Tariffs Will Continue Until Morale Improves

Via The Variant Perception blog,

The relative strength of the US economy makes tariff threats an effective negotiating tool, and “America First” trade and security priorities mean tariffs will remain a feature of Trump’s second term. Allocations to volatility and TIPS should prove the best hedges for headline risk and the stagflationary impulse from implemented tariffs.

As tariff announcements start to dominate headlines, we provide three key points to serve as anchors:

• Weak rest of world (i.e., non-US) growth means less bargaining power for targeted countries

• Demand is the US’s key “export” and the ultimate currency

• Tariffs are here to stay as MAGA 2.0 embraces Reagan + Roosevelt

Weak rest of world (i.e., non-US) growth means less bargaining power for targeted countries

At inauguration, we noted the slim Republican House majority could make tariffs a higher priority (relative to tax cuts) in Trump’s second administration than his first. One key difference between today and 2018 is the global growth backdrop, raising the likelihood of quicker resolutions to tariff threats in order to avoid a significant growth downturn in targeted countries.

On the growth front, the US economy is much stronger relative to the Euro Area and China than at the onset of the first trade war in 2018 (which was preceded by a period of “globally synchronized growth”).

This raises the stakes for non-US countries, whose economies would come under further pressure from a protracted trade war (see shaded area above). It’s possible these growth imbalances encourage targeted countries to settle tariff disputes quickly (as seen today with delayed tariffs on Mexico).

Demand is the US’s key “export” and the ultimate currency

On top of the favorable cyclical backdrop, the US’s role as the chief source of global external demand gives it more bargaining power in trade negotiations.

The US trade deficit has persisted for the past 25 years and represents the US’s role as the “shock absorber” for global excess production. In other words, one can consider consumption demand to be the key export of the US to the rest of the world. So, any like-for-like retaliation will hurt non-US countries more given the US (as the chief buyer) can turn to other sellers more easily than a seller can find a buyer that can replace the US.

Related to this, the US is also a closed economy relative to most other economies. So, any broad-based decline in trade will weigh less on the US economy than other more trade-dependent economies.

Tariffs are here to stay as MAGA 2.0 embraces Reagan + Roosevelt

The asymmetric leverage leaves the Trump administration free to pursue its MAGA/”America First” strategy of restructuring trade and security and make it likely that tariffs will be a regular feature of this administration, not only a negotiating tool.

The use of tariffs to implement the “America First” strategy appears to be a consensus among key members of Trump’s administration, notably Treasury Secretary Scott Bessent (who recently advocated for gradual implementation of US tariffs up to 20%) and chair of the Council of Economic Advisors Stephen Miran (who outlined a similar plan in “A User’s Guide to Restructuring the Global Trading System”).

The trade policy echoes Reagan’s administration, which used measures like “Voluntary Export Controls” to limit imports of foreign goods and incentivize foreign companies to invest in the US. We think Trump will use tariffs consistently to boost investment in the US, given he’s repeatedly stated that the best way to avoid tariffs is to build in the USA.

Meanwhile, the security policy echoes the Roosevelt Corollary, which extended the Monroe Doctrine to allow for more direct US intervention in the broader Americas. The threat of tariffs to force Colombia to accept repatriated citizens, Panama to not renew its key canal deal with China, and Mexico to bolster border security are all evidence of a modern Monroe Doctrine/Roosevelt Corollary in action.

S&P and Treasury yields are the best KPIs, long TIPS + vol the best hedges

While Trump has stated he is not concerned about the market reaction, we still think a meaningful equity market drawdown or economic slowdown are the key constraints to Trump’s use of tariffs. After all, the only major pause in tariff announcements in Trump’s first term was during the S&P 500’s 15% pullback at the end of 2018. Treasury yields breaching 5% on inflation fears could also prove a constraint on Trump’s tariff agenda.

Taken together, we think long exposure to TIPS and volatility will be the best hedges against tariff headline risk and the stagflationary effect of tariffs (once they are implemented).