The markets are in the middle of a historic decline. While bear markets are not uncommon, the speed of this decline is unusual. It’s rare to see such a sudden drop, especially from near-historic highs. This sudden shift has understandably left many people nervous about their investments. However, it’s important to take a step back and understand how we got here because that will help us anticipate where the markets might be headed next.
Tariffs and Trade Barriers
The short answer for why the decline is happening is: tariffs. The U.S. government has imposed significant tariffs on a wide range of products from other countries, raising overall trade barriers to levels we haven't seen since the 1930s. In response, other nations—notably China—have imposed their own tariffs, leading to fears of a wider trade war, which is also something we haven’t seen since the 1930s.
Why Are Tariffs Bad for the Economy?
Tariffs act as a tax on imported goods. When a company imports items that are subject to tariffs, their costs go up. The company then faces two options:
1. Absorb the increased cost, which reduces their profits.
2. Pass the additional cost onto consumers by raising prices.
Either way, the result is bad for the economy and the market—either profits go down or inflation goes up.
Tariffs can also disrupt supply chains. For example, companies that rely on foreign-made parts may not be able to absorb the higher cost of tariffs. This can lead to either lower product availability or higher inflation. So, for both the economy and the financial markets, tariffs cause a significant negative shock. While there may be offsetting benefits in the longer term, the short-term effects are playing out right now.
Learning from the Past
In some respects, we have seen this movie before. A good comparison is the global disruption caused by the Covid-19 pandemic. Like tariffs, the pandemic caused availability to decline and costs to rise. We saw inflation and disruption of the economy. And, of course, we saw a similar drop in markets.
However, once the shock of the pandemic passed (when the virus became less of a threat), markets recovered. The same happened during the 2008 financial crisis, when a financial shock caused a sharp downturn. But recovery came as the crisis passed. In both cases, the damage was substantial, but the recovery was real.
These past experiences offer some comfort in our current situation. In both 2008 and 2020, we saw systemic, worldwide crises no one knew how to resolve. The recovery came when each crisis was managed. In this case, however, the damage is coming from governmental policy and actions. And since the damage is under government control, ultimately so is the recovery. Policy changes got us into this situation, and policy changes can get us out. That is potentially a much more comfortable place to be than 2008 or 2020, when we had to wait for the damage to resolve itself. So that’s what to watch going forward: how the tariff policies evolve both here and abroad—because that will determine where we end up.
Long-Term Perspective
The good news is the U.S. economy is still robust, as shown by last month's strong job growth. We could recover quickly if policy returns to normal before enough damage accumulates. The bad news is consumer confidence is starting to weaken due to negative headlines and market declines, meaning the impact has already begun. Depending on how policies evolve, we can still likely weather much of this, but that won't be the case indefinitely, and the longer it takes to resolve, the longer the recovery will likely take.
Even in that case, this too shall pass. The American economy excels at adapting to significant changes, and this is certainly a big one. Over time, however, we will adjust. As we saw in both 2008 and 2020, we will get through this. And as long-term investors, it’s important to keep our focus on that eventual recovery.
Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results.
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Authored by Brad McMillan, chief investment officer at Commonwealth Financial Network®.
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