Tim Graf (TG): Hi, everyone. The problem with doing a podcast focused on financial markets is that content that you record a couple of days before publication, say, on a Tuesday morning, can become out of date by the time the episode actually goes out, in this case, on a Thursday morning.

I don't think that actually happened with this week's episode, but the announcement of a 90-day delay to the majority of the reciprocal tariffs announced by Donald Trump last week has helped to reverse a lot of the asset market weakness that my guest and I talk about on this episode.

And I don't think the message actually needs that much changing. In fact, as you're about to hear, in many ways, we've documented evidence now of just how well my guest is seeing the ball. But do forgive us if the world changes again between my recording this disclaimer late on a Wednesday night and when you eventually hear it starting early Thursday morning.

Here we go.

TG: This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets. I'm your host, Tim Graf, European head of Macro Strategy.

Each week, we bring you the latest insights and thought leadership from our award-winning suite of research, as well as the current thinking from our strategists, our traders, our business leaders, and a wide array of external experts in the markets. If you listen to us and like what you're hearing, please do subscribe, leave us a good review, get in touch with us. It all helps us improve what we hope to bring to you.

And with that, here's what's on our minds this week.

TG: “Liberation Day” was just over a week ago. And after a few days of incredible volatility, financial markets are finding their feet, but doing so with uncertainty on trade and other policies as high as ever. We are only in the early stages of coming to understand if and how the world has changed and what that all means for economic performance and market behavior.

So this week, I'm pleased to say that we have Elliot Hentov, head of Macro Policy Research at State Street Global Advisors, back with us to talk about how negotiable tariffs are and what a potential future state of trade relationships might look like. He also tackles some very important questions on asset allocation and the role of the US dollar.

One final note before we start. Something was off with my microphone during recording. It's not too bad, but it's a little boom-y in parts. So sorry about that.

Good morning, my friend. As luck would have it, you're in the prime spot as the first guest to respond to all of the news from last week. How are you holding up?

Elliot Hentov (EH): It's been manic. I'm not going to lie. It's been manic, A, making sense of the news, and B, really trying to generate forecasts and scenarios that we can work with, that investors can actually operate on.

TG: Well, I wanted to start, actually, before we level set with what's happened and what we think or what you think specifically will happen. I want to let you take a victory lap because, actually, of all the analyses done around the election, and you were on the podcast, I think it was September 28th, the episode went out. We recorded it a few days prior, and your scenario for a Republican sweep of both Houses of Congress and the presidency was actually a net negative for equities, which I don't think anybody other than you might have had. So first of all, well done.

I wanted to see if you could give a little bit of background on that and why you thought that then and how it's coming good now.

EH: Well, it certainly was not rocket science. You see what campaigns talk about, what they propose, and then you plug it in and think, well, this is what they'll probably get accomplished and when.

The biggest issue that I saw back in September was that the bad stuff would come first. There was no way for the pro-growth agenda to come early in the administration, whereas the migration control and the tariffs was certain to happen in the first two quarters. And both of those obviously growth negative.

And so we thought that would obviously first have negative spillover effects for risk assets before maybe later on you get some of the pro-growth agenda coming through.

TG: Well, we're going to get to that for sure, especially the potential for a pro-growth agenda to eventually emerge. But let's talk about what has emerged. And, you know, of course, we've had a violent market reaction to it. We're actually rallying today, but we're rallying in the fashion that always makes me a bit uncomfortable when we're in the midst of a crisis. You know, high-volatility rallies tend not to be good signals.

But before we get to all that, I wanted to ask about just what has happened, and particularly the stance of the US and its partners with respect to the potential for retaliation. We've already seen a little bit of that from China, where you see the most impactful impacts from tariffs.

So let's start with what's been announced and what is negotiable. Of the aspects of what's been announced, what do you think is the most meaningful and lasting?

EH: First off, I think most people understand it. This is not just simply about tariffs. This is about rebalancing the global economy. Rebalancing of the global economy has a lot of different features, and that's important to bear in mind.

