Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets. I'm your host Tim Graf, European Head of Macro Strategy.

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And with that, here's what's on our minds this week.

TG: Of all the things that we look at within our proprietary indicator set and the research that we write around it, one thing really stands out at the moment. Narratives like tariffs and trade wars and protectionism, these are receiving loads of media coverage. We see this from the data produced by our friends at MediaStats.
However, their data also show us that the correlations of changes in trade war coverage and changes in the US dollar or US equities, these are all pretty insignificant. For all the headlines, in other words, there are other narratives that are more influential on markets right now.

Even more strangely, many commonly followed measures of risk premia are also pretty benign right now. Volatility is very low, and since the start of Donald Trump's second term, the US dollar has actually been one of the weakest currencies in the world, with many EM currencies leading the pack.

So this week, I wanted to focus on why that is, and specifically whether much of the bad news on trade was already accounted for in price. And I wanted to do this with my colleague Ning Sun, a senior emerging market strategist in Boston. Ning was actually on the podcast last year as part of a Shark Tank session judging top trade ideas. In fact, she was the winner of the first ever bit of Street Signals merch for her efforts. But this is her first solo appearance.

TG: Hello, hello.

Ning Sun (NS): Hey, Tim. Hi. How are you?

TG: I'm good. I'm doing well. How are you?

NS: Not bad. Look at the equipment in front of you.

TG: Yeah, yeah. It’s big time. Come on.

Well, Ning, great to have you on. I should note, and I did note in the introduction, you were on a panel on the podcast last year. And of course, you won an award for the best trade idea. So it only made sense to have you back. A solo appearance is long overdue. And what better topic than to talk to you about trade and tariffs and how they affect emerging markets.

We spend a lot of time, I think, thinking about how all these tariffs we're reading about affect the US dollar, US rate markets, US demand. But we don't spend, I don't think, nearly enough time on the other side. And that's where I wanted to spend most of the podcast. I don't really want to talk about the US today, which is kind of a rarity for me.

So let's start with Mexico. We're approaching this March 4th deadline for the pause on tariffs that were put on to Mexico and Canada last month.

And so I guess as a first starting question, do you think they will now go ahead after this deadline?

NS: You mean go ahead with a 25 percent tariff increase? I think the chance for that is quite low. And I don't think the market is actually expecting that to materialize. And the general thought is that if he can give them a break in the first time, why can’t he give them a break in the second time? And there's plenty of reasons behind that as well.

I was recently in Mexico City and talking to the local people down there, I think the general feelings are like that as well.

TG: And what things do you think can be offered to avert tariffs again and have them have another moratorium put on?

NS: Yeah, it's interesting this time, you're thinking about the purpose, the goals of the Trump administration for those tariffs on those various countries, then it's not super clear. What is clear is that he gave a temporary break for Mexico and Canada because he has other goals ‒ geopolitical and also border and also the fentanyl national security.

It seems to me that both countries, I mean Canada and Mexico, are highly cooperative with the US administration on those agendas. So it seems like Trump's tariff policy is working in that regard.

He also might have other intentions this time around. Maybe he's going to use the tariffs to eventually rebalance the US economy, such as lower the current account deficit, lower the trade deficit, maybe use some of the tariffs as a measure of ways to lower US fiscal deficit. But until we see the final answer, I cannot completely, we cannot completely ask investors to completely discount those possibilities.

TG: Well, let's say though at some future point, tariffs do come into play. Mexico in particular runs out of negotiating chips that can be used to mitigate tariffs or delay them or defer them. And let's say we do get that 25 percent amount that is mooted.

Ultimately, how devastating is this for their economy and their growth outlook if they are implemented?

NS: The short answer is, it's really bad. It might be not that big of a problem in the first, like in the near term, because the central bank of Mexico can devalue their currency. The market can say currency depreciation can actually offset a lot of those tariffs, the impact on that.

But actually, when you look at supply chains, and also the uncertainty of US policy over to Mexico, I think the biggest problem for Mexico is that it could significantly impact the intention of FDI. For Mexico, this country's biggest problem is low potential growth. Potential growth is only like 1 percent to 2 percent of GDP in the future. And the biggest reason is that they don't have enough foreign investment.

