Trump, Tariffs and Trade: Toward a New Global Economic Order

Trump, Tariffs and Trade: Toward a New Global Economic Order

• 1. Whitepaper  25 Minutes February 2025 Kevin Hebner, PhD Managing Director, Global Investment Strategist, TD Epoch Trump, Tariffs and Trade: Toward a New Global Economic Order President Trump is often portrayed as being mercurial and transactional, but his economic policy framework flows from tangible principles that he has venerated for decades. For a start, Trump maintains the U.S. has been too magnanimous in providing other countries with access to the American consumer and our defense umbrella. He believes this should be conditional on balanced trade and a level playing field, otherwise tariffs are justified. Similarly for defense, where several Presidential administrations since Eisenhower’s including those of Kennedy, George W. Bush and Obama have commented that numerous NATO countries are free riding on American mettle. Further, Trump deplores the decline of domestic manufacturing jobs and is resolved to propel a revival. Reasonable people can debate the above framework. There remains many open questions about tariff policies and the global economic order that Trump has in mind. This is important for investors because Trump’s trade policies will be key drivers of discount rates, free cash flow (FCF) and market volatility over the next four years. This paper examines tariffs and is structured to answer the frequently asked questions we have received. The first set of FAQs are concerned with the American perspective, while the second group focuses on China’s leading role in the ongoing trade war. The final set emphasizes the macro and market consequences, and then we conclude with implications for investors.

• 2. Trump, Tariffs and Trade: Toward a New Global Economic Order | 2 Why does Trump love tariffs? Four reasons: he does not need Congress, and tariffs provide him with bargaining power, while also generating revenues and incentivizing homeshoring. Trump’s first rationale is that he has unilateral power civil war, tariffs raised about 90% of the federal with enormous discretion, so he can quickly impose government’s revenue (although expenses then were tariffs and does not need approval from Congress. He tiny relative to today’s leviathan). During the youth of is especially partial to the International Emergency America, a tariff was simply the only tax it could hope Economic Powers Act (IEEPA) of 1977 which authorizes to enforce. the president to regulate international commerce Additionally, history suggests tariffs could rise by a lot. after declaring a national emergency in response to The average effective duty on manufactured imports an unusual and extraordinary threat to the national is currently only a fraction of the pre-1950 range (20% security, foreign policy, or economy of the U.S. that has 1 to 50%). its source in whole or substantial part outside the U.S. 2 Tariffs are then a tempting source of funds, especially as Trump and Congress negotiate over tax Second, just the threat of large and universal tariffs policy and 2025’s “big, beautiful bill.” He could make provides Trump with a great deal of bargaining power a credible case that tariffs will add over $100 bn to to negotiate on both trade and non-trade issues government coffers, which would go a long way to (it also provides Trump with his desired photo ops, fund policy priorities, such as reducing the corporate usually at Mar-a-Lago). With Canada and Mexico, tax rate to 15% for companies producing in the U.S. he emphasizes illegal immigration and drug (Figure 1). smuggling. With trading partners in north-east Asia, Trump’s fourth reason for loving tariffs is they could he stresses trade surpluses and with EU countries help restore America’s manufacturing heartland. He Trump highlights NATO spending arrears. While this believes the U.S. needs tariffs to prevent a tsunami approach has produced some middling concessions, of subsidized exports from continuing to hollow it often appears performative and has been much less out critical sectors. Tariffs could also incentivize successful with larger countries like India and China. homeshoring of investment, production, and jobs. Next, tariffs were initially imagined as a tool to raise Conceptually this makes sense but is there any revenue. From the founding of the nation until the evidence that this is already happening? Figure 1: During Trump 45, custom duties doubled to $80 bn. An even bigger increase is likely during Trump 47, potentially helping to fund tax cuts. Source: Bloomberg Finance L.P. 40 35 30 25 20 15 10 5 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Duties (% of tax on corp income) Recession 1 The IEEPA is extremely attractive to President Trump, but he still has several other routes. In his first term, Trump used sections 201 and 301 of the Trade Act of 1974, as well as section 232 of the Trade Expansion Act of 1962. However, these legal avenues take roughly eighteen months as the USTR must first conduct an investigation and then adhere to a notice-and-comment period. 2 The authoritative source is: “Clashing over Commerce: A History of US Trade Policy,” by D. Irwin, Dartmouth, 2017.

