Three ways Trump 2.0 could impact the UK economy

In this month’s commentary our Chief Economist, Colin Warren, looks at how a second Trump presidency might impact the UK economy and public finances, focusing on three key areas: tariffs, borrowing costs, and defence spending.

Donald Trump’s victory in November’s presidential election promises to have a profound impact on the US and the global economy. With the Republican Party not only securing control of the White House, but also the Senate and the House of Representatives (a so-called ‘Red Sweep’), President-elect Trump will face fewer obstacles in implementing the policy proposals outlined during the election campaign. In our commentary of September 2024, we looked at how Trump’s policies regarding tax cuts, tariffs, deregulation, and immigration might affect the domestic economic outlook¹. In this month’s commentary we explore some of the ways in which a second Trump presidency might impact the UK economy.

Tariffs

The most direct way in which the Trump administration might impact the UK economy is via the imposition of tariffs. During the election campaign, Trump proposed a 60% tariff on goods from China and a 10-20% tariff on US imports from the rest of the world.

It is far from clear that Trump will actually follow through with these plans. The threat of taxes on imports might merely be a negotiating tactic, designed to secure more favourable terms for US exporters. Moreover, there will also be practical difficulties regarding implementation. Increasing and extending levies that are already in place on Chinese imports, which were justified on the grounds of national security and unfair trade practices, might be relatively straightforward. However, a blanket 10-20% tariff on all imports into the US is likely to face legal challenges.

If tariffs were imposed on UK exports to the US, it could have a significant effect on activity, damaging the UK’s overseas sales and business sentiment. In 2023, the US was the single biggest market for UK traded goods, purchasing £60.4 billion of products, approximately 15% of UK goods exports, or around 2.5% of Gross Domestic Product (GDP)². Higher tariffs would either lower companies profit margins or raise the prices of UK goods in the American market, resulting in weaker demand. They might also encourage firms to relocate production to the US in order to avoid the tariffs and take advantage of Trump’s proposed lower corporate tax rates. 

Estimates of the precise impact of a tariff increase are subject to a high degree of uncertainty. However, calculations from the Centre for Inclusive Trade Policy (CITP) show that, under a scenario where the US imposes a 20% tax on all imports and a more punitive 60% levy on Chinese goods with no retaliation, overall UK exports would fall by £22bn (or 2.6%) and imports would drop by £1.4bn (or 0.16%)³. According to the CITP, the most negatively affected sectors would be fishing, coke and refined petroleum products, mining, chemicals, and electronics.

Another estimate from the National Institute of Economic and Social Research (NIESR) suggests that a trade war resulting from Trump’s protectionist measures could reduce UK GDP growth by 0.7 percentage points in the first year and 0.5 percentage points in the second year⁴. Other forecasters are more sanguine. Oxford Economics reckons that Trump will not impose across the board tariffs, and the hit to UK GDP growth will be just 0.2% at its peak⁵.

Even so, with UK GDP growth slowing to just 0.1% q/q during the third quarter⁶, the economy can ill afford any further headwinds. Weaker economic activity would have knock-on repercussions for employment, government spending and taxation revenues. A shortfall in GDP growth of the order estimated by the NIESR would make it difficult for Chancellor Rachel Reeves to meet her so-called “Stability Rule” which requires that the current budget (tax revenues minus day-to-day spending) be in surplus by 2029/30⁷. This would raise the prospect of further tax hikes and/or spending cuts in future budgets.

Borrowing costs

There are also concerns that a second Trump presidency could put upward pressure on borrowing costs. We noted in our commentary of September 2024 that Trump’s proposals regarding tariffs, tax cuts and immigration policy could fuel inflation if implemented. In turn, higher inflation would impact the future path of US interest rates set by the Federal Reserve (the Fed, the US central bank). If inflation starts coming in higher than the Fed is expecting, it will limit future rate cuts, and could potentially result in rates being hiked.
 
