Tariffs – Strategic or Spontaneous?

By Rayna Penelova on April 14, 2025

Unless you’ve been living under a rock, you’ve probably at least pondered what is going on with tariffs and what the recent changes mean for the economy and markets. Keeping a cool head in an environment when major news shifts at a moment’s notice is challenging to say the least. When discussing tariffs, we really need to focus on the larger problem, what we know about the proposed solutions, alongside the current state of the markets to gain a sense of what is happening and where the major risks and opportunities lie.

                Let’s start with the problem at hand. The US now has $36 trillion in outstanding debt, and we are running consistent deficits of around 7% of GDP, despite being in an expansion. The US dollar is overvalued by around 30% on purchasing power parity terms.  This overvaluation has an effect on US competitiveness when it comes to exporting products abroad. To solve the debt and deficit issues, bold actions may be unavoidable. Below we can see the rapid rise of interest payments on government debt as percentage of nominal GDP.  Interest payments now represent close to 4% of Nominal GDP. In addition, around a third of government debt needs to be refinanced this year adding even more urgency to the issues.

US Interest Expense as % of Nominal GDP

Source: Bloomberg; as of 04/11/2025

                Steven Miran, the current Chairman of the Council of Economic Advisors wrote an article outlining his ideas for restructuring the global trading system, called “A User’s Guide to Restructuring the Global Trading System.” It proposes a combination of policies designed to reindustrialize the US and address current deficit spending without having to raise taxes or drastically cut spending. Scott Bessent, the current Secretary of Treasury, has also referenced the ideas from this paper multiple times in interviews. The main points are summarized below:

• Tariffs aimed at incentivizing onshoring and raising revenue
• Tax cuts to offset some of the pain from tariffs
• Non-tradable, 100-year, non-interest-bearing bonds sold to allies
  • To finance defense umbrella
  • To mitigate trade deficits
• User fees on treasuries for foreign governments to lower interest costs
• Coordinated currency intervention to lower the USD
  • Sovereign Wealth Fund to make the US currency interventions more potent

It looks like we are now at the first stage of this effort. In his article, Miran points out several different studies that suggest that US-imposed tariffs under 20%, would not put excessive pressure on the economy. Therefore, it is not surprising that the tariffs announced on Liberation Day amounted to just under 20%. Also, an important argument he makes to justify tariffs is that in 2018 tariffs were entirely offset by the USD appreciating versus the Chinese yuan. He also pointed out that this effect means that the US consumer doesn’t feel the effect from the tariffs. Instead, the tariffed nation would bear the brunt, as they end up with lower purchasing power, the US government collects revenue, and the increase in the dollar offsets the higher price of the goods.  This seems to be a major argument for why tariffs would improve our fiscal standing. However, since tariffs have been announced, the US dollar has declined, which exacerbates the negative effects for our importers. At the end of the day, the premise is that by imposing tariffs the US would either raise more revenue, reducing the need for higher taxes in the US, or that industries will be incentivized to onshore production. On the inflation front, tariffs are expected to directly lead to only a one-time price increase, unless they cause people to demand higher wages due to cost of living increases, which could lead to an inflationary spiral. Therefore, an offset is necessary to help companies cope with the possibility of higher price levels and supply chain dislocations caused by tariffs.  

Tax cuts have the potential to be stimulative and mitigate some of the negative effects of tariffs. Tariffs are considered a form of tax. Therefore, by raising tariffs and cutting domestic taxes the negative tariff effect can be offset for US companies and consumers.  Tax cuts can be used to encourage onshoring, as well. Dan Clifton from Stategas even suggests that R&D or even the cost of new buildings could end up being deductible once the tax cuts pass through Congress.  However, we should also keep in mind that most of the package would be simply an extension to the current tax structure, so the stimulative effect would be suppressed. If the tax cuts are very aggressive, they may also be seen as adding to the deficit and therefore inflationary, which could lead to higher interest rates. 

The concept of the 100-year bonds that do not pay an interest rate and are not freely traded is quite controversial. The cornerstone of this idea is that the US defense umbrella is valuable and should be paid for by allied nations. A way to do that is by having the US dollar denominated foreign reserves of those countries locked into a 100-year bond that offers no interest rates. If foreign banks needed liquidity, they would be able to borrow against them at the Fed. This would help the US resolve a large chunk of the debt problem, while locking in allies in the US sphere of influence, as they will be paying for US defense and unable to make other arrangements due to a significant portion of their foreign reserves being stuck in the US. At the same time, it would mean that some bond market pressure would be taken off public markets and absorbed by governments.   So how do you coerce foreign governments to make that change? By threatening large tariffs and a withdrawal of defense guarantees. Tariffs can be incrementally decreased as nations agree to the new defense pact. If they don’t agree, then the US would have higher tariff revenue and lower defense-related expenses.  As of now it seems like the European Union is not very keen on this idea, as Germany announced a new large-scale infrastructure and defense spending initiative, which even necessitated a constitutional amendment to allow for larger deficits. Every country is in a unique situation and likely to act according to their needs, but for now, we are seeing some resistance to US coercion and a push towards more self-sufficiency when it comes to defense.

The next piece of the puzzle is currency intervention which is necessary to make US manufacturing competitive on a global scale. Currency interventions only tend to work when all or most large central banks participate. When negotiating with other countries and with several proposals on the table that all impact currencies, those effects are likely to be discussed, making coordinated intervention more likely. The timing of such intervention must be very precise, given that a higher US dollar is desired to mitigate the effect of tariffs, but a lower US dollar is one of the conditions for reshoring to occur. To supplement the currency component of the plan, Miran proposes establishing a US sovereign wealth fund which would privatize some assets of the US government and when necessary, buy foreign currencies, to keep the dollar exchange rate competitive.

