It was a relatively quiet week on the tariff front. Last Friday night we had more tariff exemptions, followed by promises (or threats) of sectoral tariffs. But since then, the chatter has become all about the deals.

Ok, there is the talk about firing Fed Chair Powell, but away from that, on the economic front, we seemed to have switched from the tariff phase to the deal phase.

I do not think firing Powell would be a good thing over time. It would be a step towards reducing (or eliminating) the Fed’s independence. I don’t always agree with their policy. I do think it is weird that they feel the need to have less dissent than the politburo on their votes. But I think the appearance (and largely reality) of Fed independence helps the dollar and the Treasury market.

But markets are more likely to move on “deals” than anything else in the coming days and weeks (assuming some new, major topic doesn’t get introduced into the conversation).

Deal Messaging

The administration is touting deals. Progress. More deals. However, the administration seems to have backed off from stating that countries are begging for deals.

The U.S. messaging is clear (and less aggressive than before):

• Countries are calling. Countries are lined up.
• We will get deals. Good deals.

The messaging from the rest of the world is far from clear:

• Japan specifically met on trade and provided almost no detail. Neither side seems to have leaked any details.
• China has said very little, if anything, through official channels. Not too surprising as they are “public enemy number 1” but it doesn’t support the administration’s messaging that China is coming for a deal.
• I’ve spent hours looking for details on the deals, from the U.S. and abroad, and cannot find anything outside of the U.S. Even within the U.S. the messaging seems a bit mixed, though it is still leaning towards rectifying unfair situations and improving trade balances.

With little to no information, we have to guess which is an issue, but at least it can help us prepare a plan for how to react to the headlines.

What Are Tariffs Meant to Achieve?

The first problem in trying to evaluate our trade and tariff policy is trying to understand what tariffs are supposed to achieve.

• A bargaining position.
  • I’m not sure what we are bargaining for, but this would indicate that tariffs would be temporary.
• Increased sales of Made in the U.S.A.
  • Imported goods would rise in cost relative to domestic goods, which should increase domestic sales. That requires tariffs to stay in place.
  • If tariffs against the U.S. are reduced or eliminated, then American made goods would be less expensive to import. This would likely occur only if the tariffs were temporary.
• A revenue source. Tariffs would have to remain in place for them to generate money.

Some of the objectives that have been presented by senior people in the administration cannot co-exist. Deciphering which reasons are most important has been incredibly difficult.

One question that comes to mind is how big of an impact will tariffs have on the ability to increase sales of Made in America products?

• If tariffs stay in place, will the price increase on imports be enough to drive Made in America sales? Will it be enough to invest in factories, etc., to build more to sell?
• If other countries abandon tariffs, how much will Made in America sales increase? Very difficult to tell as non-tariff barriers can be as impactful or more impactful than tariffs. Also, it is unclear how much is a function of demand for American products, as opposed to tariffs.

With that part of the equation as clear as mud, let’s move on.

What is Missing in Trade Math

I think we can all safely agree that the administration is focused on trade deficits. We can all argue about a lot of things, but this much is clear. It is consistent with Trump 1.0 as well. Heck, it is consistent with things President Trump said long before he became president.

There are two things that I think are insane to be left out of the trade conversation, yet they are.

• The trade balance of services.
  • Why aren’t services included in our overall analysis of trade with other countries? The U.S. currently has service surpluses with most countries. Maybe it is more difficult to imagine “cloud computing” being manufactured, but it is the sort of thing that the U.S. is exporting – very effectively. Since we all know that the U.S. has become a service economy (for better or worse), it seems insane not to include this number as part of any overall trade analysis.
• Profitability of trade.
  • I assume some things are more profitable than others. If we export things with a higher profit margin than the profit margin made on what we import, basic trade balances overstate the issue. If I buy $200 of stuff from you, that you make 10% on, but sell to you $100 of stuff we make 20% on, are we more balanced than a 2:1 import vs. export ratio would indicate? I think somewhere in the conversation there should be a consideration about profitability, but nowhere does that seem to show up. Services that we export are likely very high profit margin.

A couple of other things “irk” me. Not insane, but curious at least, why they don’t come up more.

• Raw materials and intermediate goods, versus finished products. I haven’t spent much time on this, but it seems to be that knowing more details about this type of trade would help us make better decisions. Are all trade balances equally bad?
• What happens to goods manufactured for an American company that don’t come to America? I presume (for many global companies) that only a portion of the goods they make come back to the U.S. Some are probably sold in China. I assume, that for many, if you want to sell into Asia, you don’t bring them back to the U.S. to sell into Asia. So, an American company that builds something overseas and then doesn’t import it helps that American company. Though conversely, that also means that even more things could be made here because the trade deficit is even worse.

