The Dumbest Trade War in History Trump will impose 25% tariffs on Canada and Mexico for no good reason.

The WSJ Editorial Board:

President Trump will fire his first tariff salvo on Saturday against those notorious American adversaries . . . Mexico and Canada. They’ll get hit with a 25% border tax, while China, a real adversary, will endure 10%. This reminds us of the old Bernard Lewis joke that it’s risky to be America’s enemy but it can be fatal to be its friend.

Leaving China aside, Mr. Trump’s justification for this economic assault on the neighbors makes no sense. White House press secretary Karoline Leavitt says they’ve “enabled illegal drugs to pour into America.” But drugs have flowed into the U.S. for decades, and will continue to do so as long as Americans keep using them. Neither country can stop it.

Drugs may be an excuse since Mr. Trump has made clear he likes tariffs for their own sake. “We don’t need the products that they have,” Mr. Trump said on Thursday. “We have all the oil you need. We have all the trees you need, meaning the lumber.”

Mr. Trump sometimes sounds as if the U.S. shouldn’t import anything at all, that America can be a perfectly closed economy making everything at home. This is called autarky, and it isn’t the world we live in, or one that we should want to live in, as Mr. Trump may soon find out. (…)

American car makers would be much less competitive without this [free] trade. Regional integration is now an industry-wide manufacturing strategy—also employed in Japan, Korea and Europe—aimed at using a variety of high-skilled and low-cost labor markets to source components, software and assembly. (…)

Thousands of good-paying auto jobs in Texas, Ohio, Illinois and Michigan owe their competitiveness to this ecosystem, relying heavily on suppliers in Mexico and Canada.

Tariffs will also cause mayhem in the cross-border trade in farm goods. In fiscal 2024, Mexican food exports made up about 23% of total U.S. agricultural imports while Canada supplied some 20%. Many top U.S. growers have moved to Mexico because limits on legal immigration have made it hard to find workers in the U.S. (…)

None of this is supposed to happen under the U.S.-Mexico-Canada trade agreement that Mr. Trump negotiated and signed in his first term. The U.S. willingness to ignore its treaty obligations, even with friends, won’t make other countries eager to do deals. Maybe Mr. Trump will claim victory and pull back if he wins some token concessions. But if a North American trade war persists, it will qualify as one of the dumbest in history.

President Trump conceded Sunday that there may be “some pain” from his sweeping tariffs on Mexico and Canada, but they will eventually lead to a new “GOLDEN AGE.” Nice of him to promise a glorious future because the pain is already unfolding, and the tariffs won’t even take effect until Tuesday.

Mr. Trump says the tariffs will revive U.S. manufacturing. But Jay Timmons, CEO of the National Association of Manufacturers, said in a statement that “a 25% tariff on Canada and Mexico threatens to upend the very supply chains that have made U.S. manufacturing more competitive globally.” (…) “the ripple effects will be severe, particularly for small and medium-sized manufacturers that lack the flexibility and capital to rapidly find alternative suppliers or absorb skyrocketing energy costs.” (…)

The hammer blow to Mexico and Canada shows that no country or industry is safe. Mr. Trump believes tariffs aren’t merely useful as a diplomatic tool but are economically virtuous by themselves. This will cause friends and foes to recalibrate their dependence on America’s market, with consequences that are hard to predict. How this helps the U.S. isn’t apparent, so, yes, “dumbest trade war” sounds right, if it isn’t an understatement.

The NYT:

Canada, Mexico and China are America’s three largest trading partners, supplying the United States with cars, medicine, shoes, timber, electronics, steel and many other products. Together, they account for more than a third of the goods and services imported to or bought from the United States, supporting tens of millions of American jobs. (…)

“Hopes that Trump’s tariffs threats were merely bluster and a bargaining tool are now crumbling under the harsh reality of his determination to deploy tariffs as a tool to shift other countries’ policies to his liking,” said Eswar Prasad, a trade policy professor at Cornell University. (…)

Ernie Tedeschi, the director of economics at the Yale Budget Lab, estimates that a 25 percent tariff on all Canadian and Mexican imported goods — paired with a 10 percent tariff on all Chinese imports — would lead to a permanent 0.8 percent bump in the price level, as measured by the Personal Consumption Expenditures price index. That translates to roughly $1,300 per household on average. Those estimates assume that the targeted countries enact retaliatory measures and that the Federal Reserve does not take action by adjusting interest rates.

Mr. Tedeschi expects tariffs on that level to eventually shave 0.2 percent off gross domestic product once inflation is taken into account. (…)

Bloomberg:

(…) And Trump told reporters that the US would “be doing something very substantial” with tariffs targeting the European Union. (…)

Trump said he was not concerned about warnings from economists that tariffs would fuel price growth, a concern for voters which helped propel him back to the White House in last November’s election.

“Tariffs don’t cause inflation, they cause success” Trump insisted. (…)

The Tax Foundation:

We estimate the 25 percent tariffs on Canada and Mexico and 10 percent tariffs on China proposed to go into effect as early as February 1, 2025, would shrink economic output by 0.4 percent and increase taxes by $1.2 trillion between 2025 and 2034 on a conventional basis, amounting to an average tax increase of more than $830 per US household in 2025. The tariffs on Canada and Mexico alone would increase taxes by $958 billion between 2025 and 2034 on a conventional basis, amounting to an average tax increase of more than $670 per US household in 2025.

Gramm and Summers: A Letter on Tariffs From Economists to Trump Like our predecessors in 1930, we oppose the use of tariffs as a general tool for economic policy.

In an extraordinary act of unity, 1,028 American professional economists in the spring of 1930 signed a letter urging Congress to reject and President Herbert Hoover to veto the Smoot-Hawley Tariff Act. Yet that June, Congress passed it and the president signed it into law. The Smoot-Hawley Tariff helped turn a stock market rout and a building financial crisis into a worldwide depression and triggered a global trade war that halved American exports and imports.