• 3. Trump, Tariffs and Trade: Toward a New Global Economic Order | 3 Is reshoring manufacturing even possible? Yes, and it is already happening, although manufacturing will never return to 30% of the U.S. economy. Although it is still early days, there is already and north-east Asian countries. However, this compelling evidence of an American manufacturing view is contradicted by several recent successes renaissance (Figure 2). However, little of this can be in EV’s rockets, satellites, and drones. Further, attributed to the 2018-2019 tariff hikes. Rather, it is there is strong momentum in strategic industries driven by industrial policies, such as the Chips and such as solar, batteries and semiconductors. Most Science Act of 2022, as well as the perception that economists are skeptical regarding tariffs and global supply chains have become riskier and more industrial policies (more on this later), but there is vulnerable (due to COVID, the Ukraine War and rising unambiguous evidence such policies are already tensions around Taiwan). bearing fruit, and that America is well on its way to rebuilding its manufacturing base.3 This sharp rebound has surprised many. There is a common belief that Americans just are not good at making stuff, especially compared to Germany Figure 2: U.S. investment in manufacturing facilities has soared since 2022 after having languished for decades Source: Bloomberg Finance L.P. 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Investment in manufacturing facilities (%GDP) Recession Why the obsession with manufacturing? Domestic manufacturing capabilities remain critical given supply chain vulnerabilities and national security imperatives. Further, it takes decades to develop manufacturing excellence, even in a services economy driven by digital tech and AI. The case for industrial policy is particularly compelling in sectors that are strategically critical. There are two economic reasons why we should not Further, countries are increasingly weaponizing just outsource “archaic” activities like manufacturing. interdependence. A key vulnerability for America The first is the inherent fragility of hyper-efficient is critical dual-use minerals, for which its import global supply chains. That is, the type of risk dependence on China is often 80%. It also strikes us experienced through COVID (critical medical as fatally naïve to be so dependent on China for the supplies) and the Ukraine War (natural gas), and entire EV supply chain, as well as dual-use goods could occur around Taiwan (semiconductors). such as drones. 3 “Yes, reshoring American industry is possible,” by N. Smith, January 2025. Smith believes the overvalued USD and Chinese subsidies explain most of America’s deindustrialization and recommends U.S. industrial policies embrace pro-manufacturing aspirations.

• 4. Trump, Tariffs and Trade: Toward a New Global Economic Order | 4 A second reason concerns Wright’s Law and learning However, in the modern economy they have been curves. Manufacturing excellence requires modern superseded by industrial policy and Wright’s Law. infrastructure, a deep network of suppliers, a skilled This explains the rise of the manufacturing sector in workforce and profound expertise (intellectual Germany and Japan following WWII and by South property) honed over decades. This is emphasized Korea and Taiwan from the 1980s. More recently, by Wright’s Law, which expresses the relationship China’s leaders have dialed industrial policy up to between experience and manufacturing efficiency. eleven, applying it mercilessly to the production Almost a century ago, Theodore Wright found that of EVs, batteries, solar panels, drones, and so on. every time aircraft production doubled, the required However, the implications of Wright’s Law were labor time for a new plane fell by 20%.4 largely ignored in the U.S., where manufacturing became an afterthought. This resulted in domestic The classical economist David Ricardo viewed capabilities atrophying and productivity faltering natural resources, farmland, and climate as the (Figure 3). This is clearly untenable in the new global critical determinants of competitive advantage. economic order. Figure 3: U.S. manufacturing productivity growth averaged 3.4%/year from 1950-2000. However, it slowed to 0.6% since then and productivity has actually declined by 9% from its peak in 2012. Source: Bloomberg Finance L.P. 800 400 200 100 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 U.S. mfg productivity (index, log scale) Recession China Joins WTO Productivity begins to decline How does the American public view trade and tariffs? Views have shifted sharply against free and unfettered trade since China entered the World Trade Organization (WTO). Further, 83% of Americans have a negative opinion of the Chinese government, up from 29% in 2007. Public attitudes have exhibited a sharp U-turn over particularly high among Republicans (73%, up from the last two decades and become decidedly pro- 65% in 2021). Moreover, a recent Global Affairs poll tariff.5 According to a 2024 survey by Pew Research, found that 56% of Americans see trade with China as 59% of American’s believe the U.S. has lost more than weakening U.S. national security. it has gained from international trade. This share is 4 “Factors Affecting the Cost of Airplanes”, Journal of the Aeronautical Sciences, 1936. More recent studies suggest values of 15-25% for aerospace, shipbuilding, and advanced machine tools. 5 “Majority of Americans take a dim view of increased trade with other countries,“ July 2024, Pew Research Center, “American Views of China Hit All-Time Low,” Oct 2024, Chicago Council on Global Affairs and “Americans Are Critical of China’s Global Role,” April 2023, Pew Research Center.

