Trade war talk, sparked by the U.S. announcing tariffs on steel and aluminum imports, continues to ratchet higher. Contentious negotiations between the U.S. and China, as well as America’s two largest trade partners, Canada and Mexico, has many investors wondering what this means for the markets. So far the market has interpreted the political rhetoric as mere bluffs, rather than as structural concerns. Though after the G-7 summit, the current US Administration continues to throw rhetoric at its allies. In this piece, we take a look at the trade war song and dance and the reasons why this bull market may continue to run even as tensions mount.
What is the rationale for tariffs?
The gist of the Trump administration pressuring the U.S.’ main trade partners goes something like this: The U.S. gives up too much at the expense of U.S. exporters and the result has been significant trade deficits that eliminate American jobs.
There may be some truth to that line of thinking on certain micro levels, but it doesn’t necessarily paint an accurate picture of the broader economy. For example, the annual U.S. trade deficit for goods and services rose from $384 billion to $568 billion from 2009 to 2017. Over that same period, private U.S. payroll jobs jumped by 15.5 million and the unemployment rate fell from 9.3% to 4.4%.1
If trade deficits and job losses went hand-in-hand, these labor market moves would seem to be impossible. Also, trade protection measures would not necessarily lead to a reduction in the trade deficit, in part because rising prices would likely lead to a decrease in quantities. Further, trade patterns would likely adjust to find ways around the levies, similar to what happened during the 1980s trade conflict between the U.S. and Japan.
That is not to say that there aren’t issues with some of the U.S.’ trade pacts amid the new global economic norms driven by technology. But the notion that the nation’s economic problems are a direct result of existing trade agreements appears to be a leap. For that reason, the recent escalation in trade war talk seems to be more about politics than economics.
The tariff timeline
Source: Wall Street Journal
In January, the Trump administration got the tariff ball rolling with up to 30% levies on Chinese solar panels and cells.2 But that was only a warm up. The March announcement of a 25% tariff on steel and a 10% tariff on aluminum imports got the world’s attention, given that taxes on commodities as ubiquitous as these would cause the prices of virtually everything in their path to rise, from soda cans to new homes.3
Neither China nor the European Union sat idly. The E.U. said that it would retaliate against any metal tariffs and put together a package of penalties affecting a total of $3.5 billion in U.S. exports, including iconic American staples like Harley-Davidson motorcycles and bourbon. The astute noted that, not so coincidentally, Harley-Davidson is based in House Speaker Paul Ryan’s home state of Wisconsin and bourbon is the pride of Senate Majority Leader Mitch McConnell’s Kentucky.4
That gets at the bluster that’s been bandied about so far this year. The pattern seems to be the U.S. threatens tariffs, and at various points the E.U., Canada, or China counterpunch. The next round of significance may come on June 15, when the U.S. is set to announce additional tariffs on roughly $50 billion of Chinese imports.5 The question is whether there is real teeth to these threats or if it’s simply rhetoric.
Would a trade war today resemble the one from the 1980s?
The U.S. has been down the protectionist road before, and while parallels can be drawn between Japan and China, the dynamics are quite different.
Japan has been a close ally of the U.S. since the end of World War II. Its political and economic systems are similar to those in the U.S. Also, Japan is a U.S. protectorate, reliant on the U.S. for security. So even when at odds with the U.S., Japan has more reasons to go along with U.S. demands and pressure.
China has less to lose in a trade war. Its economic growth relies less on exports than Japan’s did in the ’80s. For the Trump administration, that makes it more difficult to compel China to adjust its views on trade. And Beijing does not appear to be a pushover, continually pushing back on the U.S. rhetoric. In the ’80s, Tokyo didn’t have that luxury.
Also, unlike corporate Japan of the ’80s, Chinese companies rarely go head-to-head against their U.S. counterparts. In fact, corporate America would seem to have much more to lose from a trade war with Chinese supply chains helping to make it the U.S.’ third largest export destination, behind Mexico and Canada.
How is the market responding to all this talk of a trade war?
Thus far, the talk of a trade war hasn’t meant much, giving the bulls reason for optimism. Typically, investors at least give a spring time nod to the old “sell in May and go away” line, perhaps more looking forward to their summer vacations than anything else. But this May there was work to be done.
The S&P 500 Index posted about a 2.2% gain, its best May since 2009. But the Russell 2000 Index has starred recently. The domestically oriented small-cap index bested the S&P 500 Index for a third straight month.6 Reasons for the surge could be attributed to the strengthening U.S. dollar in recent months. Small cap companies are generally less reliant on foreign revenue than their large-cap, multinational peers, and thus less exposed to such forces as, say, trade policy machinations.
For more good news, recent data suggest something other than a late-cycle bull market. Revisions to analysts’ estimates for publicly traded American companies indicated “unusually robust strength in U.S. fundamentals,” according to one recent report.7 Also boding well is that the three-month earnings revision ratio expanded for stocks with pure domestic sales last month, but moderated for multinationals. The scale of upward revisions would seem to set up U.S.-centric equities well for the near term.
Potentially adding to confidence in the U.S. story, April employment numbers continued a run of solid data. Nonfarm payrolls increased by 223,000. The unemployment rate fell to 3.8% from 3.9%.8 Wage growth beat expectations by growing 0.3% month-over-month (mom).9 Also, perhaps indicative of positive sentiment, construction spending surged 1.8% mom in April, largely due residential spending.10
Trade war consequences are likely a longer-term market story—for the U.S.
