Where Is Trump’s Next TACO?
It is true that the industrialized world’s dependence on oil and gas has declined significantly over the past decades. Solar and wind energy have become far more important. But does this mean that rapidly rising oil and gas prices can no longer cause serious damage to the economy? At first glance, this does indeed appear to be the case.
The problem, however, is that the Western world has pursued a policy for decades of steadily increasing debt. This has been done by allowing ever-larger government deficits and by continuously expanding the money supply. Under normal circumstances, such policies would have led to sharply rising inflation.
This did not happen because Western economies were increasingly flooded with cheap imports from China and other emerging markets. In addition, demographic developments and globalization created a global surplus of labor, which further suppressed inflationary pressures.
That said, the massive expansion of the money supply did in fact lead to significant inflation—just not in the Consumer Price Index (CPI), but rather in asset prices. The excess liquidity drove up the prices of equities, real estate, and other assets substantially (“asset inflation”).
At the same time, the abundance of liquidity caused credit spreads to narrow significantly. Borrowers with weaker credit ratings were able not only to obtain financing more easily, but also at much smaller risk premiums compared with borrowers with stronger credit profiles.
In recent years, this has manifested itself in a sharp rise in private debt—lending to companies outside the traditional banking system. The surplus of capital fueled rapid growth in this market, placing further downward pressure on credit spreads.
This development was understandable. Rising equity markets and the widespread belief that central banks would step in during any downturn—by cutting interest rates and creating additional liquidity—strengthened confidence in the economic outlook. As a result, the perceived risk of bankruptcies declined.
The problem is that such a policy framework can only be sustained as long as wage growth and inflation remain under downward pressure. That is no longer the case because:
- resistance to cheap imports has increased;
- this has led to more trade restrictions and tariffs;
- labor markets have tightened due to demographic trends and stricter immigration policies.
The consequence is that economic shocks have become harder to absorb. Government finances have deteriorated to such an extent that increasing fiscal deficits often brings more disadvantages than benefits. This places a growing burden on central banks, which must now consider that additional money creation could indeed lead to higher inflation.
Returning to the current war in the Middle East.
Until recently, financial markets expected several interest rate cuts from the Federal Reserve. There is certainly demand for such easing, as the war has pushed energy prices sharply higher, weighing on economic growth. However, higher energy prices also increase inflationary pressures, which limits the ability to cut interest rates—or may even require higher rates.
In other words, both economic growth and the interest rate outlook may disappoint relative to expectations that prevailed until recently. This would not be a major problem if energy prices were to fall quickly again. If that does not happen, however, the combination of high debt levels, higher interest rates, and central banks that can no longer provide substantial support could easily trigger a self-reinforcing spiral of bankruptcies.
This brings us to TACO: “Trump Always Chickens Out.” This is something Donald Trump has attempted several times by declaring that the war is essentially already won and therefore likely to end soon. In addition, large strategic oil reserves are being released and certain sanctions on Russian oil are being eased in the hope that oil prices will decline significantly.
Trump wants to avoid major economic damage before political attention shifts more strongly toward the Congressional elections in November. The problem, however, is that as long as Iran manages to keep the Strait of Hormuz effectively closed, efforts to push energy prices lower amount to fighting a losing battle.
This is especially true because energy market experts are well aware of the situation and therefore have every incentive to build up oil and gas inventories as quickly as possible—creating additional demand.
The most obvious option for Trump would therefore be to bring the war to a rapid end. However, he will likely view this as too great a humiliation for both himself and the United States. Moreover, even if the war were to stop, it remains uncertain how quickly Iran would fully reopen the Strait of Hormuz.
Our conclusion is therefore that, for the time being, the war is likely to continue, oil prices will remain elevated, and the resulting economic damage will gradually increase. This would be negative for equities but supportive for the US dollar.
