Many are rightly scared about the consequences of Donald Trump’s tariffs. Specifically, about the tariff-driven plunge in global stock markets, a now-likely US recession, and a general collapse of the global economy, perhaps comparable with 2008.
Let me start with the least of these three worries: the exceptional speed and violence of last week’s equity “correction”. The -10.5% fall in the S&P 500 in just two days was a symptom of unusual investor panic. Before last week, declines of -10% over two consecutive days had only happened on three occasions since 1952. Each of those two-day plunges — in October 1987, November 2008 and March 2020 — occurred in the early or middle stages of major bear markets.
This could be just a statistical oddity, and history need not repeat itself. But if the violent sell-off last Thursday and Friday does turn out to be a symptom of a major bear market, then US equity prices still have a long way to fall. The S&P closed on Friday only -17% off its all-time high. That compares with a peak-to-trough decline of -33% in the 1987 bear market, of -56% in 2008-09, and of -34% in 2020.
A US recession is now almost inevitable, starting in the third quarter. This is not because of the dreaded “tit-for-tat” retaliation or the unpredictability of Trump’s tariff numbers, although these are certainly problems. It is because of a much bigger and simpler worry: Trump’s enormous tariffs will represent the biggest US tax increase since the Sixties, and possibly even since the Second World War. This enormous fiscal tightening, estimated at between $300 billion to $800 billion annually (equivalent to between 1% and 3% of US GDP) will hit US economic activity and employment extremely hard. With almost no prospect of immediate tax relief, it seems that an American recession is more likely than the 60% probability JP Morgan estimated after the tariff announcement.
After this catalogue of woe, there are three possible policy changes that could avert a major bear market, US recession and global slump. First, the Federal Reserve could come to the market’s rescue by cutting interest rates aggressively to offset the fiscal tightening, although this is unlikely. The tariffs will push US inflation up from its present 2.5-3% plateau to at least 4% and will eliminate any hope of a return to 2%, even in the long term.
If, however, the Fed does cut aggressively, or even hints strongly at rate cuts, it will probably trigger a market rally. But any such Fed-driven rally could be a mixed blessing for investors. If the Fed turns unequivocally dovish while inflation rises to 4% or above, much higher inflation will become permanently embedded. This in turn will unleash wage-price spirals, ultimately pushing bond yields much higher and equity valuations lower.
Congress could agree very rapidly on a budget bill with huge tax cuts that would be paid immediately, not delayed until 2026. This seems even less likely than a Fed rescue. The Republican majorities in both houses are so narrow that the highly expansionary Senate bill, with scope for up to $500 billion of annual tax cuts (which may still not be sufficient to compensate for the tariffs) has been declared dead on arrival by fiscal hardliners in the House. The much tighter House version (with almost no scope for fiscal stimulus beyond a permanent extension of Trump’s 2017 tax cuts), has no chance of majority support in the Senate.
This doesn’t mean that the US Congress will be unable eventually to pass a tax-cutting budget. But it does suggest that a greater sense of urgency will be needed, as in the 2008 crisis, to pass and quickly pay out the huge tax cuts required to offset the new and sudden tariff-related fiscal drag.
If a 2008-style disaster is to be avoided, Europe and China will have to become much bolder about stimulating their domestic economies. Fiscal stimulus, combining tax cuts, government investment and selective industrial subsidies would be the most effective way of counteracting the contractionary effects of tariffs on global economic activity and of maintaining world trade outside the US. European Union leaders have boasted of their “strong plan for retaliation”, but what they need is a plan to offset the loss of US exports by boosting domestic demand.
The surest way to refute US protectionism is to strengthen growth in the rest of the world.
