“Humpty Dumpty sat on a wall.
Humpty Dumpty had a great fall.
All the king’s horses and all the king’s men
Couldn’t put Humpty together again.”
– SAMUEL ARNOLD and J.W. ELLIOTT
Last time out, we didn’t comment much on politics. While the new US administration was yet to take office, one had to assume that it would be thoughtful and logical in its policy agenda. Instead, we have been treated to the shopping trolley school of government, where the trolley is being pushed by somebody who treats everything like a real estate transaction. So, to the matter at hand.
The key thing about a balance of payments is that it balances. This basic accounting identity seems to have been lost in the furore about tariffs. Take the situation of Vietnam. It has been hit with a Trump tariff of 46%, which is based on the fact that the US imports lots of things from Vietnam but doesn’t sell much to it. It has nothing at all to do with reciprocity. The resulting gap is the trade deficit. A deficit surely means something is out of whack, or at least that is what Trump seems to think, as he uses words which imply Vietnam (or anywhere else for that matter) is ripping off the US. The trade deficit, though, is only one part of the equation, which states (in our Vietnamese example) that:
TRADE US to Vietnam + ASSETS US to Vietnam =
TRADE Vietnam to US + ASSETS Vietnam to US
(Sales of US goods and services to Vietnam, plus sales of US assets to Vietnam = US purchases of Vietnamese goods and services, plus US purchases of Vietnamese assets)
This is the balance of payments, and it balances.
In our case, Vietnam sells a lot of trainers (for example) to the US and doesn’t buy many goods in return. What it does do, though, is buy US assets with the dollars it has earned. These may be T-Bills or something else, but the point is that the whole thing balances out. Tariffs distort the picture, although it will still balance. Of course, the Vietnamese economy cannot deal with 46% tariffs, but equally, it cannot afford to buy many things that are produced in the US. Tariffs then have two effects. They raise the price of trainers in the US, reducing demand, and they send the Vietnamese economy into a depression. Brilliant. Also, the room for a ‘deal’ on bilateral trade is limited. Vietnam has a 9% tariff on the small number of items it imports
from the US. Reducing it to zero will barely affect the trade deficit.
Does the US want to create an industry making trainers? Well, the Trump ideology suggests that it does, even though the manufacturing facilities and skilled labour are not available in the US, and the cost of trainers would skyrocket if they were. The reality is that the US trade deficit is equal to net capital inflows from abroad. Change one, and you change the other.
Nerd note – Another way of thinking about the same thing is that the US consumes more than it produces, and the gap is balanced by foreigners buying US assets. Economic theory posits that this situation is self-correcting – the US dollar is supposed to fall, making imports more expensive, and so they fall too. The problem has been that since the 90s, investment opportunities in the US have been so attractive (high productivity/tech, etc.) that foreigners have wanted dollars to invest there, a factor that has kept the dollar strong and the trade deficit worse than it would otherwise have been. Arguably, if the US becomes a less attractive place to invest, following the existing policy mix, the situation will self-correct.
This example is by way of illustration of the intellectual and moral bankruptcy of the current policy.
But we are where we are, although who knows whether we will still be there by the time this review is finished.
Ugly global trade war?
Markets have blown an unequivocal raspberry at the tariff policy, which has fired the starting gun in what could be a very ugly global trade war. Why does this matter?
US tariffs on their own could well cause a global recession, which would otherwise not have happened. This could be exacerbated by reciprocal tariffs – at the time of writing, the Chinese had introduced a reciprocal rate of 34% and other economic blocs such as the EU are considering their strategy. Reciprocity plays well politically to a domestic audience (witness Canada) but raises the stakes for all. Economic slowdown will be accompanied by price increases as the costs of the tariff are passed on to consumers. In that sense, it is a hugely regressive tax rise that disproportionately affects the less well-off at home and the less economically developed abroad.
The US Federal Reserve (Fed) is in a difficult position here. Inflation is sticky in any event and is likely to rise further, suggesting little room for rate declines, which might well be mandated by a deterioration in the underlying economy. This is so-called stagflation. Political pressure on the Central Bank to drop rates, which is already intense, can only get worse. If the Fed kowtows without reason, the fallout is likely to be severe.
