Is this an aberration or a permanent shift?
We have always seen this as the inevitable escalation of tensions between the two major economic powers of our time, the US and China. Our view was further confirmed when the White House reduced all tariffs, except those on China.
To understand the history, we need to consider the four major events in modern history that led to this point:
- The Bretton Woods Conference (1944) pegged the US Dollar to gold, and all other Western currencies to the US Dollar, setting the scene for a post-WWII American economic, political and financial dominance.
- The Nixon Shock (1971), when the US, laden with debt, broke with the gold standard, ushering in an era of monetarism and free-floating currencies, capitalising on US dominance to repay the country’s building debts. It led to a massive inflation wave in the 70’s and the 80’s, accentuated by various crises in the Middle East.
- The Plaza Accord (1985), when Ronald Reagan decided that the system was not working, and pressured allies to allow significant US Dollar devaluation. This eventually crippled Japan’s rise and destabilised the US Dollar, which needed another accord, the Louvre Accord (Feb 1987) to try and repair the Greenback. Still, by the end of the year, instability persisted, leading to Black Monday (19 October 1987), largely considered the worst day in modern financial history.
- The Fall of the Soviet Union (1991). Whatever failings of a US-led global economic and financial system were covered by the end of the Cold War and the opening of new markets to the East
A US-led system worked ubiquitously in the years after WWII, which had left most of the world comparatively devastated. As other countries found their post-war footing, however, they would be able to compete in this US-based system, even outdoing its creator. Japan, Germany and China were the countries that emerged. Subsequent attempts to change the rules, in a way that would work for the US over the longer term, like the empires of old (the Dutch, Spain, Britain), didn’t quite succeed.
Higher labour costs and deteriorating demographics in the West were the larger trends and eventually led to a fall in productivity and competitiveness. The Chinese entry into the World Trade Organisation in 2000 allowed Americans to take advantage of cheap manufacturing for some items (car parts, clothes, electronics), reducing headline inflation. The internet accelerated trade between the two countries. China would turbo-charge its growth, and Americans would live better thanks to lower prices for many goods. The two countries became very quickly and inextricably linked, even if the geopolitical priorities of their leaderships diverged.
The internet also linked all countries together. As a result, a variety of business-driven commercial globalisation emerged, without, however, the express political strategic planning, or even acceptance, to go with it. The political class grudgingly yielded power to businesses because the system appeared to increase the wealth of their constituents.
What resulted was globalisation, without a governance system to support it. The US, through the US Dollar, the deep market and its global business reach, was the driving engine of this system. But it would sometimes act as a steward, and other times as an active competitor, seeking even to reset the whole system from time to time.
Despite the benefits of the system to America, popular demand for rapid improvements in the standards of living increased, prompting banks to exponentially increase the provision of credit, leading to the 2008-9 Global Financial Crisis. The wake of Lehman Brothers’s collapse saw a world in shock. Years of lower demand and productivity followed as central banks filled the growth void of busted commercial banks and reluctant governments. Their cheap money, focused capital mostly on financial markets, has inflated the prices of financial assets.
Investors found better returns in the stock and bond markets instead of investing in the real economy and infrastructure. As a result, growth lagged, industries dwindled, factories closed, infrastructure deteriorated, jobs became more procedural and less well-paid, and inequalities were accentuated. A precipitous buildup of government debt, to cover bailout costs and replace bank credit, was not enough to provide the growth consumers were looking for. Political furore in Western markets, across both sides of the Atlantic rose, as elected governments, re-empowered, found fault in the system, mainly China, due to its aggressive competitive practices.
By 2015, China had realised that it could not depend entirely on Western consumers, as winds were shifting. An initial focus on the internal consumer failed. The COVID-19 pandemic caused significantly inflated real estate prices to collapse, an economic situation which can hamstring growth for a long time. Exacerbating the situation were demographics, which crashed even after the “one child” policy ended. Emerging from the pandemic, instead of renewing its focus on domestic consumers, it doubled down on maintaining its role as the world’s cheap manufacturer, eventually bringing it into collision with the larger consumer, and the other superpower, the US.
The superpower clash was inevitable
In this context, tariffs are more of a negotiating tool in this trade war and less of an end, as can be seen from the White House’s frequent changes in direction. It is also evident in Stephen Miran’s (Chair of the Council of the President’s Economic Advisers) plan to impose tariffs and withdraw security from allies until enough agree to elongate some of the US debt and, effectively, sign off on a dollar devaluation. This means that tariffs may not be permanent. That is not to say that we expect to go back to pre-21 January. Rather than suggesting that the trade war is a step towards a new status quo, which we can’t yet predict, as it will, by and large, depend on the success of the strategy.
This became more evident when financial dislocations were enough to give the White House pause. The US President announced the delay of extra tariff implementation for 90 days for most countries after the Dollar and US Treasuries moved sharply down.
He shook up his economic team, which is now led by Scott Bessent, who markets consider thus far a level-headed actor, while Commerce Secretary Howard Lutnick and trade advisor Peter Navarro are confined to more auxiliary roles. Elon Musk, head of the Department of Government Efficiency and a close ally to the President, even went so far as to state that he would like a free trade zone with Europe. For many in the markets, this signalled that pressure from financial markets was enough for the President to tone down some of his aggressive rhetoric. Having said that, we would not adopt the narrative that markets would consistently “correct” and act as a check on US government policy.
Part 2: What do the US tariffs mean for the economy?
Our view is that this economic reset will have very far and wide-ranging consequences, a lot of which are currently unpredictable. Having said that, we do not anticipate a pandemic or 2008-like downturn.
Sharp economic recessions usually come from two factors;
- Financial crises
- Geopolitical externalities (wars, pandemics, etc)
While disconcerting and certainly unpredictable, the Trade war has the makings of a geostrategic shift more than those of a typical economic and financial downturn.
JP Morgan and Bloomberg analysts suggest that pursuing this trade war could cause an initial bump in core US inflation to 4.5%-5%, leading to 7% headline inflation.
Market estimates also suggest that growth, on the other hand, could slow by about 1%, to just north of 1%-1.5% per annum. Meanwhile, the EU could lose about 1% of its growth, effectively stagnating or going into recession, and China could lose half its stated growth, before accounting for any retaliation. JP Morgan’s Bruce Kasman suggested a 60% chance of a global recession. Interest rates may come down across the board, but it would take time for them to work, and they may not be enough to counter the economic damage.
In terms of the real economy, we expect growth to fall across the board, with Europe and the UK closer to a recession, as a result of lower growth pre-2025. Probabilities for a US recession have also risen, but it remains a closer call than Europe. Unemployment, as a result, would likely move higher.
Inflation remains a question mark. Where it will go is especially unpredictable, and no one can confidently forecast it. In the US, our base case is that inflation will rise if growth doesn’t fall too abruptly. In Europe, we expect deflationary rather than inflationary pressures to prevail. However, a lot will come down to consumer behaviour and the sum of the business approaches. Markets are pricing in a rebound over the shorter term. This is not suggested as much in longer-term positioning, however, which suggests that investors may be pricing in slower growth going forward.
For the US, two scenarios are gaining traction. One, where inflation is transitory as growth drags down demand, essentially moving the economy from “inflationary boom” to “deflationary bust”. The other, where it is not, and the US enters stagflation. For Europe, we believe that the higher probability scenario is that of lower growth and inflation, a “deflationary bust”.
In terms of interest rates, we would not expect the Fed to keep lowering interest rates even if inflation picks up. Presently, the market is pricing in nearly 3x cuts across the board. We feel that risks are to the upside (higher rates/fewer cuts) rather than to the downside.
Conversely, in the EU, US tariffs will likely cause a more immediate growth slowdown. So risks for the Bank of England and the European Central Bank are likely to the downside (lower rates/more cuts). The UK’s Office for Budget Responsibility has already halved the UK’s growth projections for 2025 at its most recent update.
Whereas disruption will likely continue, we don’t see a global financial and economic system that drifts decisively away from the US Dollar in the short term. Over 57% of global reserves are still in Dollars. The US features half of the world’s equity capitalisation and the deepest market by far. Deregulation will actually be inviting for capital (although the government may soon find out that it takes stability, not just deregulation, to fight uncertainty). The US wants to reorganise the global economic and financial system, while still retaining the advantages of Dollar primacy. Over time, we could see a more multi-polar global financial system, to be sure, but we see this as a very gradual process, one likely to take over a generation.
Part 3: What are the tariff implications on markets?
After “Liberation Day”, US large caps had one of their worst 2-day performances in recent history. Only three times since 1950 was a two-day event worse: 1987 Black Monday, the first days of the Pandemic and November 2008, the depths of the Global Financial Crisis.
Despite being in equity-crisis mode, the good news is that in this risk-off year (so far) markets and diversified portfolios mostly behave the way they are supposed to. Previously inflated US tech valuations have come a lot closer to planet Earth. Meanwhile, most non-US bonds still behave like the safe assets they are supposed to be.
Markets are waiting for the US Federal Reserve’s intervention, or at the very least the affirmation of the Fed Put, a reminder that when market stability is threatened, it will step in to buy assets. The most important global economic and financial agent, the central bank issuing the global reserve currency, is slow to respond, as it is also in a fight for its independence.
We believe that volatility will likely persist, as uncertainty remains. Having said that, as long as the Federal Reserve is allowed to operate as usual, we expect asset price movements to remain within normal limits, avoiding a financial-crisis-driven recession.
Given the President’s stance on the Fed, however, we feel compelled to remind readers that the Fed really has control over short-term rates. Longer-term rates, which include inflation expectations, are moved more by market forces and less by the central bank. The Fed can influence them, up to a point, especially if they buy long-term Treasuries (what is known as Market Operation or Quantitative Easing). If the Fed’s independence is somehow impeded, then the US could completely lose control over the long end of the curve, and borrowing costs would become unpredictable.
Read more on what the tariffs mean the the global, European and UK markets.
Part 4: What should businesses do following the tariffs?
Businesses want a modicum of predictability. Accepting that this is difficult, as political and economic entropy accelerate, will allow business leaders to take the necessary steps to build resilience that this business cycle requires.
We believe businesses should consider these points carefully:
- Acknowledge that a US-led global economic and financial system is prone to crises and revisions. Like the empires of old, the US frequently revisits the arrangements when it feels that the system is not necessarily working for it. Far from being one man’s folly, the 2025 trade war is another iteration of the Nixon shock and the Plaza and Louvre Accords. Its impact only emphasises the centrality of the US to the global economy, as it did in 2008.
- Build resilience. Underlying tensions will not just go away. We described a world where big changes happen roughly every decade. Entropically, those forces only continue to build up. The debt increase in the past decades, now 330% of annual global GDP, may limit further growth by borrowing. The AI revolution and a new global trade system in reverse will only accentuate pressures on corporate leaders.
- Build local expertise. A company that maintains its wish to compete fully across a multipolar world needs to remember that the commercial globalisation which made such endeavours relatively easy is now in remission. Besides the internet, there’s no major global force facilitating global expansion. The competitive differentiator will likely be that of deep and rooted local expertise. A corporation can build it, or it can buy it.
- Maintain agility. Local expertise as a differentiator means trusting local individuals to pursue business goals. Simply put, a “one size fits all” top-down strategy may not work as well as it did in an age of geoeconomic fragmentation. To fully exploit local potential, corporations should explore empowering local managers to remain flexible in investments and talent acquisition.
