Enthusiastically devouring a taco only to have it disintegrate into a messy pile can be a relatable experiencing. A similar occurrence seems to be taking place in the international stock markets, where the confidence that Donald Trump will always withdraw from imposing severe tariffs, a notion humorously referred to as the ‘TACO’, has driven stocks to reach unprecedented heights. This situation, however, is anything but stable.
In a week chock-full of unexpected declarations, Donald Trump’s threat to impose a 35 percent tariff on Canada topped the charts. Previously, a proposed 50 percent tariff on copper imports and a potential 200 percent tariff on pharmaceuticals had been announced. Yet, the market’s reaction echoed prior responses: Trump might make loud declarations, but they doubt his tariffs will significantly impact the economy.
Sitting at an all-time high, the S&P 500 reflects this optimism. Similarly, the Russell 2000 Index – comprising smaller companies more sensitively linked to the US economy – exceeds its value from April 2nd, when Trump announced country-specific reciprocal tariffs. This TACO trading strategy does, in fact, venture beyond betting on Trump’s psychology. Several compelling arguments indeed make backing out a highly probable result.
The current state of the United States, with a limited capability to rapidly launch copper mines or smartphone manufacturing plants, may force it to opt for less aggressive tariffs. Should American essential trade allies approach the 10 percent ‘baseline’ level declared on April 2nd, the economic repercussions could remain minimal. However, the TACO trade insinuates a level of predictability that may be misleading when considering the unpredictable nature of Trump.
In the past, Trump’s initial presidential term showcased a penchant for endorsing questionable strategies to combat the Covid-19 pandemic, indicating that policy missteps were not unusual under his administration. Moreover, his recent proclamations, such as Japan’s 25 percent tariff, suggest that imposed levies might surpass the baseline 10 percent. As a result, the trust generated by the TACO trade could initiate a precarious chain of events.
On a Thursday interview with NBC, Trump confidently stated that the resilience of stock markets was a testament to the favourable reception of his tariffs, rather than a detrimental effect on the economy. His inference was that the positive response gave him implicitly permission to implement more severe taxes. However, the market has yet to fully account for the repercussions of a potential trade war.
While the US has so far been able to finalize only a handful of trade accords, the threat for more rigorous negotiations and ultimatums could be on the horizon. In addition, the consequences of the tariffs announced till now on the US consumer prices will start to materialize this month. Yet, the stock prices of several profoundly affected sectors seem surprisingly nonchalant.
In Europe, pharmaceutical firms such as Novartis, AstraZeneca, Sanofi and GSK are, on average, trading at 11.8 times forward earnings, surpassing their 11.3 times level seen at the beginning of the year, as reported by LSEG data. Similarly, automobile makers like Volkswagen, Stellantis, Porsche, BMW and Mercedes-Benz are presently averaging 8 times, a notable increase from their standings at the year’s start.
Flourishing markets may necessitate retreat by Trump to avoid severe ramifications, but conversely, they also reduce the likelihood of such a surrender. On July 10, the US President announced another batch of tariffs targeted at Canada, using the thriving stock markets as proof of his successful trade war strategy.
Trump declared that Canada would face a 35 percent tariff rate starting August 1. Earlier in that same week, he proposed a monstrous 50 percent tariff on copper imports, along with a 200% tariff on drugs.
The United States is currently in the process of negotiating with crucial trade allies including the European Union, on the topic of his proposed ‘reciprocal’ tariffs announced on April 2. The market’s default assumption, regardless of these tumultuous declarations, continues to posit that Trump will backtrack on these proposed tariffs.
Despite Trump’s unpredictable nature and penchant for policy missteps in his first term, the market optimism continues unabated. But this buoyant market, albeit encouraging, could be sowing the seeds of complacency.
This complacency, reflected in the high trading multiples of European pharmaceutical firms and car manufacturers, despite the threatened tariffs, may prove to be the market’s downfall if Trump does not withdraw his high tariffs.
In this complex interplay of tariffs, negotiations, and stock market responses, lies the precarious TACO trade strategy. The basic tenet of this strategy rests on a dangerous assumption: that Trump will inevitably withdraw his high tariffs.
In summary, the current optimism reflected in record-high stock indices is, at the very least, at odds with Trump’s aggressive tariff announcements. The market seems to have laid its bets entirely on Trump backing down from the tariffs he has threatened. But will he? Only time will tell.
The preceding events on tariff impositions, reciprocal levies and looming trade wars underscore the need for markets to adapt their risk evaluation mechanisms. With the unpredictability gradient being high, whether Trump will continue to impose high tariffs or recoil into a more accommodative stance remains to be seen.