From tariffs to taxes
From tariffs to taxes
Summary
In recent weeks the rhetoric and actions around tariffs have improved. The agreement between China and the US on the 12th of May appears to signal that the imposition of tariffs announced in early April has been replaced by a more thoughtful approach to realign trade agreements. Equity markets, that initially were shocked by the severity of the approach taken by President Trump, fell through April, but recovered on the back of a more conciliatory tone.
The tariff outcome is better than the worst-case scenario that looked possible in mid-April. However, if the current tariff plans are enacted the global economy will face a US tariff environment that is significantly worse than the one that existed before April’s announcements. But, for the time being, a period of stability and silence on tariffs has been welcomed by investors.
Bond yields initially started to price in lower interest rates, reflecting the view that the imposition of tariffs proposed by President Trump would result in a US recession. Bond yields then rose sharply as interest rate policymakers indicated they were worried about the inflationary impact of the tariff policy, even in the face of slower economic growth.
While the media and markets have been transfixed by the tariff news, the US Congress has been working on a new federal budget. Republicans want to renew Donald Trump’s 2017 tax cuts, which would otherwise lapse, and make good on last year’s campaign pledges to reduce other taxes, including removing tax on tips and overtime income. Congress seems unlikely to support the sort of swingeing cuts in welfare, including Medicaid, which would be necessary to fully cover the cost of the proposed tax cuts. Higher budget deficits and rising government debt seems likely given the policy proposals.
The credit agency Moody’s downgraded the US credit rating from AAA to Aa1. The downgrade commentary from Moody’s highlighted the unsustainable path of deficits and debt. The initial market reaction of weakness in bonds and the US Dollar suggests that investors may be wary of the plans from the US government.
Company updates for the first quarter are drawing to a close. The period covered by the company updates precedes the tariff announcement at the start of April. Companies have been beating expectations, which is typical as companies tend to keep expectations low so that their results are seen as good. However, outlook guidance has been quite poor with downgrades for 2025 as a whole.
Despite better news on tariffs, the poor backdrop for corporate profitability and heightened awareness over the prospect of elevated government deficits may lead to a reassessment of investment risk tolerance, particularly as equity valuations have climbed back up through a combination of higher prices despite the prospect of lower earnings.
A tariff trip
Back to the beginning? We wrote last month that investors were focusing on the tariff tirade launched by President Trump. The on-off tariffs and delays may have left some wondering about the state of affairs. The chart opposite traces the tariff announcements of the US on imports from China, and the tariff response by China since February, alongside the price level of the US equity index (S&P 500). Tariffs on Chinese imports quickly ratcheted up from an initial tariff level of 10% to the 145% tariff rate proposed by President Trump on the 9th of April. This was followed by the 12th of May agreement to pause any tariffs for 90 days, with a 30% tariff level in place subsequently. The Chinese, having walked up their tariffs in response to the US, also dropped their tariff rate down to 10% on the 12th of May, with all other tariffs suspended for 90 days.
Investors may be confused by the current tariff landscape. At the time of typing, the vast majority of April’s “reciprocal” tariffs have been paused following the sharp de-escalation between the US and China, but the 10% baseline tariff remains for most countries and is unlikely to be negotiated lower. At the lower end of the spectrum are Mexico and Canada, which avoided the 10% baseline tariff but are now subject to 25% steel and aluminium tariffs.
Whilst the tariff announcements have eased from the frenetic pace of April, the 90-day pause on reciprocal tariffs ends in early July for most countries; China’s 90-day reciprocal tariff pause ends in mid-August. During this period one could expect more trade deals to be announced just like the UK and US deal that was announced on the 8th of May.
Equity markets have made a round-trip through this tariff chaos, falling on the initial announcements only to recover as tariffs were removed or delayed. The S&P 500 fell sharply, falling below 5000 on the 8th of April as tariffs were being ratcheted higher. As the rhetoric was toned down, equities started to recover ahead of the announcement.
The US S&P 500 index and the proposed tariffs on US and Chinese trade.
