First tariffs, then tax cuts

• Trump 2.0 Scenario is Getting More Complex: The initial market perception of Trump’s second term as growth-driven and inflationary is being reassessed. As markets delve into the transformation of the political landscape, it becomes clear that the economic trajectory is more complex than initially anticipated.
• Tariffs first, tax cuts later: Trump’s recent cabinet nominations, which included key representatives of a hawkish approach to China, signal a greater focus on trade and tariffs than on tax reforms. Tax cuts are likely being prepared, but they will require Congressional approval and are subject to fiscal limitations, making them a secondary priority at present.
• Tariffs are negative for risk-taking: The emphasis on tariffs introduces uncertainty and volatility in the market, particularly in sectors heavily dependent on global supply chains. High beta stocks including small-cap companies and cyclical sectors are particularly exposed to trade disruptions. Global markets, particularly China/Hong Kong, will feel significant effects as trade tensions escalate. This creates a downside risk for stocks, especially those linked to international trade.

• USD as a safe-haven currency: In the face of downward pressure on currencies such as CNH and EUR, brought about by escalating trade tensions, the US dollar is gaining value as a safe haven.

As Trump’s policy takes shape, one thing is clear: tariffs are becoming a priority, signaling likely escalation of trade tensions even before tax cuts are implemented. This shift has far-reaching consequences for equity, bond, and currency markets.

How can investors tactically adjust their portfolios in response to Trump’s new strategy? Understanding its complex implications, which are likely to have the most significant impact on various asset classes, is a good first step.

Tariffs: Inflationary, but negative for growth

Trade war scenarios usually increase market volatility as the trade agenda tightens, which can heavily impact some sectors and regions most exposed to tariff-related risks.

Market implications:

Equities: The focus on tariffs is generally negative for risk-taking and impacts growth, corporate earnings, especially sectors dependent on global supply chains.

• US equities:: High beta sectors and small-cap companies (e.g., Russell 2000) are particularly vulnerable as supply chain disruptions hit them harder. Defensive sectors such as consumer goods, healthcare, utilities, and select retail companies with less exposure to overseas production may be relatively more resilient.
• International markets: Significant effects are expected for stocks in China/Hong Kong due to direct trade exposure and a weaker condition of markets in Asia and other countries or regions that are intermediaries to China, such as Europe and Australia.

Bonds: While tariffs can induce some inflationary pressure, their impact on growth can balance this out, supporting bonds amid a possible yield curve flattening.

Currencies: The US dollar may gain as a safe haven, while high-beta and cyclical currencies such as EUR, CNH, AUD, and MXN may weaken under trade pressure.

Tax Cuts: Pro-growth and inflationary

Once implemented, tax cuts can boost domestic economic growth and benefit sectors focused on the US at the expense of those more dependent on global markets. Likely beneficiaries are small-cap companies and cyclical-sensitive businesses that can benefit from reduced tax burdens.

Market implications:

Equities: Shares of small-cap companies (such as those in Russell 2000) and cyclical sectors may benefit from tax cuts, but this gain may be limited by broader trade and fiscal risks.

Bonds: While tax cuts may lift yields, uncertainties related to growth in the context of tariffs may counteract this effect.

Currencies: Economic growth driven by tax cuts would support the US dollar, particularly as other economies grapple with slowdowns related to trade factors.

Deregulation: Less macroeconomic, more sector-based

The Trump administration also signals a renewed focus on regulation liberalization, which can act as a pro-business catalyst in various sectors. This is expected to simplify operations in sectors such as energy, finance, and manufacturing, lowering costs and potentially boosting domestic growth. While deregulation broadly supports the business environment, its effects are complex across different asset classes, especially considering ongoing tariff-related pressures.

Market implications:

Equities: Deregulation positively impacts US equities, especially in sectors like energy, financial services, and manufacturing where regulations have historically been costly. Simplifying rules in these sectors can lead to greater operational efficiency and improved company profitability.

• Energy: Oil and gas companies can benefit from environmental deregulation, while the renewable energy sector may suffer if tax incentives for clean energy are revoked.
• Finance: Banks and financial services can gain more flexibility in terms of lending, capital requirements, and investment activities, which may improve their financial performance.

Bonds: The economic growth stemming from deregulation may exert moderate pressure on bond yields if it leads to higher corporate profits and increased economic output.

Currencies: The narrative of growth driven by deregulation strengthens positive sentiment towards the US dollar in the medium term with a lower likelihood of the Fed cutting interest rates.

Tariff policy becomes urgent

Tax policy often takes more time to form as it requires Congressional approval. There’s a possibility that some members may be concerned about record debt and deficits. Consequently, changes in tax policy that are ultimately introduced could have a narrower scope than what was promised during the campaign. Conversely, trade and tariff policy in the US can often be shaped and sometimes directly implemented via executive orders of the president. With cabinet nominations like Marco Rubio and Mike Waltz signaling a tough stance on China, tariffs appear to be the Trump administration’s immediate target.

In summary, investors should approach the equity market cautiously as tariff-related headlines are likely to be risk-off in the short term, which could outweigh the positive effect of tax cuts. However, regardless of outcomes in this area, the US dollar stands a chance to benefit from various supportive factors, including Trump’s tariff policy, fiscal policy, Fed actions, and geopolitical risks. This dynamic explains the ongoing strength of the US dollar, even as US stocks struggle to reach new highs. The resilience of the dollar is expected to persist, making it a key beneficiary of the current macroeconomic environment.

Commentary by Charu Chanana, Chief Investment Strategist at Saxo