The Trump Administration's Trade Philosophy Is A Threat To Stocks

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Includes: F, GM, TM
by: Shareholders Unite

Summary

Capitalism is creative destruction, international trade isn't any different. Singling it out as the one cause of destruction doesn't make sense.

It is also factually incorrect, trade isn't responsible for the bulk of US manufacturing job losses.

Focusing on trade, with a deeply flawed underlying logic, risks undermining the global economic order and achieving the opposite of intentions.

The incoming Trump Administration has a curious obsession with trade, blaming it for much of the working class woes. This is deeply flawed on several levels, as we will try to show below:

  • It is factually incorrect
  • It obfuscates the benefits from trade
  • The whole thinking behind it is deeply flawed
  • It risks putting in place policies that will achieve the opposite of the outcomes intended.
  • It risks higher inflation, regressive taxation, disturbing supply chains for companies, and even trade wars and seriously undermining the global economic order.

The latter especially could become a serious problem for many US listed companies that rely on international markets for sales and supply chains.

Basically, there are many companies involved here, but car manufacturers, like Ford (NYSE:F), General Motors (NYSE:GM), and Toyota (NYSE:TM) are especially in the firing line due to their complex supply chains and additional pressure to produce more in the US itself.

We also belief that this is one of the main concerns of the market. After an initial rally in the wake of Trump's election, the rally has stalled despite generally benign economic news and earnings.

Initially, the market bought into Trump's agenda of reflation through tax cuts, spending increases and deregulation and stocks and the dollar took off and bonds sold off.

But after the trade rhetoric increased, the markets got nervous and the dollar and bonds have reversed at least some of their initial movements.

The pause is justified, in our view. The US is the main underwriter of the global economic order, which is like a commons for all trading nations.

But like every commons, we can't take it for granted it needs maintaining and active support. When that falls away it could crumble quite rapidly, especially as the second big pillar, the European Union, might very well face its own upheavals this year.

One of the more curious outcomes of that could be a reinforced China within Asia, the fastest growing trade area. The US getting out of TPP is already a step in that way.

We think this is one of the bigger risks to the world economy and by extension, to stock valuations although not every sector will be equally impacted.

It's mostly big international companies with complex international supply chains that are at risk. The (much larger) domestic service sector will escape relatively unharmed.

It's important to explain why the focus on trade is wrong, and where the underlying rationale is wanting.

Automation, not trade

We have already commented several times that we're bemused that suddenly globalization is the big bogeyman for working class woes, as there is little factual evidence to support that.

At the most general level, capitalism entails creative destruction, and there is little creation without destruction as resources have to shift from sectors that are shrinking to those that are expanding.

Trade is part of that creative destruction, but certainly not the most important part and it also contributes to a great deal of creation (see below). Besides, putting up trade barriers is likely to make things worse, not better.

Here is some evidence to consider:

Even in a country like Germany, famous for its manufacturing sector and bathing in a trade surplus of almost 9% of GDP, manufacturing employment is down, from the Brookings Institute:

Manufacturing's share of employment in Germany declined by 15.5 percentage points during 1973-2010, very similar to the U.S.'s 14.7 percentage point decline.

And according to a study by Ball State University, 87% of manufacturing job losses can be ascribed to automation, 13% to trade:

Had we kept 2000-levels of productivity and applied them to 2010-levels of production, we would have required 20.9 million manufacturing workers. Instead, we employed only 12.1 million.

There is also no evidence that NAFTA is responsible for large scale job losses (see here, here and here, for instance). So we're not quite sure what the renegotiation, which seems to be a priority for the new government, tries to achieve.

China's inclusion in the WTO probably did lead to significant US manufacturing job losses, but as we argue below, this is at least in part offset by other economic gains.

And it hasn't precluded a manufacturing job recovery, from the New Yorker:

Since March, 2010, when manufacturing employment in the U.S. hit a trough of 11.45 million jobs, nearly a million new factory positions have been created, most of them in the Southern states, particularly North Carolina, South Carolina, and Tennessee. Better still, the jobs are typically good ones: across that same five-year period, average hourly manufacturing wages have increased over ten per cent, to more than twenty dollars. On the whole, U.S. manufacturing, as measured by the Purchasing Managers' Index, has steadily expanded. Meanwhile, according to Quanton Data, which tracks global job postings by industry, open manufacturing positions in China have been dropping consistently since 2012, down nearly six per cent in that time.

Trade and globalization have not been responsible for the much, let alone most of the manufacturing job losses in the US. Productivity increases is a much bigger factor, as studies and experiences, even in manufacturing giants like Germany show. By focusing on trade the Trump administration risk throwing the baby with the bathwater, and worse, risk scoring an own goal.

Zero sum game

We "don't win" anymore with trade, others like China and Mexico and Germany are killing us. They do that either by manipulating their currency and/or by outsmarting the US in trade deal negotiations. These deals, NAFTA in particular, have been a disaster for the US and are responsible for the decimation of US industry.

