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Economic Insight
05.05.2025The “reciprocal” tariffs that were imposed by President Trump exceeded the market’s expectation by a wide margin and were based on an arbitrary formula. The consequent market reaction, rising recession fears, and warnings from influential business leaders forced a policy backtrack, which was a major but temporary relief. The markets have voted yes for the de-escalatory policy moves (pausing of “reciprocal” tariffs, tariff reprieves/exemptions, trade negotiations) with the S&P 500 rallying to reclaim its pre-“Liberation Day” level.
Difficult trade negotiations are underway with the US administration looking for some quick wins to defy critics, improve the outlook, and further assure markets. However, it is unlikely to conclude many deals in a span of 90 days. Moreover, any deals reached will likely be broad roadmaps of how to proceed going forward rather than full-fledged trade agreements, although the US administration will hail them as big wins. In the meantime, the ongoing high uncertainty is taking its toll, and the growth outlook has weakened irrespective of the upcoming tariff and trade developments. Even after the “reciprocal” tariff reversal, US recession risks remain elevated, but an enduring de-escalation should allow for a recession to be avoided. The hope is that recession fears, financial market reactions, and other pressure dynamics will continue to help in course-correcting US policy.
President Trump, on April 2nd deemed “Liberation Day”, imposed a blanket 10% tariff on almost all countries along with much-higher “reciprocal” tariffs on around 60 countries. The “reciprocal” tariffs, as previously declared by the US administration, are supposed to reflect all the tariff and non-tariff barriers (such as value-added taxes, subsidies, regulatory measures, currency manipulation, etc.) that other countries impose on the US. However, in reality, the “reciprocal” tariff rates that were imposed did not attempt to capture any of the above factors. Instead, the rates simply equated to the trade deficit that the US has with each country as a share of the total US imports from each country, divided by two, effectively meaning that, all else equal, the higher the trade deficit, the higher the “reciprocal tariff” rate. Given that simple, and arbitrary, calculation, the “reciprocal” tariffs turned out to be very high, exceeding market expectations by a wide margin. For example, the US’s top trading partners were mostly slapped with duties exceeding 20%, reaching 46% for Vietnam. To put things in context, these rates are substantially higher than estimates of trade-weighted levies that these countries impose for their total imports.
This drove a plunge in equity markets and, more importantly, in the US treasury market (10-year bond yields spiked by around 50 bps over a few sessions) along with a steep drop in the US dollar index, threatening to destabilize financial markets. In our view, this, coupled with growing recession fears, warnings from influential business leaders, among other factors, forced Trump to backtrack, pausing the “reciprocal” tariffs for 90 days, but retaining the 10% blanket tariff. The pause was a significant relief for businesses and markets but is only a temporary one. Duties on China, following its retaliation to the reciprocal tariffs, were subsequently raised in phases to currently stand at a prohibitive 145%. And in addition to the already-imposed sector-specific tariffs on steel, aluminum, and auto imports, the US administration is planning additional ones on semiconductors, pharmaceuticals, lumber, copper and critical minerals, keeping uncertainty high. On the flipside, the pausing of the “reciprocal” tariffs, the several tariff reprieves/exemptions by the US administration (such as on electronics imports, some auto-related imports, etc), news-flow indicating some progress in terms of trade negotiations with some countries, and recently, the possibility of starting a dialogue with China, which effectively are all important de-escalatory policy moves, have driven a sharp rebound in stock markets. For example, the S&P 500 has reclaimed its pre-“Liberation Day” level, rallying by 14% from its recent low. In effect, the markets have clearly cast their vote about the US tariff policy, falling on any escalatory action and rising on any de-escalatory decisions.
