In this article:
- Review of recent government policy actions
- Recap of financial market performance as of early April
- Crisis case study
- Ideas for investors facing financial market disruption
Policy Action Review
“Liberation Day” arrived on April 2, when President Trump announced his newest round of tariffs during a Rose Garden press conference.
The president also presciently warned “there may be short-term pain.” Indeed. US stockholders were collectively liberated from about $5 trillion in the most recent two trading days, according to Reuters news agency.
After stocks fell sharply on April 3 and 4, the onset of a new bear market (typically defined as a 20% market decline from the recent peak) which was hard to imagine just weeks ago, now looks much more likely.
This time around, government policies have precipitated financial market disruption and are expected to cause widespread economic dislocation.
A summary of the Trump Tariffs:
- 10% baseline on all imports, effective April 5
- Assess higher country-specific tariffs for the “worst-offending” trading partners, effective April 9
- Combining the new tariffs with those that have already been announced moves the average effective tariff rate up to about 22%
- Canada and Mexico were notably excluded from the most recent round of tariffs
- Aluminum, steel, and autos are also exempt as they are already covered by targeted tariffs
- Energy, minerals, copper, pharmaceuticals, semiconductors, and lumber were excluded, but are expected to be affected at some point by sector-specific tariffs
The new tariff regime is roughly equivalent to the high tariff levels of the early 1900s, a time when the US economy was far smaller and much less integrated with the global economy.
Tariffs likely will present a sizable shock to both prices and economic growth.
The estimated impacts to economic growth and inflation are:
Source: Apollo
These impacts, assuming the announced tariffs remain in place for some time, mean that economic growth in the US for 2025 is likely to be in the neighborhood of 1% (not a recession) and inflation will probably be in the neighborhood of 4%.
Following the announcements on Wednesday, professional forecasters began to raise the probability that the US economy will fall into recession.
For example, Goldman Sachs puts the risk of US recession at 35%, while JP Morgan now places the odds of a recession at 60%.
Despite recession odds climbing significantly, most Wall Street economists continue to support a base-case scenario of modest economic expansion in 2025.
However, because the tariffs were far steeper than expected, the reaction in the financial markets was pronounced and negative.
Financial Market Assessment
So, just how bad has damage been in the financial markets? For stocks, the short answer is: pretty bad.
The policy-driven Liberation Day was followed by investor-driven “Hibernation Days”: the broad-based S&P 500 index of large-company US stocks, for example, fell by more than 10%. US stocks are now within spitting distance of a bear market.
Bonds have provided a counterweight in balanced portfolios, with many bond funds registering price appreciation. The Bloomberg Aggregate US Bond Index (investment grade bonds) increased in value by about 0.5% during the past two days.
Below is a table of historical asset class returns, ranging from very short-term (last two days), to the long term (previous 10 years).
Source: Morningstar
How much worse could it get?
The answer depends largely upon the extent of the economic damage, which likely will be a function of the extent and duration of the new tariff regime.
Since 1950, there have been 56 pullbacks of 10% or more, according to a recent article in Barrons. Twelve months after those corrections, stocks were higher 49 times.
Of the seven they failed to rebound, six of them came during a recession. In the median recession, stocks have fallen by 25%.
The most recent “worst” recession / bear market combination occurred during the Global Financial Crisis of 2007 – 2009. The unemployment rate reached 10%, and the US stock market declined by approximately 56%.
The second worst recession / bear market combination in recent times occurred in 2000 – 2002, following the “dot-com” bubble. The unemployment rate reached 6%, and the US stock market declined by approximately 49%.
Crisis Case Study
The Trump Tariff War may turn out to be a seismic event. It may be the start of a reordering that will change economic and political relationships for decades. It might cause inflation to spike, companies to retrench, consumer and business confidence to crater, and workers to lose jobs.
Trump Tariffs may bring on an epic bear market in stocks, and stocks could stay in the gutter for an extended period. Or maybe they won’t.
In an optimistic scenario:
- foreign countries decide to negotiate rather than retaliate
- inflation rises incrementally rather than exponentially
- US companies decide to reshore operations that are currently located offshore
- foreign companies locate more of their operations in the US
- more jobs are created for US workers (who are also consumers)
- business and consumer spending goes up rather than down
- the economy continues to expand rather than contract
To expect that all this happens immediately seems a bit pie-in-the-sky. But it also can’t be ruled out.
In a less optimistic scenario, but still positive scenario President Trump may decide on a different course of action (history shows that Trump can change his mind). A new, new tariff regime may be less onerous, and the economic growth and inflation impact may be less severe than feared.
It’s fair to say that the current tariff regime is unprecedented in the US – at least in terms of the last hundred or so years. The range of potential outcomes from the new trade regime is wide, where “crisis and crash” must also be considered.
In the two worst-case scenarios referenced in the previous section (dot-com bubble and Global Financial Crisis), the issues affecting the US economy were multi-layered and deep.
In the case of the dot.com bubble, the speculative frenzy for buying “lottery ticket” stocks of unprofitable companies associated with the internet reached a fever pitch and pushed stock prices in general far beyond rational levels.
