What should investors make of Trump’s “Liberation Day” tariffs, which was characterized as “worst than the worst-case scenario”? Instant analysis from several sources shows that the weighted average tariff rate is now higher than the rates from the Smoot-Hawley era of the 1930s. Trump claims that his tariffs will raise $6 trillion over the next decade, which amounts to the largest tax hike in U.S. history.
Trump’s tariffs take a direct aim at China, the European Union and much of Asia.
Many of the depicted foreign tariff rates make no sense as they bear no resemblance to the actual rate. The chart on the next page from JPMorgan Asset Management depicts the pre “Liberation Day” tariff rates charged by the U.S. and to the U.S. Worth noting from the Trump announcement is the 17% Israeli tariff rate, despite Israel’s decision to reduce its tariffs on all U.S. imports to zero ahead of the Trump tariff rate setting decision. The White House table also shows a European Union tariff rate of 39%, which is vastly different from the figure shown in the JPM chart. In another case, like Australia, with which the U.S. runs a trade surplus, Trump has imposed a base tariff rate of 10%. In effect, he is punishing countries for the crime of trading with America.
James Surowieski discovered the calculated tariff rate charged by other countries is derived by dividing that trade deficit with that country divided by that country’s exports to the U.S. For example, the U.S. has a $17.9 billion trade deficit with Indonesia and Indonesian exports to the U.S. total $28 billion. Trump then claims (17.9/28 = 64%) is the tariff rate Indonesia charges the U.S.
As the following chart from Exante shows, the new tariff regime is not reciprocal to anything. It is instead retaliatory in proportion to the size of the trade surplus a country has with the U.S.
Equally alarming was the process of the country list generation, which is consistent with a question to ChatGPT or other LLM. The country list seems to be broken down by internet domain suffix instead of actual countries. This explains why islands populated by penguins (.hm domain suffix) and the Diego Garcia base on BIOT populated entirely by British and American military personnel (.lo domain suffix) are included on the list. It also explains why Réunion (.re domain suffix), French Guiana (.gf domain suffix) and Gibraltar (.gi domain suffix) are listed separately from France and the U.K. The tariff regime also sets up a potential tax arbitrage scheme where EU companies can reduce their 20% tariff rate by exporting through French Guiana, which is French territory with a 10% tariff rate.
The first shots of a global trade war are being seen. China announced late last week that it would retaliate with a tit-for-tat fashion with a 34% on American goods. It barred a group of U.S. companies from doing business in China and imposed strict limits of selected rare earth exports.
I pointed out last week that Trump’s abrupt shift in U.S. policy is making the world undergo a dramatic regime shift in investment environment (see
Uncharted Investor Waters: From Soft to Hard Power). The key big picture question is how investors should formulate investment policy under these new circumstances.
Targeting the Globalists
To reiterate my point from last week, Trump’s objective is to reverse the effects of globalization, which he believes are unfair to America. As Branko Milanovic showed, the winners of globalization are the middle class in emerging economies, mainly because they found more and better paying jobs, and the elite of the developed economies, for engineering globalization. The losers were the people in subsistence economies which were too undeveloped to take part in globalization, and the middle class of the developed economies.
Assuming that Trump succeeds in his America First policy, the new winners will be America’s middle class, or the providers of labour. In Trump’s zero-sum game world, the obvious losers will be the suppliers of capital, which Trump has labeled “the globalists”. As well, the highest levels of “Liberation Day” tariffs were imposed on the poorest countries such as Cambodia (49%), Sri Lanka (44%) and Bangladesh (37%). These measures are consistent with the efforts to reverse the gains of low-wage emerging market economies.
Brain Drain Ahead
I discussed the costs of Trump’s America First reshoring policy last week and I will not repeat them. One news item that came across my desk is the shocking potential for a brain drain from America.
A
Nature poll found that an astonishing 75% of U.S. researchers are considering leaving the country following Trump’s policy pivots. More damaging was the demographic composition of the potential exodus: “The trend was particularly pronounced among early-career researchers. Of the 690 postgraduate researchers who responded, 548 were considering leaving; 255 of 340 PhD students said the same.” These are the younger future scientist and researchers who make the breakthroughs.
The sudden rush of scientific talent out of the U.S. would have a depressing effect on the progress in total factor productivity in the long run.