That is also one of the reasons we still think, back to our podcast in September, that actually Mexico will probably emerge quite well from this as an example. Because structurally, if you think about imbalances, Mexico is not really a problem or a thorn in that design.

The way to think about it is we have multiple goals that the US administration is pursuing, with overall rebalancing being the ultimate destination. And that includes a smaller US current account deficit. It includes trade patterns that are less advantageous to China. It includes some partial limited reindustrialization inside the US. And it includes some revenue raising targets as a part of that.

So if you take that all into the mix and then see what has been proposed, you can see that some of it will remain permanent. That's with us forever. Well, not forever, but for a long time. Some of it makes a lot of strategic sense. So therefore, there's probably some wiggle room, but not much. And then there's elements that really are clearly just for negotiation.

There's the opening gambit. And that's where we'll see a lot of the retaliation and the dance and the game theory applied.

And in plain English, what am I talking about? The universal tariff of 10 percent is going to stay with us. The idea is throttle import demand from the US, basically lower overall current account deficit simply by raising tax on consumption and throwing a little bit of a trade barrier in, but not a big one, just a small one.

The sectoral tariffs around steel, aluminum, autos, eventually pharma, possibly even semiconductors, those will be constructed around reindustrializing because that is stuff America already makes. And expanding production is a feasible and realistic goal. What's unrealistic is attracting new industries and new industrial clusters and all of that to move to the US. That is not going to happen, and I don't think anybody in the administration seriously believes that. There's some wiggle room there, but ultimately that makes a lot of strategic sense.

And then the final part is the one that really is what's roiling markets right now. It's the reciprocal ones, because those don't fall into either of those categories. They do generate revenue, but the revenue is not the key part here. So what is that? That is clearly part of the negotiation. And so that's uncertainty. It continues to be with us, and will continue to be with us for several weeks well beyond this podcast. The negotiation is over the reciprocal element.

TG: So this morning, just before we recorded, there was a headline from Politico that Trump's demand for the EU is to import what I'm estimating to be about 100 percent of their annual energy imports in exchange for dropping tariffs. So this is clearly sort of an outrageous opening gambit, I would say. I mean, maybe they can do that, but it doesn't seem terribly likely.

Who can negotiate and who cannot, and how realistic negotiation on some of these aspects are? Who has the stronger hand here? And if you can talk through not the island with the penguins, I suspect they don’t really have a lot of room to negotiate, but the major trading partners.

EH: Yeah, let's start with the ones where we've already had progressed in negotiations quite a bit, and that's Canada and Mexico. And I think that is a little bit the template that should be, again, I love empirics. We've seen with Canada and Mexico over February and March, how that plays out. You get very aggressive opening bids by the US.

You get differing responses by the counterparties, and then you get some of the economic realities making themselves failed. The landing zone is obviously somewhere in the middle.

And so what you're getting on Canada and Mexico is some renegotiated form of USMCA or the new NAFTA. It's a little bit more advantageous to the US than the previous deals. There are additional trade barriers. There is an element of tariffs that will continue to exist. But the core industrial supply chain will be preserved, tariff free, and the trade area will survive. That's a template, because it tells us a lot about the US administration's flexibility and also the power and limits of other countries' retaliations.

So when I look around the globe, the really tough nut to crack is China. It's unlikely that we'll see a negotiated deal in the near term. There may be mini deals along the way. So some partial pausing, relief, delay, as you have episodic agreements on perhaps the sale of TikTok and so forth. But the bigger overarching issues will remain unresolved.

On Europe, I still think that's quite problematic too. You mentioned a very, very outlandish opening bid again by the US. Clearly, you cannot commit to buying 100 percent of its energy from the US. Probably even cannot commit to buying 50. Let's remember that Russian dependency at its peak was still less than a quarter of European energy and that was already, I think, taught the Europeans a lesson about excess single dependency.

Those two remain problematic, but where I think we'll see some rapid progress is other large emerging markets. Again, we're not talking about a large number of countries here, seven, eight, particularly in Southeast Asia. I think there'll be progress with India. I think other developed markets, such as Japan, Singapore, there too. It's relatively easy to find measures that are suitable for both parties.