Today, we write this letter in a similar spirit of unity. While the professional economists who have signed today’s letter differ on many issues, we are united in our opposition to tariffs as a general tool of economic policy. Even in efforts to promote national security, tariffs are prone to abuse. Many of the worst restrictions on trade, such as the Jones Act, have been implemented in the name of promoting national security.

Our united opposition to non-defense-related tariffs is based not on our faith in free trade but on evidence that tariffs are harmful to the economy. Protective tariffs distort domestic production by inducing domestic producers to commit labor and capital to produce goods and services that could have been acquired more cheaply on the international market. That labor and capital are in turn diverted from producing goods and services that couldn’t be acquired more cheaply internationally. In the process, productivity, wages and economic growth fall while prices rise. Tariffs and the retaliation they bring also poison our economic and security alliances. (…)

It is telling that the Trump tariffs implemented in mid-2018 and the Biden expansion of those tariffs didn’t stop the secular decline in manufacturing employment as a percentage of the total labor force. The decline in manufacturing employment as a percentage of total employment is being driven by the same secular forces that caused employment in agriculture during the 20th century to fall from 40% to 2% of the labor force: a vast increase in labor productivity and a decline in the demand for manufactured products relative to services. This is a worldwide phenomenon occurring in both developed and developing countries.

In the long history of the country, there is little evidence to substantiate the claim that America prospers more when trade deficits fall than it does when they rise.(…)

The tariffs on steel and aluminum created only a small number of jobs, but since for every worker in the steel and aluminum industries there are 36 workers employed in American industries that use steel and aluminum in production processes, those modest gains were offset by the jobs losses in industries that use steel and aluminum as inputs. With foreign retaliation, the estimated cost to the economy of jobs created by the 2018 tariffs on washing machines, steel and aluminum clearly amounted to many times what the jobs paid in wages.

In sum, tariffs don’t have a predictable effect of reducing trade deficits, and trade deficits aren’t necessarily an adverse economic development. Indeed, trade deficits often arise as foreign investors choose the U.S. as a preferred destination for their capital. (…)

A review of the economic history of our nation yields no credible evidence that broad-based tariffs have benefited the nation as a whole. Protectionists often point to the 19th century as a period of high tariffs and strong economic growth. But a close look at the data for the 19th century shows conclusively that the country industrialized fastest when tariffs were falling, not when they were rising. (…)

FT: The absurdity of Donald Trump’s trade war Tariffs on Canada, Mexico and China will harm America’s own economy and diplomatic power

(…) One absurdity is that these measures are entirely unprovoked in trade terms; they are being used as a coercive tool to further Trump’s domestic political agenda and extract concessions from American neighbours that may be beyond their power to give. Another is that the US will be one of the main victims — in the resulting harm to its own economy and its standing in the world. (…)

That the president is now riding roughshod even over the revised deal, the USMCA, sends a message America’s word cannot be trusted. (…)

Yet the trade war is symptomatic of a larger issue in Trump’s America. The president alone decides which issues are important, exaggerates the diagnosis, and chooses the medicine. As with his attempts to impose his own priorities by firing federal workers and freezing grants, the tools are often blunt. His trade war threatens to be disastrous, but the chaos will not end there.

How Stupid Is This Trade War? Let Me Count the Ways

In sum, even though Trump has a mandate for an anti-globalist and protectionist policy, starting with the two neighbors maximizes the risk to US jobs and prices. It offers minimal prospect of stemming fentanyl, stirs the risk of more migrants coming from Mexico, and is minimally effective in reducing the trade deficit. The reason markets appear to hate this, and didn’t believe Trump meant it, is that it’s a terrible idea. (…)

Trump’s complaints about unfair treatment by the European Union, and Japan’s US $70 billion trade surplus and the yen’s severe undervaluation suggest they’ll also be in the America-First crosshairs. Under a full-scale trade war scenario, the WTO predicts a “catastrophic” double-digit loss in global gross domestic product, as in the 1930s when the US passed the infamous Smoot-Hawley Act. (…)

Marko Papic of BCA Research argues that the US strategy is to make an example of allies, proving that it won’t use kid gloves with anyone else. But putting an onerous tax on accessing American consumers means they’ll no longer drive global growth, and the rest of the world will shift away from the US market:

China has been doing this already, and they have been extremely successful. This is something that I’ve told members of Congress directly; they are losing the battle over the hearts, minds, and pocketbooks of people in Indonesia, Brazil, Vietnam, etc. (…)

From my January 6 post Fear:

The most fearful thing about the coming tariffs brawl is that Trump is totally wrong about the history of tariffs:

September 2024 during a town hall in Warren, Michigan:

“We’re going to use tariffs very, very wisely. You know, our country in the 1890s was … probably the wealthiest it ever was, because it was a system of tariffs. And we had a president — you know McKinley, right? You remember Mount McKinley? And then they changed the name. He was really a very good businessman, and he took in billions of dollars at the time, which today it’s always trillions, but then it was billions and probably hundreds of millions. But we were a very wealthy country, and we’re going to be doing that now.”

Factchecking from various sources:

McKinley was not a businessman. He was a lawyer turned politician, elected to Congress in 1877 and only became president in 1897.

McKinley, the congressman, became chairman of the House Ways and Means Committee and was responsible for framing a new tariff bill. He believed that a protectionist tariff had been mandated by the people through the election and that it was necessary for America’s wealth and prosperity. (…)

“The Republican campaign orators and pamphleteers say that the various import duties levied by Congress are paid by the foreigners who send goods to America, denying that the price of any article which may be called a necessary expense will be increased to Americans by the operation of the new tariff law.”

