Gradually, Then Suddenly: Global Trade Shock to Economy and Markets

The unveiling of new, massive tariffs in the Rose Garden on April 2 sent shock waves through the markets, global supply chains, and geopolitical world order that could reverberate for a long time to come. Prior to April 2, we thought the worst-case tariff scenario were those proposed on the campaign trail. Now, through a series of steps, that worst-case tariff scenario has come to fruition. The April 2 announcement takes the effective tariff rate from 2.4% to 19%, the highest since the Great Depression in 1934.

We are now placing a 60% probability of a U.S. recession in the next 12 months. Importantly, we believe the downturn would be short-lived and shallow, as tariffs would be brought down at some point and the Federal Reserve would loosen policy. If the tariffs remain at current levels and are a permanent feature, we would expect a longer recession and an extended period of market weakness.

How did we arrive at a baseline expectation of a downturn? “Gradually, and then suddenly,” to borrow from Hemingway. We already expected slower economic growth in 2025 and have seen that view validated by data from Q1. The early tariff actions taken against Canada, Mexico, and China weakened the outlook considerably. The latest tariffs being put into place – a universal 10% minimum on April 5 followed by higher, individual rates for many countries on April 9 – paint a bleak picture for the U.S. and global economy. The cumulative tariffs, in our view, tip the scales to an economic downturn. Importantly, recession might still be avoided as the door for negotiations has been left wide open by President Trump and key members of his team, including Treasury Secretary Scott Bessent.

For investors, we do not think it is prudent to engage in panic selling or to meaningfully reduce risk. We don’t expect a deep recession and there is a 40% chance of avoiding one altogether. Markets have historically recouped losses within a year of short-and-shallow economic downturns and the market has already declined substantially. We are at this time maintaining a neutral allocation across asset classes having already reduced risk in November 2024 and February 2025.

Sizing up the tariffs

While saying the new effective tariff rate would be the “highest since 1934” helps give historical context, it does not convey the stunning magnitude of the action. For that, consider if these new levies were applied to import totals from 2024 and the taxes were passed to the consumer (which was largely the case for the 2018 tariffs and we believe would be the same here) it would amount to a tax hike of $620 bn, or 2.1% of nominal gross domestic product (GDP). That would place it among some of the largest tax hikes in U.S. history.

Another way to convey the magnitude is they would amount to a price hike of 7.2% for domestic retail sales, on par with the inflation recorded in the extremely painful experience of 2021-2022.  At that time, however, U.S. consumers were sitting on piles of pandemic-era savings, garnered from a combination of being locked out of spending during shutdowns as well as the influx of government stimulus. In the current environment such a price hike on imported goods would draw spending away from domestic services (such as air travel and vacations), contributing to economic weakness and, ultimately, deflation.

As a final consideration of scale, we compare to the Tax Cuts and Jobs Act (TCJA) of 2017 from the first Trump Administration. These new levies would amount to roughly the first three full years’ worth (2019 to 2021) of individual income tax cuts from that package, adjusted for inflation (Table 1). Put simply: these tariffs are massive in scale relative to history and to any current macroeconomic measure. As such, they will be a significant shock to the (slowing) economy if they come into force as scheduled over the next 5 days.

Table 1: Individual Income Tax Cuts from TCJA of 2017 ($bn)

^{Sources: Joint Committee on Taxation, Wilmington Trust.}

Murky Uncertainty

The impacts of uncertainty are more pernicious and harder to gauge than the strict, mechanical calculations above. Businesses can be quite innovative and entrepreneurial in dealing with costs but paralyzed by the unknown, and the path of tariffs seems impossible to predict. President Trump initially levied tariffs on imports from Canada and Mexico on February 1, only to grant a one-month delay 48 hours later. They went into effect on March 4, but a day later a reprieve was granted for U.S. automakers, despite previous insistence that no exceptions would be granted. Another day later, on March 6, a broad swathe of other goods from Canada and Mexico were exempted. This week, President Trump announced the new tariffs and a day later said they could be reduced if trading partners offered something “phenomenal” in negotiations. He added tariff relief could be in order for China if that government approved the sale of Tik Tok’s U.S. operations. In short, everything is written in pencil, never in pen, let alone in stone.

This type of uncertainty can be paralyzing for businesses and the deleterious effects of uncertainty can be staggering. Why would an automaker expand capacity in the U.S. if the playing field could change substantially in the next few months or years? Research on the experience from President Trump’s trade war in 2018 shows a shock to a policy uncertainty index (with a “shock” defined as a 2 standard deviation jump) can weigh on capital expenditures and GDP growth by 1-2%. Trade policy uncertainty in the opening months of the second Trump administration has surged by more than 30 standard deviations, by our calculations, and is likely already weighing on consumer spending and capex (Figure 1).

Remember the 40%

We have moved to a baseline expectation of a recession in the next 12 months with a probability of 60%, but we also stress there’s a 40% chance of avoiding such an outcome. We think that would require a reversal of most of the April 2 tariffs. The day after the announcement Treasury Secretary Bessent urged countries not to retaliate, advising patience and diplomacy, keeping the door open for negotiations, in line with President Trump’s comments Thursday. About 60% of all imports come from just four partners, China, Canada, Mexico and the European Union, and those talks have been ongoing even before April 2. Another helpful mitigant is the administration’s exclusion of critical items such as semiconductors, fossil fuels, pharmaceuticals, metals, and lumber. If the country-specific levies were removed but the global minimum of 10% remained and all retaliatory tariffs were removed, it would be a close call but likely still cause a mild and short recession.