On 7th November, the Fed cut interest rates by 25 basis points to 4.5-4.75% and Fed Chairman Jerome Powell stated that, in the near-term, the election will have no effect on the Fed’s policy decisions⁸. This is unsurprising, as central banks do not make policy on the basis of what government policy might be. However, this has not stopped the markets from dialing back expectations for interest rate cuts as the likelihood of a second Trump presidency grew stronger in recent months. At the end of September, futures markets anticipated a fall in the Fed’s policy rate to around 2.75% by the end of 2025, but now the expectation is closer to 3.75%⁹.

These developments have implications for UK borrowing costs. Although the relationship is not absolute, policy interest rates in the UK tend to closely track those in the US¹⁰ (not least because of the interconnected nature of economies and financial markets). Consequently, a shallower easing cycle in the US could result in fewer rate cuts in the UK. The Bank of England (BoE) might be reluctant to cut rates more aggressively than the Fed, as it would risk putting downward pressure on the pound, which could lead to an inflationary rise in import prices.

Moreover, as the US government is the largest borrower in the international bond markets, any increase in US bond yields is likely to drive up rates for other issuers of debt, including the UK. Expectations of higher inflation and fewer rate cuts in the US, along with concerns about rising debt issuance, have caused US bond yields to rise in recent months, with the yield on the 5-year Treasury bond currently trading at a 4-month high of 4.3%¹¹. This move will have compounded upward pressure on UK Gilt yields resulting from the increase in government spending and borrowing announced in the recent budget. In recent months the UK 5-year Gilt yield has also risen to 4.3% (its highest since November 2023) despite cuts in interest rates from the BoE. In turn, this has also seen rates on business loans and mortgages increase¹².
 
The implication is that the policies of the Trump administration and their impact on bond yields threaten to lift UK borrowing costs, dampening activity, and further straining the public finances. This comes at a time when estimates from Bloomberg Economics suggest that Chancellor Rachel Reeves already risks violating her “Stability Rule” if UK bond yields stay at current levels¹³, raising the prospect of spending cuts or further tax hikes in next year’s budget.

Defence spending

A third way in which Trump’s policies could impact the UK and its public finances is via defence spending. Trump has threatened to pull the US out of NATO and to cut aid to Ukraine, putting pressure on European countries to increase defence budgets.

According to NATO guidelines, each member state should spend at least 2% of GDP on defence. UK spending on the armed forces amounted to 2.28% of GDP in fiscal year 2023/24¹⁴, and the Labour government has committed to increase this to 2.5% of GDP, while not specifying precisely when¹⁵. However, some defence experts suggest that 2.5% of GDP is not sufficient to meet the increased threat from Russia¹⁶, and Trump has said that NATO members should target a level of 3% of GDP¹⁷. Requirements could be even higher; during the 1980s, prior to the dissolution of the Soviet Union in 1991, the UK spent over 4% of GDP on national security¹⁸.

On Ukraine, Trump has said he could end the war in a day, but this looks unlikely. Although any ceasefire is likely to involve Ukraine ceding territory, Trump will be wary of brokering a deal that makes him look weak. In the absence of a negotiated settlement, there is a clear risk that the US (by far the biggest donor to Ukraine¹⁹) will cut its military aid, potentially leaving the European Union and the UK to try and fill the gap.

Whatever the outcome, the Trump administration is likely to put pressure on the UK government to boost defence spending, ideally on equipment from US suppliers so as to benefit US exporters. With little fiscal headroom available, increased outlays on defence would probably mean higher taxes and/or spending cuts in other areas

The challenge of Trump 2.0

Not all the policy proposals made by Trump during his campaign are likely to be fully realised. Different policy permutations will have different economic repercussions, making for a high degree of uncertainty. However, a second Trump term poses a significant threat for the Starmer government as it strives to boost economic growth while maintaining fiscal discipline. Proposed tariffs could dampen business sentiment and weaken export demand, while government spending might be pressured by increased outlays on defence and debt servicing costs. Such developments would raise the prospect of further tax hikes. Labour’s claim that it inherited the worst economic circumstances since World War 2 is open to debate. But there is little doubt that Trump 2.0 will make the UK economic and fiscal outlook even more challenging.

19th November 2024