Jared Franz and Robert Lind

March 17, 2025

Tariff is a word many of us first heard in history class: we remember the Great Depression and the dark side of protectionist trade policy. Fast forward to today and tariffs are once again taking centre stage, serving as the linchpin of President Trump’s trade policy. A fierce debate has emerged over the impact they could have on the global economy — and as a cause of sharply rising market volatility.

Critics argue these tariffs mark the start of a new trade war that will hurt all countries in the end. Supporters say it is an attempt by the US to reduce long-term trade deficits and compel other countries to lower their own protectionist measures. In either case, the rewiring of global trade reflects a larger shift in geopolitical world order that is, in our view, just beginning.

To help make sense of it all, we developed this guide to tariffs and their potential implications for the economy, markets and investors.

1. What are tariffs and how are they used?

Tariffs are essentially taxes on goods imported from other countries. They are used to help protect domestic producers from foreign competition, among other purposes.

We employ a four-box framework to understand the motivations for tariffs and what they could mean for the investment environment. Four main factors — decoupling, rebalancing, negotiating and funding — will influence how the story plays out. For instance, tariffs used for negotiating purposes are unlikely to persist over long periods of time while those part of a larger decoupling process could be here to stay.

A four-quadrant graphic describes the motivations and implications of recent U.S. tariffs. The upper-left quadrant is labeled decoupling, which could shift supply chains and reduce reliance on certain countries. Potential impacts are listed for counties and industries for each motivation. This scenario is expected to have a high, persistent impact. The potential country affected is China. Industries impacted may include tech, energy, industrial materials, pharma, biotech and aircraft. The upper-right quadrant is labeled rebalancing, which would reduce trade deficits and boost domestic production. This scenario is expected to have a medium, persistent, mixed impact. The potential countries affected include China, the EU, Japan, South Korea, Vietnam, India, Mexico, Canada and Brazil. Industries impacted may include autos, steel, aluminum, agriculture, food, chemicals, consumer electronics, pharma, luxury, defense, energy and oil. The lower-left quadrant is labeled negotiating, which would create leverage through economic pressure to achieve policy outcomes. This scenario is expected to have a low, temporary impact. The potential countries affected include China, Mexico, Canada, the EU, Japan and Latin America. Industries impacted may include autos, steel, agriculture, consumer electronics, construction machinery, minerals, defense, energy and semiconductor equipment. The lower-right quadrant is labeled funding, which would generate revenue to fund domestic budget priorities. This scenario is expected to have a high, persistent impact and may result in a broadly applied universal tariff. Industries impacted may include consumer goods, autos and industrials, as well as price effects and margin pressure across industries.

Sources: Capital Group, American Compass. As of 5 March 2025

Our base case is that the United States can weather changes to trade policies, though higher tariffs would likely dampen economic activity and raise import prices. The US has the advantages of size, economic resilience and consumers with money to spend. Businesses have also ramped up investments in the US, both domestically and abroad from companies eager to maintain access to the world’s largest economy.

However, the ambiguity caused by shifting trade policies is already affecting business and consumer confidence, with potential negative consequences for the US economy and markets.

The fallout for other countries also remains uncertain, particularly those that rely heavily on the US for trade, such as Mexico and Canada, where exports to the US account for around 20% to 25% of GDP. For most European economies, exports to the US make up approximately 2% to 3% of their GDP. If the US imposes tariffs, resulting in lower exports and economic growth for these countries, then we are likely to see looser macroeconomic policy to counter the negative effects. Some governments are responding decisively. Germany, for example, has relaxed its fiscal policy dramatically and laid out plans to increase spending for infrastructure and defense, in part to reduce reliance on exports for growth.

2. Why is the US trade deficit so high?

If there is one number to know about tariffs, it is the US trade deficit for goods. That figure hit $1.1 trillion in 2024 as Americans bought imported products and a strong US dollar weighed on exports. The US has run a trade deficit every year since the 1970s.

The US trade deficit surged to near record highs in 2024

A mountain chart reflects the U.S. goods trade deficit in U.S. dollars from 1974 through September 30, 2024, with contributions to trade by top U.S. trade partners in 2024 in a column on the right. Goods trade deficit has steadily increased from 1974’s figure of $273 million to $865 billion in 2008. Goods trade deficit dropped briefly from there to hit $713.8 billion in 2013 before rising steadily from there to the most recent 2024 level of $1.1 trillion. In 2024, China’s trade deficit contribution was roughly $285 billion. The European Union followed with $226 billion, Mexico with $174 billion, all others with $137 billion, Vietnam with $118 billion, Canada with $73 billion, Japan with $70 billion and South Korea with $63 billion.

Sources: Capital Group, Bureau of Economic Analysis. Figures reflect 12-month totals through September of each year. As of 30 September 2024.

