April 2025

Tariffying the Prisoner's Dilemma

Delta Strategy Lab -   Market Update 

The prisoner’s dilemma is a classic thought experiment using two conflicted prisoners. The prisoners are incentivized to act in their own self interest which often results in suboptimal collective outcomes. The game goes as such, two prisoners are accused of a crime. If both remain silent and don’t confess, they both receive light sentences. If one prisoner confesses, and the other doesn’t, the confessing prisoner goes free and the silent prisoner receives a harsh sentence. If both prisoners confess to the crime, they each receive a moderate sentence. Both prisoners have an incentive to confess to the crime, rather than trust the opposing party to remain silent. This often results in worse than necessary punishment for both parties. The recently reinvigorated trade war mirrors the Prisoner’s Dilemma on a much broader scale. A zero tariff world would be optimal if trade partners could trust each other. Unfortunately, this isn’t the case as independent nations have differing geopolitical and financial objectives. Raising tariffs increases the probability of moderately bad outcomes for all parties, while potentially reducing the chance one country retains all of the benefits while another experiences all of the costs. We can’t begin to determine if raising tariffs to this degree is an effective long-term policy tool for Americans in the aggregate since it hasn’t been tried in a century and a lot has changed since World War II. The stock markets initial reaction to the policy announcement seems to be negative in the immediate term, while longer term reactions will take months and years to come to fruition.

Context: 

In the context of the news flow it’s important for one to understand exactly what a tariff is. A tariff is a tax on imported goods, paid by the importing business1. An example, would be BMW North America (N.A) importing a finished BMW x5 vehicle from Germany. For simplicity, if the finished value of the imported good is $50,000, a 10% tariff would add a $5,000 tax paid to the United States by the importer, making the total cost equal to $55,000. One may assume that a $5,000 added tax may immediately increase the BMW x5 vehicles’ sales price by $5,000. This may be true, but isn’t always the case. BMW has to weigh a variety of factors including profitability and market share ramifications. Other companies such as Ford, GM, etc. may have production facilities based in the United States and may not be as exposed to new tariffs. Consumers may choose the Ford over the BMW if prices were to change. Regardless, there is little dispute by economists on both sides of the aisle that tariffs are inefficient market tools in a free trade environment. The more nuanced part of the discussion is that in most areas of the world trade is not free as evidenced by 10% tariffs on US manufactured cars entering into the EU2 vs. the previously charged 2.5% by the US on foreign imports.

“The New York Stock Exchange is the only store in the world where consumers sell stuff when it goes on sale.” - Warren Buffett

What has been the market reaction?

The market reaction has largely been negative across the board. Stocks have reached official “correction” territory and are down ~16% from all-time highs. An average correction is around 13%3 and occurs once a year meaning this pullback has already been more severe than average. All broad market segments US stocks, International, and Real Estate are now experiencing negative returns on the year. On the fixed income side investors have received some reprieve in the form of lower interest rates and higher prices of their fixed income portfolios. As of this writing the 10 year treasury sits at 3.90%, down from 4.75% earlier in the year. This has resulted in a nearly 3% increase in fixed income portfolios, not including dividends. Most commodities excluding gold have seen decreases as well amid growth concerns. Since the administrations tariff announcement oil prices are down 15% and these declines are likely to be seen at the gas pump. It’s much too early to tell the long-term ramifications of all the administrative announcements, but clients should expect continued volatility in the short-term.

Reasons for Long-Term Opportunity

Taking a step back from the initial shock of the last few days, there is growing room for investor opportunity. The pullback has brought large-cap stock valuations back to an historically normal range for the first time in nearly two years. By some measures stocks are approaching metrics that would define them as undervalued. Another more abstract reason for opportunity is the resiliency of US corporations and their ability to maintain efficiency and make profits. During Covid-19 companies were able to actually grow profit margins after the initial shock and increase earnings by 48% in 20214. As Warren Buffett has said repeatedly in the past, he would never bet against America. When appropriate for a given clients goals and objectives, Delta Wealth Solutions is starting to implement a rebalancing strategy where one sells from fixed income which has experienced positive returns and purchases stocks that are now 10-15% cheaper than they were two months ago. For long-term, goal oriented investors this too shall pass. If history is any guide, similar to the Greek debt crisis, Brexit, Covid-19, Russia invading Ukraine, and the inflation of 2022 this too shall pass and investors that remain disciplined and follow the process are likely to reap long-term rewards.