So with the biggest trading partner in the North, are throwing them in big uncertainty, I think investment is unlikely to really be robust. Thinking about the past couple of years, the Mexican economy has been doing well; one of the reasons is that the reshoring, near-shoring, all of those reasons, that has actually made a lot of other countries to build up their investments in Mexico. But with the new tariffs, this 25 percent tariffs, that is essentially the end of the near-shoring operation. So investment will surely go down. So that impact could be quite big.

And to give you some numbers. Like Brookings, they did some analysis. They say that in the medium term, if let's say Mexico doesn't retaliate, if we have 25 percent tariffs, it's going to impact the GDP by 1 percent. In the medium term, it's going to be 3 percent. It's a lot for the economy grows at 1 percent to 2 percent. You can easily tip the economy into recession.

And when you talk about economy, you want to have inflation as well. For Mexico, I think inflation will drop substantially. It would be recessionary for Mexico.

And I know you don't want to hop on the US side, but I think the impact on the US economy could be even more inflationary. But on the Mexican side, it's going to be much, much more recessionary.

TG: And so does that then open up the door for a policy response? I know the Central Bank has been a little slower than the Fed, who would often in past cycles can kind of match for rate moves, whether it's up or down, and they've been a bit slower to ease.

Does this just simply mean faster and more powerful easing from them? Is there a governmental/fiscal response that would come about? Is there a retaliatory response, in fact, that you could talk about?

NS: Yeah, so number one, the policy response. We're talking about macro policy responses from the Mexican government. Interestingly, I think the pressure on them, even before this tariff talks, is that they need to consolidate their fiscal deficit. And they have this very big Pemex issue, weighing on their fiscal health. So I don't see they have too much room on the fiscal side.

But luckily, on the Mexican economy, they have been managing the monetary cycle pretty successfully. So you look at their real rates, you look at their stability of how well anchored their inflation expectation. So I think on the monetary policy side, it does give the central bank more room this time to ease their monetary policy, to alleviate the shocks from the US side.

And also, Tim, I think this is not just Mexico. You can say this is very much the fundamental structural improvement coming out of EM for the past decades. Emerging markets as a whole, and Mexico is part of it, their current account has improved quite a bit. At the same time, COVID actually opened up fiscal deficit.

But we're seeing countries are talking or working on this deficit already. And you look at the corporate sectors and households of those emerging markets, actually, the foreign exchange exposure from the real economy is a lot less than before. Meaning that if we have a sudden depreciation of the exchange rate, the shock to the balance sheet of the banks and corporates and households are going to be a lot less than before. That's going to be a lot less concern from the policy makers' perspective. Meaning that they will be more comfortable to see the currency as adjustments for macroeconomic shocks from the outside.

TG: That's really interesting because I wanted to jump ahead a little bit and think about that for, well, we'll start with the peso. But I think there's other economies in Latin America that are probably going to be brought into this. I mean, we did have sort of an eight hour trade war with Columbia a couple of weeks back over the weekend. But the peso specifically is, and I want to pull up the Bloomberg chart so I have the right data here. But the peso specifically has depreciated, I think, from its high levels at kind of mid last year when carry was everything in FX. It's depreciated about 25 percent since then. So, I mean, that's a handy coincidence for a 25 percent tariff potentially being put on your goods.

Is that everything? Or if tariffs do come, is that really only just the beginning of potential currency depreciation and how far can it go?

NS: You know, the 25 percent depreciation, if we pick a date, I think the majority of them took place after the Mexican election. The reforms there that spooked the investor, I would think maybe arbitrarily, I would say more than half of the 25 percent was because of that. So, that has nothing to do with tariffs.

And then the rest of them could be tariffs and global volatility. Let's say, worst-case scenario, if on April 1st or 2nd, they got 25 percent tariffs from the US, I think it's not my central-case scenario. But I think the peso can depreciate quite a bit. The central bank will come out and smooth the volatility, maybe not a steep depreciation in just a couple of days. But eventually, I can see the Mexican peso depreciate 20 percent in the medium term to offset those.

TG: A question I was asked at the beginning of Trump's term, which I didn't have a great answer for. I think I know the answer, but I don't have a good answer for why that might be the case or why tariffs might go ahead is, the notion of the maquiladoras that were built in Mexico, where they’re built in decades past, the 1980s and 1990s, these US companies building facilities in Mexico, facilitated by free trade agreements, things like NAFTA.