• 5. Trump, Tariffs and Trade: Toward a New Global Economic Order | 5 Related to their views on trade, 83% of Americans Until recently U.S. companies were the one holdout, have a negative opinion of the Chinese government, arguing strenuously against tariffs. However, they up from 47% in 2017 and 29% in 2007, according to a have largely gone silent about the importance of 2023 survey by Pew Research. While this perception the U.S.-China relationship. This is largely because is shared across the aisle, Republicans have American businesses no longer see China as the land stronger negative views (88% vs 81% for Democrats). of opportunity. Additionally, they view the damage Moreover, 53% of Republicans see China as an from the 2018-2019 tariff hikes as having been enemy (41% view it as a competitor and only 5% as limited and this time U.S. firms are better prepared a partner). Further, 61% of GOP supporters believe to weather a trade war. China is the main beneficiary of U.S.-China trade, with only 6% responding that America is. Reflecting these dramatic shifts, a solid majority of Americans now favor increasing tariffs on Chinese imports. Will tariffs help lower income workers? Maybe, but only at the margin. A tariff comprises two distinct policies – an industrial subsidy plus a sales tax. The former encourages homeshoring and could help lower income workers. The latter clearly does not, so the overall impact is ambiguous. Regardless, onshoring will not create enough high-paying blue-collar jobs to offset the ongoing negative impact of digital tech and AI. A key reason for the populist backlash against Further, tariffs are similar to a sales tax and the 2018 Chinese mercantilism is the plummeting labor share, hikes were partially passed onto consumer prices, which coincides with China’s entry into the WTO reducing national income by a negligible $1.4 bn per (Figure 4). Over the last three decades, workers month, but disproportionately hurting lower income have been hit by the double whammy of offshoring workers.6 Over the last two decades, voters have and digital tech. While the former is moderating, become increasingly angry about an economy they at least in sectors critical to national security, the feel does not work for them. Regrettably, we believe the latter continues to accelerate and is likely to further labor share will remain subdued and continue to be a exacerbate income inequality. key driver of populism and other challenging trends. Figure 4: From 1950-2000 the labor share averaged 67%. However, with China’s entry into the WTO it has plummeted to 59%. Source: Bloomberg Finance L.P. 72 70 68 66 64 62 60 58 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Labor share (%) Mean pre-2000 (%) Recession 6 “The Impact of the 2018 Tariffs on Prices and Welfare,” by M. Amiti (FRB NY) et al, Journal of Economic Perspectives, 2019.

• 6. Trump, Tariffs and Trade: Toward a New Global Economic Order | 6 How did China become the global manufacturing superpower? Through an extreme form of mercantilism, featuring massive subsidies, relentless industrial policy, and aggressive five-year plans like “Made in China 2025.” Over the last two decades, China has quadrupled of China’s lavish export subsidies, onerous import its share of global manufacturing while America’s restrictions and formidable state-directed lending, has declined by a third (Figure 5). To illustrate, as well as a massively undervalued currency and China’s share of global car production has increased favorable tax treatment. These have all been part twenty-fold, from 2% to 39%, while everyone else’s of the mix since the 1990s, when China was still has collapsed: Europe’s from 33% to 13%, Japan’s a relative minnow. However, it is now a whale, from 21% to 12% and America’s from 14% to 3%. China and these subsidies amount to roughly $500 bn was a net importer of autos until 2022, but its auto annually. Domestically, this has required excessive exports have increased six-fold since 2020 reflecting investment and weak consumption. Externally, massive capacity expansion (over twice domestic this has resulted in trading partners who are demand). Even more egregious, China’s shipbuilding increasingly resentful and pugnacious. capacity is now 232 times greater than the U.S. Of course, this did not just happen organically due to free markets and naturally occurring comparative advantage.7 Rather, it was the result Figure 5: Global manufacturing value added (share, %) Source: World Bank 35 30 25 20 15 10 5 0 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 China (%) Japan (%) EU (%) U.S. (%) The Second China Shock: Is its economic model incompatible with the postWar global trading system? Yes, China’s extreme form of mercantilism is unsustainable and has resulted in enormous backlash from its export markets. A recent article in the WSJ argued that China broke decades, they shifted into a much higher gear in the post-Cold War order through its growing role as May of 2015 when the State Council issued its “Made a geopolitical rival and its extremely mercantilist in China 2025” plan. The explicit objective was policies.8 While such policies have been in place for for China to become the #1 global manufacturing 7 The 19th century English phrase, ‘comparative advantage’, rings a bit archaic but can be translated into modern English as ‘relative efficiency’. That is, do what you are best at, and import the rest. 8 “We are all mercantilists now: China’s emergence as an economic power helped fuel the rise of protectionist views on trade worldwide,” by Greg Jensen, Bridgewater Associates, WSJ, December 2024. 0 5 10 15 20 25 30 35