A full-blown trade war would likely dent the U.S. economy in the long run, but not necessarily in the short-to-intermediate term. It would take time for price increases to have a structural effect on demand. Notably, though, the specter of its potential effects could be a lingering headwind.
The exporters in the crosshairs of the Trump administration’s barbs would seem to be more affected in the short term. One factor not to underestimate is the dollar’s recent surge amid the administration declining to entertain the idea of trade rebalancing through a weaker USD. The cost of doing business in USD has risen meaningfully for foreign entities, emerging markets in particular.
Now, it would be one thing if the risk of a trade war was the only issue to account for, but it’s not. Among others, a take-your-pick of geopolitical and economic events could all conspire with trade policy to upend markets, including Italy’s debt problems and its potential outsize impact on the global financial system, the Federal Reserve continuing to raise interest rates and reduce its balance sheet, the European Central Bank tapering its quantitative easing program, or global growth showing signs of slowing.
The final word: Market, meet Life
When speaking about a trade war, Apple CEO Tim Cook put it like this: “No one will win. It will be lose-lose.”11 Not lost on me when I saw that while researching this piece, with a few tunes cranking through my smart phone, was that somewhere buried (very) deep in my playlist are some rather prescient words about uncertainty from the year that was my 1982.
It’s easy to get lost amid all the bluster and figure out what means what. And let’s face it, trade war talk gives headline writers plenty of fodder to ramp up anxieties. But not to be forgotten according to J.P. Morgan Chase CEO, Jamie Dimon, is that there’s much more to the story than the barbs and quips. One of the many layers is the economic impact. Dimon has noted the strength in the economy and that the recovery could continue. However, “one of the flies in the ointments is this trade stuff.” It not only affects decision-making, he says, “it also increases uncertainty and uncertainty is not a friend of the economy.”12
To this point, and to its credit, the U.S. market has largely looked past that uncertainty and honed in on the structural factors backing the economy. Still solid fundamentals and expectations for earnings growth have lent credibility to a bull that doesn’t seem to want to quit. But as English band Asia, the noted wordsmiths that they were, once told 12-year-old me (repeatedly) through my Walkman, only time will tell.
S&P 500 Total Return Index: The index includes 500 leading U.S. companies and captures approximately 80% coverage of available market capitalization.
Russell 2000 Total Return Index: Consists of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
1. Economic Indicators, prepared for the Joint Economic Committee by the Council of Economic Advisors, Government Publishing Office, April 2018. https://www.govinfo.gov/content/pkg/ECONI-2018-04/pdf/ECONI-2018-04-Pg35-1.pdf
2. Schlesinger, Jacob M. “U.S. Imposes New Tariffs, Ramping Up ‘America’ First Trade Policy,” Wall Street Journal, 22 January 2018. https://www.wsj.com/articles/u-s-imposes-trade-tariffs-signaling-tougher-line-on-china-1516658821?mod=searchresults&page=2&pos=7
3. Tangel, Andrew and Colias, Mike. “Optimism for Manufacturers Upended With Trump’s Tariff Pledge,” Wall Street Journal, 4 March 2018. https://www.wsj.com/articles/tariffs-throw-wrench-into-manufacturers-plans-1520164800?mod=searchresults&page=7&pos=11
4. Peker, Emre. “EU Raises Pressure on Trump to Drop Tariff Plan,” Wall Street Journal, 7 March 2018. https://www.wsj.com/articles/eu-pushes-back-on-trumps-tariff-plan-1520427173?mod=searchresults&page=1&pos=11
5. Wei, Lingling and Kubota, Yoko. “U.S. Tariff Threat Could Scuttle Planned Trade Talk With China,” Wall Street Journal, 30 May 2018. https://www.wsj.com/articles/u-s-tariff-threat-could-scuttle-planned-trade-talks-with-china-1527656960?mod=searchresults&page=1&pos=1
6. Bloomberg Data, retrieved 8 June 2018.
7. Bank of America Merrill Lynch Global Research, “Revision Ratios: This isn’t how bull markets usually end,” 4 June 2018.
8. Employment Situation Summary, The Bureau of Labor Statistics, 1 June 2018. https://www.bls.gov/news.release/empsit.nr0.htm
9. Real Earnings Summary, The Bureau of Labor Statistics, 10 May 2018. https://www.bls.gov/news.release/realer.nr0.htm
10. Monthly Construction Spending —April 2018, The U.S. Census Bureau, 1 June 2018. https://www.census.gov/construction/c30/pdf/release.pdf
11. Salinas, Sara. “Apple CEO Tim Cook says iPhones won’t see a tariff amid China trade tensions: ‘I just don’t see that’,” CNBC, 5 June 2018. https://www.cnbc.com/2018/06/05/apple-iphone-wont-see-tariffs-amid-china-trade-tensions-ceo-tim-cook.html
12. Domm, Patti. “Jamie Dimon: Trump’s trade policy is a fly in the ointment that could end the economic recovery,” CNBC, 5 June 2018. https://www.cnbc.com/2018/06/05/jamie-dimon-trumps-trade-policy-is-a-fly-in-the-ointment-that-could-end-the-economic-recovery.html
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