Odd Lots - The Tariff Announcement That Shocked Financial Markets

Episode Date: February 3, 2025

Over the weekend, President Trump announced that he was following through with his plan for aggressive tariffs. Imports from Canada and Mexico will now be hit with a 25% tariff, while China will get a 10% tariff. Although aggressive action was promised during the campaign, the news still rattled global financial markets, sending futures tumbling and the dollar spiking. Then, on Monday, Mexican President Claudia Sheinbaum announced that after a discussion with Trump, the tariffs aimed at her country would be delayed by a month. Meanwhile, more talks with Canada and China are expected. So what exactly are the economics of such tariffs? Are they inflationary? Who pays for them? And what are the implications of these ongoing threats? On this episode, we speak with Paul Donovan, chief economist at UBS Global Wealth Management, who answers all of our questions on the still developing news and how things might play out.Read More: How Trump’s Tariffs Aim a Wrecking Ball at the Economy of the Americas Only Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox — now delivered every weekday — plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

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slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello, oddlod's listeners. This is Joe Wisenthall. You are listening to an emergency episode of the podcast. It was recorded at 10 a.m. Monday morning, February 3rd. The reason I am telling you this is because markets and news are moving very fast. And so by the time you listen to this, parts of it may already be out of date. But the context for the discussion was over the weekend, Trump announcing 25% tariffs against Canada and Mexico, 10% tariff. on oil, another 10% tariffs on China. Since we recorded this about a minute after we got out of the studio, Mexican President Claudia Scheinbaum announcing that the tariffs had been delayed on Mexico for a month. We're still waiting to hear if something similar happens in Canada. Other than that, take a listen. Bloomberg Audio Studios Podcasts Radio News. Hello and welcome to another episode of The Oddlots podcast. I'm Tracy Allaway. And I'm Jill Wisenthal. Joe, how many of these emergency episodes

do you think we're going to need to do over the next four years? Oh my God. You know, well, anyway, I don't know, but this is two weeks in a row a week ago. You know, we had to rustle up a deep seek expert last Monday, this time a trade expert. That's right. I feel like we might as well just preemptively convert the show into a daily because I feel like there's going to be a lot of news flow. But anyway, as you mentioned, over the weekend, President Trump basically confirm that the U.S. would be imposing 25% tariffs on imports from Canada and Mexico, which are, of course, you know, massive U.S. trading partners. He's also implementing a 10% tariff on China. All of this is being done via the International Emergency Economic Powers Act. And the tariffs are

supposed to become effective as of Tuesday, February. 4th. And of course, you know, a lot of stuff can change. The news cycle is very compressed at the moment it feels like, and we're recording this Monday morning. So we'll see what happens overnight by the time this episode comes out. But in the meantime, there are a lot of questions. And who better to ask than Paul Donovan. He is, of course, chief economist over at UBS Global Wealth Management, someone we've had on the show quite a lot and someone who's been following the ins and outs of the tariffs, including some of the technicalities of how they actually work, where I think there is quite a bit of confusion. So, Paul, thank you so much for coming on odd lots at short notice, too.

No, thank you for having me on. Why don't we just start with, I guess there's a question that a lot of people have been asking. There's a lot of confusion, as I mentioned, about who exactly is paying these tariffs and when. And the Trump administration initially seemed to suggest that foreign countries were going to pay and that they were going to set up this external revenue service to collect the income. Now, though, there seems to be a lot more talk about Americans having to accept short-term pain for longer-term gain. A 25% tariff on Mexican or Canadian goods, where is that money actually collected and who is

paying for it? So the U.S. consumer is paying. There is no question about this. We have over 4,000 years of economic history on tariffs. are literally clay tablets from ancient Mesopotamia detailing this, consumers pay tariffs, end of discussion. The point at which the tariff is collected, though, is very important. The point of entry, when the goods arrive physically in the United States, that's when the tariff is paid. And that's why a 25% tariff does not fully equate into a 25% consumer price increase.