• 7. Trump, Tariffs and Trade: Toward a New Global Economic Order | 7 powerhouse and to dominate the industries of the its batteries and 90% of consumer drones. Further, future (such as EVs, batteries, solar panels, and during the last three years, car exports have tripled, drones). The Economist estimates state subsidies with China becoming the world’s largest car exporter committed to “Made in China 2025” add up to over by units. One result is that even Germany is now $3 tn in the decade since 2015. facing a China shock, with industrial production plummeting 15% since 2017 and GDP flat since 2021. One consequence has been China’s massive and accelerating trade surplus, with a run rate of $1.2 Given this, no one in Beijing should be surprised that tn (Figure 6). This has more than doubled from its their export strategy is facing significant challenges, pre-COVID level, which was already the largest including trade barriers, outright bans, and the experienced anywhere in history, and is increasingly threat of much higher tariffs. In some ways China’s referred to as the “Second China Shock.”9 To big bet on industrial policy has paid off, however, it illustrate its magnitude, Chinese companies now has resulted in an enormous and growing backlash produce 90% of the world’s solar panels, 70% of from abroad. Figure 6: China goods surplus (USD bn), to infinity and beyond Source: Bloomberg Finance L.P. 1,400 1,200 1,000 800 600 400 200 0 -200 1995 2000 2005 2010 2015 2020 2025 Surplus (monthly data, annualized) Surplus (trailing 12m sum) Recession 1st China Shock 2nd China Shock As developed markets turn protectionist, where can China grow exports? China is pivoting toward EMs; however, they are becoming increasingly aware that China is suffocating their domestic industrial base and creating unacceptable national security vulnerabilities. Michael Pettis from Peking University has been plus the investment required to produce those pleading for decades that China needs to exports.11 This export-reliant growth model might rebalance its economy.10 Although Beijing frequently be sustainable if China was the size of Vietnam or makes public statements agreeing with Pettis, it Indonesia but is clearly untenable for the world’s has yet to put his advice into action. To illustrate second-largest economy. the degree of imbalance, we believe all of China’s The backlash from developed markets (DMs) is growth in 2024 was accounted for by net exports intensifying, with the U.S. leading the charge (Figure (a roughly 2 percentage point (ppt) contribution), 7). Note that exports to the U.S. have not grown 9 The first “China Shock” occurred from 2000-2007 when rising Chinese exports reduced U.S. manufacturing employment by an estimated 550,000 to 2.4 million jobs. Some sectors and communities were hit particularly hard. For example, furniture industry employment fell by around 300,000, or 45%. The sector was concentrated in the North Carolina piedmont, employing roughly one in every six workers. Source: “China’s Very Bad, No Good Trillion-Dollar Trade Surplus,” by Paul Krugman, January 2025. 10 He is a prolific author, as you can see here: https://carnegieendowment.org/people/michael-pettis 11 According to official statistics, China’s GDP grew by 5.4% last year. We have more confidence in the 2.4-2.8% estimate from Rhodium Group. Regarding other components of GDP, housing is likely to remain a growth headwind through 2030 and even China bulls believe consumption’s contribution to growth is no greater than 1 ppt.

