Britain's economy and financial markets have been roiled by the vote that called for Britain to exit the European Union. This damage has occurred even though Brexit has not actually taken place yet. There are many in Britain who regret their vote and many business and political leaders who wish they had done more to prevent Brexit. Both the Conservative and Labour parties opposed leaving the EU in the June 2016 vote. The political party that promoted leaving the EU was the United Kingdom Independence Party ("UKIP"). Leave won with 51.89% of the vote.
The effort to leave the EU was developing for a number of years. In the 2014 British local elections UKIP won 163 seats In the 2014 European Parliament elections, UKIP received the greatest number of votes (27.5%) of any British party. It was the first time since 1906 that a party other than Labour or the Conservatives had won the most votes in a UK-wide election. In the period prior to the Brexit vote the UKIP claimed that leaving the EU would save a tremendous amount of money that could be used to improve the British national health system and other claims that are now known to be false.
After the Brexit vote the truth about the consequences of Brexit became widely known and in the subsequent votes the UKIP suffered accordingly. In the 2017 local elections, UKIP lost all 145 seats it was defending. In the 2018 local elections, UKIP lost 124 of the 126 seats it was defending. In the 2017 election, a Snap parliamentary election initiated by Prime Minister Theresa May and held on June 8, 2017, UKIP got 1.9% of the votes (after receiving 12.6% in the previous 2015 parliamentary election where it had won seats). UKIP lost all of its' seats in the House of Commons as a result of the June 8, 2017 parliamentary election.
It is still unclear how much harm Brexit will do to the country where David Ricardo first demonstrated how free trade benefits all countries, when he developed the concept of comparative advantage. However, Brexit is clearly a setback for free trade world-wide and was seen as a gain for protectionism. It was also considered to be a harbinger of Trump's election as a populist and protectionist.
There are many similarities between the populist surge that resulted in Brexit and the election of Donald Trump. In both cases, populists falsely claimed that trade agreements had harmed their countries. Trump echoed the anti-free trade and anti-NAFTA arguments, that previously had been mainly the domain of anti-business leftists, such as by Bernie Sanders.
The motives and means used, by those that foisted Brexit on Britain and argued how America was put at risk of disastrous trade policies are interesting, but not the focus of this article. Rather, the potential impacts on financial markets of those trade policies are. Many are aware of the dangers of protectionism, but are not familiar with the mechanisms by which protectionism does its' damage. Senator Reed Smoot and Representative Willis C. Hawley probably did many things in their careers, but history only remembers them for the Smoot-Hawley tariff of 1930, which remains the prime example of the damage that protectionism can do. In a 1930 front page article, the New York Times reported that over 1,000 prominent economists had signed a petition urging President Hoover to veto the Smoot-Hawley tariff bill. At that time economists knew that David Ricardo had proven that trade benefits all countries. Since then, economists have developed more advanced tools and concepts to demonstrate how tariffs reduce real output and standards of living.
Smoot and Hawley did not think they were going to reduce real output. Those ignorant of modern economics do not understand the mechanisms by which tariffs reduce economic activity. They might easily think that tariffs on steel and aluminum simply shift production from other countries to the US, so what's the problem? Clearly there are present-day versions of Smoot and Hawley who think tariffs are a good idea.
Already, we are seeing the effects of the inevitable responses to tariffs. Not only were Trump's assertions that "trade wars are easy to win" fallacious, but the country that instigates a trade war is always by far the biggest loser. The retaliating nations always have a tremendous advantage over those instigating protectionism. This can be easily seen with the tariffs on steel and aluminum that increase the costs of every product made in the US that uses those metals. Thus, American consumers and producers are already net losers from these ill-advised protectionist tariffs, even before any retaliation. These tariffs increase consumer prices and make products produced in the US less competitive, relative to those manufactured goods made outside the country using steel and aluminum priced at the world market, rather than the artificially propped-up, protected US and aluminum steel markets.
As Trump discovered when a retaliatory tariff was put on US motorcycles by the EU, mostly impacting Harley-Davidson (NYSE:HOG), which will not raise any costs on any EU producers or for anyone in the EU except for buyers of motorcycles, the cost to the retaliating nations is miniscule. HOG has announced it will have to shift production outside of the US as a result of the tariffs. Thus, on top of the harm to US consumers, producers and exporters of the steel and aluminum tariffs, before any retaliation, American workers at HOG lose jobs and shareholders of HOG suffer as well. Polaris Industries (NYSE:PII) the US maker of Indian and Victory brand motorcycles, is considering similar actions with regard to shifting production overseas and reducing employment in the US in response to Trump's steel and aluminum tariffs and the retaliation by other countries.