25% tariff would mean about a 10% consumer price increase. Explain that further. So, essentially, if you think about it, the goods arrive in the United States, your television has arrived from China in the Port of Los Angeles. That's the point at which you have to pay the tariffs. You pay it on the value of the television at the point of Los Angeles. But after that point, the consumers still got to pay for transporting that television around the country, for the advertising, for the wholesale, for the retail costs.

retailers take a quarter of your money to cover their costs and profit margins. So of course, all of those costs add up to about 60% of the consumer price. The import price, on average, is about 40%. Okay, so maybe prices on maple syrup or avocados or whatever don't automatically translate to a 25% price increase because of the dynamics that you just laid out. But I guess the other question that's floating around in terms of the impact on the broader economy is, are these types of tariffs, you know, net inflationary or net deflationary? Because on the face of it, it seems like prices will go up. That would add to inflation. But there's this sort of contextual impact as well where you could see, you know, maybe there are fewer jobs and slower economic growth as the U.S.

economy has to adjust to a new trade dynamic. And maybe that exerts downward pressure on prices. Net-net, do you see this as inflationary or deflationary? So in the short term, by which I mean the next year, this is going to add to inflation in the United States. Because, you know, it's a sales tax. It's like a VAT tax increase or a consumer tax increase. And if you look at Japan when it's raised consumer taxes or the UK when it's raised value-added tax, you know, you see inflation coming through in the first instance. And this is just the same. It's a sales tax under a pseudonym.

So you will see inflation in the first instance. But then you're right. The question is, do we then see jobs being lost? Particularly because these taxes are a lot more focused on complicated supply chains than was the case back in 2018. That may be a lot more disruptive to the economy and potentially could create unemployment or just fear of unemployment, which would lower demand. And that would then be a disinflation force, but not now, a disinflation force in the future. future accompanied by a significantly lower growth.

One of the arguments made by advocates of tariffs from time to time is that the U.S. is still by far and away the biggest consumer market in the world, and it's a sort of a privilege to be able to sell to us. So if you want to sell to us and there's the tariff, just eat the cost yourself, lower your prices by 10% or 25% or whatever so that you can still sell into the U.S. market competitively. Does that logic fly? really. For one thing, the debatable point as to whether the US is the largest consumer market in the world, Europe is the largest middle income consumer market in the world. So it's not all about the United States. The other thing, of course, is that the US is generally a relatively competitive market. So in other words, you know, it's not that consumers are making super normal producers are making super normal profits when they're selling into the United States and we're just chipping away at those. No, you know, export us to the United States are very efficient. they're operating on thin margins, they don't have the room to do this. And if you look back at what

happened in 2018, there was no change in import prices trends pre-tariff. So import prices are the price before the tariff is applied. There was no change in those trends when tariffs were applied, because the exporters to the United States just basically don't have the room to cut the margin. The other thing that you sometimes hear is that, okay, maybe this means prices go up. up for American consumers, but some of that price increase could, in theory, be offset by a stronger dollar. And we have seen the dollar, you know, rallying in recent weeks. And I have a twofold question on this. So one, you know, how valid is that particular argument, the dollar offset idea? But then secondly, why is it that the dollar actually goes up when the U.S. announces additional

trade measures? I've kind of taken that for granted, and I've never stopped to actually think about why that's happening. Well, let's start with the second part first. So essentially, I think what is happening is traders are assuming that because the tariffs will raise consumer prices over a period of time, not all at once, that will then lead to a more cautious approach on the part of the Federal Reserve with regards to policy interest rates. If interest rates don't go down so much or indeed start to go up, that tends to be supportive for the dollar at a time when other countries are still on an easing trajectory. So it's an interest rate differential expectation, generally speaking. Does a stronger dollar help offset the tariffs? I mean, to a very minor extent, a stronger

dollar will tend to lower commodity prices that are globally denominated in dollars. But the issue here is that 95% of US imports are priced in US dollar terms. And so what that means is that if the dollar is strengthening, there's no automatic response in terms of the price of those things, because the contract specifies you owe us $100 for this product. It doesn't matter what the exchange rate is. That's what the US has dictated. And again, when we look at what happens historically, you know, for example, China's 2018 devaluation of the renimbly against the dollar, that didn't change the trend in prices to the United States because effectively the ex-exemptively the ex-exam. supporters to the United States were just grateful to get a little bit more profit margin coming out

of that process and the dollar didn't really have a big effect in terms of offset. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky and, let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients

