Since President Trump’s inauguration, headlines have been dominated by threats and implementations of US tariffs, as well as retaliatory measures by trading partners. Yet, financial markets remained remarkably buoyant until late February, when US equity prices began to decline. Until then, trade policy uncertainty only caused short-term volatility in markets. However, when the US implemented tariffs against Canada, Mexico and China in early March and announced tariffs on all countries on 2 April – which Trump termed “Liberation Day” – it triggered immediate declines in equity prices.
In this column, we ask: Why did equity prices react so slowly to the elevated trade policy uncertainty that followed immediately after Trump’s election? We argue that, typically, trade policy uncertainty mainly drives equity price volatility, affecting performance only with a lag when it starts to weaken the macroeconomy and earnings expectations. However, when very large shocks occur – such as the announcement on 2 April – equity markets can decline immediately. These findings are consistent with both the macroeconomics and finance literature.
Historical effects of trade policy uncertainty on equity prices
To understand how equity markets typically respond to trade policies, in Danmarks Nationalbank (2025) we estimate the historical effects of trade policy uncertainty on equity prices in the United States and Europe from 1990 until the re-election of President Trump. We use the Trade Policy Uncertainty (TPU) index from Iacoviello et al. (2020) as a measure of uncertainty about trade policies. The index is a text-based measure derived from seven large American newspapers, and therefore mainly reflects uncertainty about trade policies in the US.
Iacoviello et al. (2020) document that increases in TPU reduce business investment, and by design, should also raise uncertainty. Therefore, TPU should, in theory, affect equity market performance by dampening earnings expectations and raising risk premiums.
We estimate the historical effects of changes in TPU on monthly returns of the S&P 500 and Eurostoxx 600 indices, measured in US dollars, using the smoothed local projection method as in Barnichon and Brownless (2019). We control for 10-year government bond yields in the US and Germany, as well as consumer prices and industrial production in the US and the euro area.
We recalibrate the size of the shock to match the TPU index in April 2025 – the highest level observed on record.
We find a relatively limited and lagged effect from spikes in TPU on equity prices (Figure 1). At first, equity prices do not react to TPU, and the decline in equity prices only become statistically significant after around half a year in Europe, while it remains insignificant in the US. The effect of an increase in TPU peaks after about a year at around -2.6% in the US and -7.6% in Europe, which is modest when considering that the size of the shock corresponds to almost seven times the standard deviation of the TPU index in our sample.
Figure 1 Impulse response functions of equity prices to a shock to TPU
Note: Shock size is calibrated to TPU in April 2025.
A similar exercise for industrial production provides further insights into the underlying mechanism, as its response largely mirrors that of equity prices (Figure 2). In the first three months after a shock to TPU, we actually observe a short-term increase in industrial production in the US, and the macroeconomic impact only becomes negative over time. In Europe, we also observe a resemblance in the impulse response functions of equity prices and industrial production, hinting that equity investors continuously monitor the impact on the macroeconomy from trade restrictions.
What this exercise shows is that the macroeconomic response to TPU is not straightforward. The potential macroeconomic effects of trade conflicts might even be positive for some countries in the very short run – for example, if demand for domestically produced products temporarily increases as foreign goods become more expensive. It is also possible that firms accelerate projects and imports in anticipation of tariffs as well as tighter financial conditions (e.g. Fernandes and Rigato 2025). Ultimately, the effects depend on several factors, including potential retaliation and the responses of other economic policies, as demonstrated by Bergin and Corsetti (2024). The literature on the effects of the increase in US tariffs during the first Trump administration generally finds negligible effects on real income but small gains for domestic producers (Fajgelbaum et al. 2019). Based on regional variation in the US, Poilly and Tripier (2025) find that trade policy uncertainty could have significant negative effects on economic activity, but it takes up to a year for the effects to materialise.
Figure 2 Impulse response functions of industrial production to a shock to TPU
Note: Shock size is calibrated to TPU in April 2025.
Decomposing equity prices during the ongoing trade conflict
This brings us back to our initial question: Why did equity prices react so slowly to the ongoing trade conflict? Historical evidence shows that such a delayed reaction is not unusual, because the overall economic consequences of TPU can be complex and may only materialize over time. Decomposing equity prices since President Trump’s first threat – made on 25 November 2024, after his re-election – to impose tariffs on Canada and Mexico, using a classic dividend discount model from Fuller and Hsia (1984), provides further insights into the ongoing dynamics (Figure 3).
Figure 3 Decomposition of equity prices since 25 November 2024
a) S&P500
b) Eurostoxx
Note: Accumulated equity price changes from 25 November 2024 until 12 May 2025.
Figure 3 shows that the modest increases in US and European equity prices immediately after Trump’s first threat were driven by a slightly lower discount rate, whereas higher risk premia exerted downward pressure on prices, ceteris paribus. The same pattern appears around the official announcement of 25% tariffs on Canada and Mexico and an additional 10% tariff on China in early February. The upticks in equity risk premia on these dates align with our theoretical prediction that investor sentiment should fall in response to uncertainty about impending trade restrictions. Crucially, the increases in risk premia are short-lived, suggesting that potential trade policy restrictions trigger temporary spikes in risk premia and equity market volatility, rather than sustained downward pressure. This aligns with the findings of Gabaix (2012), who argues that political risks generate time-varying risk premia and, consequently, volatility in equity prices, but contrasts with Barro (2006), who suggests more persistent effects. Earnings expectations were largely unaffected by the early February threats against Canada and Mexico, suggesting no immediate downward pressure on equity prices from earnings revisions.
Developments changed in the aftermath of the actual implementation of tariffs on Canada, Mexico, and China confirmed by President Trump on 3 March 2025. The implementation led to a substantial decline in US equity prices driven by lower medium-term earnings expectations. This illustrates that uncertainty about actual implementation of announced trade restrictions may have been an important factor behind temporary and lagged responses to TPU, as more clarity was needed for trade announcements to affect prices more persistently through earnings expectations. At the same time, declines in equity prices were amplified by weaker macroeconomic indicators in the US from mid-February.
The implementation of reciprocal tariffs on 2 April led to sharp declines in US equity prices, driven by higher risk premia. The extent of the tariffs introduced that day surprised most experts and market commentators, marking a fundamental shift in US, and potentially global, trade policy (Evenett and Fritz 2024, Baldwin and Navaretti 2025). Such fundamental regime shifts are notoriously difficult to capture in traditional models and linear estimations such as our local projections exercise (see also Hartley and Rebucci 2025). However, the drop in equity prices has so far proven temporary, as lower risk premia caused a rebound in US equities.
European equities did not react until US trade measures began targeting the EU more broadly on 26 March 2025. Prior to that, European equity prices had been rising, buoyed by expectations of increased public investment in defense and infrastructure, as well as positive annual reports from major European corporations in early February. These developments underscore that markets required greater clarity on how US trade policies would affect Europe. Moreover, the impact on European equity prices has so far been temporary, as risk premia have declined.
Conclusion
In sum, our analysis suggests that trade policy uncertainty raises equity price volatility initially, with performance affected only later – and only if the macro economy and earnings expectations are revised downward. This finding accords with the macroeconomics and finance literature. However, very large shocks – like the tariff announcements on 2 April – can depress equity prices immediately by increasing risk premia.
References
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