High uncertainty takes its toll as the US administration looks for quick wins in terms of trade negotiations
Trade negotiations are already underway with several trade partners with the US administration giving priority to five countries, namely Japan, South Korea, India, the UK, and Australia. We think that the US administration is looking for some quick wins in terms of trade negotiations in order to achieve several goals such as 1) showing that its tariff strategy is working, defying critics, 2) lowering overall uncertainty which will have dividends in terms of the economic outlook, and 3) helping in further calming down the financial markets. Undoubtedly, progress in terms of trade negotiations will decrease uncertainty, support confidence levels, and help in improving the outlook. However, trade deals are usually complicated and take time to conclude. Hence, it is unlikely to seal many deals in a span of 90 days, the time during which the reciprocal tariffs are paused. Importantly, the US Treasury Secretary himself mentioned that any “deal” will be a “broad framework” or roadmap about how to move forward rather than a detailed trade agreement. Effectively, this should dilute the significance of any deal that is reached, although markets will likely react positively to such deals and the US administration will hail them as big wins. Moreover, even if proper trade deals were to be finalized stipulating, in effect, targets to narrow or eliminate the respective US trade deficit, it will take time for trade balances to reflect that and even longer to assess whether countries complied with the agreements in the first place or not.
In addition to the trade negotiations’ typical difficulties, the way the US administration sees the trade situation complicates matters for many reasons. This is so because their focus is not only on tariffs but also on many non-tariff barriers that are inherently complex matters such as value-added taxes (VAT), subsidies, regulatory measures, currency manipulation, in addition to non-trade matters altogether such as boosting investment in the US and security arrangements. For example, VAT (a consumption-based tax levied universally on domestic producers and importers), which is looked at as a tariff by the current US administration, will likely be a sticking point with many countries. In effect, the VAT is an entrenched fiscal policy tool, and to many countries, it is non-negotiable for it to be on the discussion table with the US. For the US’s top-10 trading partners, VAT rates vary between 5% (Taiwan) and 28% (India). Another fundamental matter is that President Trump associates trade deficits with “unfairness” and whereby eliminating these deficits is an overriding goal. This is tricky because there is a limit to how much an administration can interfere with the forces of supply and demand in order to boost trade balances, especially when attempted simultaneously with one’s largest trading partners.
US recession fears and financial market reactions to continue in helping course-correct US policy
Irrespective of reaching “deals” or not, it will not be surprising at all if there is further backtracking on key policy actions, including postponing again the “reciprocal” tariffs before they go into effect in July. And while these ongoing U-turns will keep uncertainty high, we believe they will be positive steps for the macro picture that will be cheered by the markets, as we have seen repeatedly. An enduring tariff de-escalation is needed and that can come from a scrapping of the “reciprocal” tariff strategy altogether and/or from genuine progress in terms of reaching some kind of deals with the US’s main trading partners. The hope is that US recession fears, financial market reactions, warnings from influential business leaders and other pressure dynamics will continue to help in course-correcting US tariff policy. On China specifically, the prohibitive tariffs that both countries imposed on each other will result in significant pain for both countries. Hence, it will not be surprising if a dialogue starts soon between the two countries, and recent news-flow corroborates this view. Absent that, the trade war between them has room to escalate into something even more serious with both countries imposing export restrictions on each other a testament to that.
Outlook weakened irrespective of tariff developments; recession risks elevated but can still be avoided
Whether there is an endured de-escalation in terms of tariffs or not, it is safe to say that the outlook for 2025 US economic growth has weakened while recession risks have increased and remain relatively elevated even following the 90-day pausing of the reciprocal tariffs. We think a re-instatement of the “reciprocal” tariffs in July will result in a US recession in the latter part of 2025 while a de-escalation from here will allow for a recession to be avoided. In terms of the inflation outlook, while tariffs are undoubtedly inflationary, the lower oil prices (Brent price now down by 27% from a recent high in mid-January) and weaker economic activities are deflationary forces. The stagflationary environment is obviously complicating the Fed’s job, which remains in a wait-and-see approach, but the cumulative 75-100 basis points cut by year-end currently priced-in by the futures market looks aggressive to us. We think such a scenario entails a sharp weakening in the labor market along with favorable inflation readings, which seems unlikely at this stage.