I’m not sure how we got to where we are on trade balances, but I suspect a more detailed discussion and analysis would reduce the perceived problem, rather than amplifying it. But that is not where we are.

The Tariff Rollout

Before thinking about what deals might occur, we do need to look at the tariff rollout.

• China, Canada, and Mexico. Initial wave of tariffs were given a “Fentanyl Reprieve” for Canada and Mexico. Despite what looked like some efforts on that front (especially from Mexico) the tariffs went ahead as the fentanyl reprieve was waived. Maybe the reprieve can come back again. The initial reprieve was positive regarding how the U.S. might address tariffs, but that went to the wayside and hinted at some level of confusion.
• Steel and Aluminum. Separate from other tariffs and were implemented globally. Demonstrated the administration was serious about tariffs.
• Backing off on USMCA Compliant Goods. First autos and then all USMCA compliant goods were exempted from the Canada/Mexico tariffs. Seems like this could have been anticipated, which likely affects how countries come to the negotiating table.
• The Liberation Day tariffs. Literally instant disbelief over the numbers presented. Reciprocal tariffs were anything but reciprocal. To the rest of the world, this looked like the U.S. had gone “off the deep end” on tariffs. (Even to many in the states).
• The Liberation Day tariffs went into effect. More confusion for markets.
• 90-Day Reprieve and “Reciprocal” Tariffs of “only” 10%. What an amazing rally in the stock market. Suddenly 90 days to negotiate (which seems like it would have made sense from day 1). Also, while 10% is at the high side of overall tariffs between countries, it was at least in the ballpark. China was not given a break. It seemed like maybe the administration was reading the T-Reports, and this had pulled us back to the “somewhat reasonable” zone and clearly indicated that China was the main priority.
• Some further exemptions on products, primarily tech. Another thing that made sense, though this looked like the U.S. was once again backing down on something they could have foreseen as an issue.
  • Then statements about how National Security and sectoral tariffs would pick up the slack here. Though it has been quiet since then.
  • Further restrictions on what chips can be sold to China. Hit some U.S. stocks, but further enforced the view that China is public enemy number 1.

How the tariffs have been rolled out and have evolved, I think is important.

The Foreign Mindset Coming Into Negotiations

As countries come to the negotiating table, I think this is a reasonable assessment of their state of mind.

• Some confusion over why they were targeted and the amount they were targeted with.
• Some trepidation about needing the U.S. market, but also about how much they can depend on any deal going forward.
• At least somewhat encouraged by what they may see as a series of miscalculations where the administration had to back down because of damage done to our markets or economy.
• The Art of the Deal is quite simple and easily understood. During Trump 1.0, few seemed to understand that. This time, many, particularly Xi, seem to understand that. Presumably, Trump knows that others know the art of the deal and they are adapting. Though, given how events have unfolded, I am not sure that the U.S. policy wasn’t dependent on getting the same reactions from world leaders as they received under Trump 1.0.

My view is that countries are coming in concerned about the economic impact on their country, but with the sense that mistakes have been made, and there is some lack of trust (i.e. deals are going to be viewed as a stopgap solution, giving them time to figure out longer-term solutions).

The Deals

Finally, we get to the main point. Are we going to get “rip your face off” rallies on the back of deals? Or will deals or the lack of deals drag markets (and the economy) lower?

• Face-saving deal. Let’s for a moment assume the administration has had a “rethink” on tariff and trade policy. That they are hearing from so many businesses that the tariff policy as enacted is not helpful. That bringing manufacturing jobs back to America will take years (and would be better accomplished by focusing on domestic policy first, to get the ball rolling). The administration has clearly backed off, so, what would a face-saving deal look like?
  • Reduced tariffs on both sides. I’m 98% convinced this could have been achieved without taking many of the steps that have hurt the administration. The other countries, at this stage, are far more likely to understand both the tariff and non-tariff barriers they have in place and where to cave and where not to cave to get the best deal for themselves.
  • Commitments to buy American made goods – with a focus on defense and agriculture. No real teeth to enforce compliance.
  • Some commitment to not allowing China to use them to change “country of origin” designations. It’s a bit tricky, but not a big deal.

My estimate for this type of deal being offered by the U.S. to most countries has jumped from about 20% likely to 70% likely (given recent news flow and actions around tariffs).

The administration can claim a win, and anyone trying to point out that these results could have been achieved without damaging the U.S. reputation, will be shouted down in social media. The end state will be a similar economy to what we had before. Tariffs were only a portion of the problem, and a minor one at that. Countries won’t increase their actual purchases of U.S. goods for long. They will take the lull to figure out ways to be less dependent on the U.S. So, markets may rally on the first deal headline or two, but fade as markets will establish that the U.S. economy and U.S. corporations are in a worse spot after these deals than before this whole thing started.

