Global economy remains vulnerable to US tariffs

Kuwait Times

04-06-2025

KUWAIT: The global economy remains vulnerable to US tariff policy with the recent US court developments injecting a new layer of uncertainty. In effect, as long as tariff cases are in front of the courts, not much progress can be expected in terms of US trade negotiations with trading partners. In the US, irrespective of court developments, the administration is sticking with its plans to impose tariffs, utilizing, if need be, other routes. In the Euro-zone, the ECB is set to cut rates again while the EU's trade negotiations with the US will likely be very difficult.
In the UK, despite positive deal-making with the US/EU/India, the outlook is shaky amid limited policy support and global trade uncertainty. In Japan, soaring bond yields further complicate the BoJ's job and bring the public finances to the limelight. Finally, despite the recent heightened China-US tensions, a resumption of the de-escalatory bias between them will not be surprising.
Irrespective of how the current tariff-related legal developments will unfold, the US administration will likely stick with its plans to impose tariffs, utilizing, if need be, several other routes. However, until the courts' final say on the current cases is clear, President Trump's bargaining power in his ongoing negotiations with the US's key trading partners is weakened substantially. Importantly, this means that not much can be expected from the US's trade negotiations with its main trading partners as long as the cases are in front of the courts.
And while policy uncertainty has already been very high since Trump took office, another layer of court-related legal uncertainty has now been added. Court developments aside, a key date is July 9, which is the date when the pause on the 'reciprocal' tariffs would end. Earlier, the US and China had diffused their trade war, but negotiations have since stalled, and tensions re-escalated recently. While further escalation following the 90-day window is possible, we think the more plausible scenario is that a de-escalatory bias will resume as the world's two largest economies got a feel of the enormous economic damage that will ensue from a full-blown trade war.
Meanwhile, the House passed the GOP's 'Big, Beautiful Bill', which is a step in the wrong direction given that it worsens an already unsustainable debt trajectory, although it is positive for economic growth in the short term. The bill is now in front of the Senate, where it is expected to undergo some amendments although it will very likely remain a debt-increasing bill. Meanwhile, GDP contracted in Q1 on tariff front-running, but the labor market remains broadly resilient with three-month average job gains at 155K/month.
Hence, the Fed will likely remain in a wait-and-see mode while markets are currently pricing-in around two 25 bps rate cuts by year-end. In our view, a US recession will be avoided on condition that a major tariff escalation does not get re-ignited. The prior tariff de-escalation drove a V-shaped rebound in the S&P 500 index although the US dollar index remains 10 percent below a recent high reached in January.
The Euro-zone economy started the year on a good note, growing by a higher-than-expected 0.3 percent q/q in Q1, strengthening from 0.2 percent in the previous quarter. Meanwhile, headline inflation is almost at target, standing at 2.2 percent y/y although further progress is needed in terms of core and services inflation. Nevertheless, more recent indicators are starting to reflect the tariff-related headwinds with the PMI dropping below 50 (49.5 in May) for the first time this year.
The ECB has carried on with its easing policy, cutting rates seven times since June 2024, and near certain to cut again in its meeting this week. Despite the bank, back in March, dropping reference to their policy remaining 'restrictive', the futures market is still indicating additional one-to-two cuts in the second half of the year, reflecting the magnitude of the trade-related uncertainties ahead.
Obviously, the EU's (US's largest trading partner) trade-related developments are a key factor shaping the outlook, especially following Trump's threat to hike the 'reciprocal' tariffs on the EU to 50 percent. Even if the courts upheld the initial ruling of blocking Trump's reciprocal tariffs, sectoral tariffs on autos and steel/aluminum (soon doubling) remain in place, while many other sectoral tariffs are in the pipeline, meaning that the Euro-zone will not be immune to further trade-related shocks.
Irrespective of the court rulings, Trump's statements, on several occasions, exhibited high animosity towards the EU, which coupled with a high merchandise trade imbalance in favor of the EU, mean that US-EU negotiations will likely be very difficult. The structure of the EU, and its generally slow decision-making process, is another factor making these negotiations challenging. Having said that, EU officials have exhibited a strong preference not to escalate matters with the US.
Notwithstanding an above-consensus GDP growth in Q1 (0.7 percent q/q), UK's outlook remains uninspiring as the rise came mainly on manufacturing and exports front-running US tariffs, while domestic consumption remained stagnant. The UK managed to strike a trade framework with the US, which should benefit UK auto exporters among others, but the 10 percent baseline tariff remained in place, the status of which is in front of the courts now. Talks are continuing to finalize details with still several key sticking points.
