There are adjustment costs associated with changing trade policy and changing the size of the government sector, and the immediate question for markets is how big the short-term pain will be.
The impact on markets and the economy depends entirely on how long the 25% tariffs on Canada and Mexico are in place. If they are removed tomorrow or later this week, then the impact on the economy will be small. If they continue for months, then the negative impact will be more significant, especially to the auto sector.
The bigger risk to markets is sentiment. We are already seeing consumer sentiment and corporate sentiment being impacted, see charts below. If policy uncertainty persists, consumers and firms may begin to hold back spending decisions. Combined with DOGE-driven layoffs, this will put upward pressure on the unemployment rate.
From a Fed perspective, the biggest problem is that tariffs increase prices and hence inflation. That is why a trade war, by definition, is a stagflation shock: Higher prices and lower sales. If tariffs on Canada and Mexico continue for several months, then the Fed will focus on the rising unemployment rate and start cutting rates soon.
The biggest downside risk is that policy uncertainty could create a sudden stop in the economy where consumers stop buying cars, stop going to restaurants, and stop going on vacation, and companies stop hiring and stop doing capex. The employment report on Friday will be stale. The key indicator to watch over the coming weeks is jobless claims, which come out every Thursday at 8:30 am ET.
Source: Conference Board, Bloomberg, Apollo Chief EconomistSource: Conference Board, Haver Analytics, Apollo Chief EconomistSource: Business Roundtable; NFIB; Federal Reserve Bank of Philadelphia, Dallas, New York, Kansas and Richmond; Apollo Chief Economist
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