If a recession is on the horizon the Federal Reserve would be cutting rates accordingly, in our view. We don’t think these tariffs would end up causing a “stagflationary” scenario of a recession and high inflation, simply because the economic weakness would bring prices down. That expectation is supported by the fed funds futures market, which is pricing in 4-5 cuts of 25 basis points (1.0%-1.25%) by end of 2025, as of Friday morning.

Figure 1: Trade Uncertainty at All-time High

Trade Uncertainty Index (Long term average = 100)

^{Source: Baker, Bloom & Davis, Wilmington Trust. Last: March 2025}

Adapting to Uncharted Territory

The present situation is unique, as tariffs are self-imposed, exogenous to the economy, and of a political nature. The unpredictable negotiating tactics of the Trump administration mean we are forced to make decisions based on the information we have on hand, but we must recognize the very wide bands of uncertainty driven by unanswerable questions, including (at the time of writing):

• Which countries will retaliate?
• Will the U.S. entertain negotiations?
• Could the latest tariffs issued under the International Emergency Economic Powers Act of 1977 be challenged or by an act of Congress?
• Will tariff revenue give Republicans the ability to issue a larger tax package that could mitigate some of the economic blow to consumers? The list goes on…

In a normal environment, our investment process is led by our economic views, and a significant revision to the economic outlook would usually lend itself to a change in portfolio positioning. However, the current policy backdrop and rapid onset of volatility creates the unusual situation where our economic call may be somewhat decoupled from our portfolio positioning. Increasing the probability of recession such that it is now our base case is not something that we take lightly, but that recession call could be reversed if tariffs are significantly reduced via negotiations or gestures by other countries to increase access to their markets. What cannot be reversed is panic selling in a down market.

Instead, we must balance our long-term strategic views with our 9-12-month investment horizon and recognize the likelihood that the equity market is recovering or (optimistically) has potentially fully recovered a year from now.  Looking at historical recessions, the median time from equity market trough to a new all-time high has been just 11 months (Figure 2)—a duration of time well within the investment horizon of the vast majority of our client base. Additionally, when the CBOE Volatility Index (VIX) has historically closed above 40—a level it breached in pre-market trading this morning—the market has been positive 12 months later 87% of the time.

Figure 2: Median Recessionary Drawdown Has Recovered in 11 Months

Maximum Drawdown and Duration of Recovery (in months) for Historical Recessions

^{Source: Bloomberg, WTIA. Reflects price return for the S&P 500 going back to 1953 (post Great Depression), as of March 31, 2025. Duration is measured in calendar days, which are then converted into months assuming 30 days/month.}

The market may have further to fall in the short term, but the economic fundamentals and lack of an obvious “bubble” candidate lead us to believe a recession would be relatively short and shallow despite the gravity of realigning global trade relationships. After all, corporate profit margins are at an all-time high, corporate cash balances are elevated, and consumer balance sheets in aggregate are healthy. Areas of the market like tech stocks or private credit could be exposed to more pain given the amount of capital that has gravitated to these assets in recent years, but we would not characterize either as a bubble capable of destabilizing the market over a longer period of time.

Patience is a Virtue

We caution against selling into a market where uncertainty and emotions are running high, but we also think the market is not yet reflecting an adequate margin of safety to warrant adding to risk, at least for fully diversified investors. (Those with excess cash can and should use this opportunity to deploy gradually into market weakness over a period of several weeks or months.) In other words, be patient.

The forward-looking price-to-earnings ratio on the S&P 500 has come down from 22.5x to below 20x next-12-month earnings. However, the policy environment has changed so dramatically that investors should arguably be paying less for every dollar of earnings in the U.S. market given considerable uncertainty about what the future looks like. On top of that, estimates of earnings growth over the next year are still too rosy, in our opinion, and are inconsistent with the probability of recession. The current P/E, therefore, is probably understated given the likelihood that the “E” is reduced in coming weeks. As first quarter earnings season kicks off next week, we should learn more about how companies will navigate the current uncertainty. For now, a neutral position to risk and across all asset classes (versus a long-term strategic benchmark) is appropriate.

It is admittedly hard to be optimistic with the market unraveling, but we are encouraged that diversification is working and the defensive parts of the portfolio are doing their jobs. Bonds are moving inversely to stocks and delivering positive year-to-date return despite concerns about stagflation. International stocks are outperforming domestic stocks in this down market. Defensive sectors like consumer staples, utilities, and healthcare are holding up. Within commodities, energy is taking a hit (which may actually help the consumer by offsetting higher prices elsewhere) but precious metals are acting as a safe haven.

The dollar is the one asset moving counter to what we may expect based on history. The U.S. dollar typically strengthens in a flight-to-safety environment, yet it has steadily weakened since inauguration day and took another leg lower this week. Economic theory would also say that tariffs should contribute to a stronger dollar. At this time, we think capital flight out of U.S. assets is overwhelming those traditional relationships, but we do not believe the current situation amounts to a crisis of confidence in the U.S. dollar as the global reserve currency. We believe that status remains intact.

A long-term perspective is one of the greatest assets of an investor. In times like these we are reminded that, while it may feel scary and unsettling to not know where the bottom is or what lies ahead, we have been here before. Many times. Each time the U.S. economy and equity market has picked up the pieces and moved higher. When we look (way) back, periods of crisis look like blips on the radar (Figure 3). With enough time, we expect the same of whatever unfolds in the coming weeks.

Figure 3: Long-term Perspective of Past Crises

S&P 500 Index Level

^{Source: Bloomberg. Reflects monthly data for the S&P 500.}

^Glossary

^{A drawdown is the peak-to-trough decline of an investment, trading account, or fund during a specific period. It can be used to measure an investment's historical risk, compare the performance of different funds, or monitor a portfolio's performance.}

^{The S&P 500 Index is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.}

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