If investors were looking for a reason to sell U.S. stocks, they found it in President Donald Trump’s sweeping tariffs. Following several weeks of volatility sparked by on-again off-again tariffs, Trump’s April 2 announcement of higher-than-expected levies against virtually every U.S. trading partner sent shockwaves through global financial markets.

After two straight years of 20%-plus returns, U.S. stocks have declined more than 13% so far this year, underscored by a sharp drop late last week amid fears of a full-blown trade war, higher inflation and the rising risk of recession. In response, several Wall Street firms have downgraded their forecasts for U.S. economic growth in 2025.

“The bottom line is that the tariffs, as announced, have the potential to significantly weaken the U.S. economy, if not cause an outright recession,” said Capital Group economist Darrell Spence. “Granted, not all of the tariffs will get passed through to consumers, and it is certainly possible that some get rescinded. However, the grandeur with which this policy was announced makes it seem unlikely that a meaningful portion of it gets reversed quickly.”

Most sectors of the equity markets, both U.S. and globally, declined sharply after the April 2 tariffs announcement. But since the start of the year, international markets have dramatically outpaced the U.S. amid a powerful rotation into value-oriented stocks, including solid dividend payers. Bonds also have held up better, serving their traditional role as an effective counterbalance when stocks come under pressure.

The U.S. economy has not yet shown signs of a downturn, apart from a recent decline in consumer confidence. U.S. gross domestic product (GDP) growth rose to 2.4% in the fourth quarter, higher than previously expected. The unemployment rate remained low at 4.2% in March. And inflation has stabilized, falling into a range of 2.5% to 3% over the past few months. Market worries, however, have focused on how the tariffs could harm consumer spending, corporate earnings and GDP growth going forward.

Equity insight: This is why downside protection matters

The sharp market selloff serves as an effective reminder that it is always a good idea to maintain a balanced portfolio with an eye toward downside protection. Even though growth-oriented U.S. stocks enjoyed a winning streak over the past decade, market sentiment can turn around quickly, says Chris Buchbinder, principal investment officer of CGDV — Capital Group Dividend Value ETF. 

“Coming into this year, I was already cautiously positioned,” Buchbinder explains. “There was a lot of enthusiasm over artificial intelligence and a lot of excitement over the positive effect that Trump’s policies could have on the U.S. economy and specific industries. To a degree, I took the opposite side of that and, so far, it feels like the right positioning to me.”

Adding to more defensive areas of the market such as health care — which has not done as well over the past two years — appealed to Buchbinder, who has significantly elevated that sector in his portfolios. He expects U.S. and global equity markets to remain choppy this year as the tariff story evolves, and he is not trying to guess how the trade war will play out. Instead, he’s maintaining his defensive posture while looking for opportunities in more economically sensitive companies as expectations are reset.

“There are many potential outcomes from the Trump tariffs,” Buchbinder adds. “They range from a severe recession to a negotiated agreement where trade barriers are lowered around the world and this whole event blows over. That said, I think the potential severity of the negative outcomes is not fully priced into the market, so it makes sense to stay cautious and wait for more information.”

Fixed income insight: Seeking shelter in the storm

Bonds have done this year exactly what they are supposed to do at times of stress in the stock market. While the S&P 500 Index has declined, the Bloomberg U.S. Aggregate Index — a broad-based gauge of the investment-grade (BBB/Baa and above) U.S. bond market — has gained 3.7%, providing a cushion against equity market volatility in well-balanced portfolios.

Much of the positive gains were driven by a big move in U.S. bond yields. Last week, the 10-year U.S. Treasury note dipped below 4% for the first time since October 2024, just a few weeks before Trump’s November 5 election victory. If the U.S. economy weakens, it’s likely that interest rates could head lower in the months ahead, roughly in line with market expectations.

Since Trump’s April 2 announcement, expectations for U.S. Federal Reserve rate cuts have moved significantly, with some market participants predicting a reduction at every Fed meeting between now and the end of the year.

“The U.S. tariffs, and the threat of retaliation, have exacerbated already elevated levels of uncertainty,” says Pramod Atluri, principal investment officer of The Bond Fund of America®. “This increases the risk of companies retrenching and further weakening the labor market.”

“At the same time, higher import prices may present a negative real income shock to the U.S. consumer, who has thus far remained resilient,” adds Atluri, also a portfolio manager with CGCB — Capital Group Core Bond ETF. “Although the situation is in flux, the risks of a U.S. recession have increased and, therefore, adopting a more defensive position is warranted.”

In foreign exchange markets, the U.S. dollar, which has fallen sharply this year, could decline further as the rest of the world reacts to the tariffs by launching more stimulative fiscal policy. This is especially the case in Germany where leaders have pledged to spend billions more on defense and infrastructure projects, even if it means abandoning previous debt limits.

“Trump’s approach to negotiations is forcing countries to make almost instantaneous decisions on defense, fiscal policy and conflict resolution,” says Andrew Cormack, a portfolio manager with Capital World Bond Fund® and CGIB — Capital Group International Bond ETF. “The consequence of this should be structurally higher European bond yields and a stronger euro vs. the dollar.”

Beyond the immediate economic shock, higher U.S. tariffs also hint at a potentially more significant policy regime shift for the global economy and financial markets. As it stands, it seems as though tariffs may not simply be a negotiating tactic, as some investors speculated.

“The U.S. appears to be stepping away from the open world trade system that it fosters, and from which it has benefited over the last 80 years,” says Capital Group European economist Robert Lind. “At the least, this implies greater volatility and a higher risk of economic policy mistakes. Risk premiums in financial markets should rise to reflect this new environment.”

Given the increasing level of uncertainty, the best offense, at least for the time being, may be a good defense. Given more than a decade of outsized gains in the U.S., investors may want to consider taking another look at their asset allocation plans with an eye toward more balanced and diversified portfolios.

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