Viewpoints: 2025

In a piece in Haver’s Viewpoints section earlier this week (Strategic Uncertainty and Market Pricing: A Game Theoretic Perspective on Recent US Policy Shifts) it was argued that markets are struggling to price a highly uncertain and rapidly evolving strategic environment, marked by the Trump administration’s shift from cooperative to non-cooperative global games—most notably via aggressive trade threats that represent a sudden break from past policy norms. While asset prices had been reflecting reduced US growth expectations, higher inflation risk, and a modestly higher cost of capital, the wide range of possible outcomes—amplified by geopolitical unpredictability—meant the path to a new global equilibrium was likely to be volatile and disruptive.

And this view has now been dramatically amplified following the decision by the US administration on April 2nd to announce a sweeping package of tariffs on a broad range of imports from key trading partners—including the EU, China, and several emerging markets. These measures were more expansive in both scope and scale than markets had anticipated, and they carry the potential for significant global economic disruption—particularly if targeted trading partners respond with retaliatory countermeasures, escalating the risk of a full-scale trade conflict.

How exactly this will reshape the world economy is still anyone’s guess. Will global supply chains fracture completely or merely bend? Will retaliatory tariffs hit US tech, agri-exports, or defence deals? Will capital flows seize up or simply redirect? Will monetary authorities act quickly enough to stabilize expectations?

But aside from game theory—which provides insight into the strategic logic of defection and retaliation—another useful framework for assessing the macroeconomic consequences of this shock is that of financial balances.

Financial Balances: An Accounting Identity with Predictive Power

Recall the national income identity in financial balances form: (Private Sector Balance) + (Government Balance) + (Foreign Sector Balance) = 0

That is: (S – I) + (T – G) + (X – M) = 0

Where: • (S – I) = private savings minus investment • (T – G) = government surplus (or deficit if negative) • (X – M) = net exports (i.e., current account balance)

If one of these balances shifts—say, a current account improvement via import compression—then either the private sector must reduce its surplus (invest more or save less) or the government must run a bigger deficit. The system must rebalance, always.

1. US Impact: From External Adjustment to Domestic Strain

The intention behind the tariffs is clear: compress imports, reduce the trade deficit, and ideally, bring back some production capacity to the US mainland. But as we've seen in past episodes, protectionism rarely leads to clean outcomes.

• If imports fall due to tariffs, and exports are simultaneously hit by retaliation, the net trade balance might not improve meaningfully. • That means the foreign sector balance (X – M) doesn't deliver the adjustment hoped for. So where does the pressure go?

It goes to the private and public sectors.

• Private sector balance (S – I) is likely to rise. Firms face greater uncertainty and may reduce capital spending, while households—facing higher prices on imported goods—could cut consumption. Net private saving rises. • This leaves the government to absorb the shock. With private retrenchment and a stagnant or worsening current account, the only way the identity can hold is via a widening fiscal deficit.

In effect, the tariffs may create an illusion of national self-reliance, but the reality is a fiscal offset to a trade-induced demand squeeze. Unless the US is willing to tolerate a deeper recession, fiscal stimulus becomes the balancing item.

2. Global Impact: Shock to Trade-Exposed Economies

Now consider the rest of the world—especially the major US trading partners. The tariffs strike at trade-dependent, export-surplus economies such as Germany, South Korea, and China. These countries have historically run external surpluses, allowing their private and government sectors to remain in surplus or near balance.

• If their exports to the US fall, their foreign sector balance deteriorates. • If they don't immediately offset that with stronger domestic demand (via fiscal or private sector action), then either their private sector must dis-save (less likely), or their governments must run larger fiscal deficits to compensate.

For surplus economies like Germany or China, this moment could trigger a major shift toward domestic demand rebalancing, but the scale and speed required are politically and economically challenging.

For emerging markets, the picture is more fragile. Weaker export revenues + capital outflows → tighter financial conditions → risk of pro-cyclical fiscal tightening, which worsens the downturn. Hence, EMs may become the shock absorbers of this global shift, through both growth and FX channels.

3. Inflation, Policy Recalibration, and Financial Markets

Tariffs act like a tax on imports. In the short term, that means higher prices, especially in sectors like electronics, consumer goods, and industrial inputs. If retaliation is met with further escalation, costs rise further.

At the same time, the private sector is pulling back—demand is softening, and investment is slowing. The result is a stagflationary impulse: higher inflation, but weaker growth.

