Summary
Liberation Day in the United States came with extremely protectionist and inward-looking tariff policy aimed at just about all U.S. trading partners. In this report, we outline some of the more strategic implications of Liberation Day and developments we will be paying close attention to going forward.
Strategic Implications of “Liberation Day”
Liberation Day tariffs will provide perhaps the sternest test of our view that markets are experiencing “tariff fatigue.” Liberation Day tariffs were extremely protectionist, and while global equity markets are down sharply this morning, FX markets are not having the same “risk off” reaction. Just looking solely at FX market performance since Liberation Day announcements, one might think the Trump administration lifted all tariffs and provided a warm embrace to globalization and all U.S. trading partners. G10 currencies are rallying across the board, while the most risk-sensitive currencies in the emerging markets are, with only a few exceptions, stronger. In our last two International Economic Outlook publications we have discussed the possibility of FX markets settling into “tariff fatigue”, where market participants have digested the fact that tariffs are here but just shrug them off. Also, “tariff fatigue” in the sense that tariffs are creating a dynamic where post-COVID U.S. exceptionalism has finally run its course. Maybe not a perpetual end to U.S. exceptionalism, but at least for the time being, as U.S. policy uncertainty is elevated and until the economic impact becomes clearer. We have also highlighted that tariff fatigue is causing other economic and policy factors to re-emerge as currency market drivers—such as the possibility of more dovish Fed monetary policy or more expansive Eurozone fiscal policy. While we forecast dollar strength going forward, our tariff fatigue view has played a role in our view that the rise in the U.S. dollar will not be as pronounced as we previously envisaged. While foreign currency strength immediately following Liberation Day is perplexing, the next few weeks and months will be a good test of whether tariff fatigue is still taking hold. Looking ahead, even if tariff fatigue does appear to be sinking in, we still struggle with the idea that U.S. dollar should outright weaken. In that sense, we remain comfortable with our view that the greenback should strengthen in the current climate, but may adjust the overall magnitude of dollar strength lower again if we observe stronger signs of tariff fatigue.
Liberation Day will also be a strong test of our deglobalization and fragmentation view. If there is a view on which we hold particularly high conviction, it is our view that deglobalization is set to continue for the foreseeable future. President Trump may be looking to actively encourage deglobalization with tariffs and renegotiating free-trade deals, although we also believe a further reduction in the connectedness of the global economy will continue well after President Trump’s second term ends. We have also observed clear signs of global economic fragmentation—our view that the global economy is fracturing into two distinct economic blocs: one led by the U.S. and one led by China—is a trend that is likely to gather momentum in the years ahead as a result of Liberation Day. Evidence suggests certain countries, particularly in the emerging and developing world, opted for the China bloc over the course of Trade War 1.0, a pattern that is likely to repeat in Trade War 2.0. One dynamic we will be focused on following Liberation Day is whether the momentum behind countries choosing to economically and geopolitically integrate with China as opposed to the U.S. picks up pace. Taking deglobalization and fragmentation a step further, in addition to a decisive shift away from China over the years, the Trump administration has also signaled a shift away from Europe this year. Tariffs on the EU signal an economic shift away from Europe, while Trump communicating reduced support for Ukraine and potentially a weaker commitment to the NATO defense pact also does not bode well for the U.S.-Europe relationship, and economic integration. Point being, Liberation Day could also mark an inflection point in fragmentation. Meaning, is the global economy shifting from a bi-polar world (U.S. vs. China) to a tri-polar world (U.S. vs. China vs. Europe)? This potential move to a tri-polar world, one defined by economic blocs with cross-tariffs on each other, is a scenario we now plan on exploring for the impact on the global economy.
Is Liberation Day still part of President Trump’s “escalate to negotiate” strategy? Probably. As we noted two weeks into President Trump’s administration, the “escalate to negotiate” strategy still seems to be the go-to approach to seek concessions. While the bar to find common ground on trade is high and elusive, tariffs are likely still negotiable. Granted, some countries are likely to impose retaliatory tariffs and be unwilling to negotiate (i.e., China, EU and Canada), while others, in particular countries with little leverage, may be more inclined to make a deal with the U.S. administration. Key elements of these deals are likely to be similar to the concessions President Trump has sought since day one: buy more U.S. product and improve/cheapen access to foreign markets. Make no mistake, we thoroughly believe one of President Trump’s motivations is significantly reducing dependence on foreign countries (among other objectives) and tariff policies will net out to be a deglobalization force, but we would be far from shocked if countries ultimately decided to lower tariff rates imposed on the U.S. and make other commitments to appease the U.S. administration. But even if select tariff rates are lowered, tariff uncertainty is likely to linger. President Trump has used tariff threats to enforce immigration, drug control and coordinated containment on China already, and if those objectives are perceived as not being met, tariff rates could still ratchet higher. Overall, tariff rates could be adjusted in either direction, meaning tariff uncertainty is set to linger for an extended period of time.
Finally, the probability low-income developing market sovereign defaults appears to be increasing. Liberation Day tariffs extend to low-income countries across Southeast Asia and Africa, countries that struggle with a lack of economic diversification and are heavily reliant on trade with the United States. In recent years, after the worst of COVID, sovereign defaults have been avoided; but default probabilities for certain targeted countries are likely to rise significantly. Our emerging and frontier market sovereign default sensitivity framework already identify a few sovereigns that face repayment capacity issues, and tariffs are now likely to compound those challenges. While individual sovereign defaults in frontier Southeast Asia and African nations are likely not impactful enough to have a material impact on investor sentiment or the global economy, multiple and simultaneous defaults could have a more profound impact on market sentiment. Also, numerous defaults could also result in spillovers to other parts of the emerging world, while spillbacks on the U.S. economy cannot be ruled out either. For now, our framework looks at repayment capacity through the lens of cash flow metrics, the sovereign debt profile as well as reserve buffers—but with tariffs extending across regions and countries, we will update our framework to highlight tariff and U.S.-trade related vulnerabilities for new default candidates. Also, we will be keeping an eye on actions from rating agencies. Fitch already moved forward with a downgrade to China’s sovereign rating—which was likely to happen irrespective of tariffs—although new and aggressive levies likely accelerated that downgrade action. Losing investment grade status for select sovereigns could result in capital outflows that pressure economies and also increase default probabilities.