• Real Trade Balance Deals. If the side that has advocated for bringing production home wins, then the U.S. will need deals like this:
  • Commitment to buy American made goods, with hard figures and punishments for failing to comply. A real effort to ramp up sales of American made goods. Countries commit to buying from America and face punishment (presumably high tariffs) for failing to comply. This might be difficult for many countries to agree to.
  • Restrictions on business with China. At the very least, countries will be forced to acknowledge that China can not use them as a conduit to change country of origination. The U.S. may try to get other countries to tariff China (which would make U.S. imports look cheap relative to China). Some willingness to combat China’s worst offenses is likely palatable, but countries will be careful about being too aggressive against China, given China’s size, and in some cases, its proximity. Also, given the erratic nature of U.S. trade policy since the inauguration, countries have to be more hesitant to be perceived as anti-China than before the policies were launched.
  • Tariffs as a mix of revenue, punishment, and wins. Tariffs drop in importance if the true aim is to get trade balances in line.
  • It would be nice if the two things that I think are missing from the tariff math are incorporated into the administration’s view, as the starting point would be much closer than it is currently being viewed.

Let’s assume this approach is now only used 30% of the time. I think this approach has a very low success rate. Countries, for a variety of reasons, are likely to resist this. As time goes on, if we don’t get deals, the market will sense that the U.S. has over-reached and will have to price in more economic problems and lower corporate profits. If the U.S. gets deals of this nature, it would be a big and actual win.

The Path of Negotiations and Deals

My base case is that the U.S. likely started down the “Real Trade Balance Deals” path and that is why we are hearing so little from other countries. They are potentially left confused or even flabbergasted by U.S. demands and are not in a rush to sign that type of deal.

Maybe some countries cave and sign that type of deal, bringing more countries to that type of deal.

But if we go weeks without deals, or worse, leaks that countries are far apart, look for the negotiating strategy to shift to “Face Saving Deals” (if it hasn’t already).

I could be wrong on how I read the “cards” at the table, but that is my best estimate of who is holding what. I think the biggest risk for markets and the economy, is that one side thinks their cards are far better than they are (and from what I’ve seen so far, that risk seems to be more likely on the American side). That would mean the problems in the global economy would mount and the risk of a deep recession would grow.

Damage to the American Brand

If the entire world lets bygones be bygones, we can get back to roughly where we were before.

I just don’t see that.

I think there will be an extended period where American stocks, bonds, and products suffer from the geopolitical and economic actions taken.

I would love to be wrong here, but I don’t think I am. Especially since even if deals are signed, the news flow, economically, geopolitically, and domestically will certainly highlight divisiveness that doesn’t help heal any wounds that have been created.

Bottom Line

I think the volatility and “beta” to any given headline has been reduced.

I think this is a path back to where we all thought we were headed – growth fueled by business-friendly strategies. Taking actions to spur the development of domestic industries, with an emphasis on issues linked to National Security. The extraction and PROCESSING of commodities, especially those that are energy-related, or crucial to future tech. Chips. A more domestic-focused policy can achieve the goals over time, and have a narrower range of outcomes (that are more predictable than trying to rebalance global trade relationships, that took years to form, in a matter of months).

A pivot is required, and we might get it.

I would be pleasantly surprised to see some very strong trade deals announced, but my base case is that we realize that this approach isn’t working, and we wind up getting some face-saving deals.

The economy is slowing, and I think that will become more evident in the coming weeks (unless I’m surprised on the “big trade deal” front).

The U.S., as an investment choice, a tourist destination, or a brand more broadly, is going to act to slow the economy and markets.

That should be good for rates, but all the hope about deficit reduction seems to be diminishing. Much of what I think would be required to make a pivot successful will involve spending.

I think that keeps bonds in a range (maybe a wide range of 4.1% to 4.5% on 10s) but a range, nonetheless. At the moment, the risk of breaking out of this range is to the higher yield side. I see more headline risk to bonds than optimism, especially on the deficit side of the equation.

Equities will suffer, in dribs and drabs, if the U.S. doesn’t back down on what we hope to achieve in trade negotiations.

To me, it comes down to undoing a lot on the trade front and pivoting sharply to doing what is in primarily U.S. control.

Good luck and hopefully the shelf life of this thought process is more than a few hours. 😊

The rate at which announcements shaping the geopolitical environment, the economic environment, and the investing landscape is staggering.

Hope you have been able to use the long weekend to regroup and get ready for more!

And hopefully it is Dealpalooza time – we could all use that!

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