And so what I expect there is you'll get some, again, either in the form of a pause or substantial permanent relief on these reciprocal tariffs so that overall this reciprocal tariff construct will not be with us for that long for a large part of the trade mix.

TG: I know it's impossible to put concrete time frames on this, but it seems like an awful lot of work to have all of these balls in the air negotiating with the various emerging markets you mentioned, but then getting to the EU and China. This sounds like a process of months or maybe years.

I'm wondering just how much damage you see potentially being done?

EH: Well, there's certainly damage. Global growth will be lower. The US has experienced a stagflationary hit. Ex-US, it's a deflationary shock. It's a demand shock. What I'm trying to get at is I think it's only weeks till we see some of these, if you think of it like the map, a mosaic of tariff rates until we see a lot of these mosaic stones falling off, particularly in emerging markets. Again, as I mentioned, Japan, India, I think those are relatively attainable. Canada and Mexico, we find some new equilibrium, too.

And what you're left then with is a shock that is more manageable. It does not mean the US goes into recession. It just means you have a growth slowdown. It does not mean inflation goes 1.5 percent, 2 percent up by the end of the year. It means probably somewhere between maybe 3 quarters of a percent, just rough estimating here.

So basically a stagflationary shock that is modest, because if you look at the import mix that the US has, half of that import mix will be resolved and smoothened out. And you basically are left with half of the shock that was estimated. And that's what I think I struggle with is the game theory here, because clearly we have limited time. The longer this lasts, the closer we get to recession, the closer we get to the political repercussions, the pressure on the US administration, and so forth.

And clearly Beijing and Brussels know that and possibly are thinking time may be on their side, and that would allow for a longer, not shorter resolution of the crisis.

TG: As part of their calculus, do you think this...This is maybe a stupid question.

Do you think this accelerates some of the process we'd already seen prior to last week with respect to efforts to improve domestic demand in China and the EU? Is that part of the calculus here where you just accelerate those efforts towards expansionary fiscal policy as part of their response and waiting this out?

EH: The irony is that is one of the things the Americans would like. I think that's precisely what they would like. If China basically said, we won't negotiate with you, but we'll bet on a long-term fiscal reflation, well I think the Americans would say, well, job done. This was a success. That would naturally partially offset some of the damage.

The demand shock would be offset by creating new demand in China or in Europe through that fiscal arm. The hope is that that's partially what would happen. I do believe that you get short-term bursts and increases in fiscal activity everywhere as the longer this goes on. But the Americans don't want a short-term, one-time kind of 12-month stimulus package in surplus countries. They want a shift to a more domestic demand model overall.

TG: Yeah. Yeah. It certainly does correct a lot of the imbalances on its own.

The pass-through effects on prices. This is something we're going to hopefully talk to Alberto Cavallo from PriceStats about in the coming weeks. I have no idea what he's going to say about it. I will say so far, the front-loading of tariff-related impact on prices is pretty modest. We're maybe seeing something starting this week, but that is far too early to say anything with confidence.

And of course, he's done work on Trump's first administration and the tariffs imposed then and how they didn't really make their way into inflation rates and why. There was currency effects, there was margin compression on the part of retailers. There was maybe some slight pass through.

I wanted to get your thoughts on where you see tariffs being absorbed and through which channels they might be felt most aggressively?

EH: This is a little bit of a circular question because I rely heavily on the research of Alberto Cavallo and his peers to guide my thinking. The simplistic mechanical way to think about it is, if you think about roughly inputs as a share of consumption in the US, roughly 10 percent, if you have a 20 percent increase, that would be 2 percent inflation. So just the basic mechanics. So you know 2 percent is the absolute high.

And then you have to work your way down by saying, well, how much will be effects devaluation? How much will be absorption by export or margins? How much will be margin absorption by distributors? And finally, how much ends up with in the past of the consumer?

And so from the research I've read, it looks like at the end, you end up with two-thirds of that headline figure. So somewhere well north of 1 percent, but probably somewhere with 1.3, 1.4 percent. That actually makes it so. But again, I'm guided by the inflationistas research more than anything else here.

