Why Underestimating Tariff Risks Could Derail the Current Bullish Market Optimism

The current market optimism, fueled by a focus on U.S. economic data and Federal Reserve policy, risks overlooking a critical wildcard: the persistent and escalating threat of tariffs. While investors have shifted their attention from trade policy to interest rate expectations, the reality is that tariffs remain a potent force capable of triggering a market re-rating. The underestimation of these risks—rooted in the belief that trade deals have stabilized the landscape—could prove costly as trade tensions evolve into a more structured, systemic drag on global growth.

The Illusion of Stability in Trade Policy

Recent developments, such as the U.S.-EU and U.S.-Japan trade agreements, have created the illusion of stability. These deals reduced immediate uncertainties for exporters and importers, allowing investors to pivot toward Fed rate cuts and economic recovery narratives. However, the underlying mechanics of tariffs remain unchanged. Barclays estimates that the U.S. effective tariff rate could rise to 15% by Q3 2025, with risks skewed higher if trade diversions are curtailed or exemptions revoked. Meanwhile, the Trump administration's 50% tariff on Brazil and 35% on Canada has pushed the effective rate closer to 17%, signaling a shift toward more aggressive protectionism.

The economic implications are clear: tariffs distort supply chains, inflate costs, and create asymmetrical burdens. For example, the U.S.-China Phase I deal has not reversed the decline in U.S. imports from China, which now stand at 14% of total imports (down from 21% in 2017). Instead, supply chains have shifted to Mexico and Southeast Asia, creating new vulnerabilities. If further tariffs are imposed on China or other key partners, these reallocations could accelerate, but not without significant short-term pain for global trade.

The Stagflationary Threat and Market Re-Rating

The most immediate risk lies in stagflation—a combination of weak growth and rising inflation. J.P. Morgan projects that tariffs could push the PCE price level up by 0.2–0.3 percentage points, complicating the Fed's rate-cutting strategy. This dynamic is already playing out: the 89.4% probability of a September rate cut reflects market expectations of a Fed forced to offset inflationary pressures while navigating a weakening labor market.

A re-rating of equities is inevitable if tariffs trigger stagflation. Defensive sectors like utilities and healthcare, which historically outperform in uncertain environments, are already undervalued relative to their historical averages. Conversely, sectors reliant on global supply chains—such as textiles, apparel, and AI-driven tech firms—face heightened exposure. For instance, AI companies' reliance on semiconductor imports makes them particularly vulnerable to tariff-driven cost shocks.

Asset Allocation in a Tariff-Driven World

Investors must recalibrate their strategies to account for the dual risks of trade policy and macroeconomic volatility. BlackRock's 2025 guidance emphasizes low-volatility equities, international diversification, and short-duration fixed income. Developed international equities, with their higher dividend yields and value factor exposure, offer a compelling contrast to U.S. stocks, which face structural headwinds from trade policy shifts.

Fixed income strategies should prioritize income generation over duration. The front-end of the Treasury curve remains attractive due to elevated rate volatility, but long-duration bonds are increasingly risky in a stagflationary environment. Corporate credit and short-duration bonds, however, provide a buffer against inflation while maintaining liquidity.

The Case for Active Management

The current market environment demands active management. While the 2018–2019 trade war saw a 32% rebound in U.S. equities after initial sell-offs, the 2025 landscape is more complex. Elevated optimism—reflected in a low high-yield bond spread of 305 basis points—suggests that investors are underpricing the risks of a "Trade War 2.0." Historical patterns indicate that markets recover when trade threats are averted, but the likelihood of further escalation remains high.

For example, the U.S.-China 90-day tariff reprieve in April 2025 temporarily boosted sentiment, but J.P. Morgan warns that a broader deal remains unlikely. If tariffs are reinstated, China's growth could falter, forcing additional fiscal stimulus and complicating global monetary policy.

Conclusion: Balancing Optimism with Prudence

Underestimating tariff risks is a dangerous game. While the Fed's rate cuts and economic data may drive short-term optimism, the long-term trajectory of trade policy could force a painful re-rating of equities. Investors must adopt a dual strategy: defend against stagflation with low-volatility equities and short-duration bonds, while selectively allocating to sectors insulated from trade shocks.

The key takeaway is clear: tariffs are not a distant threat but an evolving force reshaping global markets. Those who ignore this reality risk being caught off guard when the next wave of trade tensions emerges.