By Elwin de Groot, head of macro strategy
The Short Straw?
That Europe will probably draw the short straw in a scenario of rising protectionism and potential trade tensions with the US has been a key theme in markets since Trump’s smashing victory. Overnight, the Associated Press has called a House majority for the Republicans, which only further supports the view that this will give the incoming Trump team the confidence to make swift and broad-ranging policy changes from day one. So swift that it could overwhelm its European partners, especially since they are distracted at home.
Since mid-September, when Trump’s star started to climb in earnest, the interest rate differential between the US and Europe has widened considerably and the euro-dollar has lost some 6% of its value (offsetting the impact of a 6% US import tariff on European goods, by the way).
What seems fairly obvious is that the US will use tariffs (and maybe other policies) to attract more business to the US and will pressure allies to redirect supply chains from China. Although many businesses, sectors or states may wish not to take sides, the US’s ability to apply statecraft pressure makes this unrealistic. Compared to Europe, China is more likely to retaliate in a tit-for-that fashion (as it has already reduced its price-sensitive imports from the US, replacing them with imports from, for example, Brazil).
China could –if really pressed– also unleash domestic demand stimulus, as it is not bound by a “Growth and Stability Pact” straightjacket.
Europe’s position, on the other hand, is much more fragile.
If the US opts to raise significant additional tariffs on Chinese goods, European exporters may partly benefit from substitution (assuming that US producers cannot make up for the entire gap between demand and imports from China that arises). But a universal tariff could be a serious headache for Europe as tit-for-tat is much more complicated. First and foremost because Europe would shoot itself in the foot (think of LNG imports from the US). At best Europe will be able retaliate partially, selectively and with some delay. It may also hope to enter negotiations that will lead to reduced tariffs or avoiding them altogether (think of large purchases of LNG, defence goods, etc.). Given that Trump has a knack for making deals this is not a completely unrealistic scenario either.
But is Europe truly in a position to negotiate? French president Macron is a lame duck with a coalition that depends on support from the extreme right, and Germany is facing elections in February. This could be fertile soil for a negative feedback loop. It could accelerate decisions in board rooms to either cut back on staff (following large-scale labor hoarding) or accelerate plans to move (uncompetitive) production out of the Eurozone. Bundesbank President Nagel yesterday warned that the implementation of Trump’s tariff plans could cost Germany 1% of economic output, suggesting that German growth could even slip into negative territory next year.
Germany’s export-driven model is ill-equipped to deal with rising protectionism. This week, the German IG Metall union reached a 25-month deal with employers in the electrotechnical sector. A one-time €600 payment, a 2% pay rise from April 2025 onwards, and another 3.1% from April 2026 plus increases in sector performance surcharges are – according to our estimates – worth some 5.5 to 6%. This is a smaller increase than in the previous 2-year wage deal, but it is still more consistent with a gradual slowdown in wage growth rather than a fast one. And whilst it provides clarity and stability and may support a consumer recovery (since it is above the projected inflation rate) it will not take away any concerns about competitiveness.
The pessimism isn’t hard to grasp, but it is perhaps also the kind of sentiment that is necessary to get things moving. For one, the German elections open up the possibility for a renewed freeze or reform of the constitutional debt brake. Yesterday, Chancellor Scholz pleaded for additional measures to boost the economy. The government’s advisors, who slashed their growth forecast for 2025 to 0.4% from 1.1% previously, are also urging the government to durably increase public spending in infrastructure, defense and education. But even the CDU’s Merz, who may well be the future Chancellor, told Süddeutsche Zeitung that he is open to a reform of the strict borrowing rules, as long as additional debt is used to finance investment and not consumption or social spending. It’s just an opening shot, but it does suggest there is some sense of urgency even among some of the staunchest budget hawks.
Ultimately, European joint debt issuance and/or a freezing of the freshly-revamped EU budget rules may be required to unlock the required funds to finance Europe’s ambition to regain strategic autonomy. However, this looks politically unfeasible in the near term. Therefore, the EU has already started to look at other resources. The FT reported Tuesday that cohesion funds may be used to fund investments in military infrastructure and defence industries under certain conditions. These cohesion funds amount to 30% of the EU budget, or €392 billion. However, so far, only some 5% of the budget for the period 2021-2027 has been spent, suggesting that Member States have struggled to find good purposes for these funds. So, this is potentially a significant funding source for one of the key pillars of the strategic agenda.
It’s easy to succumb to pessimism over Europe, and we certainly agree that some very challenging years lie ahead. But this time, Europe is not completely unprepared. The Commission has a host of tools that allows them to respond to trade tensions relatively quickly. And the Draghi and Letta reports offer a host of concrete ideas to act purposefully. In the past few days we have perhaps seen a first glimpse of the age-old adage that Europe needs a crisis to grow stronger.
Briefly returning to the US, inflation for October was fully in line with expectations. The headline inflation rate rebounded to 2.6% y/y from 2.4% in September, albeit largely due to base effects. Core inflation remains sticky at 3.3% with a slightly elevated month-on-month rate of 0.3% for several months. Services less rent of shelter rebounded to 4.5% from 4.4%; it slowed down a little in month-on-month terms but remains elevated at 0.4%. This mixed picture served both hawks and doves. Minneapolis Fed’s Kashkari took the data as “headed in the right direction” and consistent with the “easing path” that the Fed is on, whilst Dallas Fed’s Logan called for caution in the cutting pace. The market took the CPI report as a sign that a December cut is very much in play, with the likelihood rising to 68% from less than 50% the other day. The relatively strong market reaction to the “in-line” figures indicates that markets have been dominated by Trump news flow: a figure just north of consensus would have forced the Fed to weigh future risks to inflation – stemming from tariffs and tax cuts – in its near-term deliberations).