• The Fed faces a credibility trap. Inflation is sticky, but growth is slowing. Cut too early and you risk fuelling inflation; cut too late and the downturn deepens. • The ECB and other central banks have a clearer path—softer inflation gives them cover to ease—but deteriorating global trade may limit the power of domestic stimulus.

Meanwhile, financial markets are struggling to find footing:

• Equities in global cyclicals, capex-heavy sectors, and exporters are weakening. • Bond markets are now arguably pricing a lower global neutral rate, with flattening curves and increased volatility. • FX markets are unsettled: EM currencies weaken, the USD fluctuates, and policy divergence risks new capital flow imbalances.

4. Strategic Rebalancing: A Slow-Motion Adjustment

The financial balances framework doesn’t tell us where policy should go—but it tells us where it must go if macroeconomic stability is to be preserved. If the external sector can’t deliver the adjustment, either the private sector must invest more (unlikely amid uncertainty), or the public sector must step in.

In the US, that likely means:

• A bigger deficit, at least in the near term; • A higher risk of longer-term fiscal sustainability debates; • And growing pressure for industrial policy, subsidies, and tax incentives to replace what trade used to deliver.

Globally, we are likely to see:

• Asynchronous policy cycles, with China and Europe stimulating more aggressively; • Ongoing FX pressure and fragmented capital flows; • And a world inching toward multi-polar demand models, where economies rely less on the US consumer and more on domestic engines of growth.

Conclusion: When Tariffs Shift the System

The new tariffs are not a policy tweak—they are a shock to the system. Through the lens of financial balances, we can already see how the global economy will be forced to rebalance: not by choice, but by accounting necessity.

In the short term, this means slower growth, higher uncertainty, and deeper fiscal footprints. In the long term, it may mean a less integrated world economy—with all the frictions and inefficiencies that implies.

The challenge now is not just to understand the game, but to read the scoreboard.

The Federal Reserve Bank of Philadelphia’s state coincident indexes continued to be on the soft side in January (February numbers will be released on April 9). In the one-month changes, Montana led with a .66 percent gain, while West Virginia and South Carolina had increases above .5 percent. 13 states registered declines, none greater than North Dakota’s .34 percent. Over the three months ending in January, only two states (Missouri and Wyoming) were down, both by small amounts. The gains were also somewhat muted, with only five (South Caroilina, Washington, Idaho, Utah, and Maryland) showing increases above 1 percent, topping off at South Carolina’s 1.35 percent. Over the last twelve months, three states were down, and eleven others saw increases of less than one percent. No state had an increase higher than four percent, and only three were higher than three percent. Washington’s index rose 3.66 percent, while Michigan was down 1.34 percent.

The independently estimated national estimates of growth over the last three and twelve months were, respectively, .61 and 2.41 percent. These both appear to be roughly in line with the state numbers.

Malaysia’s business cycle indicator assessment doesn’t make cheerful reading. Among eight Asian countries in our analysis, Malaysia’s overall indicator score ranks second lowest, just above Indonesia.

The profit cycle remains in a downswing. Since 2015, the return on equity for listed companies has stayed below the pre-pandemic (2013–2019) average of 10.8%. However, returns have improved for the second consecutive year, reaching just under 10% in 2023. Corporate balance sheets remain healthy, despite modest declines in cash flow and retained earnings per share. The credit cycle has yet to turn, with the two-year real cost of borrowing rising to 2.8%, exceeding the upper 2% threshold—an indication that monetary policy remains tight.

That said, Malaysia is in a stronger position than Indonesia, and we are overweight on Malaysian equities. The stabilisation of the profit cycle signals that the Malaysian business cycle is approaching a sustainable upswing. The key reason for our overweight stance this year lies in Figure 1.

As the Trump Administration moves forward with tariffs on a range of imported goods, it is useful to establish a benchmark for the potential inflationary effects of tariffs. To do so I modeled the impact on the price index for domestic demand plus exports of a 10% tariff on all imported goods, one proposal of then-candidate Trump.

First, some historical context. Chart 1 shows the average tariff rate on goods since 1929 and, for 2025, the rate implied by a new 10% tariff on all imported goods. Under the proposal, the rate jumps from 2.5% to 12.5%, a level not seen since the Great Depression, reminiscent of the infamous Smoot-Hawley tariff of 1930, and undoing decades of negotiations to reduce international barriers to trade.

Recent company earnings calls and sell-side analyst reports suggest heightened uncertainty and an unusual degree of hesitation among market participants regarding the future macroeconomic and geopolitical environment. In contrast, financial markets—as embodied by aggregate asset prices—must continuously express a view, even in the face of profound ambiguity.