Trump may be able to reshore manufacturing, but what will be the source of U.S. innovation in the future?
The End of Pax Americana
Wall Street celebrated Trump’s election in anticipation of his pro-growth policies of lower taxes and greater deregulation. It turns out that the price tag of those policies was America First, which is intended to reshore manufacturing. One of the side effects of that policy raises the cost of labour. If the suppliers of labour win, the suppliers of capital lose, all else being equal.
I highlighted last week the probable tectonic shift from the loss of the dominance of the USD as a reserve currency. While Trump has perennially focused on the unfairness of the U.S. trade deficit, he may not have realized the nature of America’s greatest export: Treasuries. As Americans bought goods from abroad, foreigners willingly bought U.S. Treasury paper in return. The world became flooded with Treasuries, which became the de facto risk-free asset. The term “exorbitant privilege” was born.
I highlighted the geopolitical implications of Trump’s isolationist foreign policy last week. The remarks of Singapore’s defense minister who characterized America’s “image has changed from liberator to great disruptor to a landlord seeking rent” underlines the potential of the world to fracture into distinct trading blocs and geopolitical spheres of influence. This week’s tariff announcement promises to remake America into a walled island of trade. These initiatives are signals of the end of Pax Americana, or the global U.S. led world order that began at the end of World War II.
Assuming that Trump succeeds with his America First agenda, USD investors have to ask themselves some difficult questions:
- What will be the benchmark for the risk-free rate? Not sure. The world will undergo a paradigm shift, and investors won’t know the answer until they see some geopolitical clarity. Will there be one new superpower or will it be a multi-polar world?
- Will U.S. equities continue to beat bonds? Yes, but Treasury paper will carry a risk premium of unknown magnitude. If the 3-month Treasury Bill ceases to be the risk-free benchmark, expect USD funding costs to rise and an erosion in the cost of capital advantage for U.S. corporations.
- How much will equities beat bonds? Unknown. Estimates of equity risk premium will be far less reliable as investors can’t rely on over 100 years of U.S. asset history.
- Should investors rely on the 60/40 portfolio as the default allocation? Not sure. Asset allocation of 60% stocks and 40% bonds depends on a combination of the relative returns of stocks and bonds and their return correlations under a variety of scenarios. Risk-return optimization using historical data using standard risk tolerance assumptions for long-term investors such as a pension fund usually end up at around 60/40. As the history of past returns will become less reliable, the 60/40 portfolio will carry greater risk of shortfall.
So where does that leave investors?
As Trump retreats from Pax Americana and the post-World War II era of U.S. geopolitical dominance, expect the world to fracture in regional spheres of influence. These transitions take decades. Consider the example of the British Empire, which reached its zenith just around the start of World War I in 1914. It wasn’t until the Suez Crisis in 1956 that it became apparent Britain was no longer the dominant imperial colonial power it once was.It will be a riskier world. Expect more sovereign defaults and restructurings. The accompanying chart shows a history of all sovereign debt restructurings with foreign private creditors, with size of haircuts on the y-axis. The risk is the world starts to look more like the 1980s, which was full of sovereign defaults, except there may not be a lender of last resort.
Time for Diversification
How does someone formulate investment policy under such conditions?
This is an era of greater uncertainty, and it’s far too early to discuss an alpha generation framework. In the presence of uncertainty, the default bet would be to make no bet. The benchmark portfolio should be a basket of global assets. Diversification matters. I would like to see some historical studies of how non-U.S. stocks, bonds, real estate and other assets perform under differing conditions to comment on asset allocation. In the absence of such a study, I am inclined to default to a 60/40 portfolio, with the equity benchmark composed of global equities and the bond benchmark of a basket of global bonds.
U.S. equities are expensive by historical standards. The valuation of other regions are either cheap or near their own 25-year medians. At a minimum, it pays for equity investors to diversify from a valuation and risk management perspective.
EM performed very badly during the 2008 crisis, despite being a crisis originated in the US. Eurozone has structural problems in my opinion, starting with energy and competitiveness, as pointed out by Mario Draghi many times. I am not finding good alternatives, may be of course my limitations
All regions have their own problems, but if you’re focused on one region that had been the clear winner in the last few years, recent events show that it’s not a one-way bet. In the absence of information, the minimal risk position is diversification.
