Preface

A couple of months ago, I promised to come back to the tariff saga; to offer my opinion on how the European economy and equity markets are likely to be impacted once I had a clearer picture. Although there has been no formal reply yet, leading government officials have, probably deliberately, let a few words slip to the media, and those words provide plenty of insight into what they have in mind. This month’s Absolute Return Letter is about that.

Should you reside in the US and deem this topic irrelevant to US financial markets, I would strongly encourage you to think again. As you will see below, the economic bazooka European leaders have up their sleeves will do enormous damage to the US economy if implemented. And not only that; it will hit the Americans where it will hurt the most.

The background

Although Trump has backpedalled on much of his programme, the 10% baseline tariff, which will affect all countries ex. Canada and Mexico, still stands. And many sectoral tariffs (e.g. 25% on foreign-made cars) haven’t been touched either. In other words, all goods exported from the EU to the US are now subject to at least a 10% tariff.

According to Trading Economics, in 2023, the EU exported about $675 billion worth of goods and services to the US, making the European trading block the biggest exporter to the US. Mexico was a distant second with about $480 billion of exports, and China came third with $448 billion of exports. You can see all the details here.

As you can see in Exhibit 1 below, in 2023, machinery & equipment made up nearly 30% of all EU goods exports to the US. If you add pharmaceutical products, nearly half of all goods exports from the EU to the US in 2023 were either machinery & equipment or pharma products. And Trump has already half-promised that pharma products will also be subjected to higher tariffs than the 10% baseline tariff. It is apparently only a question of time before that happens.

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The current status

Trump is not shy of using tariffs as a weapon to achieve his goals. Nor is he shy of being rather liberal with the truth, so long as it fits his narrative. An example: Recently, he told a stunned audience that the trade deal the US had negotiated with Canada was terrible (his words, not mine). “Who the hell made these deals [that] are so bad?”, he asked. What he failed to say was that it was a trade deal he approved whilst in office from 2017 to 2020 (see here).

Another example: Trump has demanded that VAT must be removed across the EU before he will even talk about eliminating tariffs. “VAT is so unfair to US industry”, he said. Nonsense! VAT is like Sales Tax in the US and charged to consumers regardless of where the goods come from. US companies do not pay VAT unless they are the final consumer of the good in question – no different from how European companies are treated.

The EU called Trump’s bluff by offering a free trade agreement on all industrial goods. Suddenly, Trump lost interest – a pretty strong sign that this whole saga is not really about international trade but about raising funds to deliver on his promised tax cuts.

Many years ago, tariffs were frequently used to raise government funds, so it is not at all something new (Exhibit 2). However, it is not a coincidence that the US economy has enjoyed spectacular growth since WW II, and that (most) Americans have enjoyed a corresponding rise in living standards. Just look at tariff levels since WW II.

It is beyond dispute that US import tariffs have never been lower than in the 80 years following the end of WW II (Exhibit 2), that tariffs hurt economic growth, and that they suppress living standards. Why do you think all the wealthiest cities around the world have built their wealth on international trade?

As things stand, the EU leadership will, to begin with, prioritise goodwill and cooperation over confrontation, so don’t expect any dramatic moves from the EU until Q3 at the earliest. However, if nothing has been accomplished by then, expect retaliation of some sort. The EU cannot afford otherwise. It is estimated that, with the tariff programme as it stands, the effective tariff rate on EU exports to the US is now 17.4%, having been less than 2% before Trump stepped up (source: Goldman Sachs).

What is also likely to happen (and Trump won’t like that) is that the new, aggressive US import tariffs implemented by the Trump administration is likely to push Europe closer to China – exactly the opposite of what he wants to achieve.

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The economic bazooka

Should the EU do like China and retaliate the conventional way, it will result in lower economic growth and reduced living standards on both sides of the Atlantic. It is therefore not the wise man’s response. As per the rumours I hear, instead, the Europeans are looking at how they can target the US technology industry – the Rolls-Royce of US industry.

The plan (I hear) is not to roll out import tariffs at all, but to do one or two things which will completely undermine the US technology industry’s leading position in Europe. Take for example existing copyright rules which protect US tech from much competition. Those copyrights could be annulled, which will open the EU market to immense competition – mostly from Asia. And the man on the street will benefit, as the price on many tech goods and services will almost certainly collapse.

EU government officials have probably leaked ideas like this in order for the tech industry in the US to lean on Trump. Whether that will work or not is too early to say.

Why Europeans are more upset about tariffs than Americans

International trade accounts for a much bigger share of GDP in Europe than it does in the US. Amongst OECD countries, the US is, by far, the country where international trade matters the least. In 2023, it only made up 25% of US GDP. By comparison, the country in Europe where international trade makes up the smallest proportion of GDP is the UK – 64% in 2023. If you take a look at Exhibit 3 below, you can see that in all European countries, international trade accounts for a much bigger share of GDP than it does in the US.

To wrap up this letter, let me make one final point. You may recall that GDP is calculated as follows:

GDP = C + I + G + (X-M)

Trump has indicated that his tariff policy programme will only affect X-M (net exports) but, in reality, it will affect C (consumer spending) and I (corporate investments) far more. Let me give you an example: Even if political leaders in the EU decide not to retaliate with higher tariffs, American consumers will still suffer from higher prices. Therefore, US demand for imported goods will be negatively affected. The slope of the demand curve will dictate to what degree American consumers decide to take the price increase on the chin, and that will vary from product to product.

As demand falls, EU exports to the US will drop (which is what Trump wants), and that will affect job security in Europe and the desire to invest amongst European businesses. If you read these lines from somewhere in the US, you may argue that such problems won’t have any impact in the US, but what I have said so far is only half the story.

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When economic policy uncertainty spikes, and it has indeed done so in the US since Trump took over (Exhibit 4), both the C and the I in the formula above are affected. Consumer spending (C), particularly spending on durable goods, collapses and business cut back on capex plans (I).

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With his chaotic policy programme, Trump has ensured that C and I will both decline, and C+I account for no less than 85% of US GDP, i.e., Trump’s tariffs have significantly increased the probability of a US recession in the next 12 months.

Adding to that, if (when) inflation begins to rise again as a result of all those tariffs, the Fed is unlikely to deliver on the rate cuts it has half-promised for 2025. In Europe, C and I will also decline as a result of Trump’s tariffs but, at least, the outlook for inflation is much brighter than it is in the US. It is therefore only fair to say that, in trade wars, there are no winners.