Tariffs’ true impact on the US economy is about to become clear

Over the next month or so we will see two sides of the stock market at work. It will behave as both a voting and a weighing machine. The first will be driven by the will he, won’t he theatrics of the US President’s on-off tariff show. The second will reflect the ultimately more meaningful contribution of company earnings, as the second quarter results season unfolds.

It was Ben Graham, the father of value investing and Warren Buffett’s mentor, who noted the distinction between the two. He understood that, in the short term, markets are driven by buyers and sellers, and their ever-changing and temporary mood shifts. This is the sentiment-driven aspect of the market. While the impact is real in the moment, longer term it is really just ‘sound and fury, signifying nothing’.

More important, to long-term investors is the steady accumulation of value that is measured every three months by company earnings. These always matter, but the results season that kicks off next week and will run until the middle of August is more than usually significant. It will be the first indication of the impact of tariffs, or the fear of them anyway, on actual company profits.

• See our current offers to help your money go further

The humdrum release of hundreds of quarterly earnings reports may be overshadowed by attention-grabbing tariff talk. As it stands, the next hard deadline for trade negotiations falls slap bang in the middle of results season. But frankly, August 1st is no more likely to be the end of it than July 9th was. Who’s to say the can won’t be kicked yet further down the road at the end of the month?

The good news is that earnings growth remains positive. The current expectation is that profits will have risen by around 5% year on year. And given that companies tend to manage down expectations ahead of their results announcements, the actual outcome is likely to be closer to the long-run average of 7% growth. That, as it happens, is Goldman Sachs’s forecast for both this year and next, although the bank admits that there is lots of scope for it to be wrong in either direction this time around.

It will be a mixed bag, as it always is. Communication services and IT (the big tech stocks) will lead the way. Energy will take a hit from the low average oil price over the quarter. Overall, revenues are expected to be higher for a 19th consecutive quarter, a measure of the strength of the underlying economy.

Profit margins are forecast to be roughly in line with the average over the past five years at about 13%. A falling dollar, down by a tenth so far this year against a basket of rivals, will help boost the value of American companies’ overseas profits.

In simple terms, the level of the stock market is determined by three things. First, the level of company earnings; second, how much investors are prepared to pay for a slice of those profits; third, how relatively attractive shares are to alternative investments like bonds.

Earnings do not need to be rising for the market to go up, but it is quite hard for it to do so in the absence of improving profits. So, a 7% rise would be a good start. It will go some way to justifying the current valuation of the US market. Goldman Sachs this week revised its year end forecast for the S&P 500 to 6,600 and to 6,900 next summer, a tenth higher than today’s record level, on the basis that investors will continue to be prepared to pay 22 times expected earnings. That looks ambitious, but not wild.

So, the key driver may well turn out to be how shares shape up against the alternatives. And that will ultimately be determined by the Federal Reserve. If interest rates do start to fall again after a seven-month pause, and if that helps bond yields ease back towards 4%, then a case can be made that shares are still competitive at their current multiple of earnings. There are a few ifs there, but the weighing machine view of the market supports Goldman’s positive revision.

What about the voting machine aspect? Here, too, sentiment seems to point to continued progress. In part that is because investors are increasingly taking the view that the President should be taken seriously but not literally. Tariffs no longer scare investors in the way they did in early April for a number of reasons.

• Get expert insights straight to your inbox with our free investor emails.

First, it’s clear that deadlines are simply milestones in an ongoing process. They stand until they are replaced by another ‘hard stop’ a bit further down the line. Second, investors are getting better at understanding the difference between a headline tariff and the real impact once exemptions and other sector carve outs are taken into consideration. Finally, companies are working out how to live with tariffs, by cutting costs, squeezing suppliers and raising prices where they can.

There are limits to this optimistic outlook, of course. The V-shaped correction and recovery that started in February and continues today is now looking unique in terms of both speed and substance. It has left the previous outliers in 1998 and 2020 behind. We are into ‘it’s different this time’ territory, which is never a comfortable place for investors to be.

I published my quarterly market outlook this week. My conclusion was that the best time to fix the roof is when the sun is shining. The outlook appears fair whether you are weighing the long-term fundamentals of the market, or counting the short-term votes. But the next few weeks could provide a stiff test on both fronts.

This article originally appeared in The Telegraph

• Read: Why you shouldn’t turn your back on the US
• Read: Investing in alternative assets - 7 funds to get you started
• Read: How might the government change Cash ISAs?

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Eligibility to invest in an ISA and tax treatment depends on personal circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.