The Trump Trade Shock
Trade Surplus Penalties, Clashing Over Commerce, Agenda Derailment Risk, Recession Watch, Buy When There's Blood in the Streets
We first wrote Cleaning Up the Industrial Policy Mess, six weeks ago. Treasuries and equities have overshot our downside targets for the S&P 500 and 10-year Treasury yields. Although we reached those targets faster than we expected, we urged caution due to sequencing of the administration’s policies and fundamental fallout. There is no change to our view that the detox from the economy’s addiction to government spending is in the early stages, but as we discuss in this week’s note, the equity market has adequately discounted the probability of recession, the Treasury market has fully priced our rate cut forecast, the policy outlook is bottoming out and the index implied volatility market suggests positioning is sufficiently defensive to support a recovery rally.
“Take a look around you Ellen, we’re at the threshold of hell!” Clark W. Griswold
This week’s note provides a comprehensive analysis of the surprisingly large trade surplus penalties, examining their economic implications and historical context. The note then discusses the decent March employment report and resultant delay in the Fed policy rate pivot. As negative as the first sections of the note read, we suspect the policy outlook is bottoming out.
Trade Surplus Penalties
(CNBC) Navarro Says the Trade Deficit Is `The Sum of All Cheating'
(CNBC) Navarro Says When It Comes to Trade We Have No Allies
Although we’ve been emphatic that President Trump wasn’t bluffing, and we expected a significant increase in the average tariff rate, however, the tariffs are shockingly high. Like most economic policy watchers, we were puzzled when we saw the numbers. Shortly thereafter, several clever individuals, none of whom appeared to be economists, backed into the methodology. In simple terms, the Council of Economic Advisors assumed bilateral trade surpluses were the result of tariff and all forms of non-tariff barriers, consequently, they derived the tariffs by dividing each nation’s US goods trade surplus by their imports. Here is the link to the CEA's release, while the equation includes price and demand elasticities, the calculus offsets, and the equation can be reduced to the surplus over total imports.
While a literal interpretation of the goods surplus tariff methodology is that US fiscal and monetary policies played no role in these bilateral deficits, cutting the numbers in half is perhaps an implicit acknowledgement that our policies contributed to the trade imbalances. Alternatively, reducing the surplus gaps in half may be an acknowledgement that market forces, dare we say comparative advantage, also play a role. Others speculated that the tariffs were constructed to meet a revenue target ($600 billion in annual revenue). Whatever the theoretical basis for these larger than expected tariffs, they are not reciprocal tariffs, they are surplus penalties that in many cases are effectively trade blockades.
(WSJ) Bessent Says Tariff Revenue Could Reach $600 Billion Annually
The goal appears to be a complete reversal of our $1.24 trillion trade deficit. Our first reaction to the methodology was shock, but not awe, however, if the surplus penalties does trigger concessions, the tariff methodology will be forgotten. It should be said that modeling the outcome is more complex than would have been the case had the tariffs been reciprocal. At this point we assume the 10% tariff is not negotiable and it is likely to remain in place throughout President Trump’s term, in other words a floor. On the campaign trail the President pledged a 20% global tariff and 60% for Chinese imports and mused about a return to the pre-income tax Constitutional amendment era when the primary source of revenue came from tariffs. The surplus penalties and global tariffs increase the average rate to ~22% and China close to the President’s 60% pledge, additionally, given that they are raising the tariff rate to levels last seen during the second half of the 19th century, the President is attempting to return to the pre-income tax revenue regime. In that sense he is delivering on campaign promises, turns out we should have taken him both literally and seriously.
We have small equity positions in Germany and China based on our view that the second Trump presidency would leave the export dependent economic systems little choice but to take long overdue measures to stimulate domestic demand. The surplus penalties are likely sufficiently punitive to force change, China’s retaliation is an exercise in futility. The market very negative reaction on Friday to China’s action is a contrarian indicator in our view.
