Navigating the Trade Tensions

Markets are moving quickly. Just a week after the Magnificent 7 sell-off triggered by DeepSeek, Donald Trump reignited trade tensions. While the timing was somewhat unexpected, higher market volatility in 2025 has always been part of what we expected¹. Despite the initial shock of tariffs on Canada, Mexico, and China—followed by a broader 25% tariff on steel and aluminum imports effective March 12—markets have absorbed the news relatively well. The direction of market movements in early February reflects the economic effects of higher U.S. tariffs. As a net importer, the U.S. is unlikely to face immediate growth concerns. However, tariffs could push inflation higher. In contrast, export-dependent economies—especially those with strong trade ties to the U.S.—are more likely to experience slower growth rather than a significant inflationary impact.

These differences help explain recent asset price movements. U.S. bond yields have risen, while European yields have declined. Meanwhile, uncertainty surrounding tariffs has driven gold and the Japanese yen higher as investors seek safe-haven assets.

While markets quickly absorbed the initial tariff announcements, a more significant shift is looming. Donald Trump has signaled plans for reciprocal tariffs—raising U.S. import duties to match those imposed by other countries on American products. This move could have broader economic and market implications, influencing trade flows, corporate earnings, and investor sentiment.

What would this mean for investors? Let’s explore the possible scenarios and their impact on markets.

The Complexity of Reciprocal Tariffs

Figure 1 highlights the countries with the largest average tariff differentials² (blue bars), with India, Thailand, and Brazil standing out. However, these blue bars represent simple country averages, and it remains unclear whether the U.S. will implement reciprocal tariffs at the country level to address this gap.

So far, Trump’s trade policy has not solely focused on average country-level tariff differences. Instead, a product-specific approach seems more likely—targeting industries with the greatest disparities (black bars). Under this product-specific weighting scheme, Turkey, India, Indonesia, and Vietnam stand out. For major European economies, the impact would be relatively moderate in U.S. dollar terms.

A country-level approach to reciprocal tariffs would be simpler to implement. However, a product-specific approach could lead to a one-percentage-point higher increase in overall U.S. import tariffs—something Trump may view as a fairer adjustment.

As shown in Figure 1, weighting tariff differences by product would result in more significant tariff changes for certain countries, while others (such as the EU) would be less affected. While many goods would see little to no impact in the EU, industries like Germany’s automotive sector could face substantial adjustments. Therefore, even though the overall impact on the EU in U.S. dollar terms may be moderate, the effect on specific industries could still be significant.

The Role of VAT

Reciprocity in trade is more complex than it may first appear. While tariffs are often the focus, non-tariff barriers—such as licensing requirements or sanitary inspections—could also play a role. Though incorporating these elements would complicate tariff calculations, another emerging factor could influence trade policy: VAT differences.

Historically, the U.S. has not viewed VAT taxes as trade barriers³, even in its annual Trade Estimate Report. However, in a recent interview⁴, National Economic Council head Kevin Hassett suggested that VAT differences could be considered in reciprocal tariffs. This would place greater pressure on countries with higher VAT rates, particularly in Europe.

As shown in Figure 2, VAT differentials are most pronounced between the U.S. and the European Union, followed by India, Mexico, and Canada. If VAT differences were incorporated into U.S. tariff policy, trade costs could shift, particularly for high-VAT economies. Figure 3 provides a template for a rule-of-thumb calculation, showing each country's export dependency versus a scenario where the U.S. increases tariffs based on VAT and tariff differentials—a relatively low-probability worst-case scenario.

With trade policy evolving, we are closely monitoring how these changes could impact global supply chains and corporate earnings.

How we navigate

The market’s muted reaction in early February came as a surprise to most. Two key factors explain this. First, the risk of a trade war is no longer an unpredictable shock—it was a defining theme of Donald Trump’s first administration. Second, most affected countries—except China—have responded with concessions and only mild retaliation, avoiding immediate escalation.

Clearly, uncertainty remains. The scope of reciprocal tariffs is unclear, and market stability depends on how they are defined. A country-average approach could limit disruption, but broader measures—including product-level adjustments and VAT differences—would likely fuel market volatility. Some industries, such as automotive manufacturing, could face outsized pressure.

With trade policy uncertainty likely to persist, investors should remain alert. While we maintain a constructive market outlook⁵ and a long equity position, hedging strategies could be crucial for performance this year.

So far, our tail hedges—such as the Japanese yen and gold⁶—have delivered strong results, with gold reaching new highs. Meanwhile, European equities have outperformed in recent weeks, driven by expectations of fiscal stimulus following German elections and Trump’s decision to delay tariffs on Canada and Mexico.

Looking ahead, the focus on reciprocal tariffs, particularly their potential impact on Europe, strengthens our view that European duration has further room to outperform U.S. duration. Investors should consider hedging strategies to navigate volatility, using equity put options, select currencies (JPY and USD), and commodities (primarily gold).