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as of right now by the way it's now 1012 a.m. on Monday the third markets falling a little bit more. NASDAQ down 2.3% S&P 500 down 1.78%. You know, this is not a gigantic sell-off by any stretch. On the other hand, it's significant. So it does seem to be a surprise. One of the things you heard, people love to say it. Oh, don't take Trump literally, take them seriously. But as far as I'm concerned, it's not clear that anyone was taking him literally or seriously when it came to tariff. People were just sort of, I don't think they were really thinking about it at all. Well, you know, when you talk to clients, when they ask you questions, how much surprise is there? How much, how different is this versus, say, what basically what people were expecting?

I think it very much depends on who you ask. I think that quite a lot of clients in Asia had been expecting quite an aggressive tariff response because, of course, they bore the brunt of the tariffs in Trump's first term, whereas I don't think that that has been such an expectation in North America and Europe is a bit mixed on this particular point overall. I think as well, I mean, the president prides themselves on their unpredictable management style, which, you know, makes my job as somebody who has to predict for a living a lot more difficult. But it also, of course, means that if we look at what happened with Colombia, where Trump retreated, you know, within hours from threats of tariff. You know, Columbia didn't really do anything. No, all of a sudden, we're backtracking because

we can't have the price of coffee going up. That sort of thing, I think, means that there is still this lingering hope that there will be some sort of Columbia-style reversal coming out of the administration on the tariffs. We've not seen it yet, and the clock's ticking. But I think there's that sort of background belief still in the minds of many investors. This is actually the other thing I wanted to ask you, which is we have seen Trump historically use the threat of tariffs as a negotiating tool, right? So hopefully he gets at least some of what he wants before the tariffs actually have to come into effect. But I feel like the more he does this, the less impact or the less bang for his buck he's going to be able to get, because at some point people are going to start calling his bluff.

I guess all of this is a way of asking, like, how many times can he do this with the same impact? Well, it's more than just sort of, you know, crying wolf all the time, which is part of what we're seeing. There are actually some quite serious long-term implications from this because, of course, you know, Trump in their first term renegotiated NAFTA. And within days of taking office in their second term has torn up NAFTA. So if you do a trade deal with the US in a year's time, how much confidence have you got that trade deal is still going to be operable in two years time or three years time? And so that's going to make doing deals actually more difficult over the longer term. So I think that's a particular challenge that we are facing here. I would also say, though, that the rhetoric from the Trump administration does seem to have shifted.

And I think that President Trump believes that tariffs are a good thing, all in capital letters, and not just a bargaining tool. They think that tariffs can be useful for revenue raising, which I personally would disagree with, but it doesn't matter what I think. That's what the president seems to believe. So I think there has been a break from the very clear bargaining tool position of the first term that there is sort of a larger role for tariffs in Trump's mind in that. the second term. I just have one last question. Explain to us, you said it earlier on, the disruptive potential of tariffing intermediate goods. One of the things we know, for example, about the auto industry, whether we're talking about the Canadian border or the Mexican border, or maybe both, you see parts and you see component crisscross the border several times along the way. Talk to us about

how this potential intersects. I think one of the problems that we have is a number of people, including I would suggest some people in the administration, are sort of stuck in the early 1970s in an imperial model of trade. You import raw materials. Everything is manufactured at home. You export the finished product. And that's sort of the state of play when Nixon did Universal Terrace back in 1971. But that's not how the world works now. A majority of global trade is a company shuffling goods between its subsidiaries. So a majority of global trade takes place inside companies as part of complicated supply chains within a firm. So when you start to impose these tariffs, if you've got an auto part in the United States, in a car made in the United States,