What matters for me though is to say, okay, well, that's the full package. As I mentioned, I don't think we're going to be, even weeks from now, be looking at the full package. As deals roll in, you're going to actually be working your way down further in terms of the past.

So, and notably, politically, what really matters, what I'm paying close attention to, is what imports are you resolving quickly? If it's food, energy, consumer staples, all of those things, if that's the portion you get a deal on very quickly, well, then the pass-through effect, politically, will be even more mitigated.

And that would suggest, to your original question, would give the US the power to have a longer term trade battles with China and the EU if it can basically minimize the inflation pass-through on electorate-sensitive CPI basket, so to speak.

TG: I want to shift gears a little bit, and we briefly talked about the fiscal response elsewhere. But I'm thinking as well about the US, and here again, harking back to your work in September, having to pursue as part of Trump's agenda, the painful policies first and focusing on the pro-growth policies later.

I have a couple of questions as to what this all means for fiscal policy, because this is the stated aim that this is a revenue generating exercise. And I debated in my mind whether it is the primary focus of this exercise. I tend to think not. Personal view is that this is in line with what you say, which is throttling back of imports and correcting global imbalances as opposed to revenue generating.

Do you see that making a meaningful contribution to some of the programs that we'll talk about in the second, that Trump also wants to pursue?

EH: Let's just take very simple math here. Deficits running on average around 6 percent. A 20 percent increase in tariffs on 15 percent of GDP, which is what imports are, that would be 3 percent at the headline. Obviously, it shrinks, so you have to assume more like 2.5 percent. That's if the full package remained intact. Nobody believes that that's going to be the case. So we can probably comfortably reduce that by another half.

So now you're looking at about one, one and a quarter percent of GDP of revenue. You can probably assume to be recurring and bake into your budget plans. It's a nice to have, but it's not a game changer. And so I'm with you. It certainly cannot be the central, primary motivation. I think it's a nice little side benefit. It allows a little bit of breathing space and flexibility in the budget process. But it's clearly secondary to the strategic points.

The other thing I would highlight is a little bit less on the sectoral ones. But remember that all these are under IEPA, the Emergency Power Act. The formal budgeting process cannot take revenues from emergency acts under consideration. Because they're not supposed to be long lasting, they're supposed to be emergency acts and therefore temporary. From a legalistic legislative procedure, it's not optimal.

Whereas some of the tariffs that are raised under these sections 232, 301, basically where the Commerce Department does a study, releases it, there's a whole process. Those are baked in for long term revenue projections.

Long story short, it's a secondary, nice to have, not a must have.

TG: Putting things in terms of the art of the possible, both from a political capital standpoint, given the Republican reaction so far is not necessarily pushing back against what has been announced, but maybe starting to question it a little bit.

How much fiscal policy expansion do you see as possible, not even related to tariffs generally, but more broadly the stated aims of deficit reduction and whether that is really a priority?

EH: Fiscal expansion, the answer is very simple, zero. I do not see any from a macroeconomic point of view, a fiscal thrust. I do not expect any expansion at all. I think at best it will be zero. It could even be slightly negative.

But from an asset allocators perspective, there could be a positive tailwind here because distributionally, where the taxes are imposed and where they are collected, that could shift. So you could get slight reduction in corporate taxes that apply to equity shareholders, so to speak, and a little reduction in public spending pulled from somewhere else.

So macro headline, zero expansion, but distributionally, there could be an effect that matters for investors.

TG: And as part of this, does that just assume the extension of the Tax Cut and Jobs Act, even though that is not a fiscal expansion, it's just removing a potential headwind. Is that part of the scenario as well?

EH: Yeah, exactly, you maintain the status quo. Plus you tinker a little bit by allowing some expense deductions, maybe some headline lower corporate tax rate for US domiciled manufacturers. And at the same time, you pull a little bit of public spending away, particularly from welfare spending, whether that's Medicaid or other non-discretionary spending.