These companies that are subsidiaries ostensibly or feed into US companies, I mean, they face the same costs of tariffs or the same risks of tariffs as well, don't they?

And the question then is, why would a US administration do this to US companies? Can you walk through the thought process of why that might be?

NS: Yeah, you just raised a very good point.

TG: It does happen sometimes.

NS: Actually, you have the answer yourself, right? Because that's so important. I think it's an important part of not just from a trade perspective, but actually from a supply chain perspective. In the grand scheme of things, I think the US needs to compete with China. And then they need to have a secure supply chain, which will benefit primarily the US economy. And then destroying Maquiladoras, those operations, does not make sense.

And we all know the story that the final product like a truck, US brand name truck, the complete product needs to across the border between US and Mexico several times during its assembly and manufacturing process. So time it's across the border, if we add 20 percent tariffs on that, that's going into the price and the US goes out of the market immediately. So that would defeat the purpose of what Trump wants.

So I see the possibility is low. Okay, so this is where you see concessions potentially coming in, maybe exclusions such that it's not across the board, 25 percent tariff. Probably.

TG: Okay. I mean, let's assume if there was a worst case scenario, and look, I mean, the ultimate answer to my question, I guess, is well, the whole point is to reshore everything to the US. That's going to take years, maybe as many decades as it took to build up the whole maquiladora process or facility of production.

What does that do, though, to an economy like Mexico or, in fact, any other Latin American economies where similar operations may have been set up?

NS: I would think Mexico is quite a different case than the rest of the Latin American economy. It's because of how close it is, how entangled it is with the US economy. So I would think it would be highly beneficiary from both sides, both the Mexican and US side.

And the US and Mexico is not just a trade issue. They have border issues like national security, fentanyl. So right now, we're hearing that the US is asking the Mexican government to raise tariffs on Chinese imports. That's a way to express the geopolitical view. I think for the Mexican government and its own economy, it makes sense for them to realign their national interests and economic interests with the United States, just given how important it is.

For example, export, goods export to the United States represents like one third of Mexico's GDP. So for that scale, that importance, it's hard to decouple from both ends, I think.

But for the rest of Latin America, it's a little bit different story. I think Mexico is the only country that has a trade surplus with the US. All the rest of the other countries like Brazil, Colombia, Peru, Chile, you name it, they all have a deficit with the US, meaning they buy more US goods than selling to the US. I'm not saying that they're out of the woods, because you could have reciprocal tax on all of those VATs. But just to compare with the Mexican part of the story, the reality is not quite the same.

TG: Thinking about that reciprocal tariff argument you brought up, and I saw a really good, it was kind of a map of the world showing average tariff rates charged to the US, and Brazil stood out to me as having a pretty high external tariff, even if it runs a deficit with the US.

I mean, do you think Brazil is also potentially at risk given the nature and scale of that external tariff that they put on influence?

NS: I do see that. India and Brazil share similarity in the way that they are more closed economies compared to Mexico. So a closed economy, there are two, I would say two-edged swords.

One is that you are more shielded from external shocks. But on the other hand, why you are more closed than the others? Because you have higher tariffs. So if US targets these higher tariffs, and then I think they could be quite damaging to their economies.

And then you look at specifically the Brazil, the situation of the economy, so they are facing higher inflation expectation, higher inflation, but no room on the fiscal side as well. From policy makers perspective, the ways to withstand external shock is quite weak as well.

TG: This is not really an economics question. It's more probably a geopolitics question or a humanitarian question. The notion of the border has been so far something that's deferred tariffs so far in terms of both Canada and Mexico taking steps to address the concerns the US has with the border. And you mentioned things like fentanyl coming into the US. I just wanted to kind of wrap up the regional side of things.

What further efforts do you think might be coming to avoid tariffs, and particularly on Mexico's side with respect to the US's southern border? Is there more that can be done, and is there more that you think they're planning to offer?

NS: On the border issue, it's not going to be easy, but I think the government have shown that they're highly likely to be more cooperative with the US demands. Also on the geopolitical side as well, for Mexico, like I mentioned before, they don't have too many choices other than to align their goals with the US.

But for the rest of Latin America, if I think US drives them too hard, the Chinese One Belt, One Road, all those initiatives, that can play a role as well over there. So I think US needs to be a little bit more careful of how to treat those Latin American countries in this geopolitical backdrop, I would say.

