In a somewhat surprising shift from his first term, Trump appears to be less focused on how the financial markets react to his policies. This shift underscores the importance of ensuring that you diversify your stock portfolio. Overall, his policies were very business friendly in his first term. While that is still the case in his second term, there are some significant exceptions. His policies on tariffs being one of the most notable shifts. Of course, the effects vary by both industry and the countries to which those industries have exposure.
Despite the way the administration would like to position the tariffs, they have been a drag on economic growth. They have caused higher prices for consumers, and lower profits for producers. The exact mix of higher prices and lower profits also varies by industry. I certainly have views on how tariffs should or should not be used, but for this article I am focused on the facts of what has occurred, and what the likely economic and financial impact will be.
The general consensus is that the tariffs currently in effect will reduce U.S. annual GDP growth by somewhere between 0.5% and 1.0%. The negative impact for 2025 will likely be on the low end of that range, since the tariffs were not in place for the full year. So far, the economy has been resilient enough to absorb this negative impact. However, that may not be the case over the long term.
Regardless of your views on the current tariff policy, abrupt and sudden changes are not good for financial markets. That was made very clear last April as the market reacted quickly to sharp increases on tariffs for certain countries. These tariff increases were then followed by reversals to many of them within days or weeks of the initial announcements. In spite of this, since that volatility last April, financial markets have had a very good year. This is likely because the most extreme tariff increases that have been announced were either dramatically reduced, or completely reversed before they had any meaningful impact.
For the most part, it now seems that markets don’t take the initial announcements of tariff increases, particularly the more extreme ones, very seriously as they tend to never get implemented. Even in cases where they did go into effect before being reduced or reversed, it was typically not long enough to do any real harm. There are certainly tariffs that are still in place from last spring, but many were implemented at much lower levels than initially announced.
The most detrimental part of this is the unpredictable, ad hoc way in which these tariff changes seem to occur. In a recent example, after seeing an anti-tariff ad paid for by the Province of Ontario that used sound bites from Reagan, the President made a late-night announcement of an additional 10 percentage point increase to certain tariffs on Canada.
This less-than-ideal way of governing underscores the importance of making sure you diversify your investment portfolio. The right type of diversification can help protect it, if there is an unexpected period of weak economic growth, along with the typical underperformance of stocks that usually accompanies a weak economy.
There are many ways to diversify the risk in a stock portfolio. Probably the most well-known of these, and also most commonly used, is geographic diversification. It is certainly advisable to have geographic diversification in a stock portfolio. However, it is also important to recognize that diversifying within the same asset class – stocks – has its limits.
If you compare the U.S. stock market with Western European markets, and the markets in Asia, particularly China and Japan, they have correlations in the 50%-70% range. This means that somewhere between half and slightly over two-thirds of the performance of each market is explained by the same factors, not particularly surprising in a world that has become more global. Even worse, when the most extreme financial events occur, like the 2008 Financial Crisis, those correlations spike to over 90%. As a result, investors get the least amount of protection from this type of diversification when it is most needed.
Geographic diversification should be part of the risk management strategy for most investors. However, it is important to recognize that may not be enough. In our next article, we will discuss more robust ways to diversify a stock portfolio.
