What are the economic and investment implications of higher tariffs

Investing.com -- The possible reintroduction and increase of tariffs in the United States, especially with the 2024 presidential election approaching, could have major effects on the economy and investments.

Tariffs, which are taxes on imported goods, were a key part of trade policy during the Trump administration.

As the U.S. considers returning to higher tariffs, analysts at UBS take a look at the potential economic and investment impacts of such actions.

Tariffs act as a tax on imported goods, directly raising the prices of these goods within the domestic market.

According to UBS, the inflationary impact of tariffs is straightforward but significant. “Thus a 10% universal tariff applied to imports to the US should raise overall price levels in the US economy by 1.3%,” the analysts said.

This increase is not merely a one-off; there is a risk of "profit-led inflation" where companies might raise prices beyond the tariff's direct impact, capitalizing on consumer expectations that prices should rise by the full tariff percentage.

Higher tariffs are generally expected to slow economic growth. UBS analysts suggest that tariffs can reduce domestic consumption by increasing the cost of goods, particularly those that lower-income households rely on.

Additionally, tariffs increase the production costs for domestic firms that use imported components, thereby reducing their competitiveness relative to foreign producers. This can lead to a decrease in economic activity and potentially lower employment​.

Under scenarios where selective or universal tariffs are imposed, UBS forecasts a negative cumulative impact on GDP over three years. For example, the U.S. GDP could decline by 1.0% to 1.5% under a universal tariff scenario.

The broader the application of tariffs, the more severe the economic impact, as rerouting supply chains becomes less feasible and the costs are more broadly felt across the economy.

Another economic consequence of higher tariffs is the likelihood of retaliatory measures from trading partners. This tit-for-tat escalation could further depress global trade, slow economic growth, and lead to higher costs for both consumers and businesses.

Retaliatory tariffs by other countries could specifically target industries that are politically sensitive, thereby amplifying the negative impact on the U.S. economy​.

UBS analysts anticipate that higher tariffs, particularly if applied universally, would put downward pressure on U.S. equities. The imposition of a 10% universal tariff, along with corresponding retaliatory measures, could lead to a decline in U.S. equity markets by about 10%.

“A higher cost of imports would most likely impact retailers, automotive manufacturers, tech hardware, semiconductors, and parts of industrials,” the analysts said.

Conversely, sectors that are more domestically focused and less exposed to imports, such as U.S.-based steel producers, might benefit from reduced foreign competition.

However, the overall market sentiment is likely to be negative, especially if tariffs lead to broader economic downturns and increased policy uncertainty​.

In response to the economic challenges posed by higher tariffs, UBS expects the Federal Reserve to take a more cautious approach, likely lowering interest rates to prevent a recession.

Although tariffs might initially drive up inflation, the overall impact on economic growth is expected to push long-term interest rates down as the Fed focuses on maintaining economic stability over short-term inflation worries.

UBS predicts that under a universal tariff scenario, the yield on 10-year U.S. Treasury notes could decline to around 2.5% to 3%, as investors seek the relative safety of government bonds amid economic uncertainty.

The immediate reaction in currency markets to the imposition of higher tariffs is likely to be an appreciation of the U.S. dollar, driven by a flight to safety and the negative impact on major trading partners' economies.

However, UBS analysts caution that this strength may be short-lived. As the U.S. trade deficit widens due to reduced exports and higher import costs, the dollar could come under pressure in the longer term​.

This article first appeared in Investing.com