• 8. Trump, Tariffs and Trade: Toward a New Global Economic Order | 8 Figure 7: U.S. imports from China are down 20% from July 2018 when Trump’s tariffs first came into effect. This raises the question of where China plans to export its excess production. Source: Bloomberg Finance L.P. 600 500 400 300 200 100 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 U.S. imports from China (USD bn) U.S. exports to China (USD bn) July 18 in over a decade. However, this might be partially that China is suffocating their domestic industrial explained by China relocating production to Vietnam base and creating unacceptable national security or Mexico, which is why the Trump administration is vulnerabilities. This means, at some point Beijing will examining the feasibility of tariffs based on the origin have no choice but to finally rebalance away from of each component within an imported product. exports and investment, and toward consumption. Economic growth will only prove sustainable when With the U.S. and other DMs increasingly pushing policy makers ditch their mercantilist obsession. back on the export tsunami, China is pivoting to EMs (Figure 8). However, EMs are increasingly aware Figure 8: China’s exports are increasingly destined for EMs rather than DMs Source: Bloomberg Finance L.P. 65 60 55 50 45 40 35 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 U.S.+EURO+JPN (share of China’s exports, %) Others (share of China’s exports, %) 35 40 45 50 55 60 65

• 9. Trump, Tariffs and Trade: Toward a New Global Economic Order | 9 Weaponizing access to the U.S. consumer: Which countries will be affected by Trade War 2.0? During Trump 45 there was a lot more talk about tariffs than there was action, except in the case of China. Trade War 2.0 is again 80% about China: But Mexico, Canada and Germany are also targets. Countries that rely on large and persistent trade is similarly exposed, with 75% of exports flowing to its surpluses to drive growth are the most exposed in southern neighbor and exports to the U.S. represent an increasingly mercantilist world. China has been, 19% of GDP. However, Canada’s bilateral surplus by far, the biggest beneficiary of hyper-globalization with America is relatively paltry and entirely driven and has the most to lose as we play the movie by energy (notably heavy oil, which U.S. refineries backwards. We predict the effective tariff rate on require). Canada actually has a manufacturing trade imports from China to rise by 20 ppts (beyond the deficit with its neighbor. If 25% tariffs were placed on 10 ppts already announced). This is one reason we imports from Canada, they would reduce GDP by expect the Chinese economy to continue to struggle 1.0% to 1.5% and increase the level of CPI by 1.5 ppts. (tariff hikes are likely to reduce GDP growth by 0.3 Germany is also in the crosshairs, as it has a to 0.4 ppts over the next 12 months) and Chinese large bilateral surplus, and we expect the tariff on equities to keep underperforming. European autos to increase by 20 to 25 ppts. The Next in line is Mexico, which represents 15% of EU has several policy options to deal with the threat America’s overall trade imbalance, just behind China’s of U.S. tariffs: retaliation (as occurred in 2018), a sizeable 25% (Figure 9). In addition, 83% of Mexico’s credible commitment to buy more U.S. products exports travel north of the border, exports to the (especially energy), scaling up defense spending and U.S. represent 25% of GDP and Trump is determined capabilities, and adopting a more restrictive stance to renegotiate the United States-Mexico-Canada on trade with China. We expect all of the above to be Agreement (USMCA). Further, there are several in play this year. vexatious issues beyond conventional trade (most Beyond these four countries, betting sites believe notably drugs and undocumented immigration). If there is a 60% chance of tariffs against Japan 25% tariffs were placed on imports from Mexico, they and Taiwan being implemented during 2025. The would reduce GDP by 2% and increase the level of the corresponding percentage for South Korea is 45%. Consumer Price Index (CPI) by 2.25 ppts. All these countries have large bilateral trade Trump often criticizes Canada in the same breath as surpluses and major manufacturing centers. Mexico. This is because it is also part of USMCA and Figure 9: Share (%) of overall U.S. trade deficit in 2023. China stands out, followed by Mexico Source: Bloomberg Finance L.P. 25 20 15 10 5 0 CHN (%) MEX (%) VNM (%) DEU (%) JPN (%) TWN (%) KOR (%) CAN (%) THA (%) IND (%)