crossing the border with Mexico 12, 14 times, if every single time it comes back into the United States, you're slapping a 25% tax on it, that very, very quickly becomes an economic proposition. And that's the real risk. So that's where the disruption comes through. Supply chains are a lot more complicated than they were 50 years ago. This ain't 1971 anymore. We sort of touched on this earlier, but I think it's an important point to hammer home and is the proximate source of the market's confusion at the moment. And also, we would be remiss if we didn't ask Paul to do his impression of a central banker. But how do you expect central bankers to react to all of this? Because as we spoke about earlier, on the one hand, you would expect this to be

inflationary in the short term. So maybe they might raise rates to try to offset some of that. But at the same time, you would expect this to slow GDP in one way or another. Eventually, central banks like being ahead of the curve, or at least they say they do, would they perhaps try to lower rates in order to offset that contraction? Which way are they going to go here? So like most questions in economics, the answer is it depends. So, if we just get first round effects, if all you see is the tax being paid by US consumers pushing up prices, central banks should ignore that. Central banks should not respond to a one-off tax increase, which is a one-off price increase, because there's nothing they can do about it. However,

if we see second round effects, and this is where it starts to get very problematic, if we see, for example, retailers expanding profit margins again, another profit-led inflation episode, if we see US companies saying, well, our competitors' goods are now being taxed, so why don't we raise our own prices, as happened with the washing machine tariff, where you slap a tax on imported washing machines and domestic manufacturers raise their prices because they can, because there's less competition, that the central bank needs to respond to. That then becomes a problem. And then there's sort of associated second round effects. Do you see wage pressures coming through in certain sectors? I think that's unlikely, but if you do, the Fed would have to respond.

If you see, for example, higher auto prices, that could lead to higher secondhand auto prices, which would lead to higher insurance costs for auto. And that sort of chain effect is something the Fed needs to start paying attention to. So the direct effect of the tariff, I think the central bank should ignore. And indeed, the Fed could conceivably continue to cut rates. But if you see those second round effects coming through, that is a, five alarm bell warning, that's where the Federal Reserve or any other central bank needs to start paying attention. All right, Paul Donovan from UBS wealth management. Thank you so much for

coming on odd lots for what is probably going to be the first of many impromptu episodes, I imagine. Thank you, Paul. Thank you. Joe, I'm really glad we could do that at short notice. It answered a lot of questions for me and also kind of contextualized a lot of the big questions. I will just say on that second order effect point that Paul made at the very end. I'm looking at my inbox right now at a note from Bank of America saying they expect U.S. car insurance rates to go up as a result of the tariffs.

So, you know, sort of already in motion. The two big things for me are, A, the sort of real risk of the second order effects, all these other things that could happen, the more persistent. And then this idea, I like what he called, you know, the imperial model of trade, one, the old style, you're importing raw goods, you build it all here, you export it, you capture that value add, versus these really complex supply chains where something goes across the border multiple times. And then to your point, and to your question, I thought this was key. Like, even if these get reversed really quickly, the idea of like, well, what does that

mean for the prospect of any sustained sort of free trade block or free trade zone that it's also rip-upable, I think is really key? Yeah, lots of questions, time to start. brushing up on our tariff and trade history. So shall we leave it there? Let's leave it there. This has been another episode of the OddLots podcast. I'm Tracy Allaway. You can follow me at Tracy Allaway.

And I'm Jill Wisenthall. You can follow me at the stalwart. Follow our producers, Carmen Rodriguez, at Carmen Armin, Dashel Bennett at Dashpot, Kale Brooks at Kail Brooks. From our Odd Lots content, go to Bloomberg.com slash oddlots. We have transcripts, a blog, and a newsletter.

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