Economists note the high trade deficit may be a sign of US economic strength — indicating consumers are buying — but the figure is nonetheless why tariffs are central to Trump’s economic agenda. Other countries rely on global trade far more than the United States, and the administration aims to leverage America’s economic position as a tool to achieve a more balanced relationship with its trading partners.

Still, the US runs the world’s largest current account deficit, which is the counterpart of huge foreign capital inflows into the US. If the US wants to reduce its deficit, it will likely mean smaller capital inflows and a weaker dollar.

Trump’s use of emergency orders to implement or remove tariffs has unnerved markets. Prior administrations have used tariffs to varying degrees, but under laws that required detailed analysis, which allowed more time for companies and stakeholders to respond. Whatever the method, tariffs may represent a pivot to an isolationist-leaning policy that could have long-term ramifications for investment portfolios.

3. Do tariffs cause inflation?

The short answer is yes, but how it plays out is much more complex.

In the event of a one-time tariff, prices would likely increase modestly but then even out over time. A more worrisome development is a trade war scenario, where tariffs ratchet higher year to year. That, in turn, could lead to higher long-term inflation with a knock-on effect of rising interest rates.

Economists agree the cost of tariffs is largely paid for by a combination of consumers and companies willing to accept lower profit margins to sell products. A common estimate is that 30% to 50% of the cost is passed on to consumers, though the rate may be higher for products with fewer substitutes. Recent research has shown that the 2018–2019 tariffs were mostly passed on to US consumers.

Trump’s decision to impose tariffs on imported washing machines, but not dryers, in January 2018, is an often-cited case study from economists at the University of Chicago and the Federal Reserve. The study found domestic US manufacturers raised prices to match competitors, despite not being tariffed. Moreover, prices of dryers also increased as manufacturers may have used tariffs to raise prices opportunistically or split the increases between the washers and dryers.

Home appliance prices increased then stabilised under Trump 1.0 tariffs

The chart reflects the inflation rate for appliances for consumers and retailer’s Producer Price Index from January 2017 to January 2019. This shows a starker contrast in price changes. From January 2017 to December 2018, retailers’ prices were 13% higher compared to consumer price increases of 6%. The following year in October 2019, prices increased 16% for retailers and only 1% for consumers.

Sources: Capital Group, Bureau of Labor Statistics, Peterson Institute for International Economics. Retailer price change is represented by the PPI retail trade for the major appliances subcategory. The Producer Price Index, which measures the average change over time in the selling prices received by domestic producers for their output. Consumer price change is represented by the consumer price index for major appliances subcategory. As of 15 December 2019.

The value of the US dollar has also changed in reaction to tariff headlines. Higher tariffs generally lead to a stronger dollar since they lower demand for imports priced in foreign currency. Conversely, limiting tariffs lowers the dollar’s value as demand for foreign currency increases. A strong dollar could help offset some tariff-related costs for consumers, similar to the way US tourists benefit from a strong dollar when traveling abroad.

4. What is trade reciprocity and how will it unfold?

At face value, the concept of trade reciprocity is simple: We charge you the same tariffs that you charge us.

The Trump administration aims to rebalance tariffs between the US and other countries to make them reciprocal. Such a move bucks 75 years of multilateral US trade policy and sidesteps rules of the World Trade Organisation, the successor to the General Agreement on Tariffs and Trade (GATT) of 1947.

This change in strategy is happening because the current US administration believes the balance has tipped too far as key American industries face steep barriers to selling their products abroad. Take cars, for example. Auto sales between the US and the European Union favor the latter. The EU currently imposes a 10% tariff on US cars sold in their markets compared to the 2.5% rate imposed by the US on imported European autos.

It is unclear whether Trump’s definition of reciprocity would include value-added tax (VAT) rates charged by many countries on domestic purchases. These rates are generally applied at each stage of production, versus a US sales tax which is levied at the final sale. Many economists argue that VATs are not taxes on imports, so they are not the equivalent of tariffs. In the case of the EU, taking the VAT into account implies a larger effective tariff rate of roughly 25%.

Trade barriers are uneven between the US and most economies

The table shows the tariff rate comparison across importing countries to the United States. For China the average U.S. tariff on its goods was 20% while China’s average tariff on U.S. goods was 7.5% for a tariff gap of 12.5%, and its VAT ranged from 6% to 13%. For Germany the average U.S. tariff on its goods was 3.3% while its average tariff on U.S. goods was 5.0% for a tariff gap of 1.7%, and its VAT was 19%. For Japan the average U.S. tariff on its goods was 3.3% while its average tariff on U.S. goods was 3.7% for a tariff gap of 0.4%, and its VAT was 10%. For Vietnam the average U.S. tariff on its goods was 3.3% while its average tariff on U.S. goods was 9.4% for a tariff gap of 6.1%, and its VAT was 10%. For Taiwan the average U.S. tariff on its goods was 3.3% while its average tariff on U.S. goods was 6.5% for a tariff gap of 3.2%, and its VAT was 5%. For Ireland the average U.S. tariff on its goods was 3.3% while its average tariff on U.S. goods was 5.0% for a tariff gap of 1.7%, and its VAT was 23%. For India the average U.S. tariff on its goods was 3.3% while its average tariff on U.S. goods was 17% for a tariff gap of 13.7%, and its VAT ranged from 5% to 28%.

