Where will US policy land?
Trump started his second term with a much clearer sense of what and how he wanted to change America. The broad direction of travel seems clear to us, even if there is quibbling over the details of various initiatives.
First, however one wants to cut and slice it, the average tariff rate in the US is going to rise to levels not seen since the 1940s. There will be some bargaining here and there, and some exemptions given to some countries or sectors but Trump’s major objectives — re-industrialising the US, reducing its trade deficit and raising fiscal revenues — can only be achieved in his mind through substantial tariffs.
Second, a more transactional national security strategy is forming but its final makeup will depend on the push and pull among various factions representing anti-China hawks, straightforward isolationists and traditional political realists. There will probably be a period of debate over how much disengagement from Europe is warranted and what commitments to Asian allies will be needed to contain China. Ultimately, we believe that no administration can long forsake more than a hundred years of consistent American grand strategy, reflecting the key US interest in intervening abroad to ensure that no single power dominates either Europe or the western Pacific.
If that interpretation is correct, then America’s defence engagement with Europe may diminish but not fall away entirely. Similarly, it would mean that the US will remain committed to maintaining its presence in north and southeast Asia through a continued military alliance with Japan, South Korea and the Philippines and an unchanged commitment to defending the status quo in Taiwan. But this may take time to become clear, and the continued commitment will entail more conditionalities. That would render the Asian region less confident about America’s support in extreme scenarios. The implication would be spending a lot more on its own defences and a need to hedge against a future America which may be less dependable — and which may even cut deals with other big powers like China that leave smaller countries in the lurch.
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The third major area of change will be the US fiscal position. We do not believe that the well-reported budget cuts that Elon Musk is pursuing will significantly reduce overall spending. His efforts are targeted at discretionary spending which only accounts for around 27% of total spending. And of that small number, half is defence spending which will be very difficult to cut. The vast majority of spending is mandated by law and cannot be changed. Even a highly disruptive administration like Trump’s will baulk at illegally slashing social security and healthcare spending that its voter base treasures. At the same time, as the budget bill that the House of Representatives passed recently showed, there is still a strong sentiment to extend the 2017 tax cuts which expire this year while also making good on some tax cuts that were promised during last year’s election campaign.
That means that those who think the budget deficit is going to fall are out of touch with reality. The most likely scenario is that fiscal deficits will rise to exceed 8% of GDP in coming years and that the US public debt/GDP ratio will be much higher than the already stratospheric 156% by 2055 projected by the Congressional Budget Office.
How about other countries, what directions will they take?
So, this is the America that the rest of the world will now have to deal with — a country hostile to trade, extremely transactional in foreign and defence policy and one with a worsening debt position. As the rest of the world adjusts to this rougher world, there will be important repercussions.
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The first big change will be in trade. It is clear that most of America’s most important trading partners will retaliate against Trump’s tariffs. China, Canada and Europe have made this abundantly clear and we are sure they will follow through with their threats. Mexico has said the same but, being more dependent on the US and poorer, is likely to be cautious in its retaliation. Others like India and Vietnam are seeking to appease the US with offers of reduced tariffs on US goods and easing non-tariff barriers to entry. We suspect though that such appeasement will not save these countries from tariff hikes.
Thus, it is likely that we get a trade war of some kind until negotiations produce a compromise — but that could take months if not longer. Even after such a compromise is reached, trust among these trading partners would have been broken and the average tariff rate globally will still be materially higher than pre-Trump.
The next big change is likely to be in the formation of new strategic partnerships and alliances, in both the economic and security areas.
In Europe, new “coalitions of the willing” are being formed for various purposes — to support the defence of Ukraine, to provide a nuclear umbrella and to create a stronger European defence industrial base that is not reliant on the US for high-tech weaponry. In the economic sphere, over time, the UK is likely to negotiate a closer relationship with the EU, partially reversing Brexit.