The Tariff Act of 1890, commonly called the McKinley Tariff, became law on October 1, 1890. The tariff raised the average duty on imports from 38% to 49.5%.

“Let the facts, which are multiplying every day, tell who it is that pays the onerous tariff taxes. They will answer that the American people pay these taxes and that the burden of them rests most heavily upon the poor, inasmuch as there are very few of the necessities of life the prices of which are not increasing on account of the McKinley tariff.” (NYT) (…)

The Tariff Act was a major topic of fierce debate in the 1890 Congressional elections. The tariff was not well received by Americans who suffered a steep increase in prices. The 1890 tariff was also poorly received abroad. Protectionists in the British Empire used it to argue for tariff retaliation and imperial trade preference.

Inflation was particularly high on what the NYT called “necessaries” such as farm products (+6-8%), textiles (+4%), metals and metal products (+6%), building materials (+5%) and “miscellaneous” (+11%) per BLS research.

In the 1890 election, Republicans lost their majority in the House with their number of seats reduced from 171 to 88.

In the 1892 presidential election, Harrison was soundly defeated by Grover Cleveland, and the Senate, House, and Presidency were all under Democratic control. Lawmakers immediately started drafting new tariff legislation, and in 1894, the Wilson-Gorman Tariff passed, which lowered US tariff averages.

Trump’s contention that the 1890s were “probably the wealthiest ever because it was a system of tariffs” also does not verify. (…)

Estimates of annual real gross national product (which adjust for this period’s deflation) are fairly crude, but they generally suggest that real GNP fell about 4% from 1892 to 1893 and another 6% from 1893 to 1894. By 1895 the economy had grown past its earlier peak, but GDP fell about 2.5% from 1895 to 1896. During this period population grew at about 2% per year, so real GNP per person didn’t surpass its 1892 level until 1899. (…)

The Smoot-Hawley Tariff Act of 1930 had a significant negative impact on the U.S. and global economy, exacerbating the effects of the Great Depression.

The Act dramatically reduced international trade:

• It raised import duties on over 20,000 imported goods, increasing tariffs from an average of 40% to nearly 60%.
  

• U.S. imports decreased by 66% from 1929 to 1933.
  

• U.S. exports fell by 61%.
  

• Overall world trade declined by approximately 66% between 1929 and 1934.
  

• At least 25 countries responded by increasing their own tariffs on American goods.
  

• Countries that retaliated against Smoot-Hawley reduced their imports from the United States by an average of 28–32%.
  

• Even countries that merely protested the Act reduced their imports from the U.S. by 15–23%.
  

• The Act highlighted the dangers of protectionist trade policies, leading to a shift towards free trade agreements in subsequent years.
  

• It resulted in a transfer of tariff-setting authority from Congress to the executive branch, as lawmakers sought ways to quickly reverse the tariffs.(!)

My friend Hubert Marleau sees the writing on the wall:

A lot of American growth is being financed with an increased amount of debt. It now takes a startling $2 of government debt to generate $1 of GDP growth, which is both unprecedented and higher than all other developed countries. Indeed, things are never that easy when there is an elephant in the room. They can bring hidden consequences, not least two other left tails in Trump’s agenda: universal tariffs, which are subject to the laws of unintended consequences, and deportation of illegal immigrants, which is an onerous direct cost for many businesses. It may not be all clear at this point which tails (right or left) will prove to be more important for the future, but as a consequence, neither should be disregarded, for the “Trump trades” may have run their course, thereby pulling bets on “American Exceptionalism.” Chinese soft power is rising all over the world. (…)

When Trump 1.0 introduced tariffs in 2017, the US failed to increase either its trading volume with other nations or create new jobs in American factories. He only increased input costs and tied American industries in knots.

World trade moved on without the US, handing it over to other nations instead. Over the past 8 years, its share of international trade to N-GDP has dipped to 25%, while more than 4 out of every 5 countries have registered significant gains. Consequently, the US share of global trade is now under 15%, having opted out of a number of bilateral and regional agreements, and abandoned trade talks on partnerships.

To date, the tariff regime has done less damage to China than to compel Mexico, Europe, the Middle and even Canada to look elsewhere to trade. A continuation of this trend could eventually jeopardize the favourable inheritance of a prosperous economy that was unwittingly gifted. Indeed, the application of broader tariffs may trigger trade wars against the U.S. that could not only undermine its relevance as a trading power, but also sap its economic prowess. (…)

On Saturday, he confirmed that a 25% tariff would be applied to goods from Canada. His justification for this economic assault is that Canada has enabled illegal drugs to pour into the U.S.; has not taken steps to stop the inflow of illegal immigrants; and has a huge $200 billion trade surplus with America. All of these allegations are false. First, the U.S. Custom and Border Protection (CPB) reported that last year 21,148 pounds of fentanyl at the southwest border were intercepted, versus a tiny 43 pounds at the northern border. Second, Canada has a plan to spend over $1.0 billion on border protection. Third, Canada has a relatively small trading surplus with the US in comparison to its other major trading partners, and on top of that is paid with a service deficit. Canadians just don’t know what is left to satisfy Mr. Trump. (…)

On February 1,at 10:06 ET, the equally conservative American Enterprise Institute had a similar message: “Trump is winging it, saying we have a large trade deficit with Canada when we don’t, and that Canadians are responsible for fentanyl coming across the border when they aren’t.”

One Response to Trump’s Tariffs: Trade That Excludes the U.S. A growing number of countries, including American allies, are striking trade deals as the Trump administration erects a higher fence around its global commerce.

In just the last two months, the European Union concluded three new trade deals.

The bloc, completing negotiations that started 25 years ago, reached a major agreement with four South American countries in December to create one of the world’s largest trade zones, linking markets with 850 million people.

