Tariffs’ leverage extends far beyond trade

Tariffs, in their modern form, are a trade measure. Higher U.S. import duties help domestic producers compensate for lack of cost competitiveness. An import tax helps reduce the U.S. trade deficit in the near term, although the longer-term picture becomes muddied by foreign exchange markets and other countries’ retaliatory moves. Thinking of tariffs as a trade measure is likely a pretty good way of understanding President Donald Trump’s proposed tariff increases on Chinese goods.

Another way of thinking about a tariff is that it’s a pay-to-play measure for countries that want access to the U.S. market. Because if there’s one area where the U.S. leads, it’s as the source of excess aggregate demand for the global economy. Fancy words aside, if you want to sell goods, you start with your domestic market and your next focus is likely going to be the United States.

Chinese exports to the U.S. have held steady despite higher tariffs

The line chart shows the value of U.S. imports from China in billions of U.S. dollars from January 2015 through November 2024, and the average U.S. tariff on Chinese imports from January 2018 through November 2024. The U.S. tariff rate began to rise sharply in 2018 from roughly 3% to a high of roughly 21% in 2020 before settling at 19.3%, where it remained through 2024. The value of imports from China has followed an annual cycle in the approximate range of $30 billion to $50 billion; after dropping to around $20 billion in 2020 in the wake of tariff increases, it has recovered to a range of $30 to $40 billion annually.

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Average U.S. tariff on Chinese imports (left)

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U.S. imports from China (USD billions, right)

Source - RBC Wealth Management, Bloomberg

Historically, the U.S. hasn’t asked for much in return for access to its consumers. The typical approach was to say that relatively free access from global producers was good for American households: more stuff at better prices. That view, however, isn’t an immutable law of physics.

Another approach—equally valid—is to seek concessions from other countries to guarantee ongoing access to the American markets. This is essentially what the United States did in the so-called Plaza Accord—a multilateral deal to reduce the U.S. trade deficit by weakening the dollar—and a series of bilateral agreements with Japan in the 1980s and 1990s to get “voluntary” limitations on U.S.-bound exports. Retaining even limited access to U.S. car shoppers required concessions in other areas of trade and finance.

We expect the Trump Administration to use and extend the Plaza Accord mentality. Rather than look for national trade advantages, we think his administration will look to extract concessions across the whole range of economic and political issues. With direct neighbors, border issues are likely to dominate. With the EU, defense spending could take center stage. But no matter what ultimate deal is cut, we think tariffs are just a very powerful means of applying bilateral pressure to allies and competitors alike.

Let’s make a deal

If the administration does use tariffs primarily to generate concessions, we think there are two key investment conclusions for U.S. assets.

First, if tariffs are just a negotiating lever, they don’t need to be applied for long periods—if at all—to work. A quick demonstration of power—or even just a threat—gets the concession, benefits accrue, and upfront costs are minimal. Much of the conversation in the press and among economists about the multi-year economic costs of tariffs and potential retaliation could significantly over-emphasize the impact of the brief application of a punitive tariff rate on a given country.

We can see this dynamic in action already. In the initial days of the administration, Colombia refused to accept U.S. government flights carrying deportees in conditions the South American nation found unacceptable. In response, President Trump threatened a 25% initial tariff with a rapid step-up to 50% on all Colombian goods. Faced with a potential economic disaster, Colombia had no realistic alternative but to concede, and it quickly did so.

With Canada and Mexico, the story—in our mind—is quite similar. Large tariffs on both countries were threatened, and then delayed for a month after both Mexico and Canada agreed to boost border security. If tariffs are imposed on Mexico, Canada, or another U.S. ally—as may happen—we think they are likely to be quite brief. Our view is that the Trump administration is more likely to ratchet up tariff levels—as was threatened in the Colombian case—instead of letting time increase the pressure on our counterparties. Again, though, this should keep the overall immediate economic cost to the U.S. relatively low.

The second implication of viewing tariffs through the prism of a negotiation lever is that policy is likely to be incredibly fluid, particularly in the early stages. Part of the leverage of tariffs is that they’re not only absolute but also relative. Being charged 10% to access the U.S. market is painful, but it’s doubly so if other nations only pay 5%. That reality means that the Trump administration negotiation stance is likely to be fluid, with lower relative tariff rates, targeted exemptions, and long phase-in times all in play at various times with different countries.

Domestic political considerations in the U.S. may also lead to ad hoc policymaking and temporary relief. In general, this fluidity should benefit larger companies—they have the scale to get the ear of policymakers and the resources to adjust their supply chains on the fly.

