Europe and China were already struggling before the election, and with Trump likely to prioritise ‘America first’ policies, the two regions will have to respond.
The re-election of Donald Trump is likely to have far-reaching consequences beyond the US. Domestically, the incoming President will almost certainly introduce more fiscal stimulus, meaning governments elsewhere, notably in Europe and China, will have little choice but to follow suit to offset any negative economic effects stemming from aggressive trade policy.
At face value, risk markets may continue to cheer the prospect of such ’pump-priming’, so we think a pro-risk stance remains sensible. However, it is imperative investors consider the downside risk that geopolitical hostilities lead to a fall in corporate confidence and recession, as well as the risk that inflation re-emerges and pushes bond yields higher.
The cross currents of taxes and tariffs
Prior to the election, the US economy appeared to be moderating as pandemic-related household savings were run down. The labour market in particular was showing signs of cooling, but in a reassuringly orderly fashion. The fact that the majority of households and corporates were dealing so well with higher interest rates was an encouraging sign of the underlying health of the US economy. With cooling activity came a reduction in inflationary pressures and the prospect of potentially significant monetary easing.
The re-election of Donald Trump brings with it the potential for new fiscal stimulus. The tax package that President Trump enacted in his first term will now likely be fully extended, rather than expire at the end of 2025 as previously legislated. If he can get support for these policies they would be supportive for household spending and corporate earnings.
There are two risks that could temper such a positive outcome that will require monitoring as 2025 progresses. The first is the risk that ongoing large budget deficits and talk of more stimulus unsettles the bond market and what is put in pockets via lower taxes is taken out in the form of higher mortgage and corporate borrowing rates, as long-term Treasury rates move higher. The second is that tariffs damage consumer and business confidence.
President Trump is certainly asking bond investors for a lot (Exhibit 1). On current policy, the fiscal deficit already looks set to stay in the region of 7-8% for the coming decade, and debt as a percent of GDP to rise to over 120% (Exhibit 2).
The bond market has digested the news of a Republican sweep relatively well so far. Where yields go from here depends on how the potential for further fiscal stimulus interacts with the potential delivery of some other campaign promises.
Tackling migration was one of the issues at the heart of Trump's campaign, and he has promised draconian immigration curbs and large-scale deportations. The last successful deportation effort was in 1956 under President Eisenhower, when roughly 1.3 million immigrants were expelled. Whether deportations prove to be practically realistic, much more stringent controls at the border, more challenging conditions for gaining asylum, and the prospect of workplace raids are likely to significantly deter both prospective migrants and US employers.
This will impact the labour market. It's worth remembering that the massive increase in immigration in recent years, while clearly upsetting the electorate, has played a major role in the US's ability to maintain a strong rate of growth and at the same time bring down inflation. A significant reduction in migrant workers could reignite wage pressures and inflation concerns.
Firms’ cost pressures could also rise if the self-titled 'tariff man' enacts large and widespread tariffs on imports. He has stated that he will impose a 60% tariff on all goods entering the US from China and a 10%-20% tariff on goods arriving from all other regions.
Is this a day one priority or a starting point for negotiation?
We expect the tariffs on China to be delivered. China being an 'unfair trader' is a view with bipartisan political backing in the US. While the 60% rate is an eye-catching number, it's worth noting that the volume of trade that the US conducts with China has already fallen significantly since President Trump's first term (Exhibit 3). Friend-shoring and near-shoring has occurred remarkably quickly, in part thanks to Chinese companies themselves moving their production to other locations like Mexico.
A blanket tariff on all other regions would have more profound effects, but how far will President Trump push this agenda? On the one hand he, and key members of his team such as his former trade negotiator Robert Lighthizer, are clearly ideologically predisposed to tariffs. They do not believe in the advantages of free trade, and see tariffs as an easy revenue raiser to fund tax cuts at home.