The first thing one notes going through statements from the likes of Trump and Navarro is that it gives a strong sense of our loss is somebody else's win, and vice versa. For Trump, this is likely to come from his background as a businessman.

As a businessman, this logic usually holds, one can enter a deal, and through smart negotiation (provided one has leverage, as The Art of the Deal argues) one can negotiate on favorable terms and force the other side to concessions.

However, whole economies work through a different logic, and here is where the danger lurks by automatically assuming that good business people will be good statesman because they have practice in the 'real world.'

We know from simple economic theory that trade isn't a zero sum game where my win necessarily comes at the expense of somebody else's loss. Trade is usually a positive sum game, the spoils are not a fixed amount that are divided according to whom got the upper hand in the negotiations, but trade arrangements themselves increase the spoils.

For instance, it's true that through China's entry in the WTO, it has enormously benefited and the economy has boomed on investments and exports. For starters, this has enabled other countries to import cheap goods from China.

This benefits consumers in other countries and spending less on certain goods because they can now be imported cheaper from China allows them to spend more on other goods and services, most of which will be produced domestically (unless we're talking of consumers in very small and very open economies).

It also allows other countries to keep interest rate lower for longer, as the cheaper imports have a mitigating effect on inflation.

Then we have other effects. The export boom has also made China vastly richer, and some of that is used to buy more from us. More goods, more services, more assets like Treasuries.

China is now the third largest US export market (behind Canada and Mexico) with exports exceeding $100B, and "China is the only major American export market that consistently exceeds 15% growth." (from Forbes).

While yes, the US has a large manufacturing trade deficit with China, but it actually has a services trade surplus, which is part of an overall trade surplus in services to the tune of 1.5% of GDP:

Winners and losers

Parties trade when both see a mutual disadvantage. This allows a series of advantages, like:

  • Specialization and economies of learning
  • Economies of scale

Location has little to do with this, in principle it makes little difference if the parties are in different nations, as the following example from the FT illustrates:

When our first child was born, I had an office job. My wife's exhausting and non-remunerated profession was stay-at-home mother. Later, she retrained as a portrait photographer. To let her return to the labour market, we needed to hire a nanny. There is more to such a decision than money but, on purely financial terms, this was a no-brainer: the nanny earned less than either of us, so by freeing us to earn money in other ways, the Harford household was richer as a result.

Yet what makes obvious sense for a household can become strange and threatening in a different context. Imagine: the proud independent nation of Harfordia had a thriving childcare sector (my wife), but it was undercut by cheap foreign competition (the nanny). There was a vast bilateral trade deficit with the nanny, and Harfordia's homegrown childcare sector was devastated. Bad! Though Harfordia's photography sector boomed as a result, you can bet that's not what the populists would be pointing to.

Indeed, the losses are often highly concentrated whilst the benefits highly dispersed. This makes the losses much more visible, and the those that lost from trade (or threatening to do so) easier to organize.

Curious logic

Trump's advisors on trade Peter Navarro and Wilbur Ross argue that the trade deficits deduct from GDP and indeed it does, but as in an accounting sense, it most definitely isn't a causal relation.

However, they argue that anything that reduces the trade deficit will increase GDP by definition. This really is quite stunning, and constitutes a really fundamental error of economic logic.

This means that reducing the trade deficit, for instance by reducing imports through tariffs doesn't necessarily increase GDP. In fact quite the contrary, it could very well reduce, not increase GDP.

As a Vox article shows, trying to eliminate the $180B trade deficit in oil does not rise the GDP by the same amount, let alone increase wages by $80B, as the Navarro/Ross logic has it.

In fact, slapping prohibitive tariffs on the import will result in lower, not higher GDP and wages as it increases prices of gasoline and other oil based products, forcing consumers and businesses to curtail spending on other products and services. And then there is this (from the NY Times):

But what about those tariffs that Mr. Trump sometimes threatens to impose on foreign countries? They would certainly curtail the amount of international trade, but they are unlikely to have a large impact on the trade deficit. When American consumers facing higher import prices from tariffs stop buying certain products from abroad, they will supply fewer dollars in foreign-exchange markets. The smaller supply of dollars will drive the value of the dollar further upward. This dollar appreciation offsets some of the effects of the tariff on imports, and it makes American exports less competitive in world markets. But it doesn't matter much, anyway, because in reality, trade deficits are not a threat to robust growth and full employment. The United States had a large trade deficit in 2009, when the unemployment rate reached 10 percent, but it had an even larger trade deficit in 2006, when the unemployment rate fell to 4.4 percent. Rather than reflecting the failure of American economic policy, the trade deficit may be better viewed as a sign of success.

One would be hard pressed finding any reputable economist agreeing to the proposition that reducing imports directly boosts GDP dollar for dollar. In fact, it's not disrespectful to simply call it nonsense. But these people are now in charge of US trade policy. While this could simply be a signaling ploy, but this remains to be seen.

