The stock market will likely be hurt by Trump's tariffs on Canada, Mexico and China, since tariffs have the potential to precipitate weaker economic activity and higher inflation. However, it may take time to see the effects, so the market may stabilize after a knee-jerk reaction as it waits to see the fall-out. This week's key US economic data could help the market stabilize if they print near consensus.
Regarding the fall-out, negatives would be further retaliatory actions by these countries and/or anecdotal or reported price hikes. Although shifting the locations of production may avoid tariffs, almost by definition the shifts would be to more costly places and not be market positive. Positives would be if the three countries agree to address the fentanyl problem and thereby end the tariffs. Also, some domestic producers could boost their profits by raising prices to match the tariffs.
Recent history shows that tariffs and trade wars are not good for the stock market. In Trump's first term, the stock market rally stalled for a year when he imposed tariffs and other trade barriers on China beginning January 2018. Just like then, Trump may not be quick to undo the tariffs -- the U.S and China signed an agreement on trade in January 2020. He may become enamored with the revenue-producing benefit for the government, helping to pay for extending his earlier tax cuts. Doing so essentially would be substituting a "consumption tax" for an "income tax." This substitution would have several implications. On the plus side, a higher consumption tax increases the incentive to save. Also, maintaining low marginal income tax rates sustains incentives to invest and work. However, the substitution makes the government revenue machinery less "progressive," that is more a burden to lower-income than upper-income people.
The tariffs will augment Trump's anti-immigration policies in working to boost the cost of goods. Imports are a way US consumers benefit from low-priced labor abroad without incurring the cost of bringing the workers to the US. Tariffs serve to close this channel. From the US labor unions' perspective, lower-priced foreign labor or increased labor supply from immigration puts downward pressure on wages. The FX exchange rate in a perfectly competitive world should offset lower wages abroad, but the FX market is not perfectly competitive and is impacted by other factors, as well.
Regarding these other factors, there is also a novel way to look at the trade deficit in the context of whether other countries are not paying their fair share of global defense. The military strength of the US is one factor behind the strong dollar. Safe-haven inflows of foreign capital lifts the dollar, which in turn widens the trade deficit. A wide trade deficit means that the US is consuming more than it produces. This "excess" consumption can be viewed as foreign payment for US defense. So, cutting the trade deficit would reduce this "payment."
Away from the tariffs, the bottom line from Fed Chair Powell's post-FOMC news conference last week is that monetary policy will be steady for the foreseeable future. More than one or two months of adverse or friendly data will be required to convince officials to change policy. He said current policy and the economy are "well positioned." And, Fed officials are not "in a hurry" to change policy.
This week's key US economic data are not expected to move the Fed. Consensus looks for a moderate January Employment Report and little change in the Mfg ISM. Nonfarm Payrolls are seen increasing 170k m/m, equaling the Q424 average m/m pace. It would be below the 186k average m/m pace in all of 2024. Some softening in January job growth could stem from the extremely cold weather in parts of the country during the month. It could have prevented some construction or other work, holding down jobs or workweek or both. Such weakness should be viewed as temporary.
The Unemployment Rate is expected to be steady at 4.1%. However, there is downside risk, as the consensus Payroll estimate exceeds the 125k pace that is roughly consistent with a steady Unemployment Rate. Consensus also looks for Average Hourly Earnings to rise 0.3% m/m, which would be an acceptable pace for the Fed. Powell, himself, does not believe wage inflation is a problem. He asserted that the labor market is "not a source of inflationary pressures."
Consensus sees an uptick in the January Mfg ISM to 49.5 from 49.3 in December. (This Report will contain historical revisions stemming from new seasonal factors.) This would keep the Index above the 48.1 Q424 average and be the highest level since March 2024. Nevertheless, the level is still historically low and signals a sluggish manufacturing sector. It is probably too soon to see any impact from the tariffs in this survey. It took a long time for the Mfg ISM to show the effects of the US/China trade war in 2018, as it stayed at a high level until November.
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