A Possible Roadmap for U.S. Tariff Policy

Our analysts Michael Zezas and Rajeev Sibal unpack the significance of a little-discussed clause in the Trump administration’s tariff policy, which suggests investors should think less about countries and more about products.

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Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income Research and Public Policy Strategy.

Rajeev Sibal: And I am Rajeev Sibal, Senior Global Economist.

Michael Zezas: Today we look through the potential escalation and de-escalation of tariff rates and discuss what the lasting impact of higher tariffs will be for companies and the economy.

It's Wednesday, April 30th at 11am in New York.

Rajeev Sibal: And 4pm in London.

Michael Zezas: Last week during a White House News conference, President Trump announced that tariffs on goods from China will come down substantially, but it won't be zero. And this was after U.S. Treasury Secretary Scott Bessent made comments about high tariffs against China being unsustainable, according to some news reports.

Now, some of this has been walked back, and there's further discussion of challenging negotiations with China and potential escalations if those negotiations don't go well. Meanwhile, Canadian voters elected a Liberal government, led by Mark Carney yesterday. That federal election played out against the backdrop of the U.S. proposing higher tariffs on its northern neighbors.

 So, Rajeev, amidst all this noise, what seems clear is that tariff levels will end up higher than where we started before President Trump took office. Though we don't exactly know how high they will be. What is it that investors need to understand about the economic impacts of higher tariffs just generically?

Rajeev Sibal: So yeah, we do view that tariffs are going to structurally be higher than they were before the Trump administration. This has been a baseline of our outlook since last year. Now I think the challenge is figuring out where they're going to settle as you've highlighted. We do think that peak tariff was probably a couple weeks ago, when we were at the max pain threshold, vis-a-vis China and the rest of the world. We've since seen the reciprocal tariffs move to 10 per cent for everyone but China.

China's clearly higher than 60 per cent today, but we do think that over time the implied rate to China will start to graduate and come down. If you look at the electronics exemption for example, that's a big step in getting the average tariff rate out of China lower. So, we think we're on a journey. We think we were past peak tariff pain in terms of level. But over the next few months, it's going to take some time and negotiation to figure out where we settle. And we are still looking to kind of our baseline outlook, that had been defined some time ago of a 10 per cent baseline with an elevated level on China, if you will.

Michael Zezas: So, I think this is an important point, that there's a lot of back and forth about tariff levels, which countries are going to be levied on, to what degree, and to what products. But at the end of the day, we think there'll be more tariffs than where we started.

Rajeev, you have a view on where investors should focus, in terms of what tariffs are durable. And maybe at the end of the day it'll be less about countries and more about products. Can you talk us through that?

Rajeev Sibal: You know, on April 2nd when the Trump administration released the fact sheet about tariffs and reciprocal tariffs, there was a small clause in there that I think the market did not pay enough attention to, and which is becoming front and center now.

And in that clause, they identified that a number of tariffs related to Section 232 would be exempted from reciprocal tariffs. And the notion is that country tariffs would evolve or shift into sector tariffs over time. And in the note that we recently published, we highlighted some of the legal mechanisms that may be at play here. There's still a lot of uncertainty as to how things will settle down, but what we do know is that legally speaking, country tariffs are coming through IEEPA, which is the International Emergency Economic Powers Act; whereas section and sector tariffs are coming through Section 232; and some of the other section structures that exist in U.S. trade law.

And so, the experience of 2018 leaned a lot more to these sections than it did to IEEPA. And that was a guiding, I guess, mechanism for us, as we thought about what was happening in the current tariff structure. And the fact that the White House included this carve out, if you will, for Section 232 tariffs in their April 2nd fact sheet was a big lead indicator for us that, over time, there would be an increased shift towards sectors.

And, so for us, we think the market should be focusing more in that direction. As we think about how this evolves over time, now that we've not completely de-escalated, but brought a materially lower tariff level and everywhere in the world except for China. The big variability is probably going to be in the sector tariffs now going forward.

Michael Zezas: So, what sectors do you think are particularly in focus here?

Rajeev Sibal: So, on the April 2nd fact sheet that the White House provided to countries and to the market, they specifically identified steel, aluminum, autos and auto parts as already having Section 232 tariffs. And we know that's true because those investigations had started in a prior Trump administration. And so, kind of the framework was already in place for them to execute those tariffs.

