Stocks In Trouble: Tariffs Are Inflationary Poison, But This May Be Necessary Medicine

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Markos Kaminis
Summary

Tariffs on these pervasive metals, incorporate in goods ranging from beer cans to automobiles and aircraft carriers are inflationary poison. Trading partners have responded actively, announcing plans for commensurate tariffs.

This dampens economic growth and weighs on equity valuation multiples. Though, I still expect investors to overlook increasing risk of a hard landing while rewarding economic & earnings growth.

Despite my economic concerns, I agree that the tariffs meant to restore domestic production of these components of tanks, warships and fighter aircraft are of relevant national security interest today.

Of all the times to introduce a series of serious trade tariffs, not when the stock market is frantically frenzied about inflationary and Fed policy concerns. Stocks are in trouble now, because trade tariffs on pervasive goods like steel and aluminum are inflationary poison, and trade war won’t help either. This will only exacerbate market fears, and this time, rightly so. However, I agree with the President that domestic steel and aluminum production are a national security concern, and therefore, despite the economic and stock market pain that may result, I agree with the maneuver. I just wish the timing was different and the rollout less dramatic. But maybe there was a purpose in that as well.

My Initial Reaction – I was Flabbergasted

I was about as bullish as I could be post the passing of tax reform legislation. There was nothing that could derail my bullish sentiment, not even the market’s fear of a more forceful Fed. That is, until Wednesday March 1st, when the President announced new trade tariffs on steel and aluminum.

I still have hope that the idea will be well-controlled, as the tariffs are not to be announced in detail and implemented until next week. Perhaps the President is using it as a ploy to get something from dumpers of steel and aluminum, as the White House was meeting on Wednesday with Liu He, China’s top economic advisor, according to the New York Times (see previous link). And we know, from his art of dealing, that the President goes in big to get what he wants, and he often upsets the apple cart in doing so.

What we know at this point is that a 25% tariff will be applied to steel imports and a 10% tariff to aluminum imports. There is some uncertainty, as reports indicate the tariffs might not be pervasive in nature, and might only apply to certain steel and aluminum goods, and not all steel and aluminum. It’s one thing to apply tariffs to washing machines and solar panels and quite another to apply them to pervasive and sometimes commodity like goods, like these metals. Do we want craft brewers paying more for beer cans?

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F Price data by YCharts

As a component to products across a wide spectrum of goods, such tariffs would be inflationary poison. On Thursday, the shares of Ford (NYSE: F), General Motors (NYSE: GM), Boeing (NYSE: BA), Caterpillar (NYSE: CAT) and Honeywell (NYSE: HON) were down 3.0%, 4.0%, 3.5%, 2.9% and 2.6%, respectively; those were outsized losses versus the SPDR S&P 500 (NYSE: SPY) decline of 1.5%, which was also significant. Note the Dow decline (NYSE: DIA) was greater, at 1.7%, reflecting the importance of steel and aluminum to industrials. The tech-heavy Nasdaq-100 (Nasdaq: QQQ) was lower by a smaller margin but dropped dramatically into the close of trading (-1.6%) as the entire market collapsed. The iShares Russell 2000 (NYSE: IWM) was down just 0.3%, because smaller cap companies are expected to have less global exposure to potential trade war.

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SPY Price data by YCharts

And Trade War is at Play

The response to the President’s announcement has not been passive. European Commission (EC) chief executive Jean-Claude Juncker issued a statement promising WTO-compatible counter-measures. He called the U.S. action blatant intervention to protect U.S. domestic industry, and not a matter of national security, which is the claim of the U.S. There’s talk that the tariffs could be targeted to China, but China is an insignificant exporter of aluminum and/or steel to the U.S. Still, Chinese steel gets into America through middle men, third-party nations, and the production capacity of China and its influence on the broader market, has a dampening effect on prices, which harms the uncompetitive American industry.

