Why The Border Tax Will Not Pass And How To Position For It

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Includes: BACHF, BIDU, CHL, JD, NTT, PIAIF
by: JP Research

Summary

Border tax and protectionist chatter continues.

But the border tax is so problematic, it might not even make it to the House floor or the Senate.

We might see targeted tariffs instead which would be a lose-lose for all parties.

Buying opportunity in Asian stocks with limited US exposure.

"They say grief occurs in five stages. First there's denial followed by anger. Then comes bargaining, depression and acceptance. But grief is a merciless master. Just when you think you're free you realize you never stood a chance." - Emily Thorne

Understanding how the Washington machine works is a big part of understanding today's economy under Trump. The five stages of grief model is particularly apt in my opinion, as the anti-Trump movement grows and seems to have moved past denial and into a drawn out phase of anger.

This has played a key role in stalling the border adjustment tax's (BAT) progress and its chances of ultimately passing. For a quick overview of the border tax, check out my previous articles on the theme here and here. Here's a brief snippet of how it works:

In a nutshell, the border adjustment tax does the following - subsidize export revenue (by excluding it when calculating companies' tax burden) but tax import revenue i.e. ban companies from deducting their import costs.

For the more visual folks out there, check out the graphic below for a snapshot of how the BAT works:

BAT Progress Update

Tax reform is tricky in so many ways. A good metaphor is perhaps likening the BAT to the Rubicon (a river but also something that's metaphorically hard to pass). For the tax to pass, Trump will need buy in, not only from the House, but also the Senate. Now the House already looks set on crossing the Rubicon but the Senate will be the key hurdle. Additionally, the White House is projecting continued uncertainty around its stance with regard to the BAT adds another obstacle to overcome.

But here's the catch - the BAT is necessary to help pay for a large chunk of Trump's policy candy; e.g. rate reductions, territoriality, 100% expensing, etc. Without the BAT, the Trump administration could find themselves staring down a ~$1tn hole (BAT is the second largest corporate offset behind net interest, and stands to raise $1.1tn in 10 years).

The BAT's major push is coming from Paul Ryan, Chairman Kevin Brady and Subcommittee Chairman Peter Roskam. The ideal scenario is one where they get a deficit-neutral tax bill out of the committee and onto the House floor by August. The August deadline is crucial - further delays could drag things out to October and the fear is that the push would wither by then.

That's a pretty hectic timeline when you consider the other bills coming through the pipeline e.g. the release of the ACA repeal bill in late March/early April and the tax reform bill by late April/May or even as late as June.

If the Republicans do fall in line and get the BAT out by August, they'll then have to fight a bigger obstacle - the Senate.

Now the Senate already has its hands full with the ACA "repeal, replace, repair" bill, which has reconciliation authority under the FY17 Budget but looks to have increasingly bleak prospects of passing nonetheless. To compensate for the delay, perhaps a two-in-one proposal where tax cuts are attached to the ACA repeal bill could be offered. This would both be in the interest of expediency and help win over the on-the-fence Republicans.

Trump hasn't quite come out supporting the BAT in full force but has hinted at a "phenomenal" tax reform bill coming in the next few weeks. Another notable point from the White House is that Gary Cohn, director of the White House National Economic Council, is not a BAT supporter and thus, we may not quite see it in the "phenomenal" tax reform Trump has promised.

The BAT will fail, but there are alternatives

My sense is that the BAT is so problematic, it might be "dead on arrival" (DOA) before it even makes it to the House floor or the Senate. Perhaps some compromise with regard to the corporate and individual tax rate to compensate for the lack of BAT offset is on the table. But a full endorsement of the border tax looks unlikely on the White House's end.

Push comes to shove, there are two alternative options Trump can pursue. First, the tax cuts could be passed through reconciliation without offsets, violate the Byrd Rule, invoke the ten-year sunset and create a Fiscal Cliff. All fair and good on paper, but Trump will want to be wary of more controversy and further loss of credibility as a result.

The second, more feasible option would be targeted tariffs on certain products and countries. The policy would be in line with Trump's protectionist stance and critical view of US trade policy, which has led him to repeatedly call for greater reciprocity in trade relationships. There will be a balance that needs to be struck though, between how broad or narrow the tariffs will be, and this is likely to depend on the degree of pushback from US trading partners.

Targeted Tariffs

Previous administrations on both sides of the political spectrum have supported unilateral steps to liberalize trade, under the assumption that trading partners would eventually follow suit, and as a means of promoting broader diplomatic and strategic goals. Trump's administration however, is likely to do the opposite, focusing on trade relationships as ends themselves rather than a means to an end. In particular, there seems to be a great emphasis on reciprocal treatment.

Here's a quick recap of Trump's 7-point plan to rebuild the American economy from a trade perspective:

1. Withdraw from the Trans-Pacific Partnership, which has not yet been ratified.

2. Appoint tough and smart trade negotiators to fight on behalf of American workers.

3. Direct the Secretary of Commerce to identify every violation of trade agreements a foreign country is currently using to harm our workers, and also direct all appropriate agencies to use every tool under American and international law to end these abuses.

4. Tell NAFTA partners that we intend to immediately renegotiate the terms of that agreement to get a better deal for our workers. If they don't agree to a renegotiation, we will submit notice that the US intends to withdraw from the deal. Eliminate Mexico's one-side backdoor tariff through the VAT and end sweatshops in Mexico that undercut US workers.