I think the fentanyl issue is quite tricky, and the US is accusing the Mexican government as collaborator to those cartels, and then it remains to be seen what the US administration wants to do, and how they want to do that. But I think there's a lot to be talked about between the two governments.

TG: Okay. Well, we're not going to do the entire podcast about Mexico, sadly. We almost will.

I wanted to focus a little bit on the rest of the world, and actually, surprisingly, I don't want to talk too much about China, even though that is clearly one of the targets in the US's move towards protectionism. I wanted to focus more on the chip sector, because last week, there was a headline about 25 percent tariffs potentially on chips and semiconductors.

And I just read Chip War. It was, going back to our Three Things to Read document in the podcast that I did at the end of the year, it was the most popular choice for people. I finally read it. It's brilliant. Read it if you can.

But it really highlighted just how integral TSMC, the Taiwanese semiconductor manufacturer is to all of these chip manufacturers generally as the production hub. So with that in mind, and particularly thinking about global equity markets and how dependent market capitalization is on chip producers and the users of chips, this struck me as quite important.

So I wanted to ask you about the prospect of tariffs on chips and what that means for Taiwan and then ultimately I wanted to get a sense of what shape do you think tariffs on exports from TSMC might take and how realistic a threat you see that as be.

NS: I see TSMC and NVDA, they have industry monopolies, meaning that TSMC is the only producer in the world for those high-end chips. Meaning that if you put tariffs on them, let's say 25 percent, they can fully just pass it on to the end users, right? Because they don't have competitors. This is just a simple rule of economics 101. So I'm not worried about Taiwan export sector, TSMC in the near term.

However, if you think about the reasons behind those tariff threat from Trump, and together, he also said he's going to lower corporate taxes for companies that have operations to manufacturing those chips in the US, it might lead to eventually in the longer run, the relocation of those manufacturer facilities, back to the US. It's not going to be a straight line, easy process, it would be a negotiation between the Taiwan and the US government, right now, for the near to medium term, I'm not worried about Taiwan.

TG: Okay, well that's a good story for the equity strategists, at least, they've got the pricing power. There are all sorts of geopolitical implications that I think are really interesting to think about, not least given there's a murmur of the US trying to get the foreign holders of its debt to turn out their holdings of debt and buy longer-dated debt. I suspect that that won't be successful.

But there are massive surplus economies in the region, Japan, Korea, Taiwan, most notably, who do own heavy portions of US assets and potentially have much to lose from tariffs on their exports. And Taiwan, we've covered a little bit. Korea is another one, which is a massive chip exporter. Even if a lot of it still also goes through Taiwan, I mean, Samsung is a major producer. And so I wanted to finish with those couple of economies.

In addition to Taiwan, Korea, Japan, these are, all three of them are US allies as well. And they potentially now face the threat of tariffs. And Japan especially has a very weak currency. And so I wanted to just kind of have some closing thoughts from you on the region in Asia and those three economies in particular.

Which ones do you see weathering this pretty well? Which ones have policy flexibility and which ones maybe will play ball?

NS: So even though Japan exports quite a bit to the US., it's less than 3 percent of GDP. I think Korea's size is more than double that. So definitely, I think the impact for Korea is more than Japan. And also, first of all, from a cyclical perspective, the inflation pressure in Korea is a lot lower than Japan's. Meaning that, I mean, maybe the Central Bank of Korea is more willing to have a weaker currency than Japan's Central Bank because they have a higher inflation pressure there. From the currency perspective, it's going to be more negative for the Korea won than Japanese yen. Those are for near term.

In the longer run, I think we need to really understand the purpose of Trump's tariff, how he's going to do that. If he say, we're going to do the universal tariff, I think you just do the numbers - whoever exports most of the US, suffers most.

But if Trump changes his tactics, he say, we do reciprocal taxes and also the VAT stuff, all those countries are more open. So their tariffs to the US is not high, and their VATs are not high either. So I would tend to see those countries less exposed to the tariff threat. The situation is that we have to wait and see. But the risk is certainly there. It's not going to be easy for investors and us.