China warned weeks ago that it could retaliate if the U.S. were to impose tariffs on metals, if its actions harm China’s interests. It appears, however, that the tariffs could have no exclusions, and therefore not target any one nation trader. This would prevent companies from trading through a third-party to avoid the tariffs. If the tariffs apply broadly, that’s bad news for Canada, the top exporter into the U.S. market. Though, Canada was exempted by President Bush’s steel tariff back in 2002.

Bark vs. Bite

There is a chance here that the initial statement is meant to broadly scare counterparties into better trade deals for America, or that the details of this tariff will show a targeting of certain producers where the White House sees minimal counter risk. In that case, perhaps allies Germany and Canada will not be targeted, but judging by prior rhetoric, it’s hard to say that.

Canada’s industry is tightly integrated into U.S. vertical markets; so unforeseen disruptive damage might result. Other exporter complaints came from Mexico, South Korea, Japan and Australia, supposed close allies of the U.S. Russia, Brazil and India would also be impacted.

Complaints filed to the WTO could take years to work out, but countermeasures might be taken, as described by the EC. Europe could target Kentucky bourbon, Harley-Davidson (NYSE: HOG) (-0.6% Thursday) motorcycles, cheese and tomatoes, while China is eyeing soybeans.

Here’s Why I Agree with the Tariffs

For decades now, friends of mine have been well-aware of my geopolitical concerns. I have often noted that American corporations seeking to widen profit margins by moving production to China and elsewhere have put America at risk. Sure, Americans will buy what is cheaper, and shareholders always want more earnings and dividends, but that may not be what is always best for America. Putting the jobs issue aside, let’s look at my greatest concern. In the case of steel and aluminum, if God forbid a significant or world war were to occur, we would have to import the metals that are used in the production of tanks, warships and aircraft. During the last world war, resources became so scarce that people at home had to have “drives” to pull in metal and other goods that our nation used to make weapons of war. I think this helps the reader to see more clearly why this is a national security issue.

I do not expect Europe to foresee or understand reasoning, or anyone else for that matter. The normalcy bias has peoples ignoring the startling geopolitical develops globally that point to escalation of conflict and increasing risk of world war.

What this Means for the Stock Market

Unfortunately, we cannot be completely sure what this means for markets just yet. Until the details are published and the rebuttals of others are enacted, we can only speculate. However, tariffs generally on pervasive goods are inflationary. Because of our higher cost of production, the price of goods that incorporate these metals, especially here at home, should increase. Profit margins for firms using these metals will be pressured, unless producers push the burden forward to sellers and then to consumers, in which case, inflation reaches the consumer.

So, expect the Fed to have something to say about this. And, I expect the Fed members will not have the same perspective as me regarding national security. Therefore, their focus will be the added pressure on prices. Given the already exacerbated attention to inflation, where previously I saw the Fed trajectory tame, now I am not as sure. Fiscal policies and trade protections are going to add pressure to inflation. This will also increase jobs for Americans, which is a good thing, but given our full-employment situation, it means compensation inflation pressures will also increase. This BBC article notes that the U.S. Department of Energy reports the U.S. steel industry employed 135,000 people in 2000, where in 2016, that number decreased to 83,600. While some of that may have had something to do with the economy generally, I expect those jobs would not be coming back without these tariffs. Companies that employ people are going to be competing for those labor resources, which means greater pay incentives and other incentives; that in turn translates into inflationary pressures.

If this is the flint that sparks trade war, then we could be in trouble. The Great Depression was exacerbated by trade war. Depending on the details of the tariffs, if we see broad response and the copying of our actions by other nations seeking to protect their important industries, this may backfire on us and impact a broad swath of goods that Americans buy.

As this weight is factored into economic projections and rightly used to penalize the “P” in the P/E valuation metric, it serves to dampen my enthusiasm somewhat about the market’s prospects. However, I still see strong benefits from full employment and from tax reform, and I still expect most investors to ignore future threats like this one and to rather reward expanded GDP growth through the course of this year, along with increased consumer spending and corporate earnings expansion. Still, this raises the likelihood of a hard landing down the road, and it makes the Fed’s job of managing inflation more difficult. Stay tuned to my column for regular updates of my market view and analysis of economic developments.

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.