Also, widespread corporate accounting fraud precipitated widespread business failures which exacerbated the stock market crash.
In the case of the Global Financial Crisis (GFC), the combination of speculative frenzy in the US housing market; overextended homeowners; loosened US financial institution regulation; wildly extended bank balance sheets around the world; fraudulent activity at US rating agencies; and failure-to-act government were all factors in the stock market crash.
In today’s situation, stock prices are generally regarded as being high relative to history, but not wildly overvalued, so the condition of speculative excess seems to be absent.
Also, the traditional US banking system appears to be stable and sound. The regulatory screws were turned tightly post GFC, which has helped to keep bank risk taking in check.
So, the Trump tariff situation strikes me to be more of a single-event flashpoint.
For a case study in what can happen during a crisis caused by a single-event flashpoint, consider the situation in 2020:
- On February 4, 2020, the City of Boston reported the first case of the “novel coronavirus” in Massachusetts, which also happened to be the eighth case of the infection reported in the US
- On March 10, Massachusetts Governor Charlie Baker declared a state of emergency
- In late March 2020, the S&P 500 index of large-company US stocks plunged to its lowest point during the pandemic, declining by a third from its record high of a month earlier.
- Covid had been in the public consciousness for several weeks, and the magnitude of the health crisis was just sinking in.
- No one knew how deadly, or how long-running, the pandemic would be.
- A recession was just starting, and the severe economic contraction would extend into the summer.
- No one knew when we would have an effective vaccine (turns out, we got one by year end)
- Investors were panicking.
- Yet stocks began to turn around on March 24 (gaining almost 10% on that day alone).
- By August 18, the stock market was back at a record high.
- The first COVID-19 vaccine received approval in December 2020
- For the full year of 2020, stocks posted a gain of 18%
The pandemic was a health catastrophe, and many folks unfortunately are still dealing with related illness and personal loss.
The period of a half-decade ago also serves as a reminder for why it’s so important to stick to your financial plan and your investment strategy.
Covid crushed consumer and business confidence and tore through the social and economic fabric of the US. Financial market deterioration was sharp and swift, registering a 34% stock market decline in a matter of weeks during February and March 2020.
But recovery was sharp and swift, too, with stocks reversing the decline by August 2020, and ultimately gaining 18% for the full year of 2020.
Market Disrupted. Now What?
What should investors do? Looking before leaping is always advisable. So is pausing before pressing the “sell” button.
Reducing risk by selling stocks may bring temporary relief to emotional stress and pain caused by a sudden drop in stock prices, but it has seldom proven an effective approach for building wealth over the long term.
Prudent action can take a few forms during financial disruption, including:
- Tax loss harvesting:fo r individual or joint brokerage accounts subject to capital gains tax, a stock market downturn might cause prices of some individual stock or stock fund holdings to fall below cost. Selling holdings below cost creates a capital loss, which can be used to offset capital gains realized in other parts of the portfolio. Or, if no realized gains are available to offset, a realized loss can be used to offset taxable income, subject to an annual limit, and carries forward for use in future year.
- Roth Conversions: a Roth conversion involves taking a distribution from a traditional IRA, paying income tax on that distribution, and immediately depositing or “converting” that distribution into a Roth IRA. If a conversion takes place during a low point in stock prices (instead of during a high point), stock fund shares will have a lower value, so more shares can be moved from Traditional IRA to Roth IRA for the same tax bill. When the markets recover, the subsequent share appreciation in the Roth IRA occurs tax free.
- Rebalancing: If you believe that corrections are temporary, and that over the long-term stock prices will rise, then a stock market drop can be viewed as an opportunity. The idea of rebalancing is simple: investors choose a target asset mix (such as: 60% stocks and 40% bonds). When asset price changes pull actual portfolio weights away from target weights, investors sell the assets that have gone up in price and buy the assets that have gone down in price. This rebalancing brings the portfolio back into line with its target. When stock prices fall, rebalancing allows investors to buy long-term appreciating assets at a discount.
When investors are faced with economic crises (whether pandemic-induced or policy-inflicted) and financial market turmoil, advice such as “keep calm”, “try going for a walk”, and “don’t look at your account statements” probably falls flat.
However, sticking to your plan is not the same thing as sticking your head in the sand. It is important to be aware of what’s going on, to try to understand how the landscape might be different in the future, and to adjust your financial situation accordingly.
Taking prudent action may mean stress-testing your financial plan to account for a new economic environment and to give you confidence that things will be OK over the long term. Or it may mean reviewing your investments to see how changes in the financial markets might affect the prospects of future returns. It might even mean asking for an interpretation of a new technological development that is causing confusion or concern.
Susan, Donna, Alex and I are here to help with any of these issues, or other items that may affect your personal financial situation.
I’ll leave you with this closing thought: it will take much more than a draconian new set of trade policies to take down US consumers, US businesses, and the US financial markets. We may feel pain from self-inflicted wounds (in the words of JP Morgan analyst Bruce Kasman, “there will be blood”), but the damage is much more likely to be terminable (and manageable) rather than terminal.