TG: That being the case, let's think very briefly, and I don't want to dwell too much on the Fed because it seems like we go there in every single episode. But I wanted to get your thoughts on how the Fed must be reacting as of last Friday, Jay Powell in his remarks and his Q&A that followed those remarks didn't seem too inclined to react.

The pricing for the Fed has accelerated to include, I think, five interest rate cuts this year. Do you think that's about right?

EH: I think that's getting ahead of the show quite a bit. Quite the contrary, we as a house have been always in the more rate cuts than fewer this year, but we're not at five, we were never at five, we've been at three this year.

Obviously, the uncertainty range here is enormous. As mentioned, we know there will be a stagflationary shock. Traditionally, all I can tell you again as a guy who loves empirics historically when there's stagflationary dynamics, eventually the growth worries outweigh the inflation worries. And so it's really a question of timing here more than anything else.

When will the Fed start to worry more about growth than about inflation? And listeners cannot see this, but Tim, I've thrown something on our screen just to show you back to how it relates to the tariffs, which is that if you look at what this administration has talked about, tariffs have always been a key plank of the policy. Redistributing the costs of the security alliance globally has been another big feature. Both of those have occurred already in the last 12 weeks in a big way. But there's been a third pillar, and that's to use the central bank very actively to help facilitate fiscal costs and basically engage in some form of financial repression around rates. And that is the next step to come. And in that battle, the Fed, we basically, this could be the last battle of the Fed where they still fight stagflation as an independent agency before the pressures come to bear and the administration starts to influence central banking as well, the way it has done with other independent agencies.

TG: So first of all, people will be able to see it because we're now publishing show notes from this. So I'm happy to say I'm going to go back in the video, steal that chart, recreate it, put it in the show notes that will be available to people who subscribe to our research. So a little plug there.

But also on this chart, you used the phrase the Mar-a-Lago Accord, and that struck a chord in me in that its own author, Stephen Mirren, has already somewhat disowned it as far as administration policy. But I am wondering if that does figure into some of these negotiations, some of the proposals within that about turning out purchases of US debt on the part of reserve managers.

Do you have any thoughts on that?

EH: Yeah, well, it's linked to it. I think it's a very logical sequence of questions here, because it links to your previous question on the fiscal, how much deficit expansion can we see? Well, we can already see in the bond market turmoil in the last days and weeks, that there is limits to demand for US government paper under the current framework.

And so at some point, if you do want to maintain relatively loose fiscal stance, and you do not want to engage in forced budgetary tightening, you are going to have to somehow find new buyers for US government paper. And the question is, how do you find them?

Well, you can find them domestically a little bit. You can tinker with the rules for banks, maybe for insurers and other big balance sheets. You can basically nudge the central bank to engage in a variety of other balance sheet operations as well.

I think the Mar-a-Lago Accord was innovative in a sense that it's saying, well, it doesn't have to stop there. We can have geopolitical financial repression, i.e. we use the geopolitics to force other foreign buyers into the desired asset class, which would be long duration US government debt. It's through a variety of ways. I know that was just one of the papers that circulated last year, but that idea remains alive. It will become more acute as we approach the budget process and the constraints on fiscal policy become evident.

TG: Let's think about markets then. Just as background, again, prior to this process beginning last week or really accelerating last week, we were already seeing, in response to some of the dynamics we talked about on the fiscal side in Europe versus the US, a reallocation from US equities into Europe. There's still an allocation, massive overweight in US equities in our institutional holdings data. That has not unwound, but what has also unwound is a big dollar overweight versus a euro underweight. So far, this has been a move back to benchmark as opposed to a reversal of those positions.

Do you see those dynamics we've already seen the first couple months of the year continuing and actually a loss of not just the US exceptionalism story on the growth side, but on the asset allocation side and a movement away from US assets? There's the fixed income impulse you just talked about, but I'm wondering if that also extends to equities as well in your view.

EH: The answer to that will really be found in how this trade war plays out and where the equilibrium ends. If Tariffapalooza, as I call it, turns out to be a big failure, then I think it will contribute to the end of the US exceptionalism story across all asset classes, particularly risk assets, equities.

