I always kind of crack up when clients ask about my crystal ball. I have a little one. It’s actually a mini-globe with all the continents frosted on, so it is truly hazy.
The fact is nobody knows for sure what will happen in the future. And in financial markets, that means we have to make predictions based on probabilities. The closer to today the prediction, the more uncertain it will be. It has always been that way.
So, in this year of major uncertainty, that prediction exercise is even more challenging. And at this juncture, with different 90-day pauses on multiple tariff fronts and the budget exercise winding through the Congress reconciliation process, employment remaining strong and inflation coming down ever so slowly, we really have to refine our thinking.
There seem to be two distinctly strong possibilities.
1. Tariffs settle to a higher-than-expected level creating revenue that helps balance a deficit from soon-to-be-passed tax cuts (higher tariffs - lower budget deficit)
2. Soon-to-be-passed tax cuts provide fiscal stimulus that offsets the negative effect to growth from the tariffs that finally end up being negotiated (lower tariffs - higher budget deficit).
Of course, there are A LOT of nuances in this binary coin toss. And we may not know which way things lean for months and months. But if we think of either outcome, and the related effects over years instead of months, it helps to have a set of expectations.
In the first scenario, a higher-than-expected tariffs level would provide revenues to the federal government that could be helpful in addressing the ever-growing debt level and yearly deficits. The current effective tariff rate is close to 15% but could come down to the 10% floor the administration seems to be targeting. It could even go lower, however, total tariff revenues are likely to be unpredictable as consumers adjust product preferences and producers rearrange their supply chains over time. This scenario would be worse for growth at least for the short-term but could have a positive effect on US debt, the dollar and, perhaps, even be deflationary longer term.
The second scenario, and possibly the more likely, could have a huge stimulative effect from tax cuts with tariffs eventually being negotiated to a rate closer to where they have been, at an effective rate around 5% or less. Growth would spike, at least in the short term. However, the effect on US debt and deficits would likely cause further downgrades to US treasuries, higher yields and eventually lead to another period of high inflation, as well as a negative effect on the dollar. We could even see something similar to the situation in the UK in the fall of 2022 when a new budget was enacted by the incoming Truss administration. Their huge, unfunded tax cut blew out the budget and the yield on guilts (UK equivalent to treasuries) spiked, with a huge drop in the pound sterling. Truss resigned before the end of that year.
Of course, neither scenario could end up coming into being, hazy crystal ball and all that. Plus, all the nuances in both the budget and tariff negotiations will make a big difference. Tariff negotiations could drag on for years instead of months. The reconciliation bill could stall and not get passed. Mid-term elections will be looming and have some sort of unpredictable effect. And, as always, an unforeseen geopolitical blow up could mean all bets are off.
We will be watching closely. Stand by.