Tariff Risk Rally: The Pause is the Cause but Macro Risk Hasn’t Thawed

In a new Macro-to-Micro note from Citi Research, quantitative global macro strategist Alex Saunders and a team of analysts and economists look at the uncertainty that remains following the U.S. pause on higher-than-expected tariffs, exploring the economic implications of those tariffs and what may lie ahead. We addressed the U.S. economics implications in a previous article and now highlight implications for the European Union (EU) and emerging markets.

Regarding the EU, we find it useful to step back and try to identify whether the volatility of current events can have lasting consequences by itself, providing perspective for policy announcements.

Economic impacts for the European Union

In the case of Europe, we expect U.S. tariff announcements to have several interwoven consequences. We see a meaningful probability that European countries attempt to move away from their traditional, export-led growth model in favor of more emphasis on domestic demand. We see the growing debate about defense spending as providing the motive and opportunity for this rotation. But while we expect this to lift European nominal growth rates over time, our fear is that in the near term, it could contribute to downward pressure on activity through a tightening of financial conditions, which would compound other negative consequences of U.S. tariffs for Europe. This suggests a form of J-curve in which growth, inflation and interest rates must first come down before all rising again (and more) in a couple of years. 

Underlying this conclusion is our observation that the trade and current account surpluses of the euro area and economies in Asia may not have been entirely fortuitous but in part the consequence of policy choices. In recent decades a number of countries have shown a preference for generating trade and current account surpluses to improve their net external position and reduce perceived vulnerability to external funding. In doing so, they’ve generated downward pressure on inflation, because a trade surplus is by construction an excess of supply over domestic demand, and put downward pressure on real rates because a current account surplus is an excess of savings over domestic investment.  
To the extent that U.S. tariff policy is intended to rebalance global trade, it creates pressure to move away from policies that maintained this downward pressure. From this perspective, we think it’s correct to suggest that U.S. policy will likely push us away from the “lowflation” environment of the 2010s.

It seems to us that this shift in the global economic order will accelerate a recognition in Europe that was already under way: that a growth model overly driven by exports wasn’t sustainable. We saw recent relatively generous wage settlements in Germany as an early sign that the political consensus was evolving toward greater emphasis on supporting domestic income.

Stronger intra-Europe links?

We also note that rising obstacles to European exports to the U.S. may strengthen links between European countries. While those countries favored export as a growth engine, they paid comparatively little attention to the economic performance of their peers. While committed to the political stability of the EU, Germany’s economic performance was arguably affected more by China’s economic performance than that of its neighbors. With China becoming more competitor to Germany than client, and the U.S. not a viable destination for net exports, it seems to us that Germany and other European countries will likely be more interested in refocusing policy toward boosting domestic demand, including via fiscal expansion. This is one reason we’re skeptical that the EU will escalate trade tensions with the U.S. or retaliate in a substantial way. The response is more likely to take the form of a shift in policy priorities.

This rotation will likely be reinforced by Europe’s potential defense challenges, which would leave European countries with no choice but substantial fiscal investment to fill the gaps in the European defense system. This suggests to us that Europe could witness an acceleration of growth, but we think increased demand won’t materialize for a couple of years, as much of the investment must follow political decisions, leaving the impact of new pro-growth initiatives backloaded.

On the other hand, the headwinds generated by U.S. tariffs and their consequences won’t be backloaded. Those consequences could include tighter financial conditions, a direct negative demand shock, an indirect uncertainty shock and the appreciation of the euro. All contribute to our downward revision of euro-area growth projections by 1 percentage point of GDP in 2025 and 2026. Those consequences should also contribute to bringing down inflation dynamics.

Given the above, we think the European Central Bank will have to cut rates to try and cushion the shock, leading us to expect that J-shaped profile for growth, inflation and policy rates. We see all of them coming down in the near term, but as Europe is pushed further toward a more robust growth model emphasizing domestic demand over external demand, all should rise eventually. (Listen to our related podcast here.)

A threat to emerging markets and “Factory Asia”

The Trump administration’s April 2 tariff announcement hit China, the countries of “Factory Asia” and the associated supply chain network particularly hard. We estimated a “crisis-level” growth shock on Vietnam that’s three times larger than the growth shock to the U.S. and China, along with meaningful growth shocks for Thailand, South Korea, Taiwan, Malaysia and Singapore. Even with the 90-day pause and product exemptions, the broad-based 10% reciprocal tariff remains in place, the threat of tariffs being dialed up again post-pause still looms, and exemptions are still under review. 

We see the latest U.S. tariffs as a significant tax imposed on U.S. consumers and businesses; as the U.S. economy is hit by this “tax,” it will have ramifications for the emerging-markets economies most exposed to the U.S. market. We see Mexico as the most exposed to a sharp U.S. slowdown, followed by Vietnam, Cambodia, Thailand, Costa Rica, Malaysia and South Korea. Beyond direct exposure, the asymmetry of the tariff incidence by sector introduced by reciprocal tariffs, most dramatically in the case of China, adds further divergence in growth impact.

Our analysis shows that while the initial hit to growth is largest in the U.S., over time the cumulative growth shock becomes larger for the more U.S.-trade-exposed emerging-markets economies of Vietnam, Mexico and South Korea, alongside China where tariff asymmetry is more extreme. Frontier African economies, Pakistan, Argentina, India, Romania, South Africa and Israel are relatively less affected. 

The CPI inflation impact of these tariffs up to 2026 is also expected to be asymmetric, with the U.S. likely facing a stagflationary shock, with CPI inflation about 0.9 percentage point higher than the baseline by 2025 but dissipating toward a disinflation path by 2026 as the slowdown advances. But our model sees a disinflationary shock vs. the baseline in emerging markets.

We have started to make significant adjustments to our macro forecasts in Asia. We’ve noted a downside risk of 140 basis points (bps) to our Vietnam growth forecast this year and downgraded our Thailand GDP growth forecast by 80 bps, China by 50 bps, South Korea by 40 bps and India by 30 bps. We’ve increasingly front-loaded and added monetary easing calls across Asian central banks; over time we see the need to move policy rates below the neutral rate to buffer a potentially large external demand shock. Fiscal support from Asian governments will likely be extended, but probably with some delay after governments get a sense of the economic impact’s severity and assess how tariff negotiations are progressing. 

Our new report, Tariff Risk Rally: The Pause Is the Cause But Macro Risk Hasn’t Thawed, offers further economic analysis and recommendations for equities, FX, rates and commodities. It’s available in full to existing Citi Research clients here.