ECB to cut rates as recession risks rise but markets dance to US tune

Steven Bell

Chief Economist, EMEA

Key Takeaways

Despite data and news supporting rate cuts in Europe, market sentiment continues to be driven by a focus on the US.
Recession fears raised by the Sahm rule have evaporated and expectations of deep rate cuts in the US have receded.
In Europe, pessimism about economic prospects is all pervasive. However, we think this is overdone and expect European growth to steadily improve over the next year.
UK attention is focused on the upcoming budget at the end of the month

Transcript

Donald Trump’s decisive victory opens the way for a dramatic reorientation of US policy, from a reversal of climate change policies, deregulation, and tax cuts. These will all have far reaching effects. This week I want to focus on the impact of tariffs. In the election campaign, President-elect Trump vowed to increase tariffs on Chinese imports to 60%, more than double their current level, impose 100% tariffs on imported vehicles and Chinese imports routed via third countries such as Mexico and Vietnam plus a 10 or even 20% tariff on all other imports. This would represent a massive change. The general market view is that there will be big exceptions to the tariffs on China and that the threat of across-the-board tariffs will be used as a negotiating tool to secure concessions, both political and economic from other countries.

My view is that the market is being too complacent. The political pendulum has been swinging away from free trade since the Global Financial Crisis, indeed President Biden retained most of the tariffs imposed by Donald Trump in his first term. There will be important impacts on individual companies and sectors. And the movement away from free trade will harm economic growth and while the direct effect on US inflation might seem limited, once again, most market analysts could be underestimating the impact. It is true that the US is a relatively closed economy. Even a wide-ranging tariff would exclude services and many commodities. The direct effect of a 10% tariff might be to raise consumer prices by less than 1%. But domestic producers will raise their prices in the face of reduced competition from overseas. The strength of demand in the US economy, likely to be bolstered by renewed tax cuts will increase this pass through, including to wages. The market has already priced in significantly higher US inflation over the next two years or so. The Federal Reserve tends to look through one-off price increases but will slow the pace of rate cuts.

US GDP would be damaged by reduced access to cheap imports but assisted by reduced competition from abroad. The net effect is likely to be modest in the near term but if protectionism continues, the loss of gains from trade will dominate.

Retaliation by foreign countries is likely to be limited. The US exports relatively little to China and is already disengaging from that country. Europe would suffer more and even a modest hit to growth would be painful given the weakness of the economy. Experience from Trump’s first term suggest that retaliation would be limited to iconic brands such as Harley Davidson and various bourbon names. The UK would be less affected as it has a smaller manufacturing sector but would be less able to negotiate concessions given its small size. The ‘special relationship’ might matter little and the much discussed free trade deal would require concessions on agricultural imports that British consumers, and its EU partners would find hard to digest. If Trump does decide to relent on tariffs on exports from the EU he would seek concessions on areas like the regulation of US tech companies. All in all, China would suffer most, the authorities there would respond with more stimulus, the EU next and the UK least.

And the stock market? US companies’ profit margins would be boosted by the tariffs. A cut in corporate taxes would provide a further lift. Companies exporting to the US would be harmed. Despite the unpopularity of globalisation, it has raised consumer incomes and corporate profitability, so the long run effects are likely to be negative.

On balance, I don’t think the tariffs will kill the bull market. I do think the first 180 days will see a burst of policy changes from the new administration, emboldened by their electoral victory and a desire to reverse Joe Biden’s policies.

7 October 2024

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