In other positive developments, the UK successfully reset its post-Brexit trade ties with the EU and signed a long-awaited trade agreement with India. Despite these favorable trade-related developments, the Bank of England (BoE) warned of US' tariff policies and their indirect impact through disruptions to global supply chains. A continued subdued growth outlook would further pressure the public finances, noting that Chancellor Reeves, in March, had reduced some welfare and other spending items to help maintain her fiscal rule.
Moreover, the hike in employers' national insurance contributions could continue to adversely impact employment levels. Accordingly, the BoE, in May, trimmed its growth forecast for the coming quarters, to only 0.1 percent q/q in Q2 and around 0.3 percent in Q3/Q4 while cutting the policy rate by 25 bps to 4.25 percent, but simultaneously guiding for 'a careful and gradual approach' and anticipating 'temporary' spikes in inflation over the coming months.
CPI inflation jumped to a 15-month high of 3.5 percent y/y in April from 2.6 percent in March mainly on higher utility and other government fees, which the BoE does not expect to persist next year. Amid an uninspiring economic landscape but still elevated wage growth (5.6 percent y/y) and slow progress on services inflation (5.4 percent y/y), markets are currently pricing-in one to two 25 bps rate cuts by end-2025.
Soaring bond yields in Japan further complicate BoJ's job and bring the public finances to the limelight. Japan's economy contracted by 0.2 percent q/q in Q1, its first decline in a year, driven by flattening consumption, a 0.6 percent q/q decrease in exports, and a sharp 2.9 percent rise in imports. Despite a robust 5.4 percent wage hike from the 2025 Shunto negotiations that built on a similar increase last year, real wages decreased in Q1, weighing on household spending while export performance deteriorated under the strain of US tariffs.
Meanwhile, inflationary pressures continued with the core CPI (excluding fresh food) rising by 3.5 percent y/y in April, the highest since January 2023 with food inflation remaining particularly acute. In response to these challenges, the government recently rolled out a relief package worth JPY2.8 trillion ($20 billion) to support households grappling with the rising cost of living and to counter the negative impact of higher US tariffs.
Trade negotiations with the US are continuing with the US-imposed 25 percent sectoral tariff on autos, a key sector for Japan, one of several important sticking points. Prime Minister Ishiba and President Trump are scheduled to meet in mid-June on the sidelines of the G7 meeting in Canada, and agreeing on some sort of a trade framework by then remains a possibility although a limited one given the court developments in the US.
Meanwhile, increasing fiscal vulnerabilities coupled with the Bank of Japan's (BoJ) ongoing tapering of bond purchases have contributed to pushing long-term bond yields to multi-year highs. This is putting the BoJ in an even more difficult position, which has already been grappling with major growth headwinds and inflation that has exceeded target for around three years. The steep rise in bond yields will strain public finances, dampen growth, and risk delivering large losses to institutional investors' balance sheets.
Despite the headwinds, the Chinese economy grew 5.4 percent y/y in Q1, beating expectations and the 'around 5 percent' government's growth target for 2025. Exports continue to be a main growth driver, surging by 12 percent and 8 percent y/y in March and April, respectively, easily beating expectations as lower exports to the US were more than compensated by higher exports elsewhere, especially to East Asian countries.
The prior de-escalation with the US, although supposedly temporary given the 90-day window, was a major relief. In our view, China has emerged having the upper hand as, even before the recent court rulings in the US, and excluding the original 20 percent fentanyl-related deemed tariffs, US tariffs on Chinese imports stood at 10 percent, equal to the Chinese tariffs on US imports. Comparatively, almost all countries globally were slapped with that 10 percent baseline US tariff, that none had retaliated against. While renewed escalation following the 90-day window is possible (especially given the current stalled negotiations), we think the more plausible scenario is that a de-escalatory bias will resume, as mentioned before.
Prior to the de-escalation with the US, overall sentiment weakened with the official PMI decreasing to 50.2 in April with the manufacturing PMI falling to a 16-month low of 49.0, before both improved slightly in May. Meanwhile, domestic demand remains muted with CPI inflation in negative territory for the third straight month in April and the PPI in deflation for more than 2.5 years. Given the headwinds, the central bank eased policy in May, cutting several of its policy rates and the reserve requirement ratio, among other measures taken. Looking ahead, while a stronger fiscal and monetary policy support may be forthcoming, a sustained de-escalatory stance with the US will lower the scale of such support.