However, it is not clear that the President can impose a universal tariff by executive order. He has authority to do unilateral targeted tariffs, but broad-based tariffs seem likely to require congressional action and that will take time. Broad-based tariffs are also economically more risky. Recent years have demonstrated how much the electorate does not like inflation and a 10%-20% tariff on imports from all destinations is likely to have a greater impact on US price pressures. Also, the uncertainty that arose from Trump's first trade war did coincide with a dramatic decline in US business investment (Exhibit 4).
Therefore, we suspect there will be scope for other regions to negotiate with respect to tariffs. Those with the largest trade surpluses – including China, Mexico, Vietnam and Germany – are likely those where negotiations will prove most challenging (Exhibit 5).
One doesn’t envy the Federal Reserve (Fed) amid all this. US policymakers will have to disentangle how tax cuts will boost demand, at the same time as understanding how migration and trade tensions may curtail supply. All being equal, these considerations are likely to push up inflation and therefore reduce the likelihood that the Fed cuts rates meaningfully through 2025. It’s also worth noting the difficult relationship between President Trump and Fed Chair Jerome Powell. In his first term, President Trump frequently criticised Chair Powell for not being a 'national champion', going as far as to say in a social media post: “Who is our bigger enemy, Jay Powell or Chairman Xi?”. He has even threatened to appoint a Shadow Chair so that the President has greater oversight on decision-making at the Fed.
Our central assumption is that the Fed will be very reluctant to increase interest rates during Trump's presidency, and will be quick to act in the event of any weakening in the data. Provided that Powell succeeds in keeping bond investors onside, a central bank reaction function that prioritises growth should be supportive for risk assets.
Europe and China will have to react
What does an ‘America first’ approach mean for the rest of the world?
Europe and China were already struggling before the election. In contrast to the US’s demonstration of confident exuberance, European households and consumers have remained cautious and reticent (see our recent On the Minds of Investors). While US households have been happy to run down the savings they accumulated during the pandemic, European households have continued to build up theirs (Exhibit 6).
The allure of higher interest rates is part of the story (Exhibit 7), but fear has almost certainly played a role as energy costs remain high, the conflict in Ukraine continues, and discussions about higher taxes to tackle government deficits have resurfaced.
Within Europe, the UK has seen the most verdant and appears to be on a modest upswing as falling headline inflation and strong real wage growth have reinvigorated consumer spending. The recent budget from the new Labour government contained significant tax rises, but even more government spending which was front-loaded and therefore has the potential to provide a net positive boost to growth in 2025.
With a very small manufacturing sector, the UK is also less vulnerable than the eurozone to the ongoing global weakness in trade, as much of the global recovery in recent years has been driven by services demand.
The weakness in global goods demand may merely be a hangover from the pandemic. During lockdowns, households focused their spending on goods and when lockdowns eased, they shifted their attention to services and making up for lost experiences. At some point, we would expect spending patterns to normalise; there is plenty of evidence for a very high average age of durable goods at present, such as cars.
Persistent weakness in demand from China is also part of the story, since China’s post-pandemic recovery has been even more disappointing than that of Europe. The property overhang – after a decade-long building boom – has continually weighed on house prices. Given two-thirds of Chinese household wealth sits in property, the sector’s woes have unsurprisingly been a continual drag on consumer confidence. With a sputtering domestic engine, firms have focused on exports but this intense competition has further challenged European manufacturers.
At face value, the US election result looks like it will compound Europe and China’s problems, but we expect both China and Europe to meet this hostility with more support for their own economies.
China’s stimulus has so far focused on making credit both more readily available and cheaper but when the underlying problem is too much debt, making credit more attractive rarely provides a lasting solution. We anticipate that foreign hostility will lead Beijing to tackle the property and local government debt overhang more directly and provide more direct fiscal stimulus to households and corporates.
Europe’s ability to react quickly may be hindered by its own political problems.
