When the world order is disrupted and tariffs are imposed on the closest allies, the expected outcomes should be: heightened volatility, rising inflation, and a pullback in corporate investment, stock prices, and growth.
Over the weekend, Trump threatened tariffs on the UK, France, Germany, and several other European nations because these countries opposed his demand for Denmark to "transfer" Greenland to the United States. US stock index futures fell in response, implied yields on 10-year Treasury futures rose, gold prices jumped, and the dollar weakened against the euro and the pound. However, even as investors attempted to price in this potential "disaster," the probability they assigned to it was minimal.
According to financial theory, investors should estimate a probability for such extreme outcomes. Trump claims his escalating tariffs are intended to pressure Denmark into selling Greenland—but this could provoke European trade retaliation and undermine NATO unity.
The long-term prospects might include Russia exploiting a weaker and more divided West; or, as Europe re-arms, the eventual rise of a new third global power. Either scenario could be highly unfavorable for investors.
S&P 500 index futures fell just over 1% overnight, similar to declines in European stocks, while gold's gain was less than 2%. This is hardly a sign of investors preparing for disaster: since 1964, the stock market has experienced an average of 21 declines of this magnitude per year; since 1979, gold futures have seen an average of 15 similar-sized gains annually.
There are four possible explanations for this market reaction.
First, investors may have become accustomed to Trump. When he first announced his "reciprocal" tariffs in April last year, the market reaction was much stronger. Ultimately, economic performance was acceptable, corporate investment increased, and although inflation was slightly higher than it might otherwise have been, it was still lower by year-end than when Trump took office. US stock markets performed well for the year, and as of last Friday, the CBOE Volatility Index was roughly level with its reading at Trump's inauguration, while the yield on the 10-year Treasury note had also declined.
Second, this may signal the return of the "TACO trade," betting that Trump will always "chicken out." Although some of his policies have persisted, how likely is it that he will follow through on his new tariff threat next month? No one knows but himself, and it's difficult to judge when he is serious and when he will back down. Even if he is serious, Congress does not support the idea, and the Supreme Court may soon rule his tariff approach illegal. It's understandable why investors might view this as a fleeting event.
Third, investors might see a potential benefit. A frightened Europe will spend more on its military, while being reluctant to pass the full cost on to taxpayers. European defense stocks surged on Monday, while domestic European utility stocks benefited from safe-haven inflows. If European governments respond with increased spending, that is good news for shareholders.
Fourth, the new world order is difficult to imagine, and investors likely find pricing in this prospect so challenging that they simply ignore it. A similar situation occurred in 1914 after the assassination of Austrian Archduke Franz Ferdinand. Investors ignored it for nearly a month, only panicking when war became clearly inevitable—which then triggered a financial crash in London, the pillar of global finance at the time.
Similarly, after the newly formed Soviet government in 1918 announced it was repudiating the debts of Tsarist Russia, effectively writing them off, the price of Russian bonds actually increased for several months. (Investors' descendants eventually received minimal compensation.)
According to data from fund management firm Winton Group, the UK stock market was indeed hit at the very start of World War II in September 1939, but by March 1940, share prices had risen to their highest level in a year. Investors at the time failed to foresee that the Nazis would sweep across the continent, destroy much of British industry in air raids, and that Britain would lose its imperial status. Share prices only collapsed when France fell.
The problem facing investors is real. If they were to react to every potential event threatening the world order, they would never dare take any risks. Correctly timing one such major turning point could lead to riches; but misjudging all the others would lead to heavy losses.
Early effects of the new world order were already visible last year: foreign stock markets significantly outperformed US markets, and the dollar fell sharply. James Mackintosh, a senior columnist for The Wall Street Journal, leans towards the view that other countries will gradually attempt to decouple from the US economically, financially, and militarily, implying that more similar situations will arise.
But it is equally plausible that a sudden, disastrous rupture occurs (perhaps as Russia exploits Western divisions), or that nothing happens and Europe concedes to the US. The new world order could take many forms, and investors betting on it will need to remain flexible.