Source: Bloomberg, Artorius
The chart on the right shows the tariffs and the yield on the 10-year US government bond. After an initial fall in bond yields as investors saw tariffs curtailing economic growth (which would bring the prospect of lower interest rates), investors appeared to switch their focus on the inflationary impact of tariffs, and yields rose even as tariffs were initially increased in April. Monetary policymakers in the US highlighted that tariffs would be inflationary, and this would limit the ability of the Federal Reserve to cut interest rates, even if economic growth slowed.
Unlike equities, bonds have not responded positively (with bond yields falling) to the good news on the 12th of May of a tariff delay and the lowering of prospective tariffs. There may be other factors starting to filter into bond markets, which we will discuss below.
The US dollar, which has fallen since Trump has come to power, has stabilised, but remains lower than it was at the start of April when the tariff announcements started. Gold which has attracted investor flow through 2024, has fallen back 7% as the tariff tensions were eased, but remains 22% higher since the start of 2025.
If the current set of tariff plans are enacted, then the global economy will face a US tariff environment that is significantly worse than was the case prior to 2025. But for the time being, a period of stability and silence on tariffs appears to be welcomed by investors.
The US 10 year bond yield and the proposed tariffs on US and Chinese trade.
Source: Bloomberg, Artorius
Moody blues?
Bond yields remain elevated despite the better announcements from China and the US with respect to tariffs.
In the US, attention has turned to the government budget. The US budget process is prolonged. The President proposes a budget, which then is subject to change and negotiation in Congress. The proposals are set to cut Federal Government spending. Republicans are divided between hardliners, who view the package as their best chance to cut spending, and more moderate Republicans from competitive districts who have warned that deeper spending cuts to social safety net programs could jeopardise the 220-213 seat Republican majority at the mid-term elections in 2026.
In addition to spending cuts, the Bill proposes to extend the 2017 tax cuts from President Trump’s first term. The tax cuts will lead to higher levels of government deficit over coming years, according to non-partisan (politically neutral) analysts. Some are even comparing President Trump’s proposals with the disastrous Truss-Kwarteng Budget in September 2022. We doubt that the US bond market will sell-off in the way that the UK gilt market did in the Autumn of 2022, but bond yields may remain higher for longer if the US Budget Bill results in elevated budget deficits and higher government debt, as seems likely.
The level of additional deficit generated by the proposed fiscal package has resulted in Moody's downgrading US Government debt from the highest AAA rating. Moody’s, which was the last of the three major ratings agencies to rate the US AAA, warned that the nation's debt burden could reach 134% of gross domestic product by 2035, compared with 98% in 2024.
"Successive U.S. administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs," Moody's wrote, adding that they didn't see enough spending cuts "from current fiscal proposals under consideration." Moody’s said it expected federal deficits to widen to almost 9 per cent of GDP by 2035, up from 6.4 per cent last year, owing to increased interest payments on debt, entitlement spending and “relatively low revenue generation.”
The downgrade to the credit rating may focus debate in Washington and prompt a compromise budget that delivers a sustainable fiscal picture. For the time being, markets are expressing a sceptical view over the state of US finances. Higher bond yields may prompt a rethinking by politicians to bring greater discipline into their policy decisions.
Comparing the UK in 2022 with the US in 2025 on fiscal measures and bond yields
| UK 2022 | US 2025 | |
|---|---|---|
| Primary Deficit Impact of Proposal in UK 2022 forecast and US 2027 forecast (% of the economy) | 1.5% | 1.7% |
| Total Deficit Under Proposal in UK 2022 forecast and US 2027 forecast*(% of the economy) | 3.9% | 7.0% |
| Deficit in Year of Announcement** (% of the economy) | 5.4% | 6.2% |
| Debt in Year of Announcement*** (% of the economy) | ~96% | ~100% |
| 10-Year Yield Before Announcement | ~3.0% | ~4.3% |
| 10-Year Yield After Announcement | ~4.4% | TBD |
Sources: Data from HM Treasury, Office for Budget Responsibility (OGL v3.0), Congressional Budget Office, Committee for Responsible Federal Budget, and Institute for Fiscal Studies. Table created by Artorius; figures adapted and interpreted independently.