Two weeks later, the European Union struck a deal with Switzerland. Then last month, the bloc bolstered trade arrangements with Mexico. It also resumed talks, after a 13-year postponement, on a free-trade agreement with Malaysia.

“With Europe, what you see is what you get,” the European Commission president, Ursula Von der Leyen, boasted to the World Economic Forum in Davos, Switzerland. “We play by the rules. Our deals have no hidden strings attached.” (…)

Of course, the United States, with the planet’s largest and strongest economy, cannot be ignored. But it can, at least sometimes, be avoided.

By punishing longtime allies with tariffs, Mr. Trump is encouraging other nations to form trading blocs and networks that exclude the United States.

This month, Indonesia became the 10th nation to join BRICS, a group including Brazil, Russia, India, China and South Africa that was established in 2009. This economic club now includes half the world’s population and more than 40 percent of its total economic output. Another eight countries, including Bolivia, Thailand, Kazakhstan and Uganda, are on the path to becoming full partners.

In May, the 10-country Association of Southeast Asian Nations, known as ASEAN, will meet the six Middle Eastern nations that make up the Gulf Cooperation Council. The summit’s host, Malaysia, has invited China to attend.

China is also poised to update its own free-trade agreement with ASEAN, which includes Cambodia, the Philippines, Indonesia and Vietnam. And trade and investment between ASEAN and India, the world’s most populous nation, is deepening.

Britain, too, recently christened a new partnership. In December, it officially joined the trans-Pacific trade bloc, a group that includes Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam. London is also looking to repair its frazzled economic relationship with the European Union.

And Brazilian and Mexican officials have talked about expanding their trade agreements.

The global economy is increasingly becoming “one that is characterized by ever deepening trade relationships excluding the United States,” said Jacob F. Kirkegaard, a senior fellow in Brussels at the Peterson Institute for International Economics.

The trend is not necessarily anyone’s preference, he said, but the arrangements offer a “second best” option given America’s rejection of a more open economic order. He added that the proliferation of trading blocs, like the one between the European Union and South American nations, also helped countries avoid an overreliance on China. (…)

The biggest changes in trade can be seen in Asia. Nearly 60 percent of Asia’s trade happens within the region, according to a new report from HSBC Global Research. And half of the world’s fastest-growing trade corridors are there. In 2023, China’s exports to ASEAN nations bypassed those from the United States.

China’s trade with Latin America — Brazil, in particular — has also been rising.

India’s status as a world economic power has grown as well. It surged past Britain to become the world’s fifth-largest economy in 2022. “India’s trade expanded across the geopolitical spectrum,” an update on trade released last week by McKinsey Global Institute reported.

And India is on the path to becoming a leading exporter of digital services, which are not subject to tariffs. An increasing number of European, Australian and Japanese multinationals are opening operational hubs — known as global capability centers — there.

New Delhi flexed its economic independence by refusing to go along with Western sanctions against Russia. And now it and China are the biggest buyers of cheaper Russian oil.

Persian Gulf nations like Saudi Arabia and the United Arab Emirates have also shifted their attention to India and China, increasing energy exports to meet the growing demand. Asia receives more than 70 percent of total gulf oil and gas exports, according to one report.

Global trade is still growing, but it is being reconfigured. (…)

Trade, it turns out, is like water flowing through a stream strewn with rocks. When it can’t go through them, it goes around them.

Goldman Sachs:

Goldman Sachs US Economics Research previously estimated that a sustained 25% tariff on imports from Canada and Mexico would increase the effective US tariff rate by 7 percentage points (pp) from the current 3%, implying a 0.7% increase in US core PCE prices and a 0.4% hit to GDP. Additionally, in an Oval Office interview on Friday, President Trump raised the prospect of levying additional tariffs on goods imported from the European Union.

Large tariffs pose downside risk to our S&P 500 earnings estimates and return expectations. If company managements decide to absorb the higher input costs, then profit margins would be squeezed. If companies pass along the higher costs to its end customers, then sales volumes may suffer. Firms may try to push back on their suppliers and ask them to absorb part of the cost of the tariff through lower prices.

We estimate that every 5pp increase in the US tariff rate would reduce S&P 500 EPS by roughly 1-2%. As a result, if sustained, the tariffs announced this weekend would reduce our S&P 500 EPS forecasts by roughly 2-3%, not taking into account any additional impact from major financial conditions tightening or a larger-than-expected effect of policy uncertainty on corporate or consumer behavior.

Our economists describe the outlook as unclear but believe there is a substantial probability that the tariffs on Canada and Mexico will be temporary.

Our FX strategists believe tariffs would also lead to further dollar strength, although this should have a limited impact on aggregate S&P 500 earnings. In total, S&P 500 companies derive 28% of revenues outside the US. Our top-down earnings model suggests that, holding all else equal, a 10% increase in the trade-weighted USD would reduce S&P 500 EPS by roughly 2%. S&P 500 companies report less than 1% of revenues explicitly from each of Mexico and Canada.

In addition to downside risk to earnings, rising policy uncertainty will likely weigh on equity valuation multiples. The US Economic Policy Uncertainty Index jumped on Friday to 502, a top percentile reading relative to the last 40 years. The historical relationship between policy uncertainty and the S&P 500 Equity Risk Premium suggests that the recent uncertainty increase should reduce the forward 12-month P/E multiple by about 3%, holding all else constant.

Combining these modeled EPS and valuation sensitivities suggests near-term downside of roughly 5% to S&P 500 fair value if the market prices the sustained implementation of the newly-announced tariffs. To the extent investors believe the tariffs will be a short-lived step toward a negotiated settlement, the equity market impact would be smaller.

