The naivety behind tariffs - Why economics is never that simple

The US administration continues to be in denial about who pays, but the impact is starting to show in inflation and corporate earnings. For now, though, the US economy continues to grow and investment spending on information technology (IT) is a key driver. The stock market likes that profits are still being generated and bond markets like yield and income. It’s hard to fight the momentum, even if the expectation is that something is bound to go wrong.

Deal or no deal?

The US trade deals announced ahead of the 1 August deadline look similar in design – a 15% across-the-board tariff and an acknowledgement from the exporting nation to increase its investment in the US. The naïve idea being that tariffs will force a redirection of US spending away from foreign goods towards US-produced goods, and that investment funds will help build capacity in the US to manufacture those products. If successful, the US trade deficit should come down and there would be inflows on the balance of payments capital account in the form of direct and portfolio investments. Under such an outcome, one would expect the dollar to be strong, not only due to a lower trade deficit and increase investment inflows, but from a sentiment point of view as well – America is winning and is exceptional.

Never simple

Life, and economics, is never that straightforward. There is no perfect substitution from imports to domestic products. Instead, import prices will rise and that will mean lower profit margins for companies that import intermediate goods or final goods to distribute into the US market. And it is likely to mean higher prices for US consumers and, therefore, higher inflation. Foreign suppliers might see some decline in demand and may reduce their selling prices, and subsequently endure a hit on their profits, but it is hard to model exactly where the costs will fall. The June inflation report showed some increase in imported goods prices. Some second quarter (Q2) earnings reports have been explicit about the tariff impact on profits and forward guidance (Ford, General Motors, Mercedes, Walmart, Diageo and UPS to name but a few).

Follow the money (is there any?)

The supposed investment funds to be invested in the US, cited as part of trade deals with the European Union (EU) and Japan, are short on detail. Do they really indicate an increase on existing direct and portfolio investment inflows to the US? There are also questions about who will fund these investments and into what sectors they will be directed – energy and defence are the most cited. But for now, they look aspirational rather than concrete. One must also ask whether all the dollars that flow into the US in the form of direct investment will be spent on US domestic output. Surely, there will be some leakage into imports which undoes some of the desired tariff effect. At this stage, sketchy high-level talks about huge investment flows into the US do not pass the sniff test as an investment strategy.

IT is the lead

The one clear bullish takeaway from the GDP report is the strength of capital spending on technology. Spending on IT processing equipment is up 19% in the first half of the year compared to the same period in 2024, while software spending is up 8%. This is very consistent with what we see at the company level – Meta’s hiring of artificial intelligence (AI) engineers, Nvidia’s huge semiconductor sales, and so on. Tariffs might be a drag on growth and an inconvenience for the Fed, but technology spending is a hugely positive driving force for the US economy.

Stick with risk but be careful

So we are back to the same old story for markets. Growth is positive, rates are stable, corporate earnings are growing and there are few evident credit problems. The icing on the cake is that AI is driving earnings in the technology sector. Of those companies which have reported so far, earnings growth for the S&P 500’s technology sector is coming in at more than 20%. So, portfolios exposed to US technology stocks, high yield, and some inflation protection will be doing well for US dollar-based investors.

Credit premium still worth it

In bond markets the outperformance of credit versus duration persists and is likely to for some time. Credit spreads are narrow and there are some concerns over the level of leveraged long credit exposure that exists in the market (through short credit default swap trades). But a credit blow-off requires a trigger and credit markets have been super-resilient to far. They did react negatively to the Liberation Day shock but have since fully recovered. It would take a rapid deterioration in US growth data, or the Fed raising rates, or a worsening geopolitical situation (what is Donald Trump going to do to Russia?) to get enough of a risk-off turn in sentiment to push credit spreads a lot wider. When it happens, it could be violent – given positioning – but for now with solid macro- and micro-fundamentals and healthy income demand, credit remains a favoured asset class.