Economic students are introduced early to the theory of comparative advantage. This theory posits that each country should produce goods where they have a relative efficiency and trade for other goods, thereby maximizing overall production efficiency. Deviating from this principle leads to suboptimal economic outcomes.

The US stock market has declined nearly 6% over the past eight trading days1, reflecting concerns over tariffs imposed by the Trump administration and the retaliatory measures from other countries. Essentially, the market is gauging the extent of the economic inefficiencies that may result. This observation is not meant to be political. While tariffs can be justified for national security or to protect specific industries and communities, they come at a cost. Businesses may either absorb the reduced profits or pass the costs onto consumers. Consequently, the financial market adjusts to expectations of weaker earnings growth, renewed inflation, or a combination of these factors.

The risk to economic growth

The market, with US Treasury rates falling2, appears to have already concluded that the bigger risk to the economy is not inflation, but rather economic growth. The uncertainty surrounding the next steps in the current trade war compounds the problem for markets. While tariffs alone are unlikely to end economic cycles, as businesses and consumers tend to adjust, prolonged ambiguity can severely impact spending and investment.

The 2018 trade war with China serves as a prime example. Business investment collapsed3, leading to a 20% market decline from peak to trough4. In response to recession concerns, the Federal Reserve (Fed) lowered interest rates in 2019.5 Already, there has been a noticeable decline in consumer sentiment.6 Could businesses be far behind?

The culmination of the 2018 market correction coincided with a temporary truce in the US-China trade war and the Federal Reserve signaling a more dovish approach. I believe the market is likely to bottom this time amid similar circumstances. Already, the market is increasing its expectations for Fed rate cuts between now and the end of the year.7 However, an end to the trade war may not come as quickly as investors initially hoped, when they believed tariffs were a negotiating ploy rather than an actual policy.

Navigating the uncertainty

In the short term, we hunker down, acknowledging that policy uncertainty and market drawdowns tend to go hand in hand. Investors may navigate this period by tactically favoring higher quality and defensive stocks, as well as higher quality US bonds. Lest we get too negative, we remind investors that peaks in policy uncertainty have tended to represent attractive buying opportunities.8 Here’s to hoping for greater policy clarity soon!