In Asia, China, Japan and South Korea have resumed their triangular summitry after a break of several years due to regional discord. In late March, their foreign ministers met and that was followed by a meeting of senior trade officials from the three countries. A free trade agreement among the three northeast Asian economic giants is now possible. Japan and China are also making better efforts to improve people-to-people ties after a long period where public sentiments against each other became more hostile.
China and India are also moving to put aside the chill in their relations that followed violent border clashes in 2020. A military agreement last year to reduce border tensions has been complemented with more efforts to improve economic ties. China has promised to step up purchases of Indian goods to reduce its huge trade surplus with India. On its part, India is planning to roll back restrictions on trade and investment with China that were introduced after 2020.
We see such efforts intensifying in the coming years, driven by the need to hedge against a less dependable US and to diversify trade away from dependence on the US market.
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Following on from the above is a third big change — in defence strategy:
A large increase in defence spending is already underway, led by countries close to dangerous flashpoints like Poland and Sweden in Europe and Taiwan in Asia. This is virtually certain to accelerate in coming years.
One area to watch will be the nuclear arena. With the American nuclear umbrella for Europe and Asia looking somewhat less reliable, some countries are likely to think what was once unthinkable — becoming nuclear states in their own right. The debate began in South Korea some time ago and is quietly emerging in Japan. Poland is keen on securing nuclear protection but, realising that developing its own independent nuclear weapons would take decades, is leaning towards gaining protection under some form of all-European nuclear umbrella.
Conclusion: get ready for a great global restructuring
The big shifts will profoundly alter the shape of the world economy as the patterns of production locations and trade flows will alter.
First, imports in the US may be displaced by local production — but at a high cost.
In Trump’s first term, the narrower set of tariffs mostly aimed at China led to some production being relocated out of China to countries such as Vietnam and Mexico. The result of tariffs against China was to reduce China’s share of American imports while raising other nations’ share of US imports. The American trade deficit continued to worsen sharply.
But now, broader tariffs imposed on more countries will incentivise local US firms to invest in new production capacity and expand their share of consumer demand. In other words, the import-intensity of American demand should lessen. Foreign firms will also switch some investment to the US in order to avoid tariffs.
But because producing in America is less competitive, the costs will be higher than before. As American consumers bear these higher costs, their real purchasing power will weaken.
Moreover, as the cost of imported components will rise with the kind of tariffs that are planned, export-oriented American firms will become less competitive in global markets, so there could be a lower US share of world exports.
However, even with these changes, we may not see a fall in the American trade deficit. Fundamentally, the external deficit is the outcome of savings and investment trends in any economy.
A country like the US where the savings rate is lower than the investment rate will have an external deficit no matter what it does with tariffs. Thus, unless US policymakers address the savings shortfall, there will not be much improvement in America’s external trade position. There is no sign of that happening.
A second shift at the global level will be that trade and investment between other countries will grow faster than trade and investment with the US. Countries outside the US will pursue trade agreements among themselves to mitigate the loss of the American market.
While tariffs may encourage some re-shoring of production to the US from elsewhere it is not clear how substantial this will be. As some CEOs of global companies have intimated, they will hesitate to make big capital commitments to the US since they do not know whether the next American administration would reverse Trump’s trade policy — and also because they are deterred by the huge uncertainty created by haphazard policymaking and the dislocations caused by Musk’s attacks on federal government services.
Given this and the continued appeal of lower costs and more efficient manufacturing eco-systems elsewhere, it is more likely that offshoring to lower-cost economies will continue with the beneficiaries broadening out beyond the original winners such as Mexico and Vietnam. The rest of Southeast Asia and India may get more manufacturing investment as would countries on the periphery of Europe which enjoy market access to Europe such as Turkey and Morocco.
Finally, if America becomes more isolated and its economy burdened by higher costs and a weaker fiscal position, its appeal as a safe haven for portfolio capital could wane. At the margin, funds will probably diversify more away from the US. America’s exceptional financial dominance in recent years — its equity and bond market seizing an extraordinary share of international funds flows and the US dollar continuously ascending new heights — will come to an end.
Manu Bhaskaran is CEO of Centennial Asia Advisors