Clashing Over Commerce
We are going to begin this section with yet another endorsement of Doug Irwin’s history of US trade policy, Clashing Over Commerce. We first read it in 2017, and it changed our view from neo-classical free trade orthodoxy. We’ve consistently argued that the Smoot Hawley tariffs were initially small ad valorem tariffs (dollar amounts) that got larger as a consequence of the banking crisis and resultant deflation and played a smaller role in the Great Depression than Ferris Bueller’s teacher concluded. The Fordney-McCumber Tariff of 1922 was larger, but the Trump global tariff and surplus penalties is larger than the 1922 and 1930 tariffs combined, and the net export channel is roughly three times larger than it was in 1930. There are other key differences, the US was the largest trade surplus nation in 1930, now we are the largest deficit country, additionally, exchange rates were pegged to the price of gold in 1930, it is widely acknowledged that the first nations to unpeg recovered from the global banking crisis, and European debt crisis, faster due in part to increased exports. The depth and duration of the Great Depression had more to do with misguided domestic fiscal and monetary policy than trade policy.
Another analog we’ve heard characterizes the tariffs as the largest tax hike since the 1968 LBJ 10% income tax surcharge that basically ended his presidency. That tax hike was targeted at the growing deficit and rising inflation, it failed on both fronts. That said, the Revenue and Expenditure Control Act was signed in June 1968, retroactive to January 1 for corporations and April 1 for individuals, and a recession did follow, but not until December 1969.
The analog we like best is the August 15, 1971, ‘Nixon Shock’, that ended gold convertibility, enacted wage and price controls and implemented a 10% global tariff intended to completely end the trade deficit. The Nixon shock did cause a major reordering of the global trading system, a series of negotiations resulted in agreements that appeared to contribute to a contraction in the trade deficit, and it did improve, albeit erratically and partially due to cyclical factors including the deep ‘73-’75 recession, through the decade.
Consequently, the Smoot Hawley and LBJ income tax surcharge analogs are flawed, the Nixon Shock may be a better analog, but the Nixon tariff was similar in size to 10% global tariff. The surplus penalties are the largest trade shock for the last 100 years and raised the average tariff to the highest level since the Underwood-Simmons Tariff Act of 1913 lowered the average tariff from 40% to 25% that at the time was the lowest rate since 1857, that act also introduced the income tax.
Consequently, unless the surplus penalties are quickly reversed through negotiations, they are likely to be a deflationary shock. We’ve been arguing for weeks that the aggregate impact of the administration’s policies is likely to be disinflationary, the market message is unmistakable as evidenced by the plunge in small caps led lower by small banks, sharply lower 2-year real rates, wider high yield credit spreads and a weaker dollar. We will dig deeper into market pricing in the final section of the note.
Policy Priorities
As we’ve discussed, our policy priorities, strictly from the perspective of an investor, are reducing government spending to stabilize our debt, supply side private sector investment tax incentives, and deregulation of the financial and energy sectors, in that order. The President’s and the public’s priorities are different, immigration and trade policy top the list. We warned investors that sequencing was a risk, and the Trump trade shock realized our policy sequencing bear case. As dark as the policy outlook currently appears, the fiscal and monetary policy outlook is probably approaching its nadir; the Senate released budget resolution using a current policy baseline that provides considerable room for supply side tax incentives, the market implied Fed policy path is approaching our forecast for 100bp in rate cuts in ‘25, the trade policy outlook is likely to improve as negotiations begin and quietly a week ago, the Fed, OCC and FDIC dropped their Community Reinvestment Act rules change proposal, the first step in financial sector deregulation.
While the policy outlook may not get worse, there is the obvious risk to business confidence that further delays a recovery in capital investment. The hit to capital spending plans in January and February, prior to the Trump Trade Shock, are already approaching recessionary levels. The less obvious risk is a negative feedback loop from the increase in relative prices of goods leading to higher unemployment, causing Congress to get weak knees on government spending, thereby derailing the most important policy initiative, reducing spending to stabilize the debt. If the Congress loses the will to reduce spending due to efforts to cushion an increase in unemployment, the reconciliation bill could be restructured to temporary fiscal stimulus or could collapse altogether. The Senate has the capacity to offset the impact of tariffs for the corporate sector but have seen plenty of misguided trial ballons like corporate SALT caps.
