Liberation Day Brings Risky Escalation to Trade Wars: Update on implications for global economic and market outlook

Tariffs are used by politicians to talk about tax increases. President Trump not only delivered tariffs, he delivered nothing less than a worst-case scenario. For Canada, Trump was more kind as Liberation Day brough nothing new for Canada and Mexico – that was a positive surprise. Still, Canada will also be negatively impacted by the ongoing trade war, both directly via higher costs, and indirectly via a slower outlook for global trade. China was perhaps the most negatively impacted with tariffs nearing 80%. Finally, a baseline 10% was also imposed on all imported goods. By imposing a broad suite of tariffs on its trading partners, the U.S. just placed the equivalent of a 2% ($620bn) tax in its economy. The effective tariff rate in the U.S. will jump from 3% to north of 20%.

While the first-order economic calculus of import duties is straightforward, it’s worth noting we cannot be certain that tariff rates will not go up or down in coming weeks. This complicates our assessment and stance on the economic and market outlook for 2025. Assuming current policies stay in place, the U.S. and global economy is facing a significant risk of a stagflation (slow economic growth and rising prices) shock unlike no others in modern history. We had COVID shutdowns, now we have a global trade war that will disrupt supply chains, consumption and investment patterns for perhaps a long time. Of course, such seismic shock to the global order brings substantial investment opportunities.

Inflation: Tariffs will bring more pain to consumers

The first order hit to the economy is inflation, as U.S. consumer goods are hit by a +8% tax. While currencies can partially absorb some of the tariffs, we expect profit margins to also take a hit because U.S. consumers are still healing from the +20% cumulative inflation since 2020, leaving them in a more vulnerable position to absorb further price spikes for goods, notably big-ticket items such as cars, whose prices are set to jump. We think U.S. inflation is likely to break above 4% by the summer, assuming current tariffs stand.

Economic Growth: Heightened recession risk, potentially the end of U.S. exceptionalism

Odds of a recession starting in 2025, perhaps as soon as the summer, are rising. In our view, it’s hard not to place those odds above 50%, a touch higher than the economic consensus (currently at 30%) (Bloomberg, 2025). Faster moving betting markets see those odds closer to 50% and rising versus last month (see chart 1). Ongoing efforts to trim government spending in the U.S., coupled with slowing immigration flows, are also weighing on the growth outlook.

Chart 1: U.S. Recession Probabilities in 2025 According to Polymarket

Source: Bloomberg, BMO GAM, as of April 3^rd 2025

We often like to say that economies don’t suddenly fall into a recession cliff (outside of COVID shutdown), but the sudden shock of these steep tariffs could torpedo the economy and sink it quickly into a recession. The magnitude of the negative impact to Gross Domestic Product (GDP) is more difficult to predict, but that tends to be of secondary importance for investors as the change of trajectory for the economic outlook is a major surprise versus the solid economy we were contemplating at the start of the year.

Canada: Could have been worse, but this will still hurt

On paper, 25% tariffs on motor vehicles alone are enough to be worried about Canada’s economic outlook. But compliance to USMCA’s (United States-Mexico-Canada Agreement) country-of-origin mean the effective tariff rate is lower. Firms are currently rushing to meet compliance standards, which should help mitigate the impact of tariffs where possible. Overall, it’s fair to say that the recession risk is greater for Canada than in the U.S. given their relative starting point on the economic backdrop and their relative dependence to trade, both in in favour of the U.S. What plays in favour of Canada is its room for fiscal policy from both the Federal and provincial governments.

Equity Outlook: Be careful, markets have already repriced for a softer economic and earnings outlook

While the economic outlook is softening, which will weigh on corporate earnings, especially for firms with greater exposure to global supply chains, investors must keep in mind that equity markets have already repriced this greater risk. We expect the trade policy outlook to remain fluid, tariffs will perhaps be dialed back, which would reassure investors and help reboot investor sentiment (see chart 2).

Chart 2: Spikes in Policy Uncertainty Tend to Unwind Rapidly

Source: Bloomberg. BMO GAM, as of April 3^rd, 2025

Our base-case was always that tariffs would be part of the global trade landscape. We also expected the initial blow of tariffs to be more punitive, but be later dialed down through negotiations, à la Art of the Deal style. Our main concern in the near-term is for a trade escalation with tit-for-tat tariff retaliations. While we are already seeing some of those, countries are also well aware that Trump has been clear he would immediately re-escalate in case of retaliation.

Looking beyond the ongoing trade wars, however, we also expect more market-friendly policy items to develop in coming months. Not only to renew the 2017 tax cuts, but other fiscal measures that would incentivise investments to support the U.S. manufacturing renaissance.

The so-called Trump put* on the S&P 500 Index might be lower than hoped by investors even though Trump 1.0 proved resilient to market pain during the first trade wars of 2018. However, we suspect damages to the labour market would resonate more with his administration, particularly with the Republican party. However, we think the first pain U.S. households will experience will be significantly higher prices for goods, but investors will be closely watching job reports on both sides of the border as recessions are not just about a contraction of GDP, but material job losses and rising unemployment rate.

Monetary Policy Outlook: Central banks cannot solve it all, but rate cuts won’t hurt

Recent communications by the Bank of Canada (BoC) suggested that monetary policy might not be the best tool to fix a weaker economy when hit by tariffs. Price and inflation spikes mean central banks are less likely to be pre-emptive with rate cuts after their bad judgment calls on transitory (not long-term) inflation in 2022. While rate hikes are unlikely here, the risk of a wait-and-see approach to monetary policy is that rate cuts might come too late to prevent an economic mess. This will be a challenging balancing act for the U.S. Federal Reserve and BoC. If job losses materialize, it will become more difficult for them to remain on the sidelines because of price spikes. They will have to step in with rate cuts if the economy softens enough.

Implications for Portfolios and Asset Allocation: Prudence and on the lookout for Truth-Social policy updates

Rarely do we have to worry about policy to this degree, but we are in this unusual macro cycle where policy is deliberately inflicting pain on the economy and markets, potentially ending a long period of U.S. exceptionalism. The Trump administration believes that this short-term pain will be followed by long-term gains, but the degree of pain that could come remains highly uncertain for investors. Without walking back some of the tariffs, it will not be easy for equities to resume their bullish trend in the near term.

A key risk for investors after large market corrections is to fear more downside. In a policy-driven market cycle such as this one, investors must remember that we are just one quick Truth-Social message away from a potential market-reboot policy tweak. This is not the time for long-term economic market views, unfortunately, it’s time to be nimble and opportunistically prudent.

Our portfolio solutions have been adjusting toward a more defensive stance in recent weeks by both lowering our equity allocation from a moderate overweight to a small underweight, and by also reallocating toward more defensive equity sectors. We were also buying equity protection when it was cheap and carried some additional interest rate duration in our portfolios, along with some longstanding positions in what has proved to be the best post COVID-era hedge…shiny gold.