Investors may rightly ask how the markets did not see this tariff-induced pullback coming. Indeed, on the campaign trail in 2024, President Trump often referred to tariffs as “the most beautiful word in the dictionary”, relenting later in the campaign to include God, Family and “perhaps” Love in front of it. Liberation Day was set in the diary, yet despite all this forewarning, why was the market so surprised and ill-prepared?

The surprise is due to the sheer size and magnitude of the tariffs announced, in addition to Mr Trump’s apparent willingness to accept ‘a little disturbance’ in asset prices in order to set his agenda on course. The market is now pricing a meaningfully increased risk of Recession in the US as a result.

Investment house, Apollo Global Management, illustrates this quite well in the chart below. To get to Mr Trump’s vision of a more mid-century American economy, the effects of globalization need to be wound back. Tariffs are his prescription for achieving this.

Short term pain/ Long term gain?

Source: Apollo Global Management, April 2025

How much pain and who wears it?

At the time of writing, US markets are bearing the brunt. Although to be fair, US markets were already weakening before Liberation Day in part due to concerns about technology valuations and the news that the Chinese Deep-seek engine could deliver much of AI’s benefits for a fraction of the cost.

Source: Elston Asset Management, Morningstar Direct, 5th April 2025

Tariffs may feel like tools for protecting domestic industries, but in practice, they’re a tax on growth. The global economy is too interconnected; hurting one link—especially a major exporter to the U.S.—ultimately sends shocks back to American businesses and consumers.

From a trade perspective, we believe that the American economy stands to lose the most in the short-term.

Trade wars are still wars. Conventional military strategy suggests that fighting a war on all fronts has proven a risky strategy.

The problem for the US economy is that by ‘attacking’ every other country with unilateral tariffs of varying rates, the impact on the US is cumulative as it spans every dollar of goods that are imported into the US. This is in contrast with almost every other major trading partner, where the individual share of trade with the US is meaningfully smaller and non-cumulative.

As Bismarck knew, fighting a war on many fronts creates asymmetry. The instigator is fighting all the world at once, but in return the world has only one target.

The numbers in the following chart help to illustrate the point:

Source: Elston Asset Management, Trading Economics, Caixa Bank, UBS, April 2025

• US imports, in total, represented 13.9% of US GDP in 2023¹. By unilaterally increasing tariffs on every dollar of imported goods, the increase in costs to American manufacturers and consumers is amplified. Tariffs are effectively taxes, and as imports represent roughly 14% of US GDP, the proposed tariffs represent the largest single tax increase in the United States, some 3x larger (adj for inflation) than the previous record tax hike in 1942 to pay for World War 2².
• European exports to the US. While Europe is the second largest trading partner to the US in dollar terms, as a % of GDP the export relationship is only worth 3.0%³ of European GDP. Different countries within Europe are affected at varying levels however, for example Ireland has 10% of their GDP exposed to US exports.
• It’s a similar story for China, the largest trade US partner in dollar terms, where only 2.9%⁴ of GDP is connected to US exports.
• There are exceptions elsewhere. Vietnam for example, has 30% of their domestic GDP represented by exports to the US.  This likely explains their urgency in seeking to negotiate.

Australian impact relatively benign

Source: JP Morgan, Aus Guide to the Market, April 2025⁵

Trade with the U.S. remains modest compared to Australia’s key partners like China, Japan, and South Korea, but among the top exports heading stateside are what some might cheekily call the three Bs: Beef, Bullion, and Blood—highlighting the dominance of agricultural and specialized goods in the trade relationship.

Importantly, exports to the US account for only around 1.7% of Australian GDP⁶. By far the more important relationship is with China where exports account for around 7.0% of Australian GDP. As a result, the Australian economy is far more likely at risk from an indirect demand shock via China, as opposed to direct US bilateral trade.

US exceptionalism

The risk that tariffs are relatively more harmful to the US than elsewhere is reflected in the most recent GDP revisions for the US economy, versus the global economy.

• Assuming an average effective tariff rate of 22%, Oxford economists are forecasting a –1.5% hit to US GDP, alongside a +1.5% bump to US inflation.⁷
• By comparison, the impact on Global economic growth and inflation is expected to be far more benign. For example, ING are only forecasting a -0.3% short-term hit to European GDP over the next 2 years.⁸

At face value, an increase in inflation combined with slowing growth represents the worst of the ‘flations’.. stagflation. These dynamics characterised much of the 1970’s in the US and were reflected in a lost decade in terms of real investment returns from equities.

