‘Priced for perfection’: Tariffs loom over richly valued stocks

The conventional wisdom on Wall Street appears to be that the US stock market’s latest march to records has been unabated because, when it comes to tariff threats, President Donald Trump talks loudly but carries a small stick.

Yet, regardless of what the levies on imports from remaining trading partners end up being when Trump makes his final decisions, some prominent voices in the market say investors are underestimating the risks even from tariffs that are already in place.

Duties paid by US importers have jumped to an average rate of more than 13%, over five times where they were last year, Bloomberg Economics estimates. Higher tariffs are enough to slash 5% or more from corporate earnings growth, according to Alastair Pinder, head of global equity strategy at HSBC. 

With the S&P 500 Index trading at about 22 times forward earnings, near its richest valuations in the post-Covid era, the concern is that any disappointments in corporate profits and economic data during the remainder of the year could pull the rug out from under the latest rally.

“Because we are priced for perfection, any disappointment, deviation from that on the downside, we could see stocks re-rate,” said Paul Nolte, market strategist and senior wealth adviser at Murphy & Sylvest Wealth Management in Dallas. “There’s a balloon wandering around Wall Street looking for a pin, and nobody knows what that pin is. It could well be this.”

How much damage could that pin do to high-flying stock indexes? To Nolte, the market is vulnerable to a true bear market: a selloff of 20% or more.

Bracing for turbulence

Even some of Wall Street’s most-outspoken bulls are bracing for turbulence as the tariffs start doing damage to companies’ bottom lines. Morgan Stanley Chief US Equity Strategist Mike Wilson, who went from noted bear to full-throated bull after the market selloff earlier in the year, is one of them. 

While he’s optimistic about stocks on a 12-month basis and doesn’t see a true bear plunge on the way, he acknowledges the risk that near-term corporate guidance could turn out to be worse than expected and cause some market indigestion.

“There is a third-quarter risk here where you get some of that passthrough, margins are going to be coming down a bit — that’s a 5-10% correction,” he said. 

While it’s still early innings in the reporting season for the latest quarterly earnings, anecdotes are starting to pile up suggesting that the tariffs in place are already biting. Companies are subject to multiple broad levies, including 10% on goods from most countries and an additional 20% on China that Trump has linked to fentanyl.

General Mills Inc. last month forecast a 1% to 2% hit to its cost of goods sold, which it’s working to limit by substituting ingredients and reformulating products. Tommy Bahama owner Oxford Industries Inc. slashed its profit outlook for the year as it accounted for $40 million in additional tariff costs. And economic bellwether Fedex Corp. warned that its earnings would be worse than expected this quarter as the trade war continues to pressure its business, including highly profitable US-China shipments.

Wall Street will get new numbers to chew on this week when several large companies with exposure to tariffs and the economy report results. General Motors Co. is subject to auto-sector levies, while Capital One Financial Corp.’s quarterly update may shed light on the strength of the US consumer.

On a more macro level, there are hints that tariffs may already be appearing in the fine print of economic reports. Tuesday’s inflation data showed that core consumer-price gains accelerated in June, and tariff-exposed categories such as furniture and apparel suggested companies are starting to pass higher costs on to consumers.

Louder warning signs may be on the way. HSBC’s Pinder is watching for retail sales to weaken later in the year, and for prices to pick up after companies burn through stockpiles of goods that they bought when tariff rates were lower. 

Slower growth

All told, the current tariff rates will leave the US economy some 1.6% smaller over the next two to three years, compared to a scenario without the levies, Bloomberg Economics estimates. Consumer prices will end up 0.9% higher, the economists say.

Any further pickup — or even stickiness — in inflation could dash equity investors’ hopes for interest-rate cuts this year regardless of how many insults Trump hurls at Federal Reserve Chair Jerome Powell. 

Of course, not all bulls are cowering. Many on Wall Street see reasons stocks can remain at pricey levels. Declining interest rates, low unemployment and elevated corporate profitability justify sky-high valuations, according to Goldman Sachs strategists.

In addition, there’s the tax and spending bill that Trump signed into law this month, which made permanent several corporate tax deductions. The bill alone is worth 5% to 7% in S&P 500 earnings growth, according to Morgan Stanley’s Wilson. 

Investors “came into this year with the expectation that the Trump administration would create some more austerity,” said Nathan Sonnenberg, chief investment officer of family office firm Pitcairn. With the passage of the spending bill, he said, “we’ve realized that there will be more of a stimulative effect.”

Still, the US president’s unpredictable nature means that any attempts to jot down estimates of the financial and economic impact of his tariff policies should be done in pencil, not ink. While Trump has backed down from some of his most aggressive tariff threats, there’s lingering risk that aggregate levels will rise significantly by his latest deadline of Aug. 1. 

Indonesia will face a 19% baseline tariff even after the country struck a trade deal with the US. Trump has announced that goods from Vietnam will have a 20% rate, although Bloomberg has reported that those talks are ongoing.

“It’s the wrong reaction to look past these tariffs and to move on,” UBS Chief Strategist Bhanu Baweja said Monday on Bloomberg TV. “When the inflation impact comes through, hits real disposable income, that’s when I think markets will begin to see this.”