By Mike Smitka
What are the market implications? Below are quick thoughts. I will refine this initial and very tentative analysis over the next month. Above all, I need to add detail on the investment implications.
There can be little doubt that we are moving to higher and higher tariffs against China; the must-be top-of-the-news mindset of President Trump makes it very hard for those on the other side to defuse things, much less back down. Trump may be riveted on the stock market, and think that swings in Chinese equity prices drive politicians there. He apparently has never heard that all politics are local, and that the Chinese leadership can scarce be seen to "cave in" to a foreign power. Will the war spread? That depends on whether the Administration lashes out in the face of a global trade deficit that is more likely to grow that to shrink. That's thanks to their own actions, the fiscal stimulus packaged passed by Congress earlier this year with Presidential support. Demand will increase, even if not by much, and that will require more (net) imports. After all, few Americans remain unemployed, so factories can't expand and we won't see much uptick in domestic output. Goods (and services) will have to come from somewhere, which means reduced exports and increased imports.
Complementing that demand-and-supply story are higher domestic interest rates. Thanks in part to a growing Federal deficit amidst a strong economy, Treasuries are more attractive to global investors, and to get those they have to buy dollars. The White House will talk of a Chinese currency war, but the dollar is stronger across the board - Canada, Europe and Japan, along with most of our other trading partners. This will offset some of the pocketbook impact of trade, keeping imports high, while the strong dollar and the higher cost of intermediate goods such as steel will hurt exporters. Again, this complements the above analysis of supply and demand. [Wonks will recognize that a net increase in Treasury purchases by non-residents must necessarily be matched by a net increase in the trade deficit.]
Myths abound. One is that tariffs will cut our deficit. A quick glance at the data should inject a dose of realism, but twitter and TV "sound bites" aren't a good way to highlight basic arithmetic. Numbers aren't the story-monger's strength. So... to data: in the year through Q2 we collected under $45 billion in customs duties, and that's already up sharply this last quarter. With higher tax rates, the total might go to $100 billion, paid of course by US consumers. Why not more? - we import $3 trillion a year, so shouldn't revenue approach 25% of that, or $750 billion? No, because all sorts of things will continue to face no tariffs. Examples include most of the goods shipped to us from Canada and Mexico ($300+ billion each) and the $250+ billion we import in energy products. That drops the amount subject to taxes by almost $1 trillion. Of course higher taxes also induce shifting to avoid them. Trade is no exception. Again, we might, possibly, collect $50 billion in additional revenue. That offsets little of the $1 trillion-a-ear increase in the budget deficit from early 2018 tax cuts passed by Congress. [Wonks should look at the history of the US prior to 1914 and the imposition of a national income tax.]
Now the Administration is encouraging the belief that the Chinese will back down, and we can return to the good old days of a strong US. Unfortunately - unless Trump caves very soon - there will be a permanent impact, as the rest of the world evolves to take advantage of the absence of the US. A lesson in point is that several of our "temporary" retaliatory tariffs to the 1963 "[frozen] Chicken War" with Europe are still in place over 50 years later. In addition, China's biggest trading partner isn't the US, it's Europe. The world will evolve without us, to our detriment, and to China's advantage in its quest for global power.
Part of the reason the impact won't soon be reversed is that no one will want to waste time negotiating with the US. After all, a 3 am tweet storm can undo everything. The President has been less than consistent, and doesn't engage in the sort of careful, briefing- and reading-intensive memo and staff work to see that he understands what negotiators can achieve, and they understand his priorities as they consider many hundreds of policy options. Plus we lack negotiators: the Administration has lots of unfilled positions at USTR, among other places. But above all the other side understands that the people across the table have no idea whether Trump will back them, and has little incentive to make a counter offer that might be on the news an hour later and claimed as a "victory," as the new starting position.
For investors, what matters are identifying stocks and bonds that will be differentially affected.
- With taxes on intermediate products (steel), avoid final goods producers (autos). However, that advice has to be muted because many such firms are global businesses that earn only a minority of their profits in the US. Be wary of "US" brands, as those may be hit by future anti-American campaigns in China, and not just what happens to their sales in the US. General Motors (NYSE:GM) sells more vehicles in China than in the US, and is highly exposed to such risk. Anyway, if you can quickly spot individual intermediate goods producers (that is, still overlooked by the market), their profits may rise. And I suspect that in a market dominated by trends, many hard-goods firms are already underpriced.
- Amazon (NASDAQ:AMZN) and Walmart (NYSE:WMT) may be hurt, as their sales depend on final goods - their customers aren't buying rolls of steel. The lower half of the income scale in the US are the ones who have benefitted the most from trade. Here's an example - I ask my students how big their closets are, and then point out that older houses (pre-WWII) in rural Virginia often have NO closets. Why? - clothing was too expensive for all but the wealthy to have more than a couple changes of clothing. With various trade deals, even the poor in the US can have 5 pairs of trousers and 20 shirts and lots of shoes, socks and underwear. Then there is consumer electronics, including cell phones. China runs labor-intensive "screwdriver" plants that import components from the US [and elsewhere] and export complete units back to the US. So the Chinese economy obtains relatively little of the value added. Unfortunately, tariffs are blind to such details, taxing the gross and not the net amount. Again, Walmart and Amazon sell a lot of those, and will be hurt. Can Apple (NASDAQ:AAPL) lobby for an exemption? If I were China, I'd try to turn on the PR machine to make it hard for Trump to carve out highly visible exceptions...
- Extrapolate: I expect the pain will show up in places we don't initially expect.
Details on the trade front are still few: most tariff hikes are still at the "promised" stage and are not yet effective. Second, much trade is under long contracts, so historically it takes 18 months for measures to work their way across the Atlantic and Pacific. Yes, tariffs can (and will) affect goods while they're in transit, so the price impact will be felt more quickly than changes in quantity. But the impact will consist on small increases in the prices of a large number of goods. Consumers may not connect the dots between trade policy and why they're having such a hard time making ends meet. But that won't be hidden to mass-market retailers, whose sales will inevitably be hit.