• 10. Trump, Tariffs and Trade: Toward a New Global Economic Order | 10 Weaponized interdependence: How will China retaliate? Similar to 2018-2019, proportionately and immediately. China’s main source of leverage this time is its dominance of critical dual-use minerals. China is not to be bullied and will retaliate promptly, autos, and aircraft.12 However, China’s main source of as occurred in 2018-2019 (Figure 10). Which American leverage this time is its dominance of critical dual-use sectors could take a hit as a result? U.S. exports to minerals. They are required for America’s industrial China largely consists of oil, agricultural products and defense sectors, and for which U.S. import (soybeans, corn, and chicken), pharmaceuticals, dependence on China is often 80%. Figure 10: China will respond immediately and in kind to U.S. tariff hikes Source: Bloomberg Finance L.P. 25 20 15 10 5 0 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20 Jan-21 Jul-21 Jan-22 Jul-22 Jan-23 Jul-23 U.S. ave tariff on China exports (%) China ave tariff on U.S. exports (%) What will be the impact of higher tariffs on U.S. growth, inflation, and corporate earnings? U.S. GDP could be reduced by 0.4 to 0.8 ppts, with the level of consumer prices increased by 0.4 to 0.6 ppts and SPX EPS diminished by $4-$8. We expect the escalation of tariffs to reduce U.S. The hit to U.S. corporate earnings could be GDP by 0.4 to 0.8 ppts. The lower bound, 0.4 ppts, significant. Globalization has been a key factor is the impact from the 2018-2019 tariffs on imports driving U.S. margins higher and boosting offshore from China (as estimated by the Peterson Institute revenues. S&P 500 margins could fall by 25 to 50 for International Economics). bps, which is worth between $4 to $8 to forward EPS estimates. Mentions of tariffs in S&P 500 transcripts We also predict a ceteris paribus increase in the level have tripled since October, especially for cyclical and of consumer prices, by 0.4 to 0.6 ppts.13 However, consumer sectors: industrials, materials, consumer this represents a rise in the price level and will have discretionary, consumer staples and heath care. a much smaller impact on inflation. Tariffs only result in a sustained, ongoing rise in prices if additional, However, reflecting the elevated level of uncertainty, continuous tariff hikes are threatened and become tariffs are not yet fully into market prices (Figure 11). imbedded into consumers’ expectations.14 12 In 2018-2019, Trump authorized payments of $28 bn to U.S. farmers (70% was soybeans) to offset their losses from Chinese trade retaliation. This represented a large share of tariff revenues. 13 Back-of-the envelope calculations: Imports represent roughly 11% of U.S. personal consumption (that is, $2.2 tn divided by $20.2 tn) and the current average effective tariff is 1.5%. If this tariff rose by 4 ppt, the level of PCE prices would increase by just over 0.4 ppt (assuming little short-run substitution away from more expensive imports). 14 For estimates of the effects on various products’ prices please see, “The Economic and Fiscal Effects of the Trump Administration’s Proposed Tariffs,” The Budget Lab at Yale, January 31, 2025.

• 11. Trump, Tariffs and Trade: Toward a New Global Economic Order | 11 Figure 11: Trump’s tariff threats are not yet priced into equities Source: Bloomberg Finance L.P. Note: “Trump tariff losers” represents a basket of 38 stocks likely to decline if tariffs are implemented. 100 98 96 94 92 90 88 Trump tariff losers / SPX (index) Nov. election Oct-24 Nov-24 Dec-24 Jan-25 Feb-25 What is the likely impact of tariffs on the USD? Tariffs will probably result in a stronger USD in the short term, but the greenback is extremely overvalued. Treasury Secretary Scott Bessent has testified that, of payments. However, the USD has already “Historically, 40% to 50% of the tariff is recovered appreciated by 6% since early October suggesting in currency appreciation.” This is somewhat higher that this might already be partly in the price. than the consensus among economists that USD/ A stronger greenback implies tighter financial CNY absorbed about 30% of the impact in 2018- conditions, and not just for the U.S. EMs are 2019. Regardless of the exact amount, we expect especially vulnerable, reflecting the tightening in additional tariffs will drive the USD even higher. funding markets and an increased burden from USD- This reflects three fundamental factors: interest denominated debt (Figure 12). Beyond EMs, dollar rate momentum, which is the key short-term driver appreciation is negative for equities broadly, but of currency pairs; the vulnerability of countries especially cyclical sectors such as materials. like China that rely on exports for growth; and the equilibrating role of currencies in the balance Figure 12: A stronger USD is bearish for Emerging Markets: -91% correlated since 1995 Source: Bloomberg Finance L.P. 110 100 90 80 70 60 50 40 30 20 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 80 85 90 95 100 105 110 115 120 MXEF/MXWO (index, lhs) USD broad (index, rhs, inverted) Recession