In contrast, equities would fall further if investors view the latest tariff announcements as signals increasing the probability of additional escalation. While equity investor positioning has declined from the extreme levels reached in December — our Sentiment Indicator now registers a moderate +0.6 standard deviations above neutral — elevated economic and earnings growth expectations underscore the potential downside risk to stocks if investors are forced to reassess the fundamental outlook.

Mr. Trump complains about the U.S. trade deficit, arguing that just about every country in the world treats the USA “very, very badly”.

Imports of goods and services (black) began to significantly outpace income and expenditures in 2014. Coincidentally (or not), this is also when households net worth accelerated as house and equity prices took off after the U.S. emerged out of the Great Financial Crisis.

Wealth exploded even more after the pandemic, initially thanks to the various pandemic-related bounties, but later boosted by continued gains in house and equity prices.

Trends in imports are more in sync with household wealth than with overall income. Various studies have demonstrated the propensity to buy foreign goods and services as income and wealth rise. In the USA, since 2014, real income and consumption rose 34% but real imports gained 45% as real household wealth exploded 72%!

Furthermore, since 2014, the U.S. dollar strongly appreciated making foreign goods and services so much cheaper for Americans, including the lesser wealthy segments. Import prices excluding foods and fuels are only up 7% against the 37% increase in core inflation.

 

Prices of imported goods ex-vehicles rose 2.6% between 2014 and 2024 while CPI-Durable Goods rose 10.1%. For the same period, CPI-New Vehicles jumped 21.7% while imported vehicle inflation was only 7.7%.

In 2014, 47.8% of motor vehicles sales were assembled in the U.S.. In Q4’24, the ratio was down to 40.3%.

Total real imports of goods and services rose 44.5% since 2014 while the USD appreciated 35.3%; exports only rose 6% since 2018.

All in all, the explosion in wealth and a strong USD largely explain the worsening U.S. trade balance over the last 10 years. Wealthier and cash rich Americans splurged on cheap and cheaper foreign goods and services, first thanks to the Fed’s post GFC policies, then to the U.S. government’s pandemic bounties and, more recently, to the additional boost to wealth from house and equity prices.

Strong December Spending Amid Only Modest Inflation

(…) Hard inflation data today suggest that price pressures persist in both goods and services. The headline PCE deflator rose 0.3%, while the core metric—excluding food and energy prices—was up a more modest 0.2%. That gain keeps the annual rate of core inflation at a sticky 2.8% annual rate for the third-straight month and the underlying drivers of inflation suggest goods disinflation is quieting still-strong services inflation, where prices rose 0.3% in December.

Real disposable personal income advanced another 0.1% in December, and is up 2.4% over the past year, still running very much at a rate that is supportive of continued consumption. That helps shore up broad economic activity in the U.S., but makes stomping out the final mile of inflation all the more challenging for the Fed.

This is particularly true when more interest-rate sensitive categories may be seeing a near-term boost in spending amid fears of tariffs. (…) It’s fanning cost plans for businesses and pushing consumers into a buy now, or pay more later mindset.

While spending was strong across categories, real spending on durables was particularly robust, up 1.1% in December along with upward revisions revealing a 2.6% pop in November spending.

Spending on autos accounted for most of November’s surge. The 5.6% pop in November spending on motor vehicles was the biggest since January 2023, this category saw a more modest gain of 0.3% in December. The strength in December durable goods spending is less about autos and more about broad-based gains in other categories. Furnishings, recreation and other goods each posted monthly increases of 1.3% or larger on an inflation-adjusted basis in December.

Rather than a reawakening in demand for durable goods we suspect some of this is a pull-forward in demand for big-ticket items and is tariff-related as consumers make key outlays now before prices go up. That said, the tariff rationale is trickier to apply to non-durable goods categories such as spending on groceries and gas, both of which posted real increases in December.

Americans may have pulled some purchases ahead of changes in EV subsidies and/or tariffs as spending outpaced labor income in November and December.

Wages and salaries keep rising 0.4-0.5% per months or 5.5% annualized but total nominal expenditures grew at a 7.6% annualized rate in the last 4 months of 2024 or 4.9% annualized in real terms, a sharp acceleration from +3.4% a.r. in the previous 4 months. Real expenditures on durable goods exploded 16.4% a.r. since August after an already very strong +6.7% a.r. in the previous 4 months.

On a YoY basis, real Durables were up 6.1% in December and 5.7% in Q4 on top of a very strong Q4’23 (+5.8%). Since 2019, Americans have increased their stock of durable goods by 31.4%. Nothing exceptional one might say since this followed +33.5% in the previous 5 years!

All this while the number of light weight vehicle sales actually declined!

Americans pounce on bargains when they see them. Even if most of them are imported…

This chart clearly shows the hugely deflationary goods prices since 1995 while imports from China mirrored the growth in spending on goods.

Tariff War Likely to Put Canada Into Recession, Economists Say

The Canadian economy is set to face the most severe shock since the Covid-19 pandemic and will probably sink into a recession if a tariff war persists, say top economists, with one calling it an “existential threat.”

President Donald Trump’s 25% tariffs on most goods the US buys from Canada and Prime Minister Justin Trudeau’s plan to retaliate on C$155 billion ($105 billion) worth of American-made products will trim real gross domestic product growth by 2 to 4 percentage points, according to economists’ estimates.

For an economy that was projected to grow at 1.8% in 2025, that would imply the first annual contraction in 16 years, outside of the pandemic. Consumer prices are likely to increase at a faster pace than the Bank of Canada’s 2% target, the unemployment rate is expected to rise and the Canadian dollar will weaken further.

Meanwhile…

• Rubio Calls ‘Status Quo’ at Panama Canal Unacceptable, as Trump Renews Vow to Seize It
• Trump Vows to Punish South Africa Over Law to Expropriate Land South African Elon Musk has spread the baseless conspiracy theory that there’s a “genocide” against White farmers in the country.