The guidance then suggested that copper, pharmaceuticals, semiconductors, and lumber would also potentially fall under Section 232 tariffs in the future. And then there's been a range of indications as to what might be in play, so to speak, for Section 232.

I know pharmaceuticals is at the top of the list of many investors, as are semiconductors. So, this is our kind of sample list, but we're pretty certain that this will evolve over time. But that's where we're starting.

Michael Zezas: Okay, so pharmaceutical, semiconductors, automobile, steel, aluminum. It's a pretty substantial list. So, if that's the sort of end game landscape here – relatively elevated China tariffs, and then all of these products specific tariffs – what does an investor need to know about a company's options in this world? Can companies just rewire their supply chains around all of this? And you know, ultimately there's some temporary price pain. But once things are rewired around this, that should dissipate. Or are the decisions more difficult than that and that there has to be some cost passed through to the consumer or to the companies themselves – because this is just too many tariffs in too many places?

Rajeev Sibal: Yeah, so I think the latter of your question – the difficulty – is really where we need to be thinking about what's happening here. If you think about the bigger picture, and you go back to the note that we collaborated on earlier in the year called Supply Chain Strain, we highlighted the complexity of moving factors of production and the extreme levels of investment that have required to shift factors of production.

So, companies, if they're going to move a factory from country A to country B, have to make sure that country B has the institutional framework, that it has the capital, it has the labor input, and this is a big, big decision. So, as a company you're not going to make that decision to shift your investment or reconstruct productive facilities in a new country – until you understand the cost benefit analysis. And in order to understand the cost benefit analysis, you really need to know what the sector-based Section 232 tariff looks like in the end.

If we remember back in 2018, the government tried to implement a wide range of tariffs. On average, it took about 250 days for each investigation to be completed. And that's a long timeframe. And so, I think what we're going through now, apart from automobiles and steel and aluminum where that process has kind of already been done, and we kind of have the framework of the tariffs and the new sectors, companies are going to have to wait for this investigation to take place so that they understand what the tariff level is. Because the tariff level is going determine the risk of actually shifting productive facilities. Or if you just kind of absorb the cost because the tariff isn't at a high enough level that it incentivizes the shift.

And so, these are the changes that I think remain an open question and will be the focus of companies over the next few months as their sectors are exposed to tariffs.

Michael Zezas: Right. So, what I think I'm hearing then, and correct me if I'm wrong, is that some of the focus on the China tariffs or the country level specific tariffs in the headlines – about they're moving up, they're moving down – might mask that at the end of the day, we're still dealing with considerably higher tariffs on a broad enough array of products; that it will mean difficult choices for companies and/or higher costs. And so therefore markets are still going to have to price some of the economic challenges around that.

Rajeev Sibal: Yeah, I think that's absolutely right. And we've seen the market try to price some of this stuff at a country level context. But it's been hard. And, you know, even the headline tariff rate in the U.S. is really hard to pin down for the simple reason that we don't know if the Mexican and Canadian trade into the U.S. is compliant or non-compliant, and how that gets counted in the current structure of the tariff regime. And so, as these questions remain outstanding, markets are going to be volatile, trying to figure out where the tariff level is. I think that uncertainty at a country level then shifts to the sector level as we go through these investigations that we've been highlighting.

Autos is a great example. We finished the investigation. We've implemented a Section 232 tariff, and we still don't know what the implied auto tariff rate is because we don't know how many parts in a car are compliant within existing free trade agreements of the United States; and if they're compliant or not really determines what the implied tariff level is for the U.S. And until companies can decide and give forward guidance and understand what their margins look like, I think markets are going to be in this guessing game.

Michael Zezas: Yeah, and that certainly syncs up with our fixed income strategy views. The idea that yield curves will continue to steepen to deal with the uncertainty about U.S. trade policy and demand for dollars, as a consequence. That equity markets might be moving sideways as perhaps we priced in some of the first order effects of tariffs, but not necessarily the second order, potentially non-linear effects on the broader global economy. And unfortunately, the lingering uncertainties that you talk about implementation, they're going to be with us for awhile.

Rajeev Sibal: Yeah, I think that's really fair. And our economics outlook mirrors that as well.

Michael Zezas: Well, Rajeev, thanks for joining us today to help us sort through all of this

Rajeev Sibal: Mike, thanks for having me on the podcast.

Michael Zezas: And to all of you, thanks for listening. If you found this podcast helpful, let us know and share Thoughts on the Market with a friend or colleague today.