In the scenario of “no bets”, it behooves one to consider the possibility of further fall in the value of US$ itself. The investment implication of US$ holders is to sell their US$ assets and buy cheaper non-US $ assets before the US$ falls more. The era of American exceptionalism may be sunsetting based on many. structural challenges described in this article.
EMs are difficult, always catch cold when developed world sneezes. And Trump seems to want to collect rent from them now.
China has unreliable data and a demographic implosion.
Maybe just hold cash until the mid-terms. They’ll probably fix the Repub’s wagon, and then we can work with less abnormal macro.
Or own treasuries, but with a ripcord? FGOVX, sold at Death Cross / bot at Golden Cross has since 1986 a CAGR of 5.05% with maximum monthly drawdown of 5.68%, which I think is a quite good risk-adjusted return.
I get it that many are nervous.
The news is not helping, but what does it really mean when the market drops?
So if someone bought AAPL at 50 and dumped at 200 is he poorer?
Will federal deficits end?
Destruction of money, has it happened? It might if we get a tsunami of defaults.
I don’t see American workers benefitting from this because AI and smarter machines will kill jobs, never mind the amount of time it takes to build factories.
I wonder when it will be time to buy precious metals and copper.
Those who are on margin, it’s gotta hurt.
Regarding the Nature poll – I don’t know how they’ve conducted it, but it does not match my observations. I’m a researcher in the US. Everybody talks and is concerned about the uncertainties ahead. But I don’t know a single researcher who plans to leave the US because of Trump’s policies.
Yes people talk but there probably won’t be action at the 75% level. But even if you get action at the 10-20% level it creates a long-term headwind for productivity.
So far, surprisingly, I have not seen much panic in the extended circle of family and friends. More of should we start taking advantage of the deep correction.
No one is thinking of longer term, yet.
Several researchers at universities are more concerned about cancellation of grants. So it’s many cross currents in play.
I raised safety cash about a month ago. Waiting to see how the dust settles.Thanks to Cam’s post.
My understanding is that the sticky points of federal grants lies in the overhead charges of expense reports submitted to Fed. Compared to private business dealing with Fed the academia chareges several times more. No one ever questions this area, never. So it has eveloved into a situation of abuse. Current admin wants NIH, NSF, and Military Research Offices to actually look at the abuse. It is not so much about cutting. It is more about reducing waste.
In response many major universities are tightening several areas. Fewer were admitted to PhD programs and hiring freezes. In reality many of these universities are sitting on sizable endowments without paying taxes. It is always easy to get money from taxpayers thru Fed Gov. If universities wants to fund their own reserach I bet they will be very efficient.
This comes to the important point about efficiency. If we apply Pareto Principle to academia/gov reserach, 20/80 is a resonable ratio. And another is this rampant data manipulation, even outright data fraud. It had eroded general confidence about academia research. The last several years all of us have seen several examples involving all these big name colleges. There are many more instances out there. Next is gov agency research. It is where conflict of interest intensifies. Most of them center around FDA. You already knew the drills. COVID-19 vaccines are products of this politics and fraud. No one would be surprised to see scrutiny coming over this area. My personal opionion about graduate programs is there are too many and student qualities are substantially diluted. I know a guy with a PhD in Neuroscicence from a top school. He is now a writer. Another PhD in Physics is working as an electrician. But it beats driving a cab or Uber.
Hi Cam,
I was wondering if one of the (many) flawed assumptions of the Trump Tariff policy is that it is trying to re-shore manufacturing into the US (to MAGA), but these days manufacturing is a much smaller faction of the economy than earlier years so it is not so important ? (i.e. Services make up almost 80% of GDP). The main importance of local manufacturing is to ensure supply chain security which is almost guaranteed in the case of countries like Canada.
I don’t understand your question. FWIW, Trump has been talking about the trade deficit since the 1980’s. It’s how he’s wired so I doubt if he’s thinking about services vs. goods.
As well, trade in services is not part of the trade deficit calculation. For example, if I, as a Canadian, go to Florida and spend money, that’s services and the payment goes into the calculation of the current account, but not trade account. Similarly, if I buy a Facebook ad in Canada, that’s also services and not part of the trade deficit. Canada runs a trade surplus but a current account deficit with the US.