Tariffs Shift the Aggregate Supply Curve to the Left
The inevitable retaliation to tariffs is not the only mechanism by which tariffs lower real output. Even if there was never any retaliation to tariffs they would still reduce real output. To understand how tariffs reduce real output requires knowing a little about macroeconomic aggregate supply and aggregate demand curves. These were introduced by Keynes in the 1930s. These curves represent relationships between price levels and the quantities of real GDP. Where the aggregate supply and aggregate demand curves intersect is the equilibrium level of prices and real output. Once in equilibrium the economy tends to stay in equilibrium. If not at the equilibrium point it tends to move toward equilibrium. When the equilibrium point is at a level of low real output and thus high unemployment, output can be stimulated by government policies that shift the aggregate demand curve to the right. Thus, increasing government spending and/or reducing taxes have been used as policy tools to move the economy from an equilibrium that is at an undesired level of output and unemployment to a an equilibrium with higher output by shifting the aggregate demand curve to the right.
Since unemployment and real GDP are negatively related, the relationship shown in the upward sloping aggregate supply curve can be represented by a downward sloping curve where unemployment replaces real GDP on the horizontal axis. This is the Phillips curve that relates price levels to unemployment. For the Phillips curve to "work" changes in unemployment and price levels have to be the result of shifts in aggregate demand while the aggregate supply curve remains relatively stable, as was the case in the 1960s.
When the demand curve is relatively stable but the aggregate supply curve shifts, the Phillips curve does not work. The events such as the failure of the anchovy harvest attributed to El Nino weather conditions, and spikes in oil prices in the 1970s and after, due to events in the middle east and Iran, caused the aggregate supply curve to shift to the left. This caused the Phillips Curve relationship between unemployment to break down. This was called stagflation, as the levels of inflation that the Phillips curve normally indicated to accompany low unemployment, were present while there was relatively high unemployment.
Trade Agreements and Globalization Have Increased Output In the US
Tariffs always shift the aggregate supply curve to the left. This is true whether or not there is any retaliation. Any trade restrictions shift the aggregate supply curve to the left by increasing input prices. Hence, any reduction in trade restrictions such as tariffs shift the aggregate supply curve to the right. When the aggregate supply curve shifts to the right, for any particular aggregate demand curve the equilibrium point of intersection occurs at a higher level of output. That is why NAFTA increased real GDP and lowered unemployment in America, Canada and Mexico.
The biggest falsehood promulgated by Trump and many of the (mostly Democrat party) politicians who oppose NAFTA and other trade agreements is that America has entered into terrible trade deals. This is particularly dangerous, because so many people who are now vehemently opposed to Trump appear to have bought into it. The exact opposite is the truth. The USA may not be number one in everything, but we are definitely number one in negotiators and lawyers.
If two foreign countries, say Brazil and Argentina were in a trade related dispute, both sides will usually hire American negotiators and lawyers. One tactic the USA has used to get the upper hand in trade negotiations was to use American women to do the face-to-face negotiation. Many foreign cultures were unused to dealing with women at that level. This gave the USA an additional advantage when negotiating the trade deals, that made America the worlds' largest and strongest economy.
It is distressing that many leftist protectionists like senators Bernie Sanders and Sherrod Brown (D-Ohio) were so quickly able to go from complaining that trade deals like NAFTA and the TPP were examples of corporate America exploiting the workers of the world, to agreeing with Trump's false assertion that the trade deals were one sided against American business interests.
Much Remains to be Determined as to Market Impacts of Trade Issues
Brexit has not yet occurred, as negotiations between the UK and EU continued. The possible outcomes from Trump's protectionist inclinations vary widely. Trump and some of his advisors such as Larry Kudlow assert that Trump is a free trade advocate who wants to eliminate all tariffs and trade restrictions. In that respect Trump could be thought of as less likely to destroy the world trading system than he truly committed protectionists like Peter Navarro, Bernie Sanders and Sherrod Brown who are prime examples of the "progressivism of fools" branch of protectionists. The only objective of tariffs supported by those protectionists is to transfer wealth to the employees and owners of favored domestic producers. That the costs and losses to the rest of Americans far exceeded the gains to the employees and owners of favored domestic producers is never a concern of the "progressivism of fools" branch.
Trump and some of his advisors' claim that he is really trying to eliminate all tariffs and trade restrictions. This has many uncertain has to what to believe. Initially, with regard to trade it was thought by many financial market participants that "Trump's bark was worse than his bite" as Trump did not pursue some of his more extreme campaign proposals such as deporting 12 million illegal aliens. Gary Cohn and Steve Mnuchin were widely thought of as exerting a free-trade influence on Trump and thus preventing Trump from acting on his worst protectionist inclinations. However, Gary Cohn resigned in protest over Trump's initial imposition of tariffs and Steve Mnuchin is now simply asserting that Trump is really trying to eliminate all tariffs and trade restrictions.