- Double down on tech investment. While the tech dream might for many a CFO seem like an unnecessary diversion, in fact, it may be technology that will ultimately help corporations break through a world that experiences such tectonic shifts.
- Find “bubbles” of stability and build resilience through diversification. Regions like Europe and the UK, previously unloved due to red tape and stricter regulation, may provide stability and predictability in an age where the winds may shift any which way.
Part 5: What should investors do following the tariffs?
Portfolio managers will seek to actively manage volatility to remain in line with their mandates. Every day that passes will be a day where investors and businesses will factor in persistent White House uncertainty and look for ways to move away from uncertainty and find pockets of relative stability, hoping that the US will eventually return to the world itself built.
Diversification exists precisely for events like that.
Investors and portfolio holders should think long-term. Ignoring any timing, if an investor bought US large caps a few days after Lehman’s collapse, they would have still made 10.94% per annum since that point – including the last two-day retrenchment. The average return since 1950? 11.2%. It is rarely the initial investment point that matters as much as taking long-term views and maintaining trust in the system to deliver returns.
Over the shorter term, of course, all outcomes are open, especially in such a volatile environment. Over the long term, however, there are three types of investors who more often than not lose money or lag performance:
- Those who run for the hills, crystallising losses and never really getting back until all the good news is priced in again.
- Those who buy mostly on strength or only after good news have been punished: investors who bought at the apex of the .com bubble made only 7% per annum since then.
- Those who fall in love and forget to diversify. They would bet everything on one theme, becoming so immersed that they often forget to sell before said theme inevitably turns around.
However, we understand it’s difficult not to be afraid. One can argue that “this time is different”. The global trading system, the driving force behind Western economic disinflation, >10% equity returns per annum in the past couple of decades, as well as a massive upgrade in our way of life, is undergoing a secular (non-cyclical) shift, which could cause long-term damage.
This is the point where we, as investors, need to be very cautious. There is damage done, and there is damage that may happen. There is also economic risk, and there is investment risk. These notions need to be distinguished. So far, actual damage is limited to uncertainty over how central market performance is to this new “Washington consensus”. Potential damage to the real economy may be bigger than the damage to the financial economy, given that central banks often offer a safety net after volatility rises significantly.
Over the short and medium term, markets may perform better than the economy, as sluggish growth could lower the cost of capital and improve returns. However, over the longer term, growth (or recessions) could very likely weigh on earnings enough to cause more frequent corrections. Meanwhile, in the real economy, slower growth and economic pain could spread.
Part 6: How worried should we be?
The true $2tn question lies not in the intention or the plan, but the execution: Can the US achieve strategic gains before market instability rises and spills over to the real economy?
On the one hand, we need to remember that there are backstops. So far, we are dealing with an equity market problem. The bond market is less volatile and investors are still finding pockets of safety in non-US bonds. Businesses have built up some resilience, in the form of higher inventories, so they can withstand a few weeks or months of trade pressures. Central banks have likely been drawing battle plans. The pullback doesn’t find investors severely leveraged, which is also good for systemic reasons. Governments, despite high debt, are also likely to deploy some stimulus if it comes to that.
Still, equity markets have been tumbling very quickly. Investors are trying to add risk premia to the trade war, but can’t calculate the magnitude of risk at this point. Already, the personal wealth of consumers is suffering, and business planning (hiring, investment) is being severely disrupted.
For the US administration to achieve its plans, time is of the essence. Can the President sit down with enough economic blocs to reach some sort of a deal before the market pressures become too pronounced, threatening to destabilise the economy and the global financial system?
For the US administration to achieve its plans, time is of the essence. Can the President sit down with enough economic blocs to reach some sort of a deal before the market pressures become too pronounced, threatening to destabilise the economy and the global financial system?
There are some scenarios where things turn out well. However, “hope is not a strategy”. The base case scenario is that things will become increasingly volatile as tariffs begin to weigh on the global economy. Professionals across the board should make sure that their investment and business plans, and decisions capture that uncertainty.
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