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Israel attacks Iran, lines are drawn in the US over immigration.
Today, markets are contending with an Israeli airstrike on Iranian nuclear facilities. Israeli Prime Minister Benjamin Netanyahu has indicated that the strikes will continue until Iran’s nuclear-weapon capability has been dismantled. In an escalation of tensions leading up to the strike, Iranian authorities warned the US that they would strike US defence installations in the region if they were attacked. US Secretary of State Marco Rubio has denied US involvement in the strike and has already ordered the return to the US of non-emergency personnel in the region.
The escalation in tensions, beginning with the US State Department’s evacuation order, followed by the Israeli strike has seen oil prices surge by around 10%, raising fears of oil prices adding to global inflationary pressures. The fallout of higher oil prices will be particularly hard on the economies of non-oil producers in the East Asian and European regions, which are already under pressure from the Trump Administration’s tariff war. Elsewhere in markets, equity prices predictably fell. But in a reversal of the recent positive correlation between equities and bonds, bond markets rallied as investors retreated to the usual risk-off response; i.e., sell equities/buy bonds.
However, a recent trend that hasn’t been reversed by the Iranian crisis is the march down in the USD, with the world’s reserve currency falling by over 1% against a basket of the world’s 5 most traded currencies. Here, the evidence is that investors continue to be wary of US assets, as opposed to the pre-Liberation Day response to crises that saw investors move funds into “safe-haven” US assets, causing a rally in the USD. The other major event this week has been the Trump Administration’s federalisation of the State-based National Guard for the first time since President Johnson federalised the Alabama National Guard to protect protesters during the 1960s civil rights marches. The move was in response to protests in Los Angeles against the ICE swoop on undocumented migrants.
The call out of the National Guard, and subsequently US Marine personnel, as well as an aggressive increase in ICE deportation activities, signals a tilt in the Trump Administration’s policy focus from tariffs to the One Big Beautiful Bill (OBBB) to immigration. Just as in Trump’s first term in office, these three policies – tariffs, tax cuts (i.e., OBBB) and immigration – remain the pillars of Trump’s second term. What is different in his second term is the speed in which Trump is attempting to implement these three policies and, at least with tariffs, the size of the policy. On speed, during Trump’s first term, tariffs were not imposed until over a year into his tenure, in 2018.
On magnitude, by the end of his first term, the Administration had only managed to raise tariffs from around 1% on average, to 2%. Similarly, President Trump did not pass his (more maturely named) Tax Cuts and Jobs Act until late 2017. On immigration, the Trump Administration was very successful in reducing legal migration numbers through the reduction in issuance of Immigrant Visas (i.e., Green Cards). Data show that the average monthly legal migrant intake fell from around 40k to 10k.
However, President Trump was unsuccessful in removing illegal immigrants, and in fact the number of total removals of illegal immigrants fell under President Trump’s first Administration with total annual removals falling from 239k in 2016 to 185k in 2020 – a far cry from the promised annual removal rate of around 2.75 million. So, where do the Trump Administration’s policies sit now, just 4½ months into his second term? On tariffs, President Trump saw his Liberation Day gambit fail and has been forced to back down. Approval for his tariff policy has sunk to 38% according to latest polls. His OBBB has drawn broad criticism for its fiscal imprudence, including an infamous confrontation with once-ally Elon Musk. The OBBB now faces resistance from Republican party fiscal hawks in the Senate. Changes to Medicaid are also creating problems among Republican party moderates. The approval rating for OBBB is down as low as 27%.
This leaves immigration. And it should be no surprise that the Trump Administration should tilt towards the strongest card in its hand. Just prior to last Saturday’s ructions, 54% approved of President Trump’s program to deport illegal immigrants. By escalating tensions in progressive States and cities such as California and Los Angeles, the Trump Administration is aiming to corner Democrat politicians into appearing to thwart what appears to be a popular policy of deporting illegal immigrants.
If successful, President Trump may be able to reduce further centrist voters’ support for the Democratic Party as well as rebuild his own approval rating. If his “immigration” tactic is successful, we would expect a resumption of a hardline on tariffs and increased pressure on Republican senators to pass the OBBB. The outcome? Increased deportations equals a smaller workforce equals a tighter labour market equals higher unit labour costs equals increased inflationary pressure. The OBBB equals increased spending equals increased inflationary pressure. Higher tariffs equals higher import prices equals higher inflationary pressure.
For the beleaguered asset allocator, the path forward remains clouded by geopolitical risks that threaten higher inflation and (on balance) lower growth. The higher inflation/lower growth scenario leads to a singular, but very unappetising, asset allocation response: shorten the duration of the portfolio. By shortening the duration of the portfolio, the asset allocator seeks to minimise capital losses that inevitably flow from higher interest rates and weaker growth. But in the process, the asset allocator must accept lower yields, and hence lower returns, associated with short duration assets.