• 12. Trump, Tariffs and Trade: Toward a New Global Economic Order | 12 Weaponizing the dollar: Can the Trump administration do anything about the overvalued USD? Yes, but it is exceedingly difficult, will take years and could cause enormous market volatility. So, the greenback is likely to get even more expensive before it gets dramatically cheaper. Trump gripes that the greenback is exorbitantly single country or durable alliance of countries can priced and a key reason for the deindustrialization meet the challenges of global leadership). of America. It is hard not to agree with him on this As emphasized by the nominated chair of Trump’s point. The USD is at the highest level it has been Council of Economic Advisors, the U.S. has historically since 1985, just ahead of the Plaza Accord (Figure pursued multilateral approaches to currency 13). This premium partially reflects policies by China adjustments. and other northeast Asian countries to keep their 15 However, this requires active cooperation from trading partners such as China, implying a currencies undervalued to subsidize exports. Such Mar-a-Lago accord (or a multinational agreement to currency debasement policies are likely to come depreciate the U.S. dollar) is highly unlikely in today’s under increasing fire during Trump 47. However, a environment. There are also unilateral tools available, replay of the Plaza (1985) and Louvre (1987) accords, multinational agreements to depreciate and then such as taxing Treasuries held by China and others. However, such solutions would drive a structural halt the depreciation respectively, is untenable in increase in market volatility and intensify efforts to find today’s G-Zero world (a world order in which no alternatives to the USD-based financial system.16 Figure 13: USD is extremely overvalued, currently 30% above 1987-2025 mean Source: Bloomberg Finance L.P. 120 110 100 90 80 70 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 USD REER (index) 1987-2025 mean Recession Nixon Shock Plaza Accord Tech Bubble COVID Stimulus AI Bubble? 70 80 90 100 110 120 Economists hate tariffs: What are their laissez-faire models missing? Economists emphasize efficiency and let markets work their magic unless there is a clear rationale for intervening. For tariffs, the key reason is critical supply chain vulnerabilities (historically just arms and farms, but now also includes semiconductors, energy, and essential medical supplies). Some economists argue that models should recognize that consumers are also producers, and additionally allow a role for tariffs to incentivize countries like China to rebalance their economies. Free trade is the closest thing to a universally held has lifted U.S. GDP by up to 8%.17 We believe this value among economists. And it is not hard to is actually a significant underestimate as it does understand why, as economists estimate trade not incorporate several key channels (that are, 15 “A User’s Guide to Restructuring the Global Trading System,” by Stephen Miran, November 2024. 16 “Underground Empire: How America Weaponized the World Economy,” by H. Farrell (Johns Hopkins) et al, 2023. 17“The U.S. Gains from Trade,” by A. Costinot (MIT) et al, Journal of Economic Perspectives, 2018.