Trump recently met with European Commission President Jean-Claude Juncker and indicated that they both agreed that eliminating all tariffs and trade restrictions between the EU and USA was an ultimate goal. However, when the EU offered to eliminate all tariffs on cars as a first step, Trump rejected it. The confusion over Trump's true trade motives on the part of financial market participants can be epitomized by Goldman Sachs (NYSE:GS) CEO Lloyd Blankfein who pointed out the extent that no one can really know what Trump's true objective regarding trade is, when he said about what Trump has done so far regarding trade "That's what you would do if you're crazy and wanted to end free trade," . Blankfein also said "That's what you would do if it was a negotiating position, and you wanted to remind your counterparty just how much fire power you had to bring to the negotiation."
A recent anonymous op-ed appeared in the New York Times, by a senior government official, thought by some to be US Ambassador to Russia Jon Huntsman. The op-ed asserted that senior officials in the Trump administration have been acting as "adults in the room" and preventing Trump from taking many very dangerous actions. This was done in some cases by not following orders or removing items from Trump's desk. It appears that with regard to defense and national security, some senior Trump administration officials are doing what Gary Cohn is thought to have done with trade. However, with Cohn gone there does not seem to be anyone in that role with regard to trade and tariffs.
An illustration of the wide range of market outcomes related to disparate possible scenarios was discussed in CEFL May Be Useful In Some Portfolios, With Its 17% Dividend Yield
..There are some scenarios in which the threat to the markets from protectionism could evaporate overnight. This could result in an equity market melt-up. At anytime, there is always the possibility that in response to some vague promise by the Chinese or others to eventually work toward smaller trade surpluses with the USA, Trump could announce victory and end the protectionist policies. The tentative Mexican-American agreement gives a hint of what could happen. That is similar to what he did with regard to the issue of North Korea's nuclear weapons. The weapons are still in place. North Korea does not care about American sanctions, rather North Korea needed to have trade relations with China resume, which has happened. Trump has declared that North Korea is no longer a threat. However, now nuclear talks with North Korea are at an impasse. On August 27, 2018, Trump called off a visit to North Korea by Secretary of State Pompeo after the latter received a belligerent letter from a senior North Korean official just hours after the trip was announced last week. The United States then announced that military exercises that had been suspended after the Singapore summit may now be resumed.
A Trump declaration of victory in the tariff wars and eliminating the tariffs would be very bullish for the stock market, even if, in reality, there was no significant change in any trade deficits. The markets would have a relief rally. However, there would still be the risk that Trump could abruptly reverse course and resume the tariffs and trade war.
There is also a scenario which could be much more bullish. If Trump were replaced by a President Pence, it would be a dream come true for the business community and the stock markets. It is likely that a President Pence would retain everything that business loves about Trump. These would include the lower business taxes and the reduction of regulation. Appointing judges who tend to favor employers rather than labor would also be a plus for business that Pence would surely retain. While keeping the things that business likes about Trump, Pence would likely remove the thing that corporate America fears and loathes about Trump.
Business and the stock markets would cheer a return to the free trade policies Republicans have traditionally stood for. As Politico reported:
...Pence succeeded his good friend David McIntosh in Congress. Now the president of the Club for Growth, McIntosh has become one of the most outspoken opponents of the administration's tariff decision on the right, calling the policy "an affront to economic freedom."
As governor of Indiana, Pence was a tireless advocate for free trade. He urged the Indiana congressional delegation to support both Trade Promotion Authority and the Trans-Pacific Partnership, which Trump campaigned against. In the letter, Pence argued that "reducing tariffs and other trade barriers so that Indiana businesses can enjoy increased market access and fairly compete on the world stage is something that Congress must do."...
Additionally, the business community and the stock market would likely take comfort in the reduced risk that Trump could take some reckless action that could precipitate military conflict, especially in the Persian Gulf region.
On July 5, 2018, it was reported that Iran explicitly threatened to block the Strait of Hormuz "Any hostile attempt by the U.S. will be followed by an exorbitant cost for them," said Esmail Kowsari, deputy commander of the Sarollah Revolutionary Guards base in Tehran, according to the Young Journalists Club, affiliated with Iran's national broadcaster. "If Iran's oil exports are to be prevented, we will not give permission for oil to be exported to the world through the Strait of Hormuz." Iranian President Rouhani reiterated that threat in a speech on Sunday July 22, 2018, that also included a warning the United States that any conflict with Iran would be the "mother of all wars."
Not to be outdone, President Trump tweeted:
To Iranian President Rouhani: NEVER, EVER THREATEN THE UNITED STATES AGAIN OR YOU WILL SUFFER CONSEQUENCES THE LIKES OF WHICH FEW THROUