Until now, financial markets have adopted a complacent “wait and see” approach when considering the prospects for the Trump 2.0 trade policy. However, the hope the new Administration’s bark would be worse than its bite has been dashed with the imposition of high tariffs on the nation’s three largest trading partners. Markets should now contemplate the likelihood of the worst case scenario. Indeed, the post-war, liberal international trading order is under threat: to be replaced by arbitrary, beggar-thy-neighbor programs.

To be clear, all countries will lose if an escalating trade war breaks out. However, understanding President Trump’s motivations may help identify the countries and currencies most at risk. As I have argued in earlier blogs, higher tariffs will not reduce America’s overall trade deficit nor curb the nation’s rising international indebtedness. Indeed, since the earlier imposition of levies in 2018, the USA’s external shortfall has continued to surge. To be sure, higher charges on China have reduced the bilateral imbalance (Chart below). However, American’s simply continued to buy stuff elsewhere. Shortfalls with Mexico, Canada, the European Union, Vietnam, and several Asian nations have satisfied America’s seemingly insatiable demand. Until the USA saves more, the nation’s overall external imbalance will expand.

Using Tariffs to Open Markets

Trade hawks in the Trump Administration like to target countries with whom the USA has large trade imbalances. However, the following Chart illustrates that’s just about everyone, although it’s easy to understand why China, the EU (Germany especially), and Mexico come under initial scrutiny.

A far more useful approach is to identify countries in which US exporters’ access to local markets is most restricted. In such situations, the imposition of tariffs could provide useful short-term leverage aimed at opening foreign markets.

The Chart above provides a crude gauge of where access for American producers is not well-reciprocated. Importantly, despite America’s large bilateral deficits with Canada and Mexico, US exporters’ access is not particularly restricted (reflecting the success of NAFTA/USMCA). Therefore, other political objectives, e.g. gaining cooperation on immigration and drug issues (and clashing personalities), may play on meaningful role in the decisions regarding these two key partners. It’s not hard to understand American policymakers’ frustration with Mexico on issues of mutual importance.

Likewise, America’s shortfall with the European Union does not appear primarily to reflect impediments to trade. America’s shortfall with Europe largely centers on Germany and Italy (both with considerable trade barriers to US penetratration), as well as Ireland (although the USA actually enjoys a surplus with Ireland when services are included). Also, access to Latam markets is better than average.

On the other hand, the greatest restrictions confronting US producers is in Asia. Imposing tariffs as a short-term tactic may be an effective tactic if aimed at negotiating market opening.

Will China Hold the Line?

With limited access to the domestic market and a large bilateral deficit, it’s not hard to understand why China remains a key focus of Trump’s trade hawks. Indeed, this may be the only issue on which there’s broad consensus in Washington. However, China and other US trading partners will not remain idle when faced with higher tariffs. Investors should anticipate other nations to retaliate with increased levies on US products.

To be sure, an escalating US trade war will add to China’s already formidable domestic economic challenges. However, China successfully offset the impact of the 2018 tariffs by significantly boosting trade with other nations, particularly within Asia (Chart above).

Likewise, if other countries view the USA as an unreliable trading partner, they will also find new markets. Indeed, several Asian countries significantly strenghtened regional trade links, especially Indonesia, Vietnam, Malaysia, and the Philippines. It’s also noteable, however, Japan, Korea, and India did not participate in the expansion in intra-Asian trade in this period. Meanwhile, many resource-oriented nations, e.g. Brazil, Chile, Colombia, and South Africa, have been expanding trade ties with China.

Importantly, the Chart above also illustrates many nations have been able to gain US market share at China’s expense since 2018, especially Mexico, Vietnam, Korea, Taiwan, Thailand, and India. Of course, some of these gains reflect a re-routing of Chinese products via third markets (Mexico and Vietnam in particular).

China’s loss of US market share combined with its successful expansion in intra-Asian trade creates an important issue. Economic logic suggests China should allow the Yuan to depreciate to offset the deflationary impact of higher tariffs on its exports. Doing so, however, would provide a competitive advantage within Asia, and might risk sparking competitive currency devaluations throughout the region. China willingness to keep the CNY steady as regional currencies collapsed during the Asian Crisis helped maintain regional stability. On the other hand, the RMB initially declined in 2018. Will China hold the line in 2025?

Strategic Considerations

• America’s imposition of tariffs is likely to support the US dollar in the near term. However, the US currency is already overvalued (Chart above). As trading partners retaliate, the US economy could experience weaker growth and higher inflation. The Federal Reserve may further delay additional interest rate cuts, and clash with the Trump team. Unless, the incoming Administration unveils a credible medium-term strategy to reduce the Federal government deficit, investors may reconsider the outlook for the greenback in coming months.
• Global equity markets, especially the S&P 500, have been complacent about whether President Trump would fulfill his pledge to raise tariffs. The heightened risk of a trade war may require an increased equity risk premium, which are now at 25 year lows.
• Despite large bilateral imbalances, trade barriers into Canada and Mexico are not particularly restrictive. Immigration and drug trade appear to be playing a major role. The Chart above indicates the C$ is already undervalued, whereas MXN is not. I expect tariffs with Canada may be relatively short-lived, and the C$ will decline only 5%. MXN’s depreciation is likely to be much larger, as US-Mexico issues will not be resolved quickly.
• President Trump has indicated tariffs will be imposed on the European Union soon. Again, trade barriers with the EU are not onerous, and the bilateral deficit centers largely on Germany and Italy (as well as Ireland). Therefore, tariffs are likely to be quite focused and limited. As a result, I believe European markets may continue to outperform in 2025.
• The 10% tariff hike on Chinese imports suggests an incremental approach; holding out the possibility of future trade negotiations. For now, China will support the RMB, which is not undervalued despite recent declines (Chart above). However, if tariffs rise an additional 25%, I would expect the CNY to depreciate 10% or so.
• Japan will be encouraged to allow the undervalued JPY to appreciate (Chart above).
• Vietnam will be pressured to open its market, and end the re-export of Chinese products to the USA.
• Asian nations could face 10% tariffs unless market accesss improves significantly. Nations will be encouraged not to allow FX rates to depreciate. However, I expect declines of roughly 5% in most Asian exchange rates. PHP and THB are quite overvalued (Chart above). The overvalued Indian rupee may decline more than usual if worries about slower growth spread. The outlook for Asian FX becomes more complicated if CNY weakens more than expected.
• Many Latam currencies are already undervalued, and trade imbalances with the USA are small (Chart above). However, political differences could lead to restrictions on agricultural trade. And, Brazil’s fiscal position remains a mess.