But there is still a chance that we end up in an equilibrium that is actually somewhat healthier from a US balanced perspective. I would not rule that out that we do arrive at a situation that does mean we have larger pockets of sustainable demand ex-US, but we also have a healthier US growth model at the end as well. And in that case, I think there'll still be a premium on high growth on growth assets per se and on innovation, where the US has a structural advantage.

But who am I to say how this actually ends up? It is still a function of the uncertainty of how this trade war plays out.

TG: And would you extend that potential optimism to the dollar? And this is again, all linked to the things we've talked about, the fiscal side of things and that movement that I discussed back from big overweight in dollars to neutral. The default setting for institutions, actually, I was surprised to learn this last week, and I should have known this because it's data I've worked with for about 17 years now, is that institutions tend to be underweight dollars in their portfolios relative to benchmark. And the thing I'm starting to grapple with is now if that default tendency returns.

We've already thought about whether the dollar has lost some of its safe haven qualities in this episode, and I'm wondering if that, in your line, becomes more permanent. And indeed, it should likely be a desired outcome, I think, for some of the players on the US side, and wondering how realistic it is to expect that as a future state?

EH: So from a cyclical perspective, we should start to see a long, prolonged period of dollar weakness relative to where we were the last few years. Not in the coming weeks, but kind of in the coming quarters and possibly years. Why is that? Well, as I described, I do think there's limits on those fiscal stance. I think there will be some constraints on US rate policy as well, and you'll get some reflation ex US. And so what you should then have is basically the supplied demand for dollar assets in general should shift a little bit and therefore reduce overall reduced demand for the currency and lead to kind of a prolonged weakening. That's kind of the cyclical point of view.

The structural question is, do we escape? Do we reduce dollar dominance as this kind of the central asset and liability that we have in our global monetary system? I think we reduce it a little bit, but we don't escape it. We remain in a dollar centric system. The way we really break a dollar centric system is a global war. World War III or World War IV, depending on how you want to categorize it.

You have to have a calamitous fracture in the global system, kind of move away from the dollar centricity. Now, some would say, hey, this trade war is kind of the beginning of that. You're really tearing at the fabric. And I would say, yeah, you're certainly tearing at it, but it's not enough to actually make it rip. And so I think prolonged dollar weakening, yes, but dollar centrality remains with us.

TG: The response to this has seen at least discussion amongst regional economies. China, Korea, and Japan is the one that was talked about last week as potentially aligning to a greater degree in response to what the US has done.

Do you see any triangulation against the US making meaningful strides, whether it's those economies or the EU and China, in a way that disrupts not just dollar hegemony, but US primacy as an economic actor in the world?

EH: All of these questions, dollar centrality, the shifting geopolitics, they all boil down to the economic simple balance of payments. They still all boil down to the same variable, which is you have to have a profound shift in where demand is generated.

Unless you get a profound shift in China's economic model, the geo-economics remain fixed. Dollar centrality, fixed. The ability of China to meaningfully build economic alliances with other surplus countries that are competitors and geopolitical adversaries like Japan and South Korea, not possible. It remains fixed.

The change comes if suddenly China says, you know what, we will be not the source of marginal supply, but the source of marginal demand. Well, then suddenly all these other opportunities open up.

I still remain quite skeptical that that's the place we land. And so I think you have a lot of the geopolitical fixtures that we think are eroding. We think the US has burned throughout all its alliances. It has not. People may not like the US as much as they did before. They may not trust it as much. But when you wake up in the morning and you face severe geopolitical threats, a lot of the alliance structure will still survive.

TG: Elliot, I can't think of a better way to end it on that relatively hopeful note, I think, or relatively non-panicked note, I guess is the best way to put it. So thank you for that. It's been wonderful to have you back on. We will do this again later this year. And we'll hopefully highlight and do victory laps around all the things you said today then, which I'm sure we will. Thank you so much, Elliot.

EH: Thanks so much, Tim. Thanks for having me.

TG: Thanks for listening to this week's edition of Street Signals from the research team at State Street Global Markets.

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