The opening salvo in Trump trade war two

Markets were recently rattled by three executive orders announcing tariff increases on Mexico, Canada, and China, marking an opening salvo of President Donald Trump’s trade war. With Europe likely next in line, uncertainty remains high—despite a 30-day delay on tariffs for Mexico and Canada—fueling further market volatility.

Trump’s opening tariffs target Mexico, Canada & China

On February 2, U.S. President Donald Trump signed executive orders imposing punitive trade tariffs on imports from Mexico, Canada, and China, citing concerns over illicit drugs and illegal immigration. He also floated a potential additional 10% tariff on imports from the European Union. The key measures of the executive actions include:

• Mexico & Canada: 25% tariff on imports, except energy imports from Canada, which will face a 10% tariff.
• China: 10% tariff on imports.
• E-Commerce exception suspended: The “de minimis” exception, which allowed duty-free entry for packages under $800, will no longer apply for these countries. This rule was largely seen as a benefit for Chinese e-commerce retailers.
• Delayed implementation: Originally set for February 4, tariffs on Mexico and Canada have been postponed by 30 days following initial agreements on drug and immigration controls. Tariffs on China remain on schedule.

Issued under the International Emergency Economic Powers Act (IEEPA) and the National Emergencies Act (NEA), which do not require investigations or reports, these actions are unprecedented and likely to face legal challenges. Notably, there are no explicit criteria for lifting the tariffs beyond cooperation with the drug and immigration measures, which adds additional uncertainty to an already volatile market.

Tariffs fuel market uncertainty

Markets initially tumbled in response to President Trump’s tariff announcement amid broad risk-off sentiment. Fears of tariff-driven stagflation sent short-term Treasury yields soaring while long-term yields fell, flattening the curve. The sharp market reaction suggests many were caught off guard. While Trump signaled tariff plans during his reelection campaign, few expected such swift action—especially with steep tariffs on both Mexico and Canada. Markets regained some ground after the 30-day delay for tariffs on both Mexico and Canada was announced. Asian equities also retraced some losses after Trump said he will hold further talks with China; however, the situation remains fluid, keeping investors on edge.

Lessons from the 2018 experience

The trade war under Trump 1.0 involved several of the U.S.’s major trading partners but was predominately focused on China, dampening both economies by 0.3%-0.7%. The dollar surged, while U.S. inflation saw only a modest 0.1% increase, allowing the Federal Reserve to begin its rate-cutting cycle in 2019 amid slowing global trade and investment.

While providing helpful context, today’s trade tariffs are much broader—covering $1.4 trillion in trade, four times the 2018 level—and much larger. Unlike in 2018, tariffs are likely to cover consumer goods and capital equipment, resulting in a potentially more significant impact on consumers and inflation. And, with inflation still a concern, policymakers and businesses are likely to be far more sensitive to price pressures this time around.

Trump 2.0 - Impact of tariffs on growth and inflation

Assuming all the announced tariffs eventually go ahead, our initial estimates (which do not take retaliation, offsetting currency impacts, or concessions into consideration) suggest a greater economic impact than in 2018:

Mexico/Canada economies: The impact of an additional 25% tariff on Mexico and Canada is likely to be sizable given how much both rely on the U.S. for trade. With the U.S. accounting for 20-30% of both economies’ total exports, rough calculations suggest that the estimated negative growth hit could range from 7% to 10% of GDP. In other words, impactful enough to throw the Mexican and Canadian economies into deep recession. Their central banks are likely to respond with additional rate cuts, putting further downward pressure on their currencies.

China economy: While the additional 10% tariff on China could lead to a direct GDP drag of about just 0.4%, the broader impact may be greater, threatening China’s global economic leadership ambitions. With an already struggling economy—still reeling from the property market downturn and weak sentiment—China remains heavily export-dependent, making it highly vulnerable to an increase in tariffs. In response, local authorities would likely ramp up stimulus measures in an attempt to offset the downside risks.

U.S. GDP growth: The broad impact of these tariffs will likely negatively impact U.S. growth and accelerate U.S. inflation. The tariff increases would push the U.S. effective tariff rate up from 3% to 11%, reducing GDP by an estimated 1.2%. While smaller in magnitude and less significant than the hit to Mexican and Canadian growth, it would represent an important growth shock. Other policy measures, such as tax cuts and deregulation, may be required to cushion downside risks.

U.S. inflation: As U.S. consumer spending on food, energy, and autos depends heavily on North American trade, these tariffs will likely have a meaningful impact on U.S. inflation. Estimates suggest that tariffs could result in a 0.5%-1.0% increase in U.S. inflation in the near term, potentially pushing headline inflation back towards 4%.

Whether the increase in inflation is sustained, however, is likely to be determined by a variety of factors, including whether wholesalers or retailers opt to absorb some of the tariffs in their margins, if U.S. consumers substitute lower-cost domestic goods, if inflation expectations remain anchored, and how much the U.S. dollar appreciates.

Fed impact: With uncertainty likely to remain elevated for investors and policymakers alike, the Fed is likely to begin a prolonged pause in policy actions until they have greater clarity about the tariffs and their impact on both growth and inflation. It is worth noting that, with disinflationary progress stalled and price pressures still above the 2% target, the Fed may be more sensitive to the inflation side of their mandate.

Navigating a volatile trade environment

Near-term tariff uncertainty may dampen business confidence and capex, pushing risk premiums higher and weighing on asset prices. However, the U.S. economy remains resilient, with strong growth, a firm labor market, and solid corporate and household balance sheets providing buffers against headwinds. While volatility is likely to persist, this backdrop suggests selective opportunities and positive market returns.

• U.S. equities: Large-caps with high international exposure, including the Magnificent 7, will face pressure from the tariffs due to China-related revenue exposure (ranging from 3-21%). Small caps have a greater domestic focus and may hold up better. Across sectors, technology and certain pockets of consumer discretionary are likely to be the most vulnerable, while defensive sectors, like utilities, healthcare and financials, should be more insulated.
• International equities: Markets have yet to fully price in trade risks, especially in Europe, where future tariffs pose a significant downside threat.
• U.S. Dollar: Continued dollar strength should be expected as tariffs weaken other economies. This may be further exacerbated by widening interest rate differentials as impacted economies loosen monetary policy to counter economic strain.
• Emerging markets (EM): Tariff risks seem to remain underpriced across EM, while a stronger dollar could challenge these economies. With ex-China EM growth healthy, the EM complex should remain relatively well supported. Differentiation will remain key as trade and foreign direct investment flows are inevitably rerouted.

President Trump’s unilateral control over trade policy ensures elevated market volatility for the foreseeable future. Furthermore, his willingness to use tariffs to attempt to achieve non-economic goals challenges the assumption that he would walk back from some of his most severe policy proposals.

Therefore, the greatest market risk likely lies in policy unpredictability—the timing, scope and duration of the Mexico, Canada, and China tariffs remain unclear—as the path forward for additional tariffs is uncertain at best. Given this environment, diversification is essential to manage portfolio risk and capture opportunities as companies, countries and markets adjust.

Principal Asset Management

Alongside Christian Floro, Market Strategist at Principal Asset Management