FYI:

How to Cover Stupidity (Including Our Own)

(…) In Homo Cretinus, Olivier Postel-Vinay describes stupidity as a “mental polyp” that subtly encloses specific brain regions, impairing cognitive flexibility. This form of stupidity, he said in an interview, is not an occasional lapse or lack of knowledge but an “attack on intellectual integrity” that renders us incapable of exercising common sense.

“Our societies have never known such a high level of education, which obviously doesn’t prevent the development of stupidity,” he says. For Postel-Vinay, stupidity transcends ignorance because it operates even in highly informed individuals, who remain ensnared by rigid beliefs.

Such beliefs lead people to ignore contradictory information and select the evidence that supports their ideas. Postel-Vinay defines this confirmation bias as the polyp’s “tool of choice” because it perpetuates a self-reinforcing cycle of false beliefs that impedes intellectual development. Thus, he says, opinions become dogma in even the most intelligent individuals. Social media echo chambers only make the situation worse.

In his recent book Elogio dell’ignoranza e dell’errore (In Praise of Ignorance and Error), the Italian writer and former prosecutor Gianrico Carofiglio distinguishes between two types of ignorance: unconscious ignorance and conscious ignorance. The former, he said in an interview, is particularly dangerous to democracy because it combines a lack of knowledge with the arrogant belief that one already knows enough.

“Unconscious ignorance undermines the foundations of democratic debate, trust in science, and respect for knowledge,” Carofiglio said, describing it as an attitude that poisons public discourse and fuels misinformation. On the other hand, he argues that we should embrace conscious ignorance—an intellectual humility that helps us recognize our own limitations while remaining receptive to the knowledge of others. This form of ignorance, like the Socratic “I know that I know nothing,” is the foundation of true competence.

By recognizing that others may hold truths beyond our understanding, we reduce the tendency for categorical statements that exacerbate division. “The truth each of us holds is, for the most part, a legitimate opinion,” Carofiglio explains. “And opinion pushes us to engage in dialogue with others, which is precisely the opposite of polarization.”

Any historian will confirm that stupidity influences the world at least as much as its noble cousins justice and truth, particularly at moments of turmoil. Postel-Vinay talks about the First World War, which he describes as “the result of an enormous concentration of stupidity at the highest levels of European political and military leadership.”

Postel-Vinay points out that even when the lessons of such events appear clear, they are rarely learned. “At the time,” he writes, “stupidity is generally only recognized as such by a minority of observers or actors, who have no influence on the course of events or who, when they have the means to intervene, lack the courage to do so.”

Postel-Vinay notes that, from Europe at least, American society seems to be in the grip of a similar moment. Isaac Asimov once said that “there is a cult of ignorance in the United States, and there always has been.” Asimov argued that this ignorance is “nourished by the false notion that democracy means that my ignorance is as good as your knowledge.”

For Carofiglio, the ethical challenge journalists face requires us first to examine how our own personal biases and assumptions affect us. We must examine our own stupidity, as human beings and as journalists. Fact-checking is not truth, and punctiliousness is not rigor.

Robust underlying growth despite US GDP disappointment

US fourth quarter GDP grew at a 2.3% annualised rate, a little below the 2.6% consensus, but the details tell a more robust story that will keep the Fed wary about easing monetary policy too far too fast.

Household-related activity continues to drive the growth story with consumer spending expanding much more rapidly than expected at 4.2% annualised while residential investment jumped 5.3%. Net trade neither added nor subtracted to overall growth in the final three months of the year despite yesterday’s surprisingly large trade deficit figures for December. Meanwhile government spending increased 2.5%.

What prompted the weakness relative to expectations was primarily a big draw down of inventories that subtracted nearly a full percentage point from the headline growth rate. It may be that the surprise strength in consumer spending contributed here. Non-residential investment fell 2.2% – primarily due to a 7.8% drop in equipment, which we attribute to Boeing strikes.

Contributions to US annualised growth (%)

Source: Macrobond, ING

Consequently, the breakdown is better than the headline suggests with inventories likely to rebound next quarter and aircraft-related investment set to recover this quarter. However, net trade is probably going to be a big drag as companies look to bring forward imports to get ahead of potential tariffs while the stronger dollar will increasingly hurt export competitiveness. At least there is strong momentum in the consumer sector to provide a solid base for growth. (…)

From Interactive Brokers:

Trump’s Tariffs Hit US Growth Before, and Threaten to Again Newly released transcripts from the Federal Reserve show just how much policymakers were scrambling to keep growth intact in 2019.

For skeptics of President Donald Trump’s threatened tariffs, the concern raised most often at home is that they will boost inflation and lead to higher interest rates. The biggest lesson from his last trade war, though, may be that it’s the hit to growth that matters more. (…)

“As tariffs on other countries go up, taxes on American workers and businesses will come down and massive numbers of jobs and factories will come home,” Trump told Republican lawmakers in Miami on Monday.

But the last time he deployed them, almost the exact opposite happened. Instead, the Federal Reserve confronted a slowing economy led by a manufacturing sector shedding rather than gaining jobs, data and new transcripts of policymakers’ discussions at the height of Trump’s first trade war show. (…)

In 2019, the first full year after Trump began imposing the levies — which were much more carefully targeted versus the broad ones he’s threatening now — the US lost 43,000 factory jobs, industrial production contracted, business investment stalled and real median household incomes fell for the first time in five years. By one estimate, the hit to consumer earnings was $8 billion.

Subsequent studies have shown Trump’s tariffs played a role in all of that. Their drag on growth — caused via higher import costs, retaliation from other countries, and a broader uncertainty over US trade policy — was soon overshadowed by the much bigger shock of the Covid pandemic.

