While investors may now better understand President Trump’s trade
strategy, the economic consequences of tariffs remain unclear.
Our Global Head of Fixed Income Research and Public Policy
Michael Zezas and our Chief U.S. Economist Michael Gapen offer
guidance on the data they are watching.
Read more insights from Morgan Stanley.
----- Transcript -----
Michael Zezas: Welcome to Thoughts on the
Market. I'm Michael Zezas, Global Head of Fixed Income Research
and Public Policy Strategy.
Michael Gapen: And I'm Michael Gapen, Chief
U.S. Economist.
Michael Zezas: Today ongoing effects of
tariffs on the U.S. economy.
It is Friday, August 1st at 8am in New York.
So, Michael, lots of news over the past couple of weeks about the
U.S. making trade agreements with other countries. It's certainly
dominated client conversations we've had, as I'm assuming it's
probably dominated conversations for you as well.
Michael Gapen: Yeah certainly a topic that
never goes away. It keeps on giving at this point in time. And I
guess, Michael, what I would ask you is, what do you make of the
recent deals? Does it reduce uncertainty in your mind? Does it
leave uncertainty elevated? What’s your short-term
outlook for trade policy?
Michael Zezas: Yeah, I think it's fair to
say that we've reduced the range of potential outcomes in the
near term around tariff rates. But we haven't done anything to
reduce longer term uncertainties in U.S. trade policy.
So, consider, for example, over the last couple of weeks, we have
an agreement with Japan and an agreement with Europe – two pretty
substantial trading partners – where it appears, the tariff rate
that's going to be applied is something like 15 percent. And when
you stack up these deals on one another, it looks like we're
going to end up in an average effective tariff rate from the U.S.
range of kind of 15 to 20 percent. And if you think back a couple
of months, that range was much wider and we were potentially
talking about levels in the 25 to 30 percent range.
So, in that sense, investors might have a bit of a respite from
the idea of kind of massive uncertainty around trade policy
outcomes. However, longer term, these agreements really just are
kind of principles that are set out for behavior, and there's
lots of trip wires that could create future potential
escalations.
So, for example, with the Europe deal, part of the deal is that
Europe will commit to purchase a substantial amount of U.S.
energy. There's obvious questions as to whether or not the U.S.
can actually supply that amidst its own energy needs that are
rising substantially over the course of the next year. So, could
we end up in a situation where six months to a year from now if
those purchases haven't been made – the U.S. sort of presses
forward and the administration threatens to re-escalate tariffs
again. Really hard to know, but the point is these arrangements
have lots of contingencies and other factors that could lead to
re-escalation.
But it's fair to say, at least in the near term, that we're in a
landing place that appears to be somewhat smaller in terms of the
range of potential outcomes. Now, I think a question for
investors is going to be – how do we assess what the effects of
that have been, right? Because is it fair to say that the
economic data that we've received so far maybe isn't fully
telling the story of the effects that are being felt quite
yet.
Michael Gapen: Yeah, I think that's
completely right. We've always had the view that it would take
several months or more just for tariffs to show up in inflation.
And if tariffs primarily act as a tax on the consumer, you have
to apply that tax first before economic activity
would moderate.
So, we've long been forecasting that inflation would begin to
pick up in June. We saw a little of that. But it would accelerate
through the third quarter, kind of peaking around the
August-September period. So, I'd say we've seen the first signs
of that, Michael, but we need obviously follow through evidence
that it's happening. So, we do expect that in the July,
August and September inflation reports, you'll see a lot more
evidence of tariffs pushing goods prices higher.
So, we'll be dissecting all the details of the CPI looking
for evidence of direct effects of tariffs, primarily on goods
prices, but also some services prices. So, I'd put that down as
the first marker, and we've seen some, early evidence on
that.
The second then, obviously, is the economy's 70 percent
consumption. Tariffs act as a regressive tax on low- and
middle-income consumers because non-discretionary purchases are a
larger portion of their consumption bundle and a lot of
goods prices are as well. Upper income households tend to spend
relatively more money on leisure and recreation services.