Trump Tariffs: Tracking the Economic Impact of the Trump Trade War
The market’s reaction to the Trump surplus penalties; lower stock prices, wider credit spreads and bull steepening of the Treasury curve, an even deeper inversion of the breakeven inflation curve, and the sharp rally in the yen, euro and Swiss franc, suggest markets are viewing US trade policy as a deflationary shock. We had been operating under the assumption that exchange rate adjustment would absorb a portion of the increased tariffs, instead on the current path, dollar weakness will exacerbate the impact of the tariffs. We suspect the 10% global tariff, if that is the ultimate destination, will be partially offset by a stronger dollar, but the surplus penalties are too large to be absorbed by our trade partners or exchange rates.
Recession Watch: Decent March Employment Internals
Unlike the February employment report’s decent headline and decidedly weak internals, the March support was surprisingly strong. As we’ve been discussing, even before we learned about the magnitude of the tariffs, there has been a two-month sharp reversal in business confidence that reduced expected orders, hiring and capital investment plans. The March employment report may just be stale data, and we would be shocked if the April manufacturing and service providing industries capital spending and hiring plans don’t plunge to recessionary levels. On a more optimistic note, as we looked through the details, we recalled the resilience and dynamism of the private sector during the most misguided policy in our 40 years in the markets, the pandemic policy panic. We suspect the markets are underestimating the ability of the dynamic private sector to overcome public policy constraints.
The 209,000 increase in nonfarm employment was flattered by a 48,000 negative net revision and the end of a grocery strike in Colorado (never noticed, maybe just Denver and Boulder). The unemployment rate was below our forecast of 4.27% at 4.152%, little changed from February’s 4.139% rate. The U6 underemployment rate did slip back a tenth as we expected to 7.9%, but that was only a small retracement of the increase from 7.5% in February. The household survey employment increased 201,000, an improvement from the 588,000 contraction in February. The labor force participation rate increased to 62.5% from 62.4%, but prime age participation fell 0.2% to 83.3%, the increase came in the volatile 16-24 age group and may be an echo of the pandemic related to spring break. The work week ticked up 0.1 from the cycle low of 34.1, average hourly earnings for production workers increased 0.25% from a downwardly revised 0.22% in February, which reduced the year-on-year pace to 3.89% from 4.18%. The aggregate hours index that had been tracking a quarterly annualized pace of -0.3% improved to 1.4% suggesting PDFP (private domestic output) was above most 1Q25 GDP forecasts, both tracking models and economist forecasts. Finally, the job finding rate improved from an exceptionally low 3.59% in February to 3.94%, and the job loss rate retraced a portion of the February increase to 3.98%, to 3.83%.
The massive 155,000 increase in government layoff announcements captured in the March Challenger Survey did not impact government employment in the March report, however, annualized government employment growth slowed from 3.2% in March ‘24 to 1.3% in March ‘25. So far, the detox from the addiction from government spending appears to be painless, not for investors, but for the labor market.
A Perfect Time for a Purple Tie
(BN) TRUMP: PERFECT TIME FOR FED CHAIRMAN JEROME POWELL TO CUT RATES
“We have stressed that it will be very difficult to assess the likely economic effects of higher tariffs until there is greater certainty about the details, such as what will be tariffed, at what level and for what duration, and the extent of retaliation from our trading partners. While uncertainty remains elevated, it is now becoming clear that the tariff increases will be significantly larger than expected. The same is likely to be true of the economic effects, which will include higher inflation and slower growth. The size and duration of these effects remain uncertain. While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent. Avoiding that outcome would depend on keeping longer-term inflation expectations well anchored, on the size of the effects, and on how long it takes for them to pass through fully to prices. Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.”