In the moment, Fed officials were already concerned about what was playing out, according to transcripts released this month of the 2019 meetings of the Federal Open Market Committee — the panel that sets interest rates. The verbatim accounts of closed-door meetings are released with a five-year lag. (…)

Fed economists in 2019 calculated that the new import taxes Trump started to impose on aluminum, steel, and select goods from China the year before — and retaliation by other countries — resulted in a net loss of US factory jobs and higher producer prices.

In a later study, economists at the New York Fed and Columbia University found that tariffs caused an $8.2 billion reduction in real income in 2018, and led American consumers and importers to pay $14 billion to the government. “Our estimates are likely to be a conservative measure of the losses,” they wrote.

What happened in 2019 matters because it was the first time policymakers dealt with the economic impact of a broad swath of higher import taxes since the 1930s. It was a rare real-world experiment in the effects of protectionism.

It’s also meaningful because Trump is threatening an even larger deployment of tariffs this time around with far greater potential for economic disruption, which Fed officials were thinking about before he even took office. (…)

“We worry that the lesson of 2019 — when tariffs unsettled the equity market and contributed to the FOMC delivering ‘insurance cuts’ — is being ignored,” Goldman Sachs Group Inc. economists said in a recent note. (…)

In 2019, joblessness fell lower than many economists believed it could go, and inflation stayed below the Fed’s 2% goal, a fact that perplexed policymakers.

But the absence of inflation concerns allowed the Fed to respond to Trump’s tariffs. After raising rates to 2.5% in 2018, Fed officials held them there in the first half of 2019 before starting cuts in July.

“Ultimately, the risk of a slowing in the economy and a tick up in unemployment outweighed the risk of easing too much and creating excesses,” then-Dallas Fed President Robert Kaplan said in a recent interview. “That’s what won out.”

Former Chicago Fed President Charles Evans recalls what was almost a recession in manufacturing unfolding. “You could see it slowing down a part of the economy after taxes had been cut,” he said in an interview last week. “That was very surprising, I thought.”

Today, the picture is almost flipped. The US is coming off two years of strong growth and the highest inflation in 40 years. While the Fed’s tightening in 2022 and 2023 helped cool price growth, it still hasn’t reached officials’ 2% target.

That’s left the Fed hesitant to cut rates further after lowering them by a percentage point at the end of 2024. Policymakers held rates steady at their meeting concluding Wednesday, and Powell has made clear any further reductions depend on inflation continuing to fall — or a marked deterioration in the labor market.

Strategist Who Coined the Magnificent Seven Warns US Tech Is Set to Lag Sees risks from overexposure to US stocks as AI spending peaks

(…) Those positions are at risk as spending on artificial intelligence is set to peak, Hartnett wrote in a note. He also sees other catalysts of a US outperformance including excess fiscal support and immigration fading this year.

“US exceptionalism now exceptionally expensive, exceptionally well-owned,” the strategist wrote. “‘Magnificent 7’ becomes ‘Lagnificent 7,’ supports broadening of US and global equity and credit markets.” (…)

• Narrow markets are the exception, not the rule

2023/24 was the narrowest stock market since 1998/99’s technology bubble, which in turn was the narrowest market since the Nifty 50 period
of the early 1970s. With only three such periods in the past 50 years, narrow markets are the exception and not the rule.

Chart 1 shows how unusual 2023/24’s market has been. Just 30% of the constituents of the S&P 500® outperformed the index in 2023 and slightly less in 2024. That is similar to the 1998/99 period, and both are well below the long-term median of 48%. (…)

Extremely narrow leadership implies a scarcity of growth opportunities, i.e., there are very few companies that can grow. An extended period of narrow leadership, therefore, implies a terrible secular period during which the economy experiences an extended contraction/recession and the resulting scarcity of earnings growth forces companies to lay off workers and decrease capital spending. (…)

Unlike during the Great Depression, fundamentals haven’t justified today’s extraordinarily narrow leadership. 2023/24’s economy was healthy and late 2022/early 2023’s profits recession was quite mild compared to that during a depression.

If the recent market narrowness assumes that competition and innovation no longer matter, it may only be a matter of time before they broaden. When markets broaden from unusually narrow periods, however, they do so suddenly and for years.

The Goldman analysis also highlights that market volatility tends to significantly increase during the year after extremely narrow markets. Diversification typically constrains portfolio volatility, but narrow markets skew indices’ constituent weightings toward fewer companies effectively making an index less diversified. Increased concentration towards a small number of cyclical companies makes the overall market more susceptible to company-specific risks.

Because narrow markets are the exception and not the rule, history shows that markets broaden for years after periods of extremely narrow market leadership. Investors, however, tend to wait for the abnormally narrow leadership to reassert itself rather than repositioning portfolios for a more normal market.

This was certainly the case after 1998/1999’s narrow markets. Chart 2 shows S&P 500® sector performance during the final year of the Technology Bubble (3/31/99 – 3/31/00). Only 1 sector, Technology, outperformed the market during this period. (…)

The Technology sector quickly started to underperform and didn’t recover even after 5 years.

Diversification was critical to surviving the post-bubble period. Although the narrow leadership dragged down the overall market performance, many sectors posted significant positive returns.

  

Investors seem unduly confident despite the increased potential for volatility after narrow markets. Diversification today is considered a hinderance to performance by many investors rather than a risk reduction tool or one that might shift portfolios toward under-appreciated investments.

Chart 7 highlights the question in the Conference Board’s Consumer Confidence Survey that asks whether respondents think the stock market will be higher in 12 months. The past two months’ readings show a level of confidence in the stock market never seen in the survey’s history.

Investors’ willingness to take risk is even more startling. Chart 8 shows individual investors’ aggregate portfolio equity beta. Admittedly, we have re-published this chart from BofA Securities for many months. We thought it was extraordinary when their equity beta rose to 1.2, but it has continued to increase as the market continued to narrow. It is now an absolutely mind-boggling 1.7!