*The UK figure was estimated by the Institute for Fiscal Studies.
** The UK figure was estimated by the Office for Budget Responsibility.
*** US debt figures reflect debt held by the public as provided by the Congressional Budget Office, while UK debt figures reflect public sector net debt provided by the Office for Budget Responsibility.
Sceptical US Dollar
Even though US Bond yields have risen relative to the likes of Germany, the US Dollar has not rallied. The chart opposite shows the US Dollar against the Euro and the way that it has tracked the spread (or difference in yields), between US and German 2-year government bonds. The higher bond yield in the US would normally have resulted in a stronger US Dollar. But the price pattern suggests that investors perceive the US dollar and US government debt as less creditworthy and are now demanding higher interest rates to compensate for the higher risk of fiscal deficits in the future.
The US dollar has not tracked the increased yield differential between US and Germany.
Source: Bloomberg, Artorius
Profits: a mixed bag
Each quarter US companies provide updates to the market. The first quarter reporting season is ending and whilst the reports cover the period that predates the impact of tariffs, companies are also providing guidance on the outlook, which have been adjusted for the tariff announcements.
Generally, companies have come in slightly ahead of expectations, albeit there have been winners and losers - but the outlook statements have resulted in downgrades to profits expectations for 2025 and 2026.
Over the past few years, companies have been upbeat about the prospects for their profitability. The change in tone from US companies may dampen the outlook for equities, particularly if we see higher bond yields as markets start to adjust to higher deficits. Over recent weeks, equity valuations have climbed back up as prices have risen despite the prospect of lower earnings. Without greater clarity over the budget and its impact on the bond market, investors may reassess their risk appetite.
US companies have lowered their expected level of profits (measured by Earnings Per Share – EPS) for 2025 and 2026
Source: Bloomberg, Artorius
Conclusion
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In recent weeks the rhetoric and actions around tariffs have improved. The agreement between China and the US on the 12th of May appears to signal that the imposition of tariffs announced in early April has been replaced by a more thoughtful approach to realign trade agreements. Equity markets, that initially were shocked by the severity of the approach taken by President Trump, fell through April, but recovered on the back of a more conciliatory tone.
The tariff outcome is better than the worst-case scenario that looked possible in mid-April. However, if the current tariff plans are enacted the global economy will face a tariff environment in the US that is significantly worse than the one that existed before April’s announcements. But, for the time being, a period of stability and silence on tariffs has been welcomed by investors.
Bond yields initially started to price in lower interest rates, reflecting the view that the imposition of tariffs proposed by President Trump would result in a US recession. Bond yields then rose sharply as interest rate policymakers indicated they were worried about the inflationary impact of the tariff policy, even in the face of slower economic growth.
While the media and markets have been transfixed by the tariff news, the US Congress has been working on a new federal budget. Republicans want to renew Donald Trump’s 2017 tax cuts, which would otherwise lapse, and make good on last year’s campaign pledges to reduce other taxes, including removing tax on tips and overtime income. Congress seems unlikely to support the sort of swingeing cuts in welfare, including Medicaid, which would be necessary to fully cover the cost of the proposed tax cuts. Higher budget deficits and rising government debt seems likely given the policy proposals.
The credit agency Moody’s downgraded the US credit rating from AAA to Aa1. The downgrade commentary from Moody’s highlighted the unsustainable path of deficits and debt. The initial market reaction of weakness in bonds and the US Dollar suggests that investors may be wary of the plans from the US government.
Company updates for the first quarter are drawing to a close. The period covered by the company updates precedes the tariff announcement at the start of April. Companies have been beating expectations, which is typical as companies tend to keep expectations low so that their results are seen as good. However, outlook guidance has been quite poor with downgrades for 2025 as a whole.
Despite better news on tariffs, the poor backdrop for corporate profitability and heightened awareness over the prospect of elevated government deficits may lead to a reassessment of investment risk tolerance, particularly as equity valuations have climbed back up through a combination of higher prices despite the prospect of lower earnings.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 23rd May 2025 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.
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