5. Instruct the Treasury Secretary to label China a currency manipulator.

6. Instruct the US Trade Representative to bring trade cases against China, both in this country and at the WTO. China's unfair subsidy behavior is prohibited by the terms of its entrance to the WTO.

7. Use every lawful presidential power to remedy trade disputes if China does not stop its illegal activities, including its theft of American trade secrets - including the application of tariffs consistent with Section 201 and 301 of the Trade Act of 1974 and Section 232 of the Trade Expansion Act of 1962.

The US currently uses a tiered system of import duties consisting of: 1) tariff rates applied to all WTO members, known as Most Favored Nation (MFN) or Normal Trade Relations (NTR), 2) preferential rates applied to partners in free trade agreements (FTAs) and to certain developing economies, and 3) restrictive rates applied to countries for which the US does not maintain normal trade relations. The chart below shows effective tariff rates across the US's trading partners.

The path of least resistance looks likely to be the Trump administration announcing some measures on China's currency policy and impose unilateral tariffs targeting some Chinese imports that compete with US production, leading China to respond proportionately. Trump will need some quick wins if he opts to go down this path and China's old economy e.g. traditional manufacturing industries like steel, aluminum, and glass will be first on the chopping block.

However, Trump will have to keep this in mind - President Xi is set for this year's Chinese leadership transition and will not want to look weak on trade. China would thus, retaliate swiftly against any targeted increase in tariffs. This could take the form of tariffs on imports from the US in key sectors such as agricultural products, cars, machines, or airplanes. Taxing US companies in China is also an option but foreign direct investment is important enough for China to avoid going down this path. In a nutshell, Trump has a lot less leverage over trading partners than he is implying. In the long run, this will be made worse by the US's exit from the TPP.

Who wins if higher tariffs are implemented?

The short answer is no one really. But there are plenty of losers.

The reality is this - trade protection is not an effective means of addressing current account imbalances (as Trump propagates). While trade policy measures may indirectly influence the savings or investment rates (e.g. through the consumption or substitution effect), the impacts are marginal. As the graph below shows, the relationship between the current account and manufacturing employment does not support Trump's theory.

The US has experienced a current account deficit, yet also a declining share of manufacturing employment in the economy. In fact, a study by Dorn and Hanson showed that since China's accession to the WTO in 2001, it still accounts for only about one-quarter of the employment dislocation in US manufacturing.

Considering the potential impact of further protectionist actions in retaliation, the cost might just outweigh the benefits. This would reduce the overall efficiency of the global economy and weigh on economic growth, which is hardly an ideal outcome for all parties involved. As for the US economy, the 35% and 45% tariff rates (suggested on imports from Mexico and China respectively) translate into an increase in the average effective tariff rate of around 11%. Tariffs bring in higher revenue sure, but only if the underlying volume can be sustained (unlikely).

But here's the reality with higher tariffs - the burden of tariffs on Mexican and Chinese imports would fall not only on firms there, but also on US firms and consumers. Around one-tenth of the US CPI basket is imported and thus, inflation would accelerate as a direct result of an increase in import prices. This suggests that the most immediate impact would be rising inflation. Once inflation kicks in, tariffs would simultaneously weigh on US growth. Assuming Mexico and China retaliate with equivalent tariffs, this would substantially reduce demand for US exports, depressing US GDP.

In fact, tariffs would likely hit US GDP so sharply that the Federal Reserve would be prompted to reduce interest rates to cushion the blow - despite an increase in inflation. One thing is for sure though - investor concern that markets are not pricing correctly the risk from Trump's unpredictability will remain high.

(Source: CLSA)

So the key question is not who wins but who loses the least from higher tariffs. In a prior piece that I wrote on the border tax impact, I advocated for domestically-oriented retailers like Burlington, with minimal direct foreign import exposure, to benefit most in a hostile trade environment.

Looking away from the US, Asian stocks with minimal US revenue exposure is also a good way to play this theme. Why? Valuations. China's P/E is 7.2 times- one third the valuation of US companies- and its CAPE is 12.8 - less than half that of the United States stock market.

Names like China Mobile (NYSE:CHL), Baidu (NASDAQ:BIDU), Ping An (OTCPK:PIAIF), JD.com (NASDAQ:JD), Nippon Telegraph and Telephone (NYSE:NTT) and Bank of China (OTCPK:BACHF) offer investors a great way to play this theme. Some of these big caps are not in the direct line of fire of Trump's policies yet will find themselves the victim of worsening sentiment toward EMs. Here's the key - a lot of these stocks do not trade at a premium now, but might one day be given a premium for their (lack of) US involvement.

(Source: CLSA)

Conclusion

Whilst the Trump Administration points warning fingers at major trading partners, speaks of border taxes and plans to put America first in all regards, this will create a buying opportunity in Asia, where valuations have suffered as a result.

Border tax implementation chatter aside, the BAT is so problematic, it might be DOA before it even makes it to the House floor or the Senate. In fact, Trump might even completely exclude it from his "phenomenal" tax plan set to be released over the next few weeks.

What may happen instead though, is higher targeted tariffs (think Mexico and China). The reality is that all parties would lose out from less trade so the exercise becomes a matter of picking the "winning" losers.

In this regard, Asia looks attractive - China currently trades at one third the valuation of US companies. Names like China Mobile, Baidu, Ping An, JD.com, Nippon Telegraph and Telephone and Bank of China, which have minimal international revenue exposure, offer investors a great way to play this theme.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.