Per the Merriam-Webster dictionary, a tariff is a “schedule of duties imposed by a government on imported or in some countries exported goods.” In economics, a duty is a type of tax levied by a state. According to Merrill Lynch, the current administration’s proposals would put tariffs at the highest level in 70 years.

Why are markets reacting negatively?

In response to a tax, the quantity of goods goes down and prices go up. Lower demand means lower growth. Eventually this leads to lower incomes for households and lower profits for companies.

For those that want to get a little wonky, see below (otherwise skip below the next chart).

A tariff shifts the supply curve(S) up and to the left, as shown below in the “S pre-tax” and “S post-tax” chart below. The result is that Quantity on the horizontal axis shifts to the left, from Q1 to Q2. This causes Price on the vertical axis to increase from P1 to P2. Overall there is a shift in demand to the left.

According to the Art of the Deal, taking an extreme negotiating position to end up somewhere in the middle against an adversary is a part of the everyday playbook. While this may be an old hat for deal-makers, markets dislike uncertainty. Markets search for the equilibrium, trying to price what level of new tariffs will be placed upon the global economic system.

In addition, the markets are digesting that the Federal Reserve is determined to normalize (increase) interest rates and trim the Fed’s balance sheet. This comes after the Fed held interest rates at 0% for 7 years following the great recession (top chart below). In addition, the balance sheet expanded from just under $1 trillion to $4 trillion during the same time (bottom chart below).

This month the Fed raised interest rates for the 7th time since December 2015. The median projection by the Fed is for two more interest rate increases in 2018 and two each in 2019 and 2020.  The market is slowly coming around to the idea that the green arrow (above) is going to continue higher. In addition, the balance sheet is shrinking at an accelerating rate as bonds coming due are not reinvested (red arrow above). This is removing dollars and liquidity from the system, which lowers risk taking capacity for investors.

Whether the tariffs come to fruition or the Fed stays on its current course, markets are adjusting to the possibility of lower growth due higher tariffs (taxes) and less money in the system.

Questions about this blog? Contact Michael McKeown at 440-449-6900 or email Michael.

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