TG: Well, I think it's an interesting perspective because in the introduction I noted just how little markets seem to be affected by all of the cacophony of headlines we have on tariffs. I think the way you phrased it is quite elegant in that it really does depend. I think people are waiting to see what is reality as opposed to what is just headline and headline discussion.

I have one final question, and I said we weren't going to talk about China, but I did want to ask one quick question about the Renminbi itself. We saw a fair bit of depreciation as Trump's probability of winning the election started to rise in October. But in fact, to start the year, it hasn't been that poor a performer even since the inauguration of Trump.

I wanted to ask just as a closing thought, what you thought about the Renminbi from here and whether it was as insulated from some of the tariff pressures as say maybe Taiwan, which you mentioned before, or if in fact, it's more like a Mexico where we've only just seen the beginning of depreciation.

NS: You know, the issue regarding US-China tariff is even more complicated than all the geopolitical, economical and problems with China. I think US administration probably hasn't made up its mind how to deal with the China issues. Maybe they're just talking with their, you know, get their agenda accepted by their allies and regional players before they tackle the biggest problem which is China. So that is one possibility.

And I want to also throw in some numbers here. So I know a lot of people say that China is trying to solve this economic problem through exports, but I want to say this is not really doable. I think China knows that as well. For example, like the Chinese direct export to the US is only 2.5 percent of GDP. So China is by far a very much investment-reliant economy than an export-oriented economy.

I'm still saying that China has a very competitive export sector, but a larger part of the economy is actually investment. And they're trying to boost domestic consumption, which is another topic we can talk about later.

Another one is you look at the dominance of Chinese manufacturing on the global scale. I think its global market share has already peaked. So meaning that incremental increases for overall China export to the rest of the world is going to be quite limited. I'm not saying that tariff is not a problem for China. I think they will still reserve a currency depreciation as a tool to offset those shocks.

But at the same time, I don't expect Chinese government to actively push their currency weaker just to achieve better results on the export front because that's not going to stop the problem, number one.

And then secondly, they can actually bring more problems to the Chinese economy, which is financial instability. This is last thing the top leadership wants to have. So limited currency depreciation and depreciation from other economies you potentially mentioned as a tool.

TG: I guess I keep saying it's the last question, but now this is the last question.

Is that it when it comes to retaliation? Can emerging markets who are in these positions vis-à-vis the US that might be threatening to their growth models, is there actual retaliation beyond that that they can offer other than maybe just using the currency a little bit to absorb the shock?

NS: Definitely, that's the easy and useful one, especially when you are in the downward cycle, inflation pressure is going to be a lot lower than you're in the upward cycle of the economy. So, this time is easier cyclically.

And structurally, if you talk about the structural impact, let's say if US can successfully bring those supply chains back to the US., and that would be, I would say, less investment to emerging market, maybe more investment to the US., that would be negative for the emerging market, I would say. So those emerging market needs to have some reforms to their structural basis economy, maybe have more investment from their domestic source to support their economic growth.

But at the same time, the new administration mentioned several times that this world is like to be a multipolar rather than a unipolar world before. So multipolar means that other economies can have their own cooperation, maybe China with Latin America, that could be a good example. Maybe with Europe, with Latin America, with China. That's another good example. If let's say, at the end of the day, US doesn't honor USMCA, they can easily just say, I don't respect that. That makes the credibility of any of the US agreements very low. And that would be naturally for lots of economies to think of other ways to make the economy safer and prosper in the future. That's a final thought, I should say.

TG: Ning, you won a mug for the prize at the research conference last time. That's a final thought worthy of further Street Signals merch, I think. Maybe a T-shirt.

How is the mug?

NS: Oh, it's sitting beautifully on my table. Yeah, I think it's the envy of the team right now.

TG: As it should be.

NS: Yeah, looking forward to the next competition.

TG: Very good. Very good.

Ning, it was great to catch up. I've learned so much, as I often do, being an emerging market dummy. It's always great to talk to an emerging market expert as you are. Thank you so much for doing the podcast this week.

NS: Oh, thank you for the invitation.

TG: Thanks for listening to this week's edition of Street Signals from the research team at State Street Global Markets. This podcast and all of our research can be found at our web portal Insights. There you'll be able to find all of our latest thinking on macroeconomics and markets where we leverage our deep experience in research on investor behavior, inflation, risk and media sentiment, all of which goes into building an award-winning strategy product.

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We'll see you next time.