How To Think About And Defend Our Portfolios Against A Trade War

Summary

• A trade war is a very real possibility we can't afford to ignore.
• The main consideration in determining winning and losing stocks.
• How to defend our portfolios and grow them at the same time in a trade war environment.

Source: Red State

With the announcement by President Trump that he was going to impose tariffs on all imported aluminum and some steel, it suggests this could be the beginning of a trade war that investors need to understand in regard to implications to their portfolios over the next few years.

Initial plans are to impose a tariff of 25 percent on steel imports and a 10 percent tariff on aluminum imports. It remains to be seen if there will be some exemptions to the tariffs or they'll blanket the entirety of foreign markets. Another issue is whether or not specific products may enjoy exemptions.

Contrary to some headlines, the reality is China, which only accounts for approximately 2 percent of U.S. steel imports, won't be affected much. On the other hand, countries like Brazil, Canada, Mexico and South Korea would be hit much harder. All of them have asserted they will retaliate if tariffs are enacted on steel and aluminum. The EU is another trading partner that have vowed to retaliate.

What needs to be weighed by investors is what the implications of this would be to our portfolios if a trade war does break out, and what the best ways to defend against it while continuing to build our wealth.

The possibility of a trade war is real

The first thing is to not assume there won't be a trade war; it's a very real possibility, with the caveat it'll probably be targeted at certain companies or products, rather than entire markets. In other words, it's unlikely to be at the expansive level President Trump may impose on steel and aluminum.

In watching the president since he took office, it's not in his nature to back down from public policy statements he makes, so it should be taken as a given that there will be some form of tariffs imposed on steel and aluminum. The details may change a little, but they are coming.

Where the uncertainty lies is in whether or not the response from the nations mentioned above is just rhetoric, or if they in fact do plan to respond to the tariffs with some of their own.

That's not as easy to do as it sounds, as the U.S. doesn't need those markets, as a whole, as much as those markets need the U.S. For that reason, whatever response there may be, it's likely to be tempered. The most probable scenario is there will be limited response in order to placate the citizens of those nations so they don't appear to being pushed around by the U.S.

If there is a stronger response, that's where the possibility of a significant trade war would rise. With President Trump not being supportive of the Trans-Pacific Partnership (TPP) and NAFTA deals as they exist, the environment surrounding the tariffs is more antagonistic than it has been in the past.

With Trump's negotiating skills, what remains to be seen in general, is whether or not a lot of this is positioning to extract concessions and obtain a better deal with U.S. trading partners.

Either way, there is no doubt in my mind tariffs are coming in the near future. If they extend beyond steel and aluminum is the question, as well as how the U.S. would respond if its partners impose tariffs on American goods, and at what level.

Major considerations for investors

Assuming a trade war of some type is imminent, there are a couple of major things to take into consideration understand how to play it.

The first is how much exposure we should have to multinational companies such as those represented in the S&P 500. Of those companies, a little under 50 percent of revenue comes from countries outside the U.S. That obviously means almost half of their revenue is at risk.

All of us need to re-access our portfolios if they include large cap multinational companies. We need to know how much of their revenue and earnings comes from global markets, and how much from the U.S. Most if not all of them will come under immense pressure if a prolonged trade war breaks out.

On the other hand, the second thing to take into account is what companies will do the best in a trade war, and it will be those that don't trade across borders, or do little trading outside of the domestic markets they are based in; the majority of the best options will be companies based in the U.S.

What I'm saying here is, as a whole, small caps will outperform large caps during a trade war.

How to play a trade war

Since small caps will be the main beneficiaries of a trade war, those are the companies to take a closer look at. Be aware that just because a company is small doesn't mean it doesn't engage in international trade. Always check that out if you're looking individual companies.

For me, the easiest and best way to play this from a defensive and offensive point of view, is to grab shares of the iShares Russell 2000 ETF (NYSEARCA:IWM). The ETF has started to show strength at a time the Dow and S&P 500 have come under pressure. That will continue to be the case if trade conditions worsen around the world.

Source:Stockcharts.com

I like this play the best because there are so many variables involved with individual companies that can add to overall risk outside of a trade war.

The major question is how long it may last and to what depth.

Other sectors that should do very well for a prolonged period of time are steel companies, and firms with heavy exposure to metallurgical coal, which is used to make steel and iron.

My thought on that is tariffs on steel and aluminum are probably going to remain in place for a long period of time. For that reason domestic U.S. companies in those spaces should do very well for some time.

That includes the additional benefit of infrastructure spending that will further boost the steel and metallurgical coal industries. Among the steel companies to watch closely are U.S. Steel (X), Nucor (NUE) and Steel Dynamics (STLD).

Even so, the cornerstone of playing a trade war should be the iShares Russell 2000 ETF in my opinion. It balances off the pros and cons of individual companies and provides a broad exposure to small caps that will benefit from a trade war.

Conclusion

It's apparent to me that President Trump, by winning the presidency with his Make America Great Again slogan, isn't going to back down from attempting to make that a reality.

Whether we agree with that as investors or not isn't the point, the point is we have to deal with the cards that are handed us, and those cards will include tariffs on steel and aluminum for sure, with the outcome of that yet to be determined because we'll have to wait for the details of the tariffs and the response of U.S. trading partners to them.

Large cap companies with a lot of international exposure would be hit the hardest, while domestic small cap companies, in general, should outperform them.

For that reason I see iShares Russell 2000 ETF as the best way to play a trade war, as it provide a defense position against tariffs from a variety of countries, while at the same time helping to grow the value of our portfolios.

If you want to look at individual companies, just be sure to research if there is any international exposure and what percentage of sales it represents.

Analyst’s 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.