On April 2, the US government announced a new set of economic tariffs whose magnitude caught many off guard, spawning competing narratives about their economic impact.
This constant flow of uncertainty and narratives is not helpful for investors. To better understand the potential impact, we have examined the range of potential outcomes for key asset classes using data that shows how sensitive different sectors are to various economic outcomes. This research is designed to help investors fully understand their exposure to tariffs. We exclude real estate from this analysis because of differences in modeling this sector.
Using three different methods, we find technology to be the most sensitive sector, while utilities is the least sensitive. The range of estimated tariff sensitivity found by our three methods illustrates the challenges of confidently making predictions, and investors can interpret and use this data differently. Still, a long-term investor will better understand the robustness of their portfolio if they’re armed with this data.
Stock Sectors and Shocks to the Economy
To determine each sector’s sensitivity to tariffs, we started by creating two macroeconomic shocks, termed demand and supply shocks.[1] Demand shocks only have a short-run effect on output, which disappears as prices and wages adjust and bring the economy back to equilibrium. Conversely, production (supply) shocks can have a permanent effect on output. We calculated the fundamental sensitivities of each sector to these shocks and then ranked the sectors by sensitivity. Among US sectors, technology is most sensitive to both demand and supply shocks, while utilities and healthcare are the least sensitive.
Next, we decomposed stock returns into cash flow and valuation components and calculated the sensitivity of each US sector to a shock to those variables.[2] We focused primarily on the former, as a negative shock to aggregate cash flow is a more serious risk to long-term investors, since it represents a permanent decline in wealth. In contrast, valuation risk is temporary, as falling valuations in the short term are balanced by higher expected future returns.
If we experience negative cash flow news, the most sensitive assets will be consumer cyclical and technology stocks, while the least sensitive ones will be in consumer defensives, utilities, and healthcare.
Finally, we compared the behavior of stock prices to the frequency of newspaper articles discussing trade policy uncertainty, measured by the Trade Policy Uncertainty Index.[3] For many decades, the index has been fairly stable (previous spikes include the Nixon shock in 1971 and the Ford shock in 1975). However, we have seen large increases in volatility over the last decade. Technology returns have been most sensitive to movements in this index, while utilities have been least sensitive. There’s been a recent increase in returns for investors willing to bear this risk.
Looking Ahead at Tariffs and the Stock Market
The interplay between tariffs, macroeconomic shocks, and equities will likely remain a central theme in the investment landscape. While external factors like trade policy uncertainty are difficult to predict, understanding how sensitive equity positions are to various shocks is crucial for a long-term investor maintaining robust portfolios and staying aligned with financial goals. Given this uncertainty, it is equally important to ensure that the price you pay for an asset includes a margin of safety to allow room for error in estimating the fundamental value of a security.
[1] Olivier Jean Blanchard and Danny Quah, “The Dynamic Effects of Aggregate Demand and Supply Disturbances,” American Economic Review 79, no. 4 (1989): 655–673.
[2] John Y. Campbell and Tuomo Vuolteenaho, “Bad Beta, Good Beta,” American Economic Review 94, no. 5 (2004): 1249–1275.
[3] Caldara, Dario, Matteo Iacoviello, Patrick Molligo, Andrea Prestipino, and Andrea Raffo (2020), “The Economic Effects of Trade Policy Uncertainty,” Journal of Monetary Economics, 109, pp.38-59. https://www.matteoiacoviello.com/tpu.htm
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
