Recently the news has been dominated by talk of tariffs, and it seems like the direction shifts daily – tariffs are announced, then potentially paused, then reapplied with different scopes. For those of us in the business of lending to small businesses, understanding the implications of these trade policies is crucial. Let's break it down in simple terms.
A tariffs primer
At its core, a tariff is a tax imposed by a government on goods or services imported from another country. When applied, imports cost more, potentially making them more expensive compared to domestically produced goods. Governments use tariffs for a variety of reasons, often rooted in the desire to protect domestic industries. One key tariff justification that’s been presented is to protect domestic strategically important industries and can give them a temporary shield, so they can grow, innovate, and become more competitive - on a global stage.
So why the alarm bells?
While tariffs have long been a tool in the global economic policy toolkit, the recent actions of the US government have garnered extraordinary attention. Why? Because the scale and scope of the tariffs under discussion and, at times, briefly implemented, are unlike anything the global economy has witnessed in nearly a century. Past uses of tariffs were often targeted at specific industries (or nations) and involved relatively modest rates. What we've seen recently involves the potential for broad-based tariffs across numerous sectors and major US trading partners, with some reciprocal tariff increases being applied to US exports to those partners in response. This departure from historical norms is what has sent shockwaves through the global economic community.
Decoding the market’s volatile reactions
The financial markets, particularly the stock and bond markets, have reacted sharply to the tariff news, with significant volatility when tariffs are merely proposed or paused. To understand this reaction let’s look at how these markets operate. First, equity markets are forward-looking, pricing in future expectations for corporate earnings and economic growth. The tariff uncertainty creates a significant headwind to reliably predict the future. All businesses face the prospect of higher input costs, disrupted supply chains, and reduced exports, all of which are expected to negatively impact business profitability. This profitability uncertainty leads investors to become risk-averse, resulting in lower valuations and wild market swings.
The bond market's reaction, specifically the rise in yields, is also part of this uncertainty. Typically, US Treasuries are a "safe haven" during times of economic turmoil. However, the current unpredictable nature of tariff policy is eroding this perception of safety. Right now investors believe that the proposed tariff policies could damage the US economy or lead to retaliatory measures that harm US Treasury holdings, so investors may demand a higher yield to compensate for this increased risk.
Additionally, the fear that tariffs will fuel US inflation (by increasing the cost of imported goods) can push bond yields higher as investors anticipate a need for higher interest rates to combat rising prices. Markets hate uncertainty, and the inconsistent nature of tariff announcements fuels this uncertainty, leading to lower equity valuations and a reassessment of the safety of traditional safe-haven assets.
In 2022, there was a spike in inflation, making goods and services more expensive to produce. Tariffs have a similar impact, causing the cost of goods to increase, particularly for manufacturers, importers and construction businesses. Are small businesses ready for potential increases in the cost of goods? Do they think they’ll be able to pass those costs on to their customers?
The experience of the 2022 inflation spike offers some insights here. While most businesses attempted to increase prices to maintain margins, success varied. Some businesses with strong pricing power were able to pass on most of the cost increase to their customers. However, others, particularly those in more competitive sectors or those with longer-term contracts, experienced margin compression as they were slower or unable to fully offset the rising input costs. The concern with tariffs is that they could create another wave of cost increases, and the ability of small business clients to absorb or pass these on remains a key uncertainty. The current cautious consumer sentiment might make it more challenging for small businesses to raise prices without impacting demand.
At Rapid we have been lending through a bunch of ups and downs in the credit cycle. What are the keys to managing through these times effectively and supporting small business clients?
The key to navigating challenging economic times is proactive and empathetic client engagement. It's about working collaboratively with our clients to understand their specific situations and challenges. This involves open communication, offering support and guidance where possible, and exploring potential solutions to help them weather the storm. Our goal is to ensure that our clients can navigate these difficulties. By fostering strong relationships, we not only improve their chances of success but also strengthen our long-term partnerships. It’s about viewing our clients as partners and supporting them through tough times so they can emerge stronger on the other side.
The current tariff landscape presents a complex and evolving situation. By understanding the economic principles at play, closely monitoring market reactions, and maintaining a proactive and resilient approach, small business lenders can navigate these uncertainties and continue to support the small businesses that drive our economy.