A severe drop in the stock markets has resulted from the first two days after Trump’s Liberation Day announcement, which imposes significant tariffs on companies bringing goods into the U.S. from other countries. The VIX Index is nearing 5-year highs. These increased costs and volatility are casting a shadow over U.S. stock markets.
President Donald Trump’s Liberation Day announcement introduced a sweeping set of international tariffs on goods brought into the U.S. While 4:00 p.m. may seem like an odd time to announce such a large-scale change to foreign economic policy, an alternative motive was that he did not want his announcement to occur when the main U.S. stock exchanges were open, leading to side-by-side screens of his remarks and the stock market’s response.
He was right to be cautious, as as the ensuing two days of trading were marked by significant selloffs in the stock market. Indexes like the Nasdaq have fallen into bear market territory, suggesting that the group of stocks is significantly below its recent peak value.
Given the complexities of the stock market and the global economy, it can be challenging to understand why something like a tariff can have such a significant effect.
What Is A Tariff?
A tariff is the price one pays to bring goods from one country into another. While it does not meet the strict definition of a tax, it has several complementary aspects, such as being collected by national governments and the proceeds used to cover government services costs.
Unlike taxes, governments levy tariffs on foreign businesses’ exports of goods to the destination country. While the goods are now more expensive to bring to that country, businesses typically do not absorb those costs and pass them on to the consumers. This notion leads to several different economic reasons for having tariffs, such as encouraging the purchase of domestic goods and altering foreign economic policy.
How Are Tariffs Impacting Stock Prices?
A stock price is the sum of the expected value of future cash flows for that company. As macroeconomic and firm-specific news surface, the expected value of these future cash flows increases or decreases, leading to a corresponding change in the stock price.
A significant increase in tariffs (not unlike those introduced on Liberation Day) may impact stock prices in three ways.
- Lowering future revenues for companies. As a company must now pay more to import a good (or a part of a good) into the U.S., it has a clear choice regarding how it responds to these increased costs. If the company absorbs the costs, it will yield lower profits, and the stock price should decrease. If the company passes the costs onto consumers, the consumers will be less able to afford these products, and demand will decrease. If that occurs, the stock price should also decrease. Either way, these increased costs should impose downward pressure on stock prices.
- Other Countries Imposing Reciprocal Tariffs. While Trump suggests that the April 2 tariffs were reciprocal were reciprocal, it did not stop countries like China from going further and imposing additional tariffs in response to his announcement. As these tariffs against U.S. companies go into effect, U.S. goods will now be less competitive in those countries, lowering consumer demand for those products. This lower demand for these U.S. company products should result in a decline in the stock price among companies subject to those tariffs.
- Increased Stock Market Uncertainty. Over the last three months, many have wondered whether or not the Trump administration will impose tariffs, when these tariffs will go into effect, and if they will be there to stay (or just part of a negotiation tool). As uncertainty increases, consumers tend to spend less, which applies significant downward pressure on corporate profits. In fact, the VIX Index, which tracks stock market volatility, is near five-year highs. This increased uncertainty typically leads to stock price decreases.
How Should Investors Respond To The Tariff-Induced Stock Market Decline?
While it might be tempting for investors to pull their funds, the amount of time invested typically yields better long-term results than attempting to time the market. However, this week’s events are a good reminder to diversify investments and not only carry higher volatility and risky investments in a portfolio.
If investors are further away from retirement, they will likely be better off by continuing their investments as if nothing happened in anticipation of a rebound. Investors needing these funds sooner may wish to consider taking on lower-risk investments (such as bonds and high-yield savings accounts) to moderate the volatility.
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