Trump’s terrif(ying)ic tariffs
Not two weeks into his presidency and Trump has already kicked off his second trade war by announcing 25% tariffs on Canada and Mexico, and a more modest 10% on China and Canadian energy.
While his campaign promises ranged from “ending inflation” to curbing illegal immigration, one promise that was not a major factor for most Trump supporters was tariffs. Nevertheless, Trump has pushed forward with tariffs as he views international trade as a win/lose proposition rather than a mutually beneficial arrangement. As a result, Trump appears to be using tariffs to achieve several possible outcomes.
Tariffs could serve as an additional source of revenue to offset upcoming tax cuts, be used to right the US trade deficit by bringing back US manufacturing, or as a political negotiation tool to achieve specific outcomes.
Mexico and Canada’s response
Given that 29% and 18% of Mexico’s and Canada’s GDP consists of exports to the US, Trump targeted these countries first given their dependence on US trade. This, providing him with greater negotiating power.
At present, the situation remains fluid as both countries have responded with tariffs of their own and have come to the negotiation table. President Claudia Sheinbaum of Mexico has agreed to deploy 10,000 Mexican soldiers to the Mexico/United States border, with the purpose of stopping the flow of fentanyl, and illegal migrants.
It’s not clear what Trump wants from Canada given that last year the US seized just 43 pounds of fentanyl at the Canadian border, insignificant relative to the over 21,000 pounds seized at the Mexican border. Furthermore, there are more people crossing illegally from the US into Canada than the other way around. Regardless, Canada has in any case agreed to secure the northern border.
The responses appear to have appeased Trump, and for now both countries have been granted a 30-day tariff delay. We caution that this respite may prove to be short lived. Trump promised to shift the tax burden away from domestic income to foreign sources, and tariffs are likely his primary vehicle to achieve that.
The impact of this weekend’s tariffs if implemented
Trump’s first term tariffs led to the effective US tariff rate rising from 1.4% to 2.8%. This round of tariffs is much larger, and we estimate that a 25% tariff against Canada and Mexico, and 10% on Chinese imports, would raise the effective US tariff rate to nearly 10%. As seen in Figure 1, the highest since 1946. If tariffs are imposed on EU countries and others, something he has pledged to do, then the impact on the effective US tariff rate could still rise further yet.
Figure 1 – US import tariff could reach the highest level in decades
Most studies have found that the effect of the higher effective tariff rate described above could lead to US real GDP declining by about 0.5% while consumer prices rise by 0.7% – see Figure 2. However, these studies tend to focus solely on the impact on aggregate demand from higher import prices. We believe this understates the potential growth damage from a trade war when the real shock is likely to come from the supply side.
Figure 2 – Trade uncertainty could exacerbate the drag on economic growth from tariffs
For example, the North American auto industry is highly integrated with GM, Ford and Stellantis having a manufacturing presence across North American regions. If production were to shift back to the US over 5 million additional light vehicles would need to be produced locally. Furthermore, US production incurs significantly higher labour costs than Mexico, inevitably pushing up costs for car buyers.
Trump’s decision to violate the United States-Mexico-Canada Agreement, a deal that his own administration negotiated, runs contrary to the rule-based global trading system that the US helped create after the Second World War. There is no doubt that other countries are currently asking themselves what arbitrary reason Trump will dream up to place tariffs on them in the future. We believe the net effect of Trump’s actions will, over time, lead to a reduction in US geopolitical influence in the world and potentially even push more countries to side with China.
The return of inflation in Japan
Last week the Bank of Japan (“BoJ”) raised its policy rate by 25 bps to 0.5%, the highest level in 16 years. This marks the next step in the BoJ’s goal of normalizing monetary policy after years of near zero rates.
The recent rate hike was accompanied by the BoJ increasing their inflation forecast – see Figure 3. The BoJ now expects its core measure of inflation to average 2.4% in 2025, and 2% in 2026, essentially achieving its goal of price stability around 2%.
Figure 3 – The BoJ expects above target inflation over the next two years
The recent uptick in inflation can be attributed to wage growth, which in turn is creating an increase in consumer spending. In other words, a virtuous cycle where increasing income leads to heightened spending is emerging, exactly what the BoJ had hoped for to lift the economy out of decades of chronically low inflation.
However, to sustain this trajectory, continued strong wage growth is required. Last year the annual spring wage (Shunto) negotiations resulted in an 5.1% increase in wages. This year the Japanese Business Federation has requested the same wage increase. Whether employers are willing to meet these demands, will only become clear in April.
As a result, the BoJ is likely to wait to see the outcome of these negotiations before making any further policy decisions. If we were to hazard a guess, we expect that another year of strong increases would lead to the BoJ following with additional rate hikes.
How much further can the BoJ raise rates?
The BoJ recently published their estimate of what the neutral policy rate could be. Providing some guidance as to how much higher rates could go. At present, the real policy rate is -2.5%, well below the estimated neutral policy range of -1% to 0.5% – see Figure 4. Assuming the Japanese economy does settle at the targeted 2% inflation, we could see another 50 bps of rate hikes before the policy rate is within the bottom end of the neutral range. In other words, we agree with Governor Ueda’s comments that there is “still some distance to the neutral rate.”
Figure 4 – Room for further rate hikes
The yen and Japanese equities remain cheap
As seen in Figure 5, the yen remains incredibly cheap based on its purchasing power parity (“PPP”) fair value. Typically, when a currency is as undervalued as the yen is right now against its PPP fair value, investors have earned an annualised return of 9% per year over the proceeding five-to-ten years.
Figure 5 – The yen remains cheap
However, it’s not just the yen that is undervalued, as Japanese equities are currently trading at a 70% discount to the price-to-book of US equities. Historically this discount has been the result of Japan’s deflationary environment, and the disregard held for minority shareholders by Japanese management teams. However, now that the BoJ is reporting the first signs of a virtuous cycle of consumption and inflation, and the Tokyo Stock Exchange is implementing reforms to create a more shareholder conducive environment, Japanese domestic equities are well positioned to appreciate.
Investment takeaway
In the near-term substantial uncertainty remains around the timing and implementation of tariffs, however, if implemented unchanged they will raise the effective US tariff rate to nearly 10%, the highest since 1946. Placing a drag on GDP growth and introducing supply-chain disruptions. Looking further out, tariffs will likely damage US geopolitical influence and could even push other countries to build relations with China instead.
The depressed valuation of the yen and Japanese equity market has led to a potentially interesting entry point for investors. We expect the improving, inflationary, macro-economic backdrop and corporate reforms will see asset prices mean revert. Especially if other foreign investors take note and foreign inflows pick up.
If you are interested in finding out more about how cognisance of the macroeconomic backdrop impacts our investment decision making process, connect with Integrity Asset Management and let us help you navigate your investing journey.
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Source: Bloomberg, 31 January 2025