Sources: Capital Group, PWC, Census Bureau, World Trade Organization (WTO). Average tariff rates reflect average Most Favoured Nation (MFN) applied rate based on 2023 figures from the WTO, except where noted below. Canada, Mexico and South Korea have free trade agreements with the U.S. and are excluded from this list. China's average tariff rate on US goods does not include retaliatory tariffs. VAT refers to value-added tax. ¹Consumption tax. ²Goods and Service Tax (GST). Bars that extend to the right in the "tariff gap" column indicate tariff gaps that are more preferential to the US; bars that extend to the left indicate the opposite. Only China’s tariff gap favored the US. As of 10 March 2025.

Given the one-on-one nature of these trade negotiations, details matter. Tariffs on major trading partners such as China, the EU, Canada and Mexico can reduce US trade deficits and boost domestic production by giving local firms an edge over imports.

They could also invite retaliation, such as Canada’s removal of US liquor from its shelves. China could ban critical mineral exports to the US, decrease purchases of airplanes and agriculture products, and increase investigations of US-based companies with exposure to China, including Apple, Starbucks and Tesla.

5. What impact did tariffs have during the first Trump administration?

Investors may be experiencing a strong sense of déjà vu as tariffs make headlines. The first Trump administration pursued a similar goal of reducing the trade deficit by imposing tariffs on China. That move sparked a trade war that whipsawed markets and dominated the news, much like now.

Tariffs dominated headlines under Trump’s first term

The chart shows the value of an initial $1,000 investment in the S&P 500 Index on January 1, 2018, through December 31, 2019. That dollar amount has risen to $1,257. It also shows the annual Consumer Price Index on the right side which increased from 2.15% on January 31, 2018 to 2.85% in July 2018 before falling to 2.15% in November 2018. It hovered at that level before ending in December 2019 at 2.32%. The chart also lists headlines or events during that period. These include January 22, 2018, when Trump imposed tariffs on solar panels and washing machines; March 23, 2018, when broad tariffs on steel and aluminum went into effect; June 1, 2018, when the U.S. ended tariff exemptions for the EU, Canada and Mexico; June 22 through July 1, 2018, when the EU and Canada retaliated; July 6, 2018, which marked the first phase of China/U.S. tariffs; July 24, 2018, when subsidies for American farmers went into effect; August 23, 2018, when the second phase of China/U.S. tariffs was introduced; September 24, 2018, when third phase of China/U.S. tariffs began; December 1, 2018, when the U.S.-China tariff truce was declared; February 24, 2019, when the tariff increase was delayed; May 10, 2018, when the U.S. raised the China tariff rate on previous list; May 17, 2019, when the U.S. lifted tariffs on Canada and Mexico; May 30, 2019, when the U.S. applied tariffs on Mexico to deter migrants; June 1, 2019, when China raised retaliatory tariffs; June 7, 2019, when tariffs on Mexico were called off; August 1, 2019, when the U.S. announced tariffs on almost all remaining Chinese imports; August 17, 2019, when Trump delayed the auto tariff decision; and December 13, 2019, when Trump called off December tariffs in anticipation of a China deal.

Sources: Capital Group, Bureau of Labor Statistics, Peterson Institute for International Economics, Standard & Poor's. Value of hypothetical investment in the S&P 500 reflects the total return of the index over the period from 1 January 2018, to 31 December 2025. Past results are not predictive of future performance. As of 10 March 2025.

In hindsight, the impact on inflation was muted in the aggregate, with the annual consumer price index ranging from 1.50% to 2.85% in 2018 and 2019. The S&P 500 Index declined in 2018 but rallied sharply in 2019, both years driven by factors other than tariffs.

The world has changed since that initial round of tariffs. The impacts of the pandemic, wars in Ukraine and the Middle East, and the greatest inflation shock in decades continue to ripple through the economy. How tariffs and federal spending cuts will affect growth is even more uncertain given the evolving nature of Trump’s policies.

The lesson may be that in times like these, it is important to be clear about what we do and do not know — recognising that tariffs are just one part of the equation. Focusing on investment principles such as diversification and staying invested in the face of market volatility become more essential to achieving long-term investment goals.

Jared Franz is an economist with 19 years of investment industry experience (as of 12/31/2024). He holds a PhD in economics from the University of Illinois at Chicago and a bachelor’s degree in mathematics from Northwestern University.

Robert Lind is an economist with 37 years of investment industry experience (as of 12/31/2024). He holds a bachelor's degree in philosophy, politics and economics from Oxford University.