On Sunday 2 February, President Trump signed 25% tariffs on Canada and Mexico, 10% on China. Canada and Mexico have vowed to retaliate against the US, raising the odds of a tit for tat trade war, says Peter van der Welle, strategist, Sustainable Multi Asset Solutions.

The move marks a new phase of the trade war, targeting multiple countries, to meet US economic and geopolitical policy goals.

While the freshly appointed Treasury Secretary Scott Bessent has been a proponent of a more gradual approach towards raising tariffs, Trump reiterated his threat to enact across-the-board tariffs that are “much bigger” than 2.5%.

Immediate market reactions

The swift execution of his tariff threat wrongfooted markets, spurring equity market volatility with the usual safe havens gold and the dollar rallying. After Trump abruptly pulled the threat of sweeping tariffs on Colombia earlier last week, after reaching a deal on the return of deported migrants, the market was convinced Trump’s bite would be softer than his bark. As things stand also in the enactment of the latest tariffs on Canada and Mexico,

Trump's bite is predominantly a function of his willingness to seal a deal on border security and achieve his policy goal on restraining migration. On Monday, Mexican President Claudia Sheinbaum said that tariffs will be held off by the US administration for a month, after speaking with Trump. In exchange, Mexico will increase efforts to secure the Mexican-US border. The news led to a swift weakening of the trade weighted dollar.

Asset market implications

Tariffs negatively impact global trade volumes as higher import prices lower demand for foreign goods. Our research shows that a slowdown in global trade volumes is typically associated with a stronger US dollar, higher gold as well as US Treasury bond prices and equity markets trading lower. The 2018/2019 tariffs announcements during the first Trump administration showed that the S&P500 as well as it’s Chinese counterpart the CSI300 traded around 2% lower in the subsequent 20 trading days.

With markets now forced to second-guess President Trump on further trade policy actions, US trade policy uncertainty has reached the highest level in 40 years, except for summer 2019 when the US-China trade war was at its peak. We expect market volatility to remain elevated near term in reflection of a significant risk of another high impact trade announcement towards China, Europe, and/or Japan.

The swift deal between the Mexican president and president Trump again underlines the mercantilist nature of the new US presidency. Countries with a high trade surplus with the US, like Germany, will likely take their lessons from Mexico’s gesture, take a pragmatic approach and fend off a tit for tat trade war by buying more US LNG and ramping up defence spending further above 2% of GDP. Yet, the EU works by consensus and more autarkic countries like France could prove to be a spanner in the wheels for the EU to form a strong, unified front in trade negotiations.

Broader economic implications

We continue to watch the impact on inflation and growth of trade negotiations by assessing three main transmission channels. First, the potential for US consumers to mitigate the erosion of their purchasing power by substituting away from tariffed import goods to cheaper domestic goods.

Especially rich countries like the US have a high demand elasticity due to available domestic goods variety, potentially denting the inflationary impact of tariffs. Second, currency market fluctuations play a critical role.

During the first trade war of 2018/2019, the strengthening dollar offset a decent chunk of the inflationary impact of the US tariffs on Chinese goods, whereas China mitigated the erosion of its competitiveness by letting the yuan slip against the dollar. Third, the duration of the tariffs put in place matters. Judging by the actions from the White House last week markets need to price the call optionality of any tariffs enacted.

Positioning

We saw complacency about the risk of tariffs announcements at the end of last week, bringing along more pronounced downside risks. This was on top of an already existing susceptibility to a trade shock judging by the gap that has opened last year between historically elevated P/E multiples and US earnings revisions.

A stronger dollar for longer erodes US multinationals external competitiveness, creating a potential earnings headwind. We therefore trimmed our equity exposure last week, while increasing our gold position and US dollar position.

By Peter van der Welle, Strategist, Sustainable Multi Asset Solutions