- Macro Strategist
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Just as investors were starting to explore the potential for growth in Europe, Trump’s tariffs landed. Twenty percent risked turning into 39% but has — for 90 days at least — been reduced down to 10%. In a battle of fiscal versus tariffs, what wins out? And to what extent is the case for Europe still intact?
Key takeaways:
- Growth will take a hit, but in a lower-tariff scenario, fiscal expansion in Germany should remain the more dominant theme for Europe.
- However, risk persists — negotiations could still fail and EU tariffs could rise. The impact of a trade war between China and the US remains to be seen.
- As expected, the European Central Bank (ECB) has cut rates to 2.25% in April. It makes sense for the market to price a 1.50-1.75% terminal rate if US tariffs slice around 1pp from growth, or slightly below if the euro keeps appreciating. Longer term, however, trade fragmentation is likely to cause higher inflation, limiting how long the ECB can keep rates that low.
At current levels, tariffs shouldn’t undermine the European re-rating story
Germany’s transformative shift in fiscal policy was beginning to trigger a reappraisal of Europe’s structural growth potential and re-rating of its assets. Then tariffs hit. Trump’s 90-day reprieve on tariffs reduces the most likely hit to euro-area growth. But there will still be a significant impact on GDP — a 10% global tariff with 150% on China is likely to slice around 1% from European growth this year.
Will that undermine the re-rating of European assets relative to other markets prompted by Germany’s fiscal shift? In short, as long as we avoid the more escalatory scenarios for tariffs and trade wars, we think the structural re-rating of Europe on a relative basis is likely to continue. In fact, US tariffs could accelerate it.
If tariffs remain at this level, over time, the boost to growth from Germany’s fiscal announcement should dominate — an addition of at least 1 percentage point (pp) per year in Germany and 0.3 pp in the euro area for the next 12 years.
In addition, whilst tariffs are a blunt tool to reduce the trade imbalance between Europe and the US, the counterpart is less capital flow from Europe into US assets — which should also serve to narrow the huge valuation gap between the two markets. Europe has accumulated a stock of USD 15 trillion in US assets which could also now be reassessed and potentially partially repatriated.
What would make this murkier?
US tariffs may still escalate and broaden out into a global trade war. The probability of this path has fallen now that President Trump has stepped back from the most aggressive tariff scenarios. But it is still a risk to monitor.
Trade talks could break down between the US and EU. The EU can offer to purchase more liquefied natural gas (LNG) and buy more American military equipment. But if the US is not willing to relax its demands on reparations, value-added tax (VAT) and nontariff barriers, it will be hard to find agreement. If talks break down, and both the US and Europe raise tariffs on each other in response, the shock to growth will multiply. Europe will also increase the drag on growth if it raises tariffs on other nations to protect its own industries from dumping — such as China.
What could this mean for the ECB?
Developments over the past few weeks increase the likelihood of more easing by the ECB. A 1 pp GDP shock from US tariffs requires 25 – 50 basis points additional easing to offset the hit to growth. The higher euro and sharp fall in commodity prices will also weigh on inflation. The ECB expected to cut to around 2% before the tariffs. That suggests a terminal rate of around 1.50% – 1.75% is more appropriate, or slightly below if the euro keeps appreciating. Longer term, however, trade fragmentation is likely to cause a higher inflation/growth trade-off, limiting how long the ECB can keep rates that low.
The issue for the ECB is that its own research suggests that global trade fragmentation eventually leads to a much worse inflation growth trade-off. That could inject some caution into how fast it is prepared to get there.
For now, fiscal may have the upper hand
In sum, the structural re-rating of European assets versus other markets should continue at current levels of tariffs — the shift in German fiscal policy should dominate the shock on growth, and the impact of US tariffs on capital flows between Europe and the US could even work to narrow the valuation gap between the two markets. But it would become murkier, however, if we move into an escalatory and retaliatory phase for global trade protectionism.