Uncertainty and confusion
There is also a major disruption to global supply chains – even if you manufacture a car in the US, lots of parts come from elsewhere, and this effect will typically increase costs for almost all (US) domestically manufactured goods. Uncertainty and confusion mean that businesses aren’t sure where to invest, how to manage supply chains, inventories and so on. They also don’t know whether the tariffs are a negotiation or not, and if not, are they there for the long term, or will a future administration untangle the web? By the same token, even where agreements exist, as between the US, Canada and Mexico, the US seems willing to rip them up in its self-interest.
The upshot of all this is that growth in the years ahead is likely to be slower than otherwise, and the degree of uncertainty will be greater than anything we have seen in recent decades.
Nerd note – Trump has made it clear that he thinks a deficit is ipso facto a sign of weakness. Attempts to fix deficits by moving to zero tariffs (as suggested by the EU) will not work, as the existence of a deficit is not a function of tariffs alone. For example, sales of champagne cannot be replaced by making champagne in the US. Our examples here are fairly straightforward, but, in reality, the picture is more nuanced. Foreign exchange rates play a part, as do government subsidies and non-tariff barriers, such as the refusal by the EU to import chlorine-washed chicken or hormone-fed beef from the US.
Declines in markets bring dangers. Large and sudden falls lead to margin calls and enforced liquidation of anything which can be traded. Nobody knows who is swimming without trunks, but the chances are that the naked are out there, and more market turbulence could unveil some unpleasant sights. The canary in the coal mine is when safe haven assets fall in an environment where you would expect them to rise. In the US, there have been intermittent signs of this, but things are contained so far. Unlike 2008, we are not seeing major structural imbalances in the financial sector (which, of themselves, caused that crisis). Instead, this crisis has its roots in politics, and a reversal of policy would mitigate its effect, although it has probably already gone too far to avoid some negative economic effects. Indeed, the softer end of the Republican Party is beginning to push back on tariffs because of the likely damage to their reelection chances in 2026, albeit while continuing to pay court to the king.
One could argue that the reason the decline has been so severe is that starting valuations were so high, as we have suggested in previous reviews. Nevertheless, the chaotic policymaking in general is likely to mean that investors demand more of a risk premium to invest in equity assets (i.e. they need to be cheaper to attract capital than was the case before Trump).
If the goal of US trade policy is to unpick the fundamental trading principles which have contributed to one of the greatest alleviators of poverty around the world, one is left wondering why. The US playing the victim is quite a hard act for non-Americans to swallow, but it also should be difficult for Americans. US policy has dominated the world for decades; it has not only made the US the world’s richest and most successful economy (albeit unequally so) but also helped everybody else. As are most developed economies, the US is predominantly a service-based system. In our Vietnamese example from earlier, we ignored services, but the design of the trainers the Vietnamese make, the software that runs the machines on which they are made, and much else are all aspects of US expertise and are. in fact. exports of services. Politicians appear unable to understand that activity that does not involve making something you can hit can also be economically significant.
A BREXIT for the largest economy?
A retreat into autarky will reverse this, and the US could end up as the biggest loser, a sort of BREXIT moment for the largest economy in the world. Does the US really want to start manufacturing mass-market clothing? Trainers? Assembling iPhones? A thousand other things which are better and cheaper if sourced from elsewhere?
On top of having to think about trade policy, the world order also seems to be changing in geopolitics, and we are facing dangers which were under the surface only three months ago. Europe (including the UK) faces a nasty wake-up call and will have to step up defence spending – Ukraine is an existential moment for the rules-based liberal order. Indeed, you could argue that Trump has singlehandedly called time on the expansion of the European welfare system and pushed the entire political edifice to the right; the Middle East is dangerously fragile, and China is increasingly belligerent about Taiwan. It is impossible to know how Trump will behave when faced with any of these issues, so it is not worth speculating. We will not even comment on the Trumpian rewiring of the US institutional framework to make it look a bit like Hungary, of all places.
What is an investor to do?
The first thing is ‘don’t panic.’ As these declines are not caused by structural imbalances, policies will either shift, or markets will find a sensible base level, even if that is lower than today’s. Selling now will feel good until things turn, and you have difficulty getting back on the escalator. Second, ignore commentators. None of them forecast what would happen, and nobody knows what comes next. Logical argument is so 2024. Third, be diversified by asset class, sector and geography – this is the only investment advice anybody needs. All else is fluff.
Steve Bates
CHIEF INVESTMENT OFFICER
GUARDCAP ASSET MANAGEMENT LIMITED
