Key takeaways:
- Direct impact of U.S. tariffs is small but a global trade war is the real threat.
- The reaction from global policymakers, particularly central banks, will shape market sentiment.
- Despite European economies showing signs of recovery before the tariffs, most European governments, including the UK, are fiscally limited in their ability to respond.
- Markets may stay volatile until policy clarity returns, but long-term fundamentals will ultimately reassert themselves.
What’s happened?
As investors are uncomfortably aware of, global equity markets have been in freefall since President Trump’s announcement of “reciprocal tariffs” on April 2. As of writing (April 4 16:00 BST), UK and European shares are down by close to 10% since the announcement. Government bond yields have fallen by 0.2 to 0.3 percentage points as investors rush to safe havens.
The direct impact of U.S. tariffs on both economies is relatively small. Exports to the United States from the European Union account for just 2.9% of EU GDP in 2023. The exposure of the UK is smaller at 2.3% of GDP. On their own, these tariffs would be manageable, knocking somewhere in the order of 0.5% off GDP growth projections for 2025, with a smaller impact in the UK compared to the EU.
However, the global nature of the trade war is a problem. The EU might only have a small direct exposure to U.S. exports, but overall exports of goods account for nearly 40% of GDP. For the UK, it’s around 15% of GDP. Markets fear that the trade war, potential retaliation and the policy uncertainty from the White House will cause a global recession and magnify the impact of the individual tariff decisions.
Retaliate or negotiate?
One issue to watch is whether governments choose to retaliate or negotiate. China today announced 34% retaliatory tariffs on U.S. imports. European Commission (EC) President Ursula von der Leyen has taken a more measured approach, saying that she will wait four weeks before announcing a response. And that the EC preferred to negotiate to “remove any remaining barriers to transatlantic trade.” The UK has made no official announcement, presumably on relief at the “low” 10% tariff imposed.
Another key factor will be whether President Trump decides to reduce tariffs on countries that he feels are taking steps to reduce what he perceives as unfair trade barriers. There is precedent for this behaviour, as President Trump has a track record from his first term of making aggressive policy announcements to exert the maximum possible pressure, before relenting and announcing that he has achieved a great deal.
Release the doves
Meanwhile, the response of policy makers is also worth watching. Markets are anticipating more rate cuts from the ECB and the Bank of England. Dovish statements from central bankers will help to settle market nerves. The reaction of Fed chair Jay Powell will matter most. Indications that the inflation impact of tariffs will slow the pace of easing could deepen investor fears about a U.S. and global recession. Conversely, a clear signal that policy will quickly become accommodative to support economic growth will help investor confidence.
Europe’s trajectory
Bear in mind that Europe’s economy was on an improving trend prior to the “Liberation Day” announcement. Bank lending had been trending higher since late 2023 and retail spending was gradually improving. There is also a seismic change underway in Germany’s fiscal policy since the election, with added infrastructure and defence spending.
Of course, the other major economies in the region—France, Italy and Spain—are still constrained on the fiscal side with government debt-to-GDP ratios over 100%. Same goes for the UK. The takeaway? Outside of Germany, governments will be limited in providing fiscal support to offset the trade shock.
The bottom line
We have been through these periods of market panic before. Markets are likely to remain volatile until there is more policy certainty. Over time, the long-term fundamentals of economic growth and corporate profit growth will come back into focus.
At Russell Investments, we remain focused on portfolio diversification through this volatile period and are watching closely our measures of investor sentiment for signs that market dislocations have moved to an extreme.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.