The juxtaposition of investors’ historic confidence relative to the performance history when markets broaden from extremes suggests that investors might be ill-prepared for volatility.

It appears that 2025 could be the year when investors’ extreme confidence and willingness to take significant portfolio risk comes face-to-face with the volatility associated with the broadening of a speculative market.

Diversification is one of the basic tenets of investing, but investors’ greed during speculative periods leads them to shun diversification because it looks stodgy, boring, and a lead weight on the potential for high returns. Themes regarding “The Magnificent 7”, “US exceptionalism”, and others reflect the current shunning of diversification. (…)

Today’s narrowness is even more dangerous than previous ones given the rising share of passive investments. A high beta works both ways…

(Apollo Management)

Goldman Sachs:

The equity markets’ correction, triggered by news of the DeepSeek LLM model, has been the first fall of more than 3.5% of the Magnificent 7 since last Autumn. In our view this is a correction and not the start of a sustained bear market.

Most bear markets are triggered by expectations of falling profits driven by fears of recession. Our economists remain confident about world growth and remain above consensus on their forecasts for the US, putting the probability of recession in the next 12 months at 15%.

We also expect interest rates to be cut, albeit modestly this year, alongside more progress on inflation moderation – and a cheaper entrant into the AI space might increase confidence in this trend. This combination of macro conditions has historically been supportive of risk assets.

Nevertheless, we have argued that context is important and that equity markets came into the year priced for perfection, leaving them vulnerable to disappointments. Returns in equity markets, led by the US, have been unusually strong over the past couple of years, and particularly since October 2023 as investors began to become more optimistic about the prospects for lower inflation and interest rates alongside a soft landing.

Overall levels of valuation had reached very high levels, particularly in the US, and P/E multiples have increased meaningfully since Q4 2023. In the case of the US, while much of this reflects the largest technology companies, the equity market remains expensive relative to history even if we exclude large cap technology (the second column). Furthermore, while other equity markets around the world are much cheaper than the US, most are not particularly cheap relative to their own history. The main exception is China.

While surging equity returns coupled with high valuation provide fertile conditions for a correction, it is also the concentration of equities as an asset class that has left equity investors vulnerable to disappointments. The rising concentration in equities has taken three forms: the growing dominance of the US equity market in the global index, the ascent of the technology sector, and the rise in single stock concentration (particularly in the US).

To be clear, these factors have emerged as a function of strong fundamentals, not as the result of speculation or irrational exuberance. The growing dominance of the US equity market has simply mirrored its relative profit growth since the financial crisis.

Meanwhile, the growing influence of technology on market returns reflects the significant outpacing of technology profits relative to other industries over the same period.

Furthermore, the dominance of the biggest companies in the US equity market is a function of their vastly superior earnings power over the past decade.

The dominance of US equity market, technology sector, and dominant companies does not represent a bubble based on irrational exuberance but is rather a reflection of superior fundamentals. Nevertheless, while stronger growth has justified the patterns of returns that have driven equity markets over the recent past, they do not tell us about the future expectations or returns.

On a forward-looking basis, while the US equity market is likely to move higher based on solid earnings growth, its superior earnings growth at the index level is set to fade, opening up opportunities for more diversification. For this year at the index level our top-down forecasts are similar across all regions (except for Europe), suggesting more opportunity for geographic diversification.

At the same time, our US strategists expect the strong pace of earnings growth of the dominant technology companies to continue but also to moderate on a relative basis.

The dominant companies are still expected to see superior growth but the gap is narrowing. We have argued that this leaves a risk in such a concentrated market. The price action of the GRANOLAS in Europe last year, provides a good use-case for the risk of high concentration in the US with the Magnificent 7. Despite their earnings continuing to grow faster than the rest of the European market, the GRANOLAS valuations have significantly declined, resulting in flat year-over-year performance. This derating has negatively impacted the overall market due to the size of these companies. (…)

History provides some useful lessons. First, the original capex spenders on revolutionary technology are not always the biggest beneficiaries; the experience of the Telecom companies in the late 1990s is a good example. Second, even very dominant companies eventually succumb to competition – often from new companies in the same sector – just as AMD and Intel experienced, for example, with the ascent of Nvidia.

The extent to which these observations are relevant to the current market setup is still not clear. But the news around DeepSeek has been a wake up call that has shaken the confidence that was reflected in market pricing. Indeed, our technology analysts argue “DeepSeek has introduced pricing competition into the foundational model layer at a point in time where models are just about good enough for many enterprise use cases”. The revelation of a cheaper competitor entering the AI space has exposed the risk of concentration. This is relevant because equity markets are not typically driven by absolute outcomes, but rather by outcomes relative to expectations.

We noted last week that the polling responses to questions asked at our annual Global Strategy Conferences revealed a very strong consensus that the patterns of leadership that drove the returns over the past couple of years is set to continue, leaving room for disappointment. For example, at our London conference, 58% of the votes – the highest ever – were for the US equity market to be the best performer in 2025.

This marks an increase from 32% last year and 18% the year before. Meanwhile, Europe remains the least preferred, receiving only 8% of the votes compared to 13% last year. We find similar examples of US exceptionalism as a driver of outperformance in the responses at our Asia Strategy conference where a record low 3% believed Europe would outperform.

There was a similar degree of confidence in the ongoing dominance of the technology sector as the likely winner this year. (…)

While the macro set up for equities remains supportive, we have been recommending that investors stay invested but diversify to improve risk adjusted returns.

The line to watch on this chart id the yellow Rule of 20 Fair Value line which is EPS x 20 minus inflation. Profits are still rising faster than inflation.