Keep the Wheels on the Cart

President Trump's cabinet is outlining a radically different economic order with three areas that can see the U.S. slide into a growth panic or proper recession as early as the second half of this year. The market remains completely oblivious to all of this.

A key goal is to create jobs and secure supply chains by revitalizing American manufacturing, which they attribute the decline of to a strong dollar, though are not looking to use FX intervention as a primary tool. Instead, the preferred strategy is to "speak softly and carry a big stick" - negotiate by offering access to U.S. markets and the U.S. security umbrella with weakening the dollar as a next resort. Their vision involves the imposition of higher tariffs not only as a negotiating tool, but as a means of financing budget deficits. A permanent tariff wall and looming FX interventions suggest the potential for enormous market volatility, but that is hardly the only thing that can induce a material downturn.

A more restrictive immigration policy - even one falling far short of its impressive goals - would prove very disruptive to the U.S. labor market in the near term. Understanding where employment goes next comes down to thinking about what three years of a red hot labor market (read: three years of reckless immigration policy and inflated statistics) will do when it inevitably cools off.

A priority made clear by Trump, and perhaps the most important key to the credibility of his populist rhetoric, is to reduce inflation. Scott Bessent seeks to recalibrate the composition of the deficit to more closely match the Treasury's pre-Covid goals, which would be very disinflationary in risk assets like equities and would dampen activity in sectors that are sensitive to interest rates (such as homebuilders).

Each of these, or some combination of the three, will effect an economic decline that arrives in the second half of this year or shortly thereafter. The stock market remains in wait-and-see mode with tariffs, the bond market doesn't expect Scott Bessent to change Janet Yellen's issuance profile and the Fed continues to assert they will cut rates only twice in 2025. There's plenty of money that will be caught offsides, and at least three ways for it to happen.

- Mike on X

 

The Tariff Wildcard

Trump has for decades argued in favor of protectionism and sought to reshape global trade to the benefit of the U.S. and, given that these four years are his last opportunity to do so, it's better to take him at his word. Having learned from 2017-2021, he's assembled a loyal team best fit to implement that vision. Aside from supporting employment and domestic manufacturing, there are at least two reasons for why we can expect Trump to levy higher and more aggressive tariffs than he did during his first term:

1. As an explicit source of revenue: Tariffs collected $75 billion in 2019, which would be laughable for an administration wanting duties to finance nearly a trillion dollars in tax cuts and subsidies. This time, however, Trump has explicitly called for tariffs as a means of financing the Federal budget, a policy not very relevant since before the 1913 income tax and one that will demand a broad tariff wall regardless of negotiations.

2. National security: A nation that is, for example, 100% reliant on global supply chains is one that is extremely vulnerable to national security risks. Advances in AI and geopolitical tensions have made supply chains meaningfully different, more vulnerable and more critical since 2020 and Trump's first term.

There's a difference between tariffs designed to collect revenue & finance the most ravenous government in history, and tariffs intended to be a tool for the President to use in his negotiations with a foreign power.

The latter, called "Section 232 tariffs", can be imposed at the stroke of a pen, so long as they're under the pretense of national security. Trump attributed yesterday's announcement of tariffs to combating the opioid (fentanyl) crisis, which days earlier he formally declared an emergency:

*TRUMP:TO ANNOUNCE CANADA, MEXICO TARIFFS BECAUSE OF FENTANYL— zerohedge (@zerohedge) January 30, 2025

A broad wall of tariffs designed to collect duties on all U.S. imports and finance the budget, on the other hand, are "Section 301 tariffs" and would require a more lengthy legal process that could take several months (i.e., around mid-to-late 2025; Howard Lutnick says April) to formally install.

The market seems to perceive tariffs as largely of the "Section 232" kind - negotiating tools, which are not nearly as disruptive as broad, permanent tariffs because said negotiations are supposed to make progress and then be walked back. Negotiating tools are negotiating tools. The reason for the benign outlook is probably thanks to the consensus that Trump wants to be a stock market-positive President, which may be true and likely is.

But yesterday, Trump confirmed that tariffs will be deployed regardless of the outcome of negotiations, predictably sending stocks into a tailspin as certain supply chains (and hence related products) are left to anticipate and price-in irreconcilable, elevated costs:

TRUMP: NOTHING CAN BE DONE BY CHINA, MEXICO AND CANADA RIGHT NOW TO FORESTALL TARIFFSTRUMP: WE MAY INCREASE TARIFFSTRUMP: NOT LOOKING FOR CONCESSION— zerohedge (@zerohedge) January 31, 2025

Of course, a broad tariff wall is the only way to make an 'External Revenue Service' anything more than a political gimmick. It's very unlikely that an ERS would completely replace the dreaded IRS, but don't doubt it making a meaningful change in the way the government funds itself over the next several years.

In any case, the coming tariffs are much more likely to cause higher unemployment, slower economic growth and worse business sentiment than stoke high inflation. Though both should be similarly disruptive, the market is much more anxious to dump equities on account of a recession than it is because the Fed is on hold for a little longer, which is already priced in.

One important thing to note about tariffs, as the market expectedly appears to anticipate higher inflation, is that they are not necessarily inflationary for consumer prices because their impact can be mitigated by currency strength and business margin compression.

One potential outcome in a tariff scenario is for an exporter to lower prices such that the post-tariff price is unchanged for importers. The consumer at the end is not affected by the tariffs at all. The exporter would only be willing to do this when his currency (i.e., the Chinese yuan) has depreciated against the importer’s currency (i.e., the U.S. dollar). For example, an exporter cutting prices by 7% in dollars could be offset by a 7% appreciation in dollars such that his home currency profit is unchanged:

A different scenario that doesn't raise consumer prices is for the price impact of tariffs to be absorbed by the importer rather than the exporter. Here, the importer pays the same prices and also pays the tariffs, and doesn't pass on the added cost to consumers, compressing their margins. The NBER looked at China and found that this is what occurred in 2018, where after looking through the pricing data of around 100,000 products mapped by their origin and tariff status, the overall data made clear Chinese tariffs had a very limited impact on consumers prices (aside from some examples such as washing machines).

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