
Markets are pricing in a 96% probability of a 25 bps rate cut next week. They see a 78% chance of a cut in January.
If those expectations are not met – markets may correct 5%+
Irrespective, fundamentally I don’t see value in the market at current levels (i.e., trading~22x forward expected earnings with a 10-year yield at ~4.40%)
This ratio is heavily skewed by large cap tech – where five of the Magnificent Seven forward EPS multiples exceed 32x.
The two exceptions are Meta and Google.
For example, Google trades ~21x forward – heavily discounted due to perceived regulatory risks.
Google is my largest single position – given its trading well below a market multiple (however deserves a premium given the quality of its business; cash flows; balance sheet; operating moat etc)
(Full transparency – I work at Google)
Putting it All Together
It’s very easy to understand why Trump’s protectionist policies resonate with people.
But it’s important to always look beyond visible benefits.
For example, whilst they will likely result in short-term domestic benefits (creation of jobs; new factories etc) – long-term such protectionist policies lead to inefficiencies, higher costs, reduced productivity, and lower real wages.
Protectionism, while politically appealing, distorts markets and stifles innovation.
Inefficient industries requiring protection (to survive) are subsidized at the expense of others.
Coming back to my example, the additional “$5 spent on the U.S. made sweater” will be $5 less spent on something else. It’s “$5” the consumer didn’t need to previously spend.
Adam Smith’s principles highlight the enduring benefits of free trade, fostering global prosperity over time.