Trade Tensions Must De-Escalate

Since the pandemic and leading into the inauguration of Donald Trump as the 47^th President of the United States, the U.S. economy has been extremely resilient, growing above assumed real trend growth of 2% per annum *85% of the time (*quarterly data, annualized, 16/19 instances). Healthy consumer appetite and robust fiscal spending drove strong growth despite policy interest rates that had increased over 500 basis points from zero since after the great financial crisis, and which recurred during the pandemic. A fall in inflation towards the Fed’s 2% target led to the end of tighter monetary policy and even a super-sized rate cut of 50 bps in the fall of 2024. Further, the buzz and build out of artificial intelligence (dominated by U.S. firms) earned U.S. assets the label of “exceptional” for everything from equities to the dollar. Implied equity volatility, as seen in the VIX, was below 20% and it seemed everyone including investors wanted a piece of the U.S. economy and its markets.

More recently, however, this exceptionalism has been challenged as U.S. assets began to underperform for a few reasons. It is often said that the economy is not the stock market and vice versa. So, it should not be surprising that ditching the global trading system championed by the U.S. since WWII could have a negative impact on U.S. assets. Was the president serious about his obsession with trade deficits with other countries and intent on reducing those to balance when they are merely a reflection of the basic laws of economics 101—that of comparative advantage and the highest per capita wealth in the world leading to more U.S. imports of goods and services?

Of course, it is the right of the American people to make these changes by electing President Trump to a second term with a mandate to bring more manufacturing jobs back to the U.S. after decades of offshoring (and automation, which receives little attention because it doesn’t fit the narrative). But one might then question if a new U.S. (and world) economy could emerge and have serious impacts across a range of asset classes and sectors that could impair the dominance of U.S. asset pricing.

The likely impact of this “new” potential economy would be weaker near-term growth and higher inflation, raising the probabilities of both stagflation and even recession. Both would put a dent in the asset prices and could result in a significant shift out of the U.S. from short-, medium- and even long-term investors that had built up “exceptional” position sizes in U.S.-denominated assets. Even if longer term investors like endowments, pensions and sovereign wealth funds looked for incremental diversification away from the U.S., billions of U.S. assets could be impacted.

So, while there may well be merit to some of Trump’s economic policies in terms of fairer trading relationships and diversifying the U.S. economy to bring back some manufacturing jobs, it is probable that markets will need to re-price in the short term as uncertainty remains high. How can businesses think about capital investment in such uncertain times?

Recently, there has been a broad climbdown from tariff levels, most importantly with China, where tariff levels had escalated to 145%, effectively amounting to a trade embargo. This escalation was meant to bring China to its knees as Trump believed he held all the cards. Unfortunately, what he seems to have missed is the fact that China now exports much more to other parts of the world, particularly ASEAN and the Mid-East, making up for lost exports to the U.S. U.S. exports and the associated slowdown because of these punitive tariffs, while hurtful, account for less than 3% of the Chinese economy, making China much less dependent than earlier this century.

Even as tariff levels decrease from worst-case scenarios, they are here to stay, and tariffs are a tax on consumers and businesses, hurting growth and raising prices. Volatility and higher risk premiums are likely to be a feature of this chaotic administration, and for those that have read Trump’s “Art of the Deal” book, this is all part of the plan.