This time however, we believe the risk of prolonged stagflation is less likely. The inflation spike from tariffs appears to be a one-off event which is unlikely to compound in future years. This is very different to the wage-spiral and energy driven inflation experienced in the 1970s. The inflation pop from tariffs will take some time for the economy to digest, and will likely result in lower growth, which should feed into moderating inflation elsewhere in the economy.

Well-regarded economists Oxford Economics reflect this in their most recent estimates⁹.

US: Real GDP and core inflation

Source: Oxford Economics, Haver Analytics, April 2025

• Growth is now expected to broadly flatline through 2025 before resuming on trend next year. This is less than the market was expecting and reflects the increased risk of a recession.
• Inflation is expected to pop once the tariffs are fully implemented, however due to the one-off nature of the tariffs, plus the likely effect on growth, inflation (and not charted but interest rates) are expected to subsequently fall aggressively.

None of this reflects Armageddon, but it does reflect a meaningful change to market expectations.

Furthermore, import data in the US suggests a surge in ‘pre-buying’ in Jan-Feb¹⁰ as manufacturers sought to get ahead of the tariff cliff. This could mean industrial growth is about to enter an air pocket as we enter the 2Q. In any case, investors should prepare for consistent growth downgrades as the slowdown begins to bite.

The Trump Put

It is less easy to identify the potential upside risks arising from the implementation of Mr Trump’s tariff policies.

At this point, with significant damage already reflected in market prices, the most investors may be able to hope for is a softening of the Administration’s hardline approach to tariffs. The ‘Trump Put’, as it became known during his first term, was triggered by relatively milder market drawdowns and delivered a positive jolt to markets as the President walked back proposed tariffs with Mexico and China during 2019.

However, this time around, our sense is that Mr Trump appears willing to endure meaningfully more market pain in order to deliver on his agenda. The President certainly enjoys more political capital and seems set to use it, with recent quotes suggesting the market needs to ‘take a little medicine’ before becoming stronger.

Furthermore, following Vietnam’s lead (who are reported to have agreed a free trade agreement with the US over the weekend), should additional countries bend the knee and agree to more balanced trade agreements with the US, the temptation for a regular drip feed of positive news may be too tempting a political carrot to forsake.

On balance, we suspect there needs to be more pain experienced before the ‘Trump put’ becomes a viable option.

Uncertainty creates opportunities

In recent months we have been reviewing the notion of US exceptionalism, with fundamentals consistently suggesting opportunities outside of the US are increasingly attractive.

With the fundamental pivot in German fiscal policy during the quarter, where investments in infrastructure and defense could approach EUR one trillion over the coming ten years, the seasons of investment may be starting to change and tilting away from the US. Particularly when considered alongside valuations, which continue to reflect ‘US exceptionalism’ in terms of a valuation premium for American equities.

Elsewhere in the portfolio, exposures such as fixed income are providing defensive characteristics during a time of market stress. These exposures provide an element of stability and when possible, may allow for fresh capital to be deployed into newer opportunities and other securities that may have been oversold.

Uncertainty in investing is a constant. Using the current elevated uncertainty, we are reviewing portfolios to redeploy capital and will provide additional details in due course.

As always, we at Elston thank you for placing your trust in our team.

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References

¹ https://tradingeconomics.com/united-states/imports-of-goods-and-services-percent-of-gdp-wb-data.html#:~:text=Imports%20of%20goods%20and%20services%20(%25%20of%20GDP)%20in%20United,compiled%20from%20officially%20recognized%20sources.
² https://edition.cnn.com/2025/03/31/economy/tariffs-largest-tax-hike/index.html
³ https://www.voronoiapp.com/trade/-US-EU-Export-Interdependence-Diverging-Trends-Since-the-Global-Financial-Crisis-3925
⁴ https://www.caixabankresearch.com/en/economics-markets/activity-growth/exposure-chinese-economy-us-tariff-hike
⁵ https://am.jpmorgan.com/au/en/asset-management/adv/insights/market-insights/guide-to-the-markets/
⁶ Elston Asset Management, Trading Economics, Caixa Bank, Voronoi, UBS, April 2025
⁷ Oxford Economics (April 25): US: Tariff Monitor – Turning the tariff dial to 11
⁸ https://think.ing.com/articles/europes-worst-economic-nightmare-has-just-really-come-true/
⁹ Oxford Economics (April 25): US: Tariff Monitor – Turning the tariff dial to 11
¹⁰ https://au.finance.yahoo.com/news/automakers-report-stellar-sales-ahead-094124823.html