Traversing the new tariff topography

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Global financial markets were sent reeling last week after the Trump administration’s Liberation Day tariffs were more severe than anticipated. The situation remains extremely fluid as investors continue to digest the historic scope of the tariffs, and policymakers around the world respond in the coming days, weeks and months.

Key takeaways:

• On 02 April, the Trump administration announced higher tariffs averaging approximately 16% on every major trading partner (except Mexico and Canada), bringing the overall effective U.S. tariff rate to roughly 27%.

• We estimate that with these increases, the overall year-to-date drag of tariffs on U.S. economic growth is -1.7%.

• We project tariffs will add +2.0% to the core Personal Consumption Expenditures (PCE) Price Index — the U.S. Federal Reserve’s preferred inflation barometer — this year. The annualized core PCE rate was 2.8% in February, the most recent data available.

• We believe the outlook for interest rates is now skewed toward more Fed interest rate cuts (a total of 6-7 reductions in 2025-2026, versus 4 in our previous estimate), and a lower 10-year U.S. Treasury yield by year-end (4% versus 4.5% previously).

• Globally, we anticipate slower economic growth, additional policy rate cuts by the European Central Bank (ECB) and the Bank of Canada (BOC), and retaliatory tariffs levied against the U.S.

What happened? The Trump administration unveiled broad increases to U.S. tariffs on every major trading partner. Notable exceptions to the higher levies are Canada and Mexico, both of which are already facing 25% tariffs on goods not covered by the 2020 USMCA trade agreement. Canada is also subject to a separate 10% tax on energy exports to the U.S. Add to the list a 25% tariff on all non-U.S. auto imports, and our estimated effective U.S. tariff rate rises to 27%, from 11% previously (Figure 1). This is at the higher end of the 22% to 30% range of estimates we have seen from various industry analysts and exceeds the tariff rates imposed by the Smoot–Hawley Tariff Act of 1930.

Certain imported goods are excluded from last week’s big announcement:

• Steel and aluminum, which are already taxed separately.

• Copper, pharmaceuticals, semiconductors and lumber, as specific tariffs are already being considered on these items.

• Gold bullion.

• Energy and other minerals not available in the U.S.

What does this mean for the economy and inflation? We estimate the collective impact of all tariffs announced year to date to be a net negative for U.S. real GDP growth, to the tune of -1.7%. As for inflation, we estimate that tariffs will add 2.0% to the core PCE Price Index in 2025; its most recent reading (for February) was 2.8%. Unemployment, meanwhile, will likely rise 0.6% more than it would have without the tariffs. The unemployment rate for March, as reported in last week’s nonfarm payrolls release, ticked up slightly to 4.2%. Job growth, at least in March, beat estimates, but the report did not distract the market from tariff news. These forecasts also don’t reflect current unknowns, such as retaliatory tariffs or other actions from trading partners, or the impact of further U.S. economic deceleration driven by continued uncertainty.

What does this mean for the Fed and markets? Because the tariffs announced thus far are higher than previously expected, we think the risk is now skewed toward more rate cuts by year-end. The debate around further cuts, however, has shifted from inflation to decelerating growth. Notably, our probability-weighted guidance has increased from a total of four Fed cuts through 2025 and 2026 to 6.6 cuts, while our assessment of fair value for the 10-year U.S. Treasury yield has fallen from 4.5% to 4.0%.

Among asset classes, equities with a more defensive profile — in the current environment, those with less revenue driven by global trade activity — may weather the tariff storm better than other areas of the market. Dividend growers should continue to benefit from capital flexibility and balance sheet strength to help mitigate cost pressures. Infrastructure companies also appear resilient, as their revenues come from long-term contracts or concessions using their hard assets to deliver essential services for which demand generally holds steady even in challenging economic times.

Private markets, including credit, real estate and both equity and debt infra structure, tend to be more insulated from macroeconomic volatility as well.

While the range of potential outcomes in fixed income is wide, we believe duration will continue to act as an effective portfolio diversifier to equities in this market, presenting opportunities to take advantage of historically elevated yields. Among our highest-conviction ideas: municipal bonds.

Portfolio considerations

While it wasn’t a stellar first quarter for municipal bonds, with investment grade and high yield total returns of -0.22% and +0.82%, respectively, their broad underperformance didn’t reflect deteriorating credit quality or other fundamentals, but rather a combination of heightened policy uncertainty, unfavorable market technicals and short-term seasonal factors.

Among the specific headwinds: (1) uncertainty regarding changes to the tax code, namely a fear of munis losing tax-exempt status (unlikely, in our view); (2) surging new supply, with $115 billion of issuance through 26 March — up more than 15% year-over-year (and 2024 was a period of heavy supply); and (3) the ramping up of tax season, a cyclically weak technical environment leading to outflows from municipal ETFs and mutual funds in three of the past four weeks.

The silver lining is that these struggles have created better entry points with higher starting yields. For example, rising muni yields have driven the 5-, 10- and 30-year municipal-to-Treasury yield ratios up by 6%, 8% and 12%, respectively, since the start of the year (Figure 2). Historically, undecided investors have eventually entered the muni market when muni-to-Treasury ratios were elevated. Given today’s compelling ratios, we expect investor interest in munis to increase.

We’re especially confident in high yield municipals. These are primarily revenue bonds funding projects that are financially independent from the city, county or state they serve. These bonds offer higher yields to compensate investors for the risk(s) associated with a specific project. High yield muni investors pay close attention to a project’s economics and are generally not focused on the issues typically associated with a municipal government’s general obligation (GO) bonds, (e.g., managing public services, balancing budgets and funding pension costs).

During prior equity market selloffs, credit spreads for high yield munis have tended to remain stable. Since 1970, muni default rates have been lower than those for their taxable counterparts. The 10-year cumulative default rate for high yield munis is just 7.1%, compared to 29.7% for taxable high yield corporates. At the index level, high yield munis have longer duration than investment grade munis. The positively sloping municipal yield curve and lofty muni-to-Treasury yield ratios at the longer end of the curve make a persuasive case for allocating to high yield munis in a diversified portfolio.

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Endnotes

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