Trade Chaos, Part Two
In early March, we wrote a note highlighting the uncertainties and complexities arising from the Trump Administration’s trade policy intentions. Based on our analysis we increased our overweight to fixed income by reducing equities.
President Trump’s “Liberation Day” tariff announcements have been worse than the most pessimistic of scenarios. This is not simply because of their levels, but because the manner in which they were calculated defies the logic of multilateral trading. Targeting bilateral trade balances cannot work without inflicting significant damage to both countries.
A tariff of over 40% on Madagascar will not balance its trade with America by creating jobs in vanilla production. America does not have a tropical climate. All that these tariffs will achieve is to lower real vanilla consumption. The only likely beneficiaries of this policy are artificial vanilla flavour producers, most of which are Swiss companies.
One can argue about the fairness of various trade practices, or unfair non-tariff barriers to trade. But the big picture is simple. Trade deficits mean that a country is investing more than it saves, or that it is spending more than it collects in taxes, or both. America is running a trade deficit because it is doing both. The Federal government is running a big fiscal deficit. Tariffs are a tax, and they reduce the trade deficit by reducing the fiscal deficit. America invests more than it saves, and it can do so because America is an attractive investment destination for the rest of the world. The unreasoned tariff policies have diminished America’s attractiveness. In past market sell-offs, the dollar has risen, as it was seen as a haven for the rest of the world. This time around, it has fallen.
Whether the deficit declines because taxes rise, government spending falls, or investment falls, it is likely to have a similar impact on near-term growth. A recession is no longer a mere possibility, but a probability. Faced with abrupt policy changes, the possibility of further changes occurring in short order only damages business and consumer confidence. This is already beginning to show in economic data.
What happens in the economies of the rest of the world depends on how other countries respond. China has already announced retaliatory measures. Europe has not yet. Retaliatory measures are politically difficult to resist. But to the extent that tariffs damage the growth prospects of both parties, widespread retaliation will only dampen global growth prospects. An eye for an eye leaves the whole world blind.
It is not always easy to resist the urge to react amidst sharp market movements. But it is important to maintain focus on the medium-term trajectory. The starting point for the sell-off happened amidst a dominant narrative: the exceptionalism of the US economy justified lofty equity valuations. America's economy is far less dependent on the rest of the world than the reverse. It may well be that even if the economy enters a recession, real economic performance will be better than that of the rest of the world. But the confidence that underpinned lofty valuations has been shaken. It will be justified to reduce broad equity exposure with any rebound.
Looking at Europe, however, valuations have not been stretched. This has been justified by the lower growth of the European economies, and the lower profitability of European companies. However, European valuations have started to look reasonable. In light of Europe's defence spending and infrastructure needs, fiscal expansion likely offers sufficient justification for increasing exposure.
We have been overweight fixed income but tilted our exposure to short duration and high-quality credit. While the prospect of lower growth generally justifies increasing duration, we think it will be risky for medium term investors to do so for two reasons. First, inflation is still far from the Fed’s target, and tariffs will increase prices and likely raise inflation expectations. Duration is not an appropriate strategy for a stagflationary environment. Second, the trajectory of fiscal policy is unclear. Tariffs will only raise meaningful revenues if consumers do not shift away from buying imported goods. A recession will lower revenues. President Trump has also hinted at tax cuts, while the savings that DOGE has identified have been meagre. In other words, the deficit could well rise at a time when foreign investors could shy away from USD assets. In such a scenario, long term rates may rise.