So, we would then expect growth in private consumption, primarily
led by lower and middle-income spending softening. We think the
consumer would slow down. But into the end of the year. Those are
the two main markers that I would point to.
Michael Zezas: Got it. So, I think this is
really important because there's certainly this narrative amongst
clients that we talk to that markets may have already moved on
from this. Or investors may have already priced in the
effects – or lack thereof – of some of this tariff escalation.
Now we're about to get some real evidence from economic data as
to whether or not that view and those assumptions are
credible.
Michael Gapen: That's right. Where we
were initially on April 2nd after Liberation Day was largely
embargo level tariffs. And if those stayed in place, trade
volumes and activity and financial market asset values would've
collapsed precipitously. And they were for a few weeks, as you
know, but then we dialed it back and got out of that. So, yeah,
we would say it's wrong to conclude that the economy , has
absorbed these tariffs already and that they won't have,, a
negative effect on economic activity. We think they will just in
the base case where tariffs are high, but not too high, it just
takes a while for that to happen.
Michael Zezas: And of course, all of that's
kind of core to our multi-asset outlook right now where a slowing
economy, even with higher recession probabilities can still
support risk assets. But of course, that piece of it is going to
be very complicated if the economic data ends up being worse than
you suspect.
Now, any evidence you've seen so far? For example, we had a GDP
report earlier this week. Any evidence from that data as to where
things might go over the next few months?
Michael Gapen: Yeah, well, another data
point on trade policy and trade policy uncertainty really causing
a lot of volatility in trade flows.
So, if you recall, there's big front running of tariffs in the
first quarter. Imports were up about 37 percent on the quarter;
that ended in the second quarter, imports were down 30 percent.
So net trade was a big drag on growth in the first quarter. It
was a big boost to growth in the second. But we think that's
largely noise. So, what I would say is we've probably level set
import and export volumes now.
So, do trade volumes from here begin to slow? That's an
unresolved question. But certainly, the large volatility in the
trade and inventory data in Q1 and Q2 GDP numbers are reflective
of everything that you're saying about the risks around trade
policy and elevated trade policy uncertainty.
Second, though, I would say, because we started out the quarter
with Liberation Day tariffs, the business sector, clearly – in
our mind anyway – clearly responded by delaying activity.
Equipment spending was only up 4 to 5 percent on the quarter. IP
was up about 6 percent. Structures was down 10 percent. So, for
all the narrative around AI-related spending, there wasn't a
whole lot of spending on data centers and power generation in the
second quarter.
So, what you speak to about the need to reduce some trade policy
uncertainty, but also your long run trade policy uncertainty
remains elevated? I would say we saw evidence in the second
quarter that all of that slowed down capital spending activity.
Let's see if the One Big Beautiful Bill act can be a catalyst on
that front, whether animal spirits can come back. But that's the
other thing I would point to is that, business spending was
weak and even though the headline GDP number was 3 percent,
that's mainly a trade volatility number. Final sales to domestic
purchasers, which includes consumption and business spending, was
only up 1.1 percent in the quarter.
So, the economy's moderating; things are cooling. I think trade
policy and trade policy uncertainty is a big part of that story.
Michael Zezas: Got it. So maybe this is
something of a handoff here where my team had been really,
really focused and investors have been really, really focused on
the decision-making process of the U.S. administration around
tariffs. And now your team's going to lead us through
understanding the actual impacts. And the headline numbers around
economic data are important, but probably even more important is
the underlying. Is that fair?
Michael Gapen: I think that's fair. I think
as we move into the third quarter, like between now and when the
Fed meets in, September, again, they'll have a few more inflation
reports, a few more employment reports. We're going to learn a
lot more than about what the Fed might do. So, I think the
activity data and the Fed will now become much more important
over the next several months than where we've been the past
several months, which is about, has been about announcements
around trade.
Michael Zezas: All right. Well then, we
look forward to hearing more from you and your team in the coming
months. Well Michael, thanks for taking the time to talk to
me.
Michael Gapen: Thanks for having me
on.
Michael Zezas: And to our audience, thanks
for listening. If you enjoy Thoughts on the Market, please leave
us a review and tell your friends about the podcast. We want
everyone to listen.
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