“Crunch time” on US tariffs

It keeps getting shunted forward and now it is on August 1^st, the day the US is threatening to ratchet tariffs back up for those countries that have been unable or unwilling to conclude a trade deal. Of these, it is the EU that’s likely to determine whether crunch time for the politicians is ‘crater time’ for financial asset prices.

The EU’s trade negotiation is key because it, along with China, is most likely to retaliate with tariffs of its own if a trade deal cannot be agreed and the US puts tariffs back up. The EU seemingly faces an increase in the US tariff rate from 10% to 20% on August 1^st, which was the original ‘liberation day’ rate, although Trump has talked about as much as 30% and, in addition, there are the steep tariffs on products such as autos, plus those to come in the future, such as pharmaceuticals.

Could a trade deal be agreed to avoid the tariffs? Steven Barrow, Head of Standard Bank G10 Strategy, said there would be no chance of a full trade deal. The EU takes years to negotiate trade deals with Canada (7 years) and Japan (5 years) just two examples. It won’t rush through a full trade deal just to avoid tariffs. However, what might be agreed upon is a sort of framework deal that basically concludes that the two sides are willing to negotiate a comprehensive trade deal over time. The US can claim this to be a ‘proper’ trade deal, while the EU might be able to avoid steep tariffs. But while this might seem the best outcome possible at this stage, there’s no guarantee that it will happen.

With this in mind, it might be worth investigating the financial market implications should the pair fail to agree on even a basic framework deal that leads to the sort of tit-for-tat tariff war that we saw between the US and China back in April. Now clearly this would be a huge decision by the EU. Other countries, with the notable exception of China, have rolled over meekly to accommodate President Trump’s aggressive trade agenda. Should the EU decide that it needs to stand up to Trump and impose tariffs of its own, the consequences could be quite grave.

As we’ve already said, such action would surely lead the US Administration to up the tariff rate still further. The EU could respond with more tariffs and it could also use its anti-coercion instrument (ACI) to impose restrictions on access to EU markets, or the so-called ‘nuclear option’. This would likely hit the US tech companies hard and that’s already a sore point for the US Administration as it hates foreign digital taxes.

How would financial markets respond to such an escalation? Clearly not well. Equities will presumably nose-dive in a way that is at least a mini-repeat of the post liberation day rout. What we remember about the slump in asset prices in April was that US assets were disproportionately damaged. US stocks went down the most, and the US dollar crumbled. But was this because the market perceived US tariffs as so much worse for the US than elsewhere?

Steven Barrow is not so sure. He thinks the tariff announcement exposed the vulnerable positions of traders and investors who, on reflection, appeared to be overexposed to US stocks and overexposed to the US dollar. As these positions were covered, so US stocks and the US dollar took bigger hits than elsewhere. But fast-forward to August 1^st and he suspects that the market response to a dramatic rise in trade tensions between the US and the EU will be based on assessments of the winners and losers from the trade spat, not from the overexposed positioning factors that were in place in April. And, if we are right about this, it will be the euro and euro zone stocks that will be hit the most. It certainly stands to reason that the euro should slide against many other currencies where trade deals with the US have been agreed (like the UK) and against others that face a lower tariff rate than the EU.

Could the euro unwind all the strength against the dollar that we’ve seen since liberation day? Probably not. Unlike then, the market will assume that the trade spat will be resolved quickly and, in Steven Barrow’s opinion, that could limit any pullback in euro/dollar to the 1.10 region. But clearly if a dispute arises, and if it is not resolved rapidly, a deeper slide in the euro is very possible.