                At first glance, the US is in pole position to make ambitious demands. It has much lower exports than its trading partners and its allies are currently being pressured by the war in Ukraine and a mix of threats from Russia, such as higher energy prices. Asian allies are also under pressure from Chinese advancements.  However, there are key vulnerabilities in the US related to foreign holdings of US securities and the unwinding of the yen carry trade which were not discussed in the “User Guide to Restructuring the Global Trading System.”

Due to a mix of an accommodative Fed since the Great Recession, and even more so since Covid, and the remarkable technological advancements in the US, the dollar and US assets have benefitted tremendously by international flows of capital. For example, the US stock market is now 70% of the All-Country World Index, while representing just 26% of Global GDP. The vortex of a strong US dollar and technological advancements in the US meant international investors were enticed to buy US stocks without hedging the currency.  In April of 2024, the Treasury department estimated foreign investors held $26.9 trillion in US securities including $12.9 billion in stocks and $12 billion in debt securities. (https://home.treasury.gov/news/press-releases/sb0037#:~:text=The%20previous%20survey%2C%20conducted%20as,securities%20(see%20Table%20A))

At the very least, from the perspective of international investors, it is now risky to hold 70% stock exposure in one foreign market, even more so when that market is now accompanied by a volatile currency. US stocks, especially when purchased without hedging the currency, have delivered remarkable returns for foreign holders over the last few years.  The price below shows the massive divergence of stock returns between the US and the rest of the world’s. The divergence is now at extreme levels. With the new spending initiatives in Europe and the euro moving higher it is logical that foreign institutions will move their portfolios to a more balanced stance between US and non-US assets. That would create outflows and lower the propensity to buy the dip in US stocks.

Source: Bloomberg, MI2 Research; as of 03-27-2025

Another risk to US assets is the unwind of the yen carry trade. Japan’s central bank has been suppressing interest rates for a long time and pushing Japanese investors to seek better returns abroad. The capital outflows combined with the emergence of some inflation pressures caused the yen to continually decline.  Large institutions around the world were able to benefit from this dynamic by borrowing in Japan, benefitting from lower rates and a declining currency, while investing abroad, often with leverage, and repeating the process over and over again. The illustration below describes how this dynamic has benefited investors around the world over the last several years.

For illustration purposes only

 In August 2024, the Bank of Japan was forced to start raising interest rates which caused a large spike in the value of the yen and a correction in US stock markets. The orange line in the chart below is the Japanese yen vs US dollar. an orange line going up is Japanese yen depreciating. The blue line on this chart is the Nasdaq. The correlation between the two is remarkable!

Source: Bloomberg; as of 04-11-2025

As you can see, US asset markets have benefited tremendously over the last decade from a self-reinforcing cycle. However, this cycle can start to work in reverse, if other countries decide to stimulate more than us, in response to tariffs and defense considerations. There is an old market adage that money goes where it is treated best, and for many years it was treated best in the US. It remains to be seen if other countries have the willingness and the ability to incentivize capital to move back home. But future capital flows are a powerful bargaining chip for them.

If countries around the world start retaliating to US tariffs and enact restrictions of their own, we could see large scale demand destruction around the world and a Global recession. However, if they decide to spend money on infrastructure, defense and technology and add other stimulative measures, capital may be incentivized to move back home. The result could be a global inflationary boom. Inflationary, not simply because of tariffs, but because of supply chain shocks, as well as a demand surge for commodities. If the supply chain shocks are severe enough, we may face shortages and ultimately lower levels of growth. Many geopolitical analysts we follow expect a mix of stimulative measures, retaliatory tariffs and negotiations. Countries would want to have bargaining chips on the table once they sit down to negotiate with the US and retaliatory tariffs would be of benefit. They would likely attempt to offset some of the negative impacts from global trade imbalances by stimulating local consumption.

The recent 90-day pause in the reciprocal tariffs over 10% was most likely caused by the interest rates surging combined with the dollar declining, indicating outflows from US assets. In addition, the fact that inflation expectations as factored in by the market declined while interest rates increased, suggests the interest rate increase wasn’t due to higher inflation expectations but due to loss of confidence. This is very alarming, and the president’s administration could not ignore the warning. Afterall, one of their major objectives is to lower the interest expense of the US government.

The trade war is more than just that, it is an effort to restructure the global order, including trade and geopolitical arrangements. As such it is almost certain to cause a few more grey hairs to be on our heads. The short-term consequences of tariffs are felt right away while the restructuring they are trying to incentivize will take years to complete, causing a mismatch resulting in volatility in markets. Our aim is to gain a sense for what assets are likely to emerge as leaders and outperform over the next 2-5 years. The current environment is likely to lead to infrastructure spending not only abroad but in the US, since we aim to reindustrialize the economy. At the same time, the high uncertainty means that goods producers would aim to secure more than one supplier for each of their components. Supply chains are likely to move around with just-in-case taking priority over just-in-time policies, further benefiting raw material producers and industrials. We won’t be surprised to see a continued cycle of capital outflows from US assets back to other countries. In a world of rapid change, we need to keep a cool head and strive to see the forest for the trees in order to be able to adapt and identify the opportunities before us.