In this market update, I’ll discuss the impact of Donald Trump on the markets and share my outlook on how this may unfold.
In last quarter’s newsletter, I explored how, over the past 70 years, the global trend has been toward reducing trade barriers like tariffs — and why it’s economically counterproductive for the US to now be establishing significant barriers against its largest trading partners.
In short, I argued that tariffs are a tax on your own citizens because they end up paying more either through taxes at the border when a good is imported or via higher labour costs from onshoring of manufacturing where wages are higher and production less efficient.
Now that Trump has finally shown his hand, we have an insight into what problem he is railing against. And I’ll give you a clue, he isn’t primarily fighting against tariffs imposed on the US from other countries. “Reciprocal tariffs” is a bit of a misnomer because a) when he presented his tariff announcement in the Rose Garden on the 2nd of April, the tariff imposed on the US by other countries includes “currency manipulation and trade barriers”, and b) the calculation he appears to have used is not half of this number (as presented) but the trade deficit with that country divided the total exports of that country to the US. In this quarter’s update, I’ll provide an insight into what is driving one of the largest shifts in the economic environment in recent memory.
As the above formula alludes to, Trump is not really targeting other nations’ tariffs. He is targeting the trade deficit with tariffs. An increasing trade deficit is a problem for an economy, and Warren Buffett himself has previously preached on the topic. In an article for Fortune Magazine, he wrote: “Our trade deficit has greatly worsened, to the point that our country’s ‘net worth’, so to speak, is now being transferred abroad at an alarming rate”. Buffett then goes on to say that to protect against this, he has been buying foreign currencies. What is striking about this opinion piece is that it was written in 2003!
A trade deficit occurs when a nation – in aggregate – purchases more goods and services from abroad than it sells abroad. In effect, money flows out of the country on a net basis. The net importing country (the one with the trade deficit, in this case, the United States) will fund this flow by issuing debt (in the form of bonds), which will be purchased by those that have excess cash (the net importers). These bonds – like any debt – are a claim on the future production of the borrowing entity (nation, company, individual) and without productivity gain or increased labour to pay it down, capital will need to be sold to service the debt. This includes ownership of land, but also American companies.
Basic economics teaches that this can only go on for so long and at a point, ever-growing trade deficits would end in currency rate adjustments and an unwillingness for creditors to accept additional debt.
The US has gotten away with a trade deficit for so long due to the status of the US dollar as the world’s reserve currency. The ability of the US to repay its debt has been unquestioned. Until recently. While borrowing rates in the US have not blown out yet, the level of national debt and the associated interest payments (not helped by the rapid rate rises experienced in the last couple of years) continues to rise. The trade deficit is part of this, but fiscal deficits (the US government spending more than it earns) are also a major contributor.
Trump is coming at both of these deficits: the former via tariffs and the latter via the Department of Government Efficiency, led by his buddy Elon Musk (and also via the taxes he expects tariffs to raise).
However, it also goes deeper than this. Trump is certainly trying to rectify the trade deficit, but the trade deficit is the result of decades of de-industrialisation that resulted from the Bretton Woods system, and the ensuing neo-liberal world order. Without going into too much detail, Bretton Woods was an agreement made in the wake of the Second World War by 44 largely Western nations, whereby the signatories would peg their currency to the US dollar (which was backed by gold, an arrangement known as the gold standard). These countries would also rely on the US for military protection and the US would give them favourable trade by allowing higher tariffs for exports to the US than imports from the US. This had the effect of giving them access to the world’s largest consumer market, while also establishing the USD as the world’s reserve currency. This status led to the USD strengthening and the nation becoming very rich.
As the global economy grew, this system became unsustainable, as the gold that backed dollars could not keep up with the immense demand for dollars. President Nixon then decided to unpeg the dollar from gold to keep the growth going. This led initially to economic turmoil but eventually resulted in the neo-liberal regime that was characterised by low barriers to trade and capital movement across borders, flexible exchange rates, and America acting as the World’s police. This last point is important, as US defence spending is higher than other countries by an order of magnitude, and Trump’s pulling back from Ukraine is a taste of what Trump may threaten if other nations don’t come to the table.
The USD kept its status as the global reserve currency due to entrenchment and convenience so non-US countries were incentivised to stockpile USD by making it easier to export to the US than import. The US and the World Trade Organisation allowed this as they believed that it would enrich the rest of the world, which would be a more peaceful world.
As demand for US assets grew, the USD went up, making manufacturing relatively more expensive in the US, so it was then outsourced to places like China, Vietnam, Cambodia, and Bangladesh. Manufacturing has continued to decline through this whole period to the point that Trump and his advisers now believe it is a national security threat because manufacturing is the heart of any war effort. But to bring manufacturing back onshore would mean reversing a lot of what led to this point. Most experts believe this is not possible without losing the status of the USD as the world’s reserve currency.
The current tariff chaos that Trump has created is just step 1 in his plan. Trump and his advisers are on the record saying this is to create negotiating leverage. If foreign nations want access to the largest consumer market in the world, and if they want to remain inside the US’s military protection umbrella, they are going to have to play ball.
Trump does want reciprocal tariffs (or more accurately, reciprocal trade barriers, as the foreign trade barriers he has cited have included various non-tariff barriers), to provide a fairer playing field. But this isn’t really about tariffs. It’s about currency and it’s about the trade deficit. By imposing punitive trade barriers Trump can force their trade partners to the negotiating table where what he wants for America is not really lower reciprocal tariffs but agreements to weaken
the US dollar. This strategy was dubbed by Steven Miran (chair of the Council of Economic Advisers and key engineer behind this strategy) the “Mar-a-Lago Accord”, a nod to the 1985 Plaza Accord where the G5 nations agreed to something similar. A weaker USD would make US exports more competitive and manufacturing abroad less attractive. If the tariffed nations do not agree, the US may withdraw military support or keep tariffs high, neither of which are attractive options, and which would reduce their access to the largest consumer market in the world.
When viewed in this light, there is a kind of crazed logic to the chaos Trump has unleashed. Most economic experts, however, have denounced the theory. Is it crazy enough to work? We don’t know, but Trump seems to be betting the farm that it will.
Written by Luke Durbin
Lead Portfolio Manager
Oracle Investment Management
Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.