Varied outcomes and heightened risks

Tariffs as a negotiating tactic versus a trade measure may lead to better outcomes for some investors, but it’s not without negative implications nor without risk.

We think the most obvious negative is for major U.S. trading partners. Even the threat of tariffs can lead to supply chain shifts, cutting sales for overseas suppliers to U.S. companies. That pain will be felt even if no tariff is ever applied and can be durable.

For certain combinations of industries and countries, U.S. exports are critical for production economics. Canadian oil tends to find its way to U.S. refineries, for instance, and not all refineries are equally adept at handling Canadian-grade crude. Even a temporary disruption to exports from these national critical sectors can carry meaningful economy-wide impacts to U.S. trading partners, as we recently discussed with reference to the Canadian economy. It’s worth noting that some—but admittedly far from all—economists have argued that the Plaza Accord contributed directly to Japan’s poor economic performance during the 1990s, the so-called “Lost Decade.” Adding to the concern is that many non-U.S. economies are currently in a relatively fragile growth position. A downturn in a particular export to the U.S. could be an economic nuisance during a boom, but a grave threat when the economy teeters.

Not just China: bilateral trade characteristics leave many countries vulnerable to tariff threats

Monetary values in billions of U.S. dollars as of 12/31/23.

Source - RBC Wealth Management, U.S. Bureau of Economic Analysis, World Bank, Bloomberg

This does not mean that tariffs will be painless in the United States. As our RBC Economics colleagues have discussed, the U.S. is not invulnerable to a trade war, although Canada is likely in a weaker position overall given the trade and manufacturing realities both countries face.

This brings up what we see as the primary concern for U.S. assets if tariffs are used as a negotiating lever: the U.S. position is so strong that it could easily lead to a miscalculation that hurts both sides. The U.S. is the global growth leader in dollar terms, and in nearly all bilateral relations, any interruption to trade is more costly for foreign exporters than U.S. consumers.

The risk that we see is that the U.S. overplays its hand, asking for political impossibilities such as territorial concessions or economically catastrophic shifts in terms of trade. If counterparties are pushed too far, the U.S. could end up kicking off a trade war on the assumption that it will all be resolved quickly and favorably but ends up dragging out. This could conceivably lead to a global economic growth slowdown.

This is not our base case, but it should not be dismissed out of hand. We think negotiations are ripe with opportunities for misunderstanding, and domestic political realities are often opaque to outsiders. The risk that a negotiating tactic morphs into a mutually painful trade war is not merely theoretical.

Short-term gains versus (potential) long-term pain?

More generally, we think the tariff issue reflects what will likely be a tendency by the Trump administration to focus on short-term results over amorphous long-term benefits. Prior administrations, for instance, largely avoided using tariffs for non-trade negotiations in the hopes of fostering better bilateral relationships to confront other issues. The Trump administration is clearly operating under a different set of priorities.

To be clear, neither approach is obviously superior; it boils down to what concessions can be negotiated versus what impact—if any—diminished goodwill may have in the future. Neither point is known today, and the latter could potentially be unknown for years. But it’s clear to us at least that the Trump approach likely entails both risks and benefits to the U.S. with the bulk of the gains upfront as risks accrue over time.

We can see the same trade-off in other areas as well. Bank capital requirements are a good example. We think it’s very likely that Trump-appointed bank supervisors will look to slow the implementation of higher capital requirements on U.S. banks. All else equal, tying up more capital in bank vaults tends to slow economic growth while simultaneously allowing banks to absorb future credit losses more easily, potentially lowering the probability and cost of any future financial crisis.

Like most regulations, there’s no single correct answer when setting those requirements. Reasonable people can, and do, differ. We think it is fair to say, however, that on this, as with most regulatory issues, the Trump administration will look to tilt the scale in favor of near-term economic growth, while de-emphasizing other regulatory goals. Over most investors’ time horizon, we think the pro-growth policy bias is likely to dominate. As time progresses, however, the risks of miscalculation likely grow.

Same, with a twist

There’s nothing new with the idea that investors need to strip away labels and focus on fundamentals. The nuances we see with the administration are a greater willingness to use the widest possible range of policy moves to apply negotiating pressure on other countries, as well as a sharper focus on stimulating near-term economic growth. For investors, we think the message is to position for continued global economic growth led by the United States, but with a watchful eye toward risk and valuations. We see those risks likely accumulating over time, emphasizing the need for pragmatic analysis and nimble positioning.