In Germany, Chancellor Olaf Scholz’s designation of Trump’s re-election – paired with the war in Ukraine – as an ‘emergency situation’ that should allow for a temporary suspension of the debt brake1 was met with resistance from the fiscally conservative FDP party.
The government coalition has since collapsed and we are likely to see a general election in February. The fall in popularity of the FDP, according to current polls, suggests that the party’s fiscal responsibility is not being rewarded. Indeed, the FDP currently looks unlikely to reach the crucial 5% level needed in the popular vote to enter the German parliament. It is uncertain whether Germany can quickly form a government with a credible plan for its domestic economy and policy towards Ukraine. In our view, while the deficits projected in the US for the next 10 years seem unwise, Germany’s extreme obsession with fiscal conservatism appears like an extraordinary act of self-harm.
France’s political situation is similarly precarious. After President Macron called surprise legislative elections in June, his coalition lost its majority. It then took several months for a new centre-right coalition government to be formed, to the fury of the left-wing alliance which had won the most seats. Michel Barnier – the new prime minister – inherited a fragile fiscal situation. The deficit is projected to reach 6.1% over 2024, and France is now subject to the European Commission’s ‘excessive deficit procedure’, forcing it to spell out consolidation measures.
France’s new budget plan thus includes €40bn of spending cuts and €20bn of tax rises. This plan is likely to be rejected by parliament. If attempts are made to force it through via a controversial constitutional article, this could trigger a no confidence vote and new legislative elections, although these cannot be held before June 2025.
Europe also needs to reflect on its approach to climate policy. While it is undoubtedly admirable to prioritise the future of the planet, other regions do not have the same sense of urgency. Under President Trump, the regulation gap between Europe and other regions looks set to widen, becoming an increasing headwind for European industry. Europe either needs to adapt its current plans, or subsidise those companies affected and erect its own borders to protect against competition from goods produced in regions with less stringent environmental policies.
It’s tempting to be pessimistic and assume that Europe’s politicians will not have the urgency or ability to provide a solution to these problems. However, it’s often in times of global crisis that the eurozone’s policymakers are galvanised to step up. Consider the continent’s response to the war in Ukraine or the post-pandemic cooperation that led to the EU Recovery Fund, which was an extraordinary move towards a much needed fiscal union.
Today’s crises may again prove to be the vehicle for further stimulus. Many European countries now meet their NATO commitment to spend 2% of GDP on defence (Exhibit 8). But President Trump has recently said that this number should be 3% of GDP.
Government support may take time, so the European Central Bank (ECB) will be pressured in the first instance. Unlike the Fed, the ECB is unlikely to be hindered by concerns about a resurgence in inflation, so we still expect multiple interest rate cuts from the ECB over the course of 2025. Moreover, given how tight financial conditions are in Europe, this loosening of interest rates could have a material impact on the rate-sensitive business sector and perhaps even encourage households to spend some of their ample savings.
The Bank of England is unlikely to provide as much stimulus, given more robust demand in the UK and ongoing concerns about a tight labour market due to low and falling domestic participation.
Known unknowns
Overall, we have to remember that there is a high degree of uncertainty about US domestic and foreign policy and the policy responses that will be enacted by other regions. While an ‘America first’ policy stance might lead to ongoing ‘US exceptionalism’ across asset classes, we’d argue that at a multiple of 22x forward earnings, vs 14x in Europe, a lot of that relative optimism is already priced into the equity market (see Challenging the discount on European stocks and China’s stimulus and prospects for emerging market stocks). Investors also need to be very mindful about how to manage their equity allocations as the AI boom needs to progress from hype to reality (see AI investing: More broadening than bubble).
We should also recognise that beyond the cyclical implications, today’s picture reinforces some of the structural views that we have been communicating for some time. These include the fact that, with a regime shift in the interaction of fiscal and monetary policy compared to the pre-pandemic era, the risk of higher and more volatile inflation forces us to re-think the basics of portfolio diversification (see Re-thinking portfolio diversification).