Scenario Analysis: Tariffs and a Strong US dollar

Despite President Trump's preference for a weak U.S. dollar,^[1] diverging monetary policy and strong growth in the U.S. could lead to USD strength. Global uncertainty, fueled by tariffs and other geopolitical tensions, could also drive investors toward safer assets such as Treasury bonds, which could further strengthen the dollar. We highlight a scenario, using the MSCI Macro-Finance Model, to help multi-asset-class investors assess the potential impact of tariffs and a stronger U.S. dollar on their portfolios. In this scenario, the value of a diversified portfolio of global equities and U.S. bonds could decline by almost 15%.

Historical periods of US-dollar strength

Historically, dollar rallies have been driven by a diverse set of factors such as:

• Higher U.S. interest rates relative to other economies
• Stronger domestic growth compared to global peers
• Safe-haven inflows during times of crisis
• The dollar’s role as a global reserve currency

The exhibit below outlines key six-month periods of dollar appreciation, highlighting the diversity of conditions that have accompanied these rallies.

The dollar has rallied alongside both increasing and decreasing interest rates. For example, in 1981 and 2022, U.S. rates rose significantly, attracting capital inflows. Conversely, during the 2008 global financial crisis, rates declined, but the dollar benefited from a flight to quality. Similarly, the dollar’s strength has coincided with both rising and falling equity markets. When the global market is rising, but the U.S. market outperforms others, the dollar has often strengthened (e.g., 1988). During equity sell-offs, the dollar has benefited from its safe-haven status (e.g., 2008).

We will explore a forward-looking scenario where tariffs impact growth and inflation while the dollar remains strong, examining the potential economic and market implications.

Not all dollar rallies were the same

A scenario for tariffs and dollar strength

In our scenario, we assume tariffs and retaliatory measures lead to a short-term inflation spike of about 1 percentage point above the baseline, but that this shock dissipates relatively quickly. In contrast, economic growth faces a more persistent slowdown, with long-term growth settling around 20 basis points below the baseline.^[2] We also assume a sustained 8% appreciation of the U.S. dollar relative to foreign currencies, returning the dollar index to levels last seen in 2002. This surge reflects several factors: higher interest rates due to inflationary pressures, a U.S. economy that may prove more resilient in a trade war and elevated economic and geopolitical uncertainty favoring safe-haven U.S. assets. As the exhibit below illustrates, these economic shocks go along with a higher interest-rate path.^[3]

Trajectories for macroeconomic variables under the scenario

The shift in macroeconomic expectations from the baseline to the alternative scenario leads to an asset repricing. The table below summarizes the resulting shocks to various U.S. asset classes: Equities sell off as real rates rise, Treasury bonds decline as nominal rates increase and oil prices move higher. We also include additional shocks for global ex-U.S. equities — which underperform U.S. equities due to a greater impact from tariffs — and for European interest rates, which we assume will ease slightly amid larger headwinds in European economies.

Scenario assumptions

Assumptions about risk-factor shocks are informed by the MSCI Macro-Finance Model, analysis of historical data and judgment. Equity shocks are expressed in local currency. Breakeven inflation (BEI) is measured in basis points (bps). A negative shock for EUR/USD implies a strengthening of the U.S. dollar relative to the euro.

To evaluate the impact of this scenario on multi-asset-class portfolios, we used MSCI’s predictive stress-testing framework and applied it to a hypothetical global diversified portfolio consisting of global equities and U.S. bonds and real estate.^[4] Under the scenario, the portfolio’s value drops 13%, as both bonds and equities trade down simultaneously. International assets sell off more steeply due to larger headwinds combined with weakening home currencies. The exhibit below provides more detailed results.

Portfolio impact under our scenario

The first two months of the year have underscored the uncertainty investors face. In this blog post, we explored a scenario that assumes USD strength, a short-term inflation spike and a longer-term growth drag. Under these conditions, both equities and bonds sell off, with international equities taking the larger hit.

The authors thank Will Baker for his contribution to this blog post.