Economic Outlook Chair Jerome H. Powell
In March ‘21, the Fed was buying $80 billion of Treasuries, $40 billion of mortgage-backed securities and reinvesting ~$55 billion of mortgage paydowns per month, and the 117th Congress passed, and President Biden signed into law the $1.9 trillion American Recovery & Reinvestment Act. The net effect was the largest monetary and fiscal policy expansion in US history, with mobility restrictions in place, the demand shock, combined with supply chain disruptions led to an immediate spike in core goods prices from 1.3% in February ‘21 to 12.5% in March ‘22. House prices spiked up 46% in 18 months with .96 correlation of the 20 cities in the Case Shiller Composite Compare for 10 months, leaving little doubt that the primary cause of the price spike and housing affordability crisis was Fed asset purchases. The Fed didn’t lean against the massive increase in stimulus that a number of mainstream Democratic new-Keynesian economists (Summers, Furman, etc.) urged against, instead they turbocharged the stimulus. The Fed leadership has never acknowledged the central role of fiscal policy in the pandemic inflation shock, it appears to be a policy blind spot.
Compare and contrast the current policy backdrop, monetary conditions for small & medium banks and their small business customers including builders are tight as evidenced by the 3m10y (borrowing deposits and lending long) curve. Fiscal policy is beginning to tighten and likely to tighten for years to come. To be sure the trade surplus penalties are a supply shock, but the monetary and fiscal policy current settings and outlook are the antithesis of March ‘21. Chair Powell and the Committee’s lack of perspective on the necessary conditions for sustainable inflation, or the unmistakable market message, suggests they will be late to respond to the growing recession risk. Their approach stands in stark contrast to their approach to fiscal stimulus in ‘21.
Buy When There’s Blood in the Streets
The median decline in the S&P 500 associated with a recession is 24%, as we are writing this note the S&P is down 17.5%, the economically sensitive Russell 2000 small cap index is down 26%. One simple way to guesstimate the market implied probability of recession is the S&P change divided by the median recession related decline, that approach assigns a 72% probability. As discussed earlier, the 3m2y yield curve is discounting a recession as well.
Although the FOMC is not ready to begin easing their policy rate, and Powell’ speech and Q&A exacerbated Friday’s 6% S&P 500 plunge, they did ease at the March meeting by virtually eliminating QT. Due to the Fed’s institutional view they play a significant role in the setting of inflation expectations, FOMC participants will continue to offer unconvincing explanations for that decision, nevertheless, the current coupon Fannie Mae 30-year fixed rate par coupon yield is 36bp lower since the March meeting is 93bp off the January high. We didn’t get an employment report that triggered the rate policy pivot that will begin the process of easing conditions for floating rate borrowers, small banks and businesses, but the market implied Fed policy path is for slightly more than our 100bp of ‘25 cuts forecasts.
The policy outlook is about as negative as we recall but following the employment report and Chair Powell’s Chip Dilliard ‘remain calm, all is well’ speech on Friday morning, the equity market reached full panic mode. The VIX, VVIX and term structure of VIX futures were all close to 3 standard deviations above their longer-run medians. Realized volatility at 40% is at level’s reached when Bear Stearns collapsed (S&P -10%), the 2010 Flash Crash (S&P -15%), the 2015 Chinese yuan devaluation (S&P -11%), the February ‘18 Volmageddon (S&P -12%), the December ‘18 QT Crash (S&P -20%) and the Oct ‘22 peak monetary policy tightening cycle (S&P -18% August to October). The equity market reaction to the tariff shock is in line with all but three of the largest volatility spikes over the last two decades. Could we turn on our screens Sunday night and see S&P futures down another 100 points and the VIX above 50, absolutely, nevertheless our recommendation is to put some significant capital to work on Monday morning.
This begs the question; is this the low for policy expectations and we think it is. On trade, we expect the 10% global tariff to stick, but much of the surplus penalties to negotiated away, over time. Barely mentioned this week was the Senate’s decision to use a current policy baseline, while the risk of derailing spending cuts we discussed earlier is possible, further urgency for corporate tax investment incentives is marginally more probable. The expected revenues from tariffs likely won’t be part of reconciliation, but as we’ve discussed the current policy baseline provides more room for tax cuts, and expected revenues from tariffs should placate budget hawks in the House and Senate. We expect to hear shortly that financial regulators are scrapping the Biden regulatory team’s bank capital proposal following the Community Reinvestment Act (CRA) proposed rule changes. Also overshadowed by the Trump Trade Shock this week, OPEC agreed to a production increase this week, look for rule changes from Energy Secretary Wright to soften the blow for the energy sector. There are five important policy initiatives, spending, taxes, regulatory policy, immigration and trade. The vast majority of the focus has been on trade, we strongly suspect that is about to change and the focus will shift to tax and regulatory policy.