Currently, the market appears to have revised its expectations in three key ways. First, growth expectations have declined markedly: our cross-asset growth factor implies that US GDP growth priced into markets recently fell from above 2% to effectively zero. We note in pasting that the Atlanta Fed’s latest Nowcast for GDP growth in Q1 is still negative. Second, inflation expectations have nudged higher. Third, there has been a modest upward revision in the expected cost of capital.

State labor markets were again generally little-changed in February, though three states (Missouri, New Jersey, and Ohio) had statistically significant increases in payrolls; moves in all others were not significant., though in some cases were up or down by more than 10,000. The sum of payroll changes among the states was well under the national result (88,000 vs .151,000). The January numbers now show a loss of 4,000 jobs when the state figures are summed, which is very much under the nation’s 121,000 increase. There are any number of reasons why the summed state result will differ from the nations, not only different seasonal adjustment factors, but also different base quarters for benchmarking the not seasonally adjusted figures.

Florida was the only state to report a statistically significant change (up .1 percentage point) in its unemployment rate. The highest unemployment rates were in Nevada (5.8%), California (5.4%), DC (5.4%), Michigan (5.4%), and Kentucky. Montana, North Dakota, South Dakota, and Vermont had unemployment rates under 3.0%, while South Dakota’s 1.9% was again the lowest in the nation.

Puerto Rico’s unemployment rate was unchanged at 5.4% and the island’s job count inched up by 100.

Trump's tariff theory suggests that by placing substantial costs on imports, it can alter the competitive dynamics in manufacturing, especially in the automotive sector. However, he and his economic team are mistaken. The transition from being a net exporter to a net importer is a typical evolution of a mature industry like the automotive business. American prosperity has historically been fueled by creating new products and technologies and importing other goods that others produce more cheaply. Trump's tariff policy will not lead to better balanced growth or an increase in manufacturing jobs; instead, it will raise costs and harm American companies and consumers.

Half a century ago, US companies dominated the motor vehicle industry, with General Motors, Ford, and Chrysler, the big three, making up about 70% of total sales. Currently, only two of these companies remain, and their market share has dropped to less than one-third, despite significant direct and indirect support from the federal government over the past several decades.

The US experiences a trade deficit in motor vehicles with both high-wage countries like Germany and Japan, as well as low-wage countries such as Mexico and South Korea, including those with which it has a free trade agreement.

The transition to becoming a net importer of U.S. motor vehicles aligns with the product life cycle theory proposed by economist and Harvard Business School professor Raymond Vernon. His theory suggests that products are initially developed in countries with capital, demand, and income. Eventually, as production and technologies become standardized, they are adopted or replicated in other regions, leading the country that originally created the product to become a net importer. This is a common outcome—consider the product life cycles of cars, computers, televisions, textiles, and so on.

Attempting to reverse this strong trend would lead to economic disruption, be extremely costly, and possibly the greatest disappointment is that it won't generate additional manufacturing jobs.

In the early 2000s, I published a study on global manufacturing employment in the largest 20 largest economies. My research discovered that from the mid-1990s to the early 200s over 22 million manufacturing jobs were lost, and the biggest decline occurred in China, with a net loss of 16 million manufacturing jobs. Since that study was published the US lost another quarter of its manufacturing jobs but so did other countries.

The study on manufacturing employment should send a straightforward message to Trump's economic advisors: improving the manufacturing sector is done by increasing production and quality with new technologies, rather than by elevating costs. Over the past 20 years, manufacturing output has grown by more than 40% with fewer jobs.

Trump's tariff policy is expected to increase costs and raise the prices of both new and used vehicles, without necessarily boosting production or job creation. In essence, it will do more harm than good, and if fully implemented, it could certainly end America's exceptionalism.

Private credit involves nonbank financial institutions direct lending to private firms. It is a rapidly growing sector of the financial markets. According to McKinsey & Company, private credit “totaled nearly $2 trillion by the end of 2023, roughly ten times than it did in 2009”. Private credit increased in popularity following the Great Financial Crisis after which commercial banks came under increased regulation. But US commercial banks have steadily become involved in the private credit market indirectly. Banks have done this by increasing their lending to nonbank financial institutions, the institutions that make the direct loans to businesses.

Chart 1 shows the steady growth in commercial bank lending to nonbank financial institutions starting in 2015 (when the series first became available form the Federal Reserve). In January 2015, commercial bank loans to nonbank financial institutions were 4.2% of commercial banks’ total loans and leases. By February 2025, this percentage had risen to 9.4%.