• 13. Trump, Tariffs and Trade: Toward a New Global Economic Order | 13 admittedly, hard to estimate empirically). For In addition, a minority of economists argue that example, relative to purely domestically oriented governments need to recognize that consumers firms, exporters are more innovative and productive, are also producers.19 The logic is that too much because they face greater competition and are more offshoring can weaken working class wages and exposed to new products and techniques. cripple consumption. Economic theory suggests this is acceptable (Pareto efficient) as losers from However, the laissez-faire consensus among globalization can receive transfers and retraining, economists is beginning to fray. Comparative but in the real world this rarely happens. Further, advantage is clearly a critical guide to production many communities get destroyed, as occurred decisions and trade patterns, but only in a risk- during the China Shock of 2000 to 2007. As local free global economy.18 As supply chains become infrastructure deteriorates and skills atrophy, it riskier and more vulnerable, there is increasing becomes increasingly difficult to rebound leading to agreement that economic efficiency should be extended periods of economic decline. part of the decision-making process, but not the only consideration. Further, some economists argue that tariffs can incentivize the U.S. and China to rebalance Is Ricardo’s theory still valid in a world with supply their economies. The U.S. economy suffers from chain vulnerabilities and national security risks? excess consumption, low savings, and a declining Supply chains are vulnerable to geopolitical conflicts manufacturing share. China has the opposite (as in the Middle East, Ukraine or potentially, problem, overinvestment, and surplus capacity, Taiwan), as well as natural disasters (such as the which results in massive trade imbalances that are Japanese tsunami of 2011) and pandemics (COVID). extraordinarily far from the free trading world of Indeed, this has always been the case, especially Econ 101. Michael Pettis argues that tariffs, along for critical sectors like farms and arms. However, with other types of industrial policy, can address the during the last decade the list of sectors viewed as causes of these conditions and help reverse them. critical to national security has expanded to also include semiconductors, energy, the EV supply chain, Finally, tariffs are winning the debate because other and critical medical supplies. This means Ricardo policy options are not realistic. In a perfect world, is still valid, but we need to balance the benefits of the IMF would impose currency adjustments, and comparative advantage and economic efficiency the WTO would enforce fair trade. However, the with the imperatives of resilience and security. experience of the last two decades has left Americans contemptuous of multilateral organizations. What exactly is “the new global economic order”? With the rise of China, we have moved from a unipolar to a bipolar world, with both countries determined to dominate the industries of the future. Further, increasing supply chain vulnerabilities and China’s extreme form of mercantilism have forced the U.S. to embrace industrial policies and tariffs. Presidents Trump and Xi are both determined to With the rise of China, we have moved from a redefine the global economic order but have quite unipolar to a bipolar world. China is becoming different ideas of what that means. However, the increasingly assertive, insisting its economic and two superpowers do agree on two things: that the military heft merits a commensurate voice in defining industries of the future will be centered around the rules and institutions of the new global economic digital tech, AI, and advanced manufacturing; order. In many ways, that is entirely reasonable. and that dominating these industries is critical to However, since President Xi’s ascension in 2012, their economic strength and national security. For China has ramped up a host of mercantilist policies investors, this has induced the most disruptive and that are incompatible with WTO norms. The intended challenging macro environment since the end of the result was export-driven growth to compensate first Cold War for weak domestic consumption and an imploding real estate sector. Unfortunately, though, China’s 18 “Is comparative advantage valid in a geopolitical world,” by Richard Baldwin, IMD, January 2025. 19 “Economists’ Way Out of the Wilderness: They must stop treating production as an afterthought,” by J. Galbraith, U Texas, 2025.

• 14. Trump, Tariffs and Trade: Toward a New Global Economic Order | 14 mercantilist behavior has undermined support for We believe tariffs will constitute a key investment free trade and the WTO has withered into irrelevance. theme through 2028. However, we should be careful about analyzing the impact of tariffs in isolation. The two behemoths now view interdependence as Trump’s overall agenda is pro-growth, emphasizing a risk to both global supply chains and national tech, deregulation, and tax cuts. We will be writing security. This especially applies to semiconductors, about each of these during the next few months and energy, the EV supply chain, and critical medical believe policies regarding tech and deregulation supplies, as well as the defense industry. For the U.S., could be especially impactful. the new global economic order features a much more expansive and intrusive role for the state, with We expect above trend volatility in equities, rates, greater emphasis on national security and resilience and FX, reflecting the transition to the new global and markedly less on comparative advantage and order, the acceleration of AI and digital trends, market efficiency. and rising geopolitical tensions. To our eyes, this is the most disruptive and challenging macro An America First Trade Policy: Implications environment since the end of the first Cold War. for investors. Given this, investors should be wary of today’s highly We are at the beginning of a new high tariff era. Even concentrated equity markets. We believe investors though markets have been focused on tariffs for can benefit from holding a more diversified portfolio, months now, we believe they are not yet priced in. across both countries and sectors, while maintaining Our base case assumption is that tariffs will reduce a focus on companies that generate sustainable FCF U.S. GDP by 0.4 to 0.8 ppts, with the level of consumer and are superior capital allocators. prices increased by 0.4 to 0.6 ppts and SPX EPS diminished by $4 to $8. Most impacted will likely be cyclical and consumer sectors: industrials, materials, consumer discretionary, consumer staples and health care. Additionally, we expect roughly one-third of the tariff to be recovered through a stronger USD.

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