There is one more important equity market topic before we complete this week’s note, earnings season. We’ve been noting falling negative cyclical sector net revisions since 4Q24, while stock prices were rallying amidst policy optimism during the Fed’s 100bp rate recalibration cycle and presidential election, the rate of change of earnings estimate momentum was negative. With economists’ slashing growth estimates the first evidence of the impact on earnings is likely to be bank reserves. The change in FASB accounting standards late last business cycle known as CECL (Current Expected Credit Losses) led to excessive reserves and a sharp drop in profitability measures in ‘20, however, the loan to deposit ratio for commercial banks is 7% lower than in early 2020 and below the prior 6 recessions. The declines in bank equities over the last couple of days appears to be an overreaction.
We expect earnings estimates to get marked down, but it is possible net revisions will bottom out during over the next three weeks. It looks to us like a classic case of share prices front-running estimate cuts, we will be looking for stocks to rally when estimates get reduced.
We first wrote Cleaning Up the Industrial Policy Mess, six weeks ago. Treasuries and equities have overshot our downside targets for the S&P 500 and 10-year Treasury yields. Although we reached those targets faster than we expected, we urged caution due to the policy process and fundamental fallout. There is no change to our view that the detox from the economy’s addiction to government spending is in the early stages, but as we discussed, the equity market has adequately discounted the probability of recession, the Treasury market has fully priced our rate cut forecast, and the index implied volatility market suggests positioning is sufficiently defensive to support a recovery rally. Earnings season is the next big hurdle, we are less concerned with next week’s CPI and PPI reports, the deep inversion of the 2s10s breakeven inflation curve is screaming disinflation. Time to add equity exposure, we suggest reducing intermediate fixed income by 5% and adding 2.5% to financials and energy.
Sector and Asset Allocation Tables Explained:
The US Equity Market Allocation table is our recommendations for a US equity investor, a similar approach to when we were the Head of Barclays US Equity Portfolio Strategy. The first six columns are valuation metrics, the seven is a Z-Score summary of the metrics relative to each sector’s valuation range since S&P introduced each sector (1990 for all but Real Estate). A reading of 1 implies the sector is 1 standard deviation above its historical median. The equity risk premium (ERP) column, also known as the Fed Model, is the forward (expected) earnings yield less the real 10-year yield (TIPS). Index weights are the S&P 500 with the exception of the Russell 200 small cap index, that is based on the market cap of the Russell 2000 relative to the Russell 3000. The final three columns are the Ironsides recommended weight, the 30-day volatility of the sector and portfolio contribution of our recommended weights to the risk (volatility) of the portfolio. Importantly, this approach does not integrate cross correlation of the sectors.
The asset allocation table benchmark is a 60/40 (stocks/bonds) portfolio, under the assumption that the investor is investing US dollars. We begin with our recommended weights, add the yield, the third columns are valuation metrics. ERP is the equity risk premium. TP is the term premium for Treasuries using the Adrian Crump & Moench model from Bloomberg. OAS is the option adjusted spread (early call risk) for fixed income securities. ‘SD’s’ from the median is a Z-Score approach to the valuation metrics, positive readings imply the asset is expensive, negative readings imply the asset’s valuation is below its longer-run median. The sixth column is the assets contribution to the risk of the portfolio, its volatility multiplied by the recommended weight of the asset. The index weights for equities use the same approach as the equity only portfolio, the fixed income weights are based on the Bloomberg US Aggregate Index, adjusted for the 60/40 benchmark. The final two columns are self-explanatory.
Barry C. Knapp
Managing Partner
Director of Research
Ironsides Macroeconomics LLC
908-821-7584
bcknapp@ironsidesmacro.com
https://www.linkedin.com/in/barry-c-knapp/
@barryknapp