Contrary to expectations (or hopes) that President Trump would move slowly in his pursuit of higher tariffs, he announced over the weekend of 2/3 February that he would impose 25% tariffs on imports from Canada and Mexico and an additional 10% on goods from China. Tariffs will now also be applied on packages worth less than USD 800 from China, which will likely have a significant impact on its direct-to-consumer business model.
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The primary justification cited for the tariffs was the president’s view that Canada and Mexico were not making sufficient efforts to reduce the smuggling of fentanyl into the US. Seizures of pills containing the substance have increased dramatically over the last few years (see Exhibit 1).
Subsequently, in discussions with president Trump, both governments agreed to take significant measures to address the smuggling, allowing for a one-month delay in the implementation of the tariffs.
While one can disagree with the notion of using the threat of tariffs to achieve a political aim, president Trump’s strategy was successful primarily because of the extreme dependence of both Mexico and Canada on the US for their exports.
About 83% of Mexico’s exports and 77% of Canada’s go to the US. By contrast, just 17% of US exports go to Mexico, with a similar figure for Canada. The US economy is anyway far less reliant on exports for growth.
Trump administration sees tariffs as preferable to income tax
While there has been a reprieve in the short term, tariffs may nonetheless rise in the medium term due to the view in the administration that tariffs are a better alternative to income or corporate taxes as a source of government revenue.
President Trump posted on social media platform Truth Social that the system put in place in 1913, when income taxes replaced tariff revenue (a form of consumption tax), was a mistake. Previously, tariffs had ranged from 20-30%.
Not coincidentally, the tax reform passed by president Trump in his first administration expires at the end of this year. Though any subsequent legislation must be passed by Congress, president Trump may well take advantage of the opportunity to remake the current make-up of US government revenues (see Exhibit 2).
Investors are well aware of the potential catastrophic consequences of a global trade war, but if tariffs are imposed in a gradual fashion, companies would be able to adapt their production. The impact will nonetheless not be negligible.
The cost of any tariffs would be borne by
- Foreign producers to the degree that the US dollar strengthens
- US firms which would see margins squeezed as input costs rise
- Consumers paying higher prices.
Higher prices would not only be on imported goods, but possibly on domestically produced goods, too, as less import competition leads companies to raise prices. There would be benefits, however, if individual or corporate taxes are subsequently reduced.
The outlook for artificial intelligence (AI)
Though it already seems a long time ago, just last week markets were in significant turmoil after the announcement that a Chinese company, had been able to develop an AI tool at a far lower cost than the current market leaders.
This announcement led to sharp falls in the equity prices not only of semiconductor manufacturers, but also of other industries linked to AI. Even though markets subsequently rebounded, most industries were still nursing losses at the end of the week (see Exhibit 3).
While the developments will impact the profits of particular companies, we do not believe it fundamentally changes the outlook for AI-linked industries. Innovation is to be expected, and price declines will encourage greater usage of the technology. The slices of the pie may change in size, but the pie itself looks set to continue to grow.
US GDP slips in fourth quarter
US economic growth in the fourth quarter of 2024 disappointed: the headline figure declined to 2.3% from 2.8% in the previous quarter (quarter-on-quarter, seasonally adjusted annual rate). Core economic growth (GDP excluding government spending and inventories), however, actually rose to 2.8%, with consumer demand in particular still firm.
There was a surprising decline, however, in business investment. Investment in AI-related infrastructure should be ongoing, and previously planned investments linked to the Biden administration’s Inflation Reduction Act (IRA) would also have advanced.
The industry breakdown shows that AI investment was actually positive. The industries contributing the most to business investment growth were software, and research & development (see Exhibit 4).
There was less investment than one might have expected in industrial equipment and manufacturing, though the biggest drags came from transportation equipment and information processing equipment.
The former can be quite volatile as the investment swings from quarter to quarter are often large. But one might suppose that information processing equipment investing would almost always be positive as companies continually invest in computer hardware.
The reality is that investment in the sector often drops on a quarterly basis, even though the medium-term trend is positive.
Looking ahead, IRA-linked investments may well be cancelled, though some of the outlays will likely be directed to other sectors. A positive effect of cancelled IRA-investments will be to improve the US budget deficit as many of these plans benefited from tax rebates or credits that will no longer be used.
China purchasing managers’ indices (PMIs)
While the tariffs on Mexico and Canada have been postponed, they have not been for China. Nonetheless, the initial reaction of the Chinese government was muted.
The most recent PMI data may give a hint as to why.
Both manufacturing and services PMIs came in below expectations and declined compared to the previous month. Particularly worrying was the drop in the China Federation of Logistics & Purchasing Manufacturing PMI from 50.1 to 49.1, indicating that the sector had moved from slight expansion to contraction.
Observers had hoped for better following significant stimulus from the government over the last few months. With the Chinese economy continuing to struggle, and China’s far greater dependence on exports to the US than vice versa, it makes sense that the government would be looking to avoid any escalation in tensions with the US.
Looking ahead
PMI data for Spain and Italy will be released this week. Data so far for other countries in Europe has been modestly encouraging; the manufacturing sector is still contracting, but at a slower pace, and there was greater expansion in the services sector in Germany. If Europe can avoid an escalation in trade tensions with the US, reductions in central bank policy rates may give a further boost to the region’s growth.
The key figure for investors this week will be US non-farm payrolls data. Last month’s strong number provoked worries of an overheating economy. Forecasts of the number of likely cuts in the fed funds rate dropped. Subsequent inflation data has assuaged those worries, but comments last week from the Fed indicated that it remains concerned about the implications for both growth and inflation of the Trump administration’s policies.
Given president Trump’s desire to increase manufacturing in the US, even as deportations of illegal immigrants are ongoing, another robust payrolls figure could rekindle worries of a US economy growing too quickly for its own good.