On the one hand, Trump's election victory is in no small measure cemented on the trade issue, but on the other hand, a large swathe of the Republican and business establishment is distinctly pro free-trade.

This isn't all. Trump's trade people seem to think that the US can just slap tariffs on imports and boost GDP as a result, but also for instance to pay for that Mexican wall. The funny thing is, such tariffs will be paid for by the importer, that is, US consumers.

Of course, Navarro doesn't take this lying down (from Business Insider):

Peter Navarro, the head of Trump's National Trade Council, laid this callous view of economic policy out in an interview on CNBC last week. When host Melissa Lee pointed to a Citigroup estimate that taxing imports from other countries - a provision called "border adjustment," which acts like a tariff - would be a massive hit to retail companies' earnings and put thousands of American jobs at risk, Navarro called Citigroup "fake news."

What's more, tariffs are a highly regressive form of taxation (from VOXEU/CEPR):

Tariffs - taxes on imported goods - likely impose a heavier burden on lower-income households, as these households generally spend more on traded goods as a share of expenditure/income and because of the higher level of tariffs placed on some key consumer goods.

So much for letting the Mexican pay for the wall or boosting GDP or the working class. And we haven't even factored in secondary effects. Mexico will indeed get hit, so their economic growth will be affected, and hence they will also import less from the US.

That is if they not retaliate, which is quite likely. Countries, especially when galvanized by inflammatory rhetoric, tend not to take these things lying down:

On the call, Trump reportedly threatened Peña Nieto with a 10% tax on Mexican exports and a 35% tax on exports that hurt Mexico the most. Problem is, that would just really hurt us. The Wilson Center, a nonpartisan think tank, estimates that 4.9 million American jobs depend on our trade with Mexico, and if people don't have jobs, they can't have any nice things, American or Mexican. The Peterson Institute - another think tank - says a trade war with Mexico and China would push us into recession. So that's one thing. Another thing is that Mexico is the US's third-largest trading partner. In 2015, the US imported $295 billion worth of goods from the country.

And the effects might be larger still. Much of US industry runs on carefully crafted supply chains and networks that source from all over the world. Here is Timothy Taylor (our emphasis):

A lot of the US discussion about international trade seems to assume that we can simultaneously discourage the importers and encourage the exporters. But this belief assumes, implicitly, that importers and exporters are different firms. If the US firms that import have a lot of overlap with firms that also export, then if you impose costs on these firms by hindering their imports, you will also make it harder for them to export... For example, out of the 2,000 US firms that are in the top 1% of exporters, 36% are also in the top 1% of importers; conversely, of the 1,300 US firms that are in the top 1% of importers, 53% are also in the top 1% of exporters.

There is other curious logic, like brandishing China a currency manipulator when they spend $1 trillion in order to keep their currency from falling more. Or every time Trump bashes Mexico, their currency falls more. Some in Trump's administration see that as a sign of leverage (from Business Insider)

Commerce Secretary Wilbur Ross gloated that Trump had put the US in a great position bargaining with other countries, especially Mexico. "The peso didn't go down 35% by accident. Even the Canadian dollar has gotten somewhat weaker - also not an accident. He has done some of the work that we need to do in order to get better trade deals," Ross said

This is pretty amazing. When others 'manipulate' (imagined or not) their currencies lower they call it currency manipulation, when the currencies of trade partners go lower because of stuff that is said by people from their own administration, it's leverage.

Perhaps we should call the Trump administration currency manipulators. Well, that's not serious, of course, but it's still curious that they seem to think this is positive. A lower peso only makes Mexico more competitive

TPP

So one of the first moves of the new government was to back out of the Trans-Pacific Partnership, a big trade agreement with Asian countries (but not China) that has been concluded but not yet ratified. One group of Americans won't be happy, from CNBC (our emphasis):

The U.S. withdrawal from the Trans-Pacific Partnership (TPP) trade deal won't just leave the U.S. on the outside looking in, it will devastate American agriculture, a former U.S. Trade Representative told CNBC. " We're now going to be competing against other countries who are going to reduce over 18,000 tariffs. Those tariffs will now stay in place for the U.S.," Ron Kirk, who was the U.S. Trade Representative (USTR) from 2009-2013, told CNBC's "Squawk Box" on Tuesday. " This is going to be devastating for American farmers and ranchers and businesses."

China, left out of the TPP deal, might be rejoicing as it gives them more scope to conclude trade deals in Asia, the fastest growing trade environment in the world.

Bring back the jobs?

We don't doubt that the Trump administration, with a program of tax cuts, deregulation and spending increases will be able to create jobs, although it's not going to be entirely straightforward, given rising bond yields, near full employment and a Fed that could very well raise rates more.

But the emphasis on trade, and more disturbingly the whole thinking behind that is deeply and worryingly flawed. Implementing these ideas is liable to achieve an own goal, rather than a home run.

It risks not only upsetting complex supply chains but undermining the global liberal order that implicitly underpins stock valuations especially of big internationally operating corporations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.