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July the 9th was supposed to be the definitive tariff day. Markets hoped this disruptive process would end, allowing the tariffs and their economic impact to be priced in so the Bull market could resume. At this point, the issue has simply been postponed. Now the new “final” day is the 1st of August. Thus, global stock and bond markets remain in limbo. President Donald Trump told reporters at a cabinet meeting that he would also levy tariffs of 50% on copper and 200% on pharmaceuticals, in response, US stocks hardly moved. That suggests the markets now see these pronouncements as part of the negotiation process and not definitive. With a revised list of tariffs on Asian countries including South Korea and Japan, the current net import levy is around 20%. The market however thinks it will end up at around 10%. Clearly, there is scope for market disappointment here. There are currently only two trade deals that have been agreed, one with the UK and another with Vietnam.
US Tariffs
What we know so far are that there are deals with the UK and now with Vietnam. The UK deal sets a developed market template of a 10% tariff with concessions for UK car manufacturers and a nil rate on aerospace products. The EU is trying for something similar. Vietnam was originally going to suffer a 76% tariff, so the agreed 20% is a big move down. Nike, which depends on Vietnamese manufacturing, saw its shares rise following the news. A further quirk of the Vietnam deal is a 40% levy on transhipped goods, i.e. Chinese imports rebranded as Vietnamese. China has used Mexico and Vietnam to circumvent tariffs and quotas. This suggests that the final tariffs on China will thus be in the 30% to 40% range which is what the market expects. Although things are messy, the trend appears positive.
UK Economy
It has been 12 months since Keir Starmer won the General Election, from an economic perspective there have been some positives, new trade deals including a so far limited rapprochement with the EU and investment in renewable energy. Both of these developments are anticipated to have a long-term positive impact. However, increased business taxation to fund public sector salaries has impacted the UK economy in the short term and halted its recovery from the inflation caused by Russia’s invasion of Ukraine. Rachel Reeves manifesto plan required growth to balance out increased government spending. As the above chart shows that growth has not come, which is a problem. Rather than stimulating economic growth, the Budget has reversed it. There is a significant risk that this downtrend could accelerate, as bankruptcy rates are nearing record levels and industrial businesses are increasingly closing or relocating overseas. The United Kingdom is now regarded as having an unfavourable environment for business, with the previous optimism, fostered by falling interest rates, now dissipated. This situation is further complicated by a government funding crisis, as proposed benefit reductions intended to help balance the budget have been rejected by Parliament. Rachel Reeves has a set ceiling on Government borrowing and that ceiling is getting dangerously close.
UK Interest Rates
The markets have a sniff of an impending crisis and Gilts have started to weaken. So far this seems to be a gentle warning to the Treasury. This is important as it is the Gilt market that sets mortgage and commercial loan rates, not the Bank of England. A move up in funding costs could easily tip the UK back into recession. How can this be avoided?
UK Taxes
Reeves has three broad options; cut spending; raise taxes; ignore the problem and hope it goes away.
It is evident that reducing expenditure, especially in high-cost areas such as the NHS and welfare benefits, is unlikely to gain support from party backbenchers. Additionally, Starmer remains committed to increasing defence spending. As a result, significant cost savings appear unfeasible. Inaction risks raising interest rates and increases the potential for economic decline. Consequently, it is probable that taxes will need to rise. Given that businesses faced substantial pressure in the first Budget and that high earners are relocating abroad, the responsibility of addressing the government’s deficit may fall primarily on ordinary taxpayers. The question remains as to which areas will be most affected by these necessary fiscal measures.
1. Fuel Duty.
This raises c£24billion and is 0.8% of GDP, it used to be 2.0%. Given falling oil prices this looks to be an easy win for the Treasury, though would be inflationary.
2. Council Tax.
Another tax that has been “left behind” as a percentage of household wealth. This puts it high on the list of possible tax-raising measures. The last revaluation was in 1991 and an expansion of the bands to target higher value properties is a high probability. Could in theory ultimately raise as much as £20bllion and be enough to satisfy the bond markets and bring Gilt yields down and thus lower mortgage rates, thus limiting the net impact on the consumer.
3. Income Tax.
Labour made a manifesto promise not to increase income tax, VAT and employee national insurance contributions (NICs). While party strategists felt this was vital to win the general election, most economists think it was a serious mistake as it locks the Chancellor out of her major revenue raising options. Raising the basic rate of income tax by 1p would yield an extra £8bn a year, while a 2p increase in employee NICs would result in about £10bn. It is worth noting that revenue from employee NICs fell by £20bn under the previous administration. A year after the election and approximately four years before the next could be considered as an opportune moment to revisit or alter a manifesto commitment? Raising National Insurance but also unfreezing Income Tax allowances might be politically acceptable?
4. Others.
Pensions, dividend allowances, Capital Gains Tax are also high probability fund raising options but might be seen by the Gilt market as “tinkering” rather than solving the problem. An alternative approach might involve implementing a new type of income tax, such as a health and social care or defence levy, comparable to the proposal introduced by Boris Johnson and later discontinued by Liz Truss.
5. Hoping for the best.
This would mean that the UK will be reliant on Trump’s America generating the economic “animal spirits” that have been “snuffed out” in the UK. The US Federal Reserve Bank should cut interest rates as soon as they can see what the impact of the tariffs are on US inflation. If they do, then the Bank of England might just be able to follow suit. However, if the US data prevents the Fed from cutting, then the longer the UK delays in raising taxes the greater the political cost when they finally accept that it is inevitable.
Markets
Markets are still hostage to the statements from Donald Trump. Despite the extended tariff period and the revised tariff rates for the various Far Eastern economies, markets still believe that the overall tariff impact on the US economy will end at around 10%.Maybe markets are being too complacent? Tariffs themselves are not necessarily problematic; the main concern is their effect on US consumer price inflation. A short-term blip to around 4% is forecast from a 10% tariff rate, which is fine. Higher tariffs mean higher inflation and for longer. That would reduce the odds of interest rate cuts from the Federal Reserve. US Treasury Bond Yields which are already under pressure from the Big Beautiful Budget Act would have to move higher with negative consequences for markets. The US economy has proven to be remarkably resilient despite high real interest rates and the threat of tariffs. However, there is strong evidence that the US consumer has brought forward purchases ahead of the tariffs, this suggests that there could be a growth shock after the tariffs are introduced. Trump has got away with it so far, markets have recovered strongly from the initial tariff shock. However, as further trade deals get agreed, he has to strike the correct balance between winning a trade war but not losing the economy.
