Will the Stock Market Crash As President Trump's Tariffs Take Effect? History Offers a Clue.

Investors have become increasingly unnerved by President Trump's trade policies in recent weeks. The benchmark S&P 500 (SNPINDEX: ^GSPC) has not only dropped 4% year to date, but has also declined more than 8% from the record high it reached last month.

Will the stock market continue falling as tariffs impact the U.S. economy? Here's what investors should know.

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Image source: Official White House Photo by Andrea Hanks.

The Trump administration has sown uncertainty with its trade policy

Donald Trump during his recent presidential campaign outlined plans for aggressive tariffs, but many analysts interpreted those plans as a negotiation tactic meant to secure more favorable arrangements with U.S. trading partners. However, Trump has forged ahead with his trade war since returning to the White House, but has done so in an inconsistent and seemingly indecisive manner.

According to a recent Bloomberg report, "In a span of three days in the past week, Trump imposed 25% levies on most Canadian and Mexican goods, then promised a one-month delay on those that comply with the North American trade agreement, then threatened major new tariffs against Canadian lumber and dairy."

Investors dislike uncertainty. Tariffs naturally create uncertainty because it is impossible to predict how all involved parties will respond. Will other countries hit the U.S. with retaliatory tariffs? Will U.S. companies absorb the cost increases or pass them along to consumers? But the Trump administration has also sown uncertainty by whipsawing on its trade policy.

Consequently, every major U.S. stock index has fallen from its high. As of March 10, the broad-based S&P 500 is down 8.6%, the blue-chip Dow Jones Industrial Average (DJINDICES: ^DJI) is down 6.9%, and the technology-focused Nasdaq Composite (NASDAQINDEX: ^IXIC) is down 13.4%. That means the Nasdaq has already entered stock market correction territory.

History says the stock market may keep falling as Trump's tariffs hit the economy

Trump imposed a 10% tariff on Chinese imports in February, then tacked on an additional 10% tariff in March. He also implemented a 25% tariff on Canadian and Mexican imports in March, but he has since granted a temporary exemption to goods that comply with the free trade agreement. The exemption expires in April.

Trump has also discussed a 25% tariffs on imports from Europe. And he has threatened reciprocal tariffs on imports from countries that retaliate, meaning the U.S. would levy import taxes equivalent to duties aimed at U.S. goods. Trump also wants to "counter non-reciprocal trading arrangements" that contribute to the U.S. trade deficit with the "equivalent of a reciprocal tariff."

In total, the nonpartisan Tax Foundation estimates all tariffs Trump proposed as of Feb. 27, including those mentioned, would raise the average tax on all U.S. imports to 13.8%. The last time the average tariff rate reached that level was 1939, which makes it difficult to discern whether the U.S. stock market is headed for a crash.

But history still offers an important clue: Trump during his first term imposed tariffs that ultimately raised the average tax on U.S. imports from 1.4% in 2017 to 2.7% in 2019. That 1.3-point bump pales in comparison with the 11.3-point increase his current plans imply. Yet the S&P 500 still suffered an intrayear drawdown of 19.8% in 2018 as the market contemplated Trump's agenda.

That data has worrisome implications for the U.S. stock market today, at least in the near term. If a relatively small increase in the average tariff rate between 2017 and 2019 led to a 19.8% declined in the S&P 500, then more aggressive changes to trade policy Trump has outlined this time may trigger a much steeper decline.

However, there are a few silver linings for investors. First, while the situation may get worse before it improves, the Trump administration may not implement every proposed tariff. And those that are implemented may be temporary. Goldman Sachs strategists estimate the average tax on U.S. imports will rise 4 percentage points, much less than the possible 11.3-percentage-point increase the Tax Foundation projects.

Second, the U.S. stock market recovered remarkably quickly from the tariffs imposed during the first Trump administration. Specifically, while the S&P 500 declined 19.8% over a three-month period between September and December 2018, the index had already recouped its losses and reached a new high by May 2019.

Here's the bottom line: History says Trump's tariffs could drag the S&P 500 lower, perhaps much lower, but there is a chance the stock market could recover quickly. Investors should treat the ongoing drawdown as an opportunity to buy their highest-conviction stocks. But it makes sense to move slowly, rather than investing huge sums of money all at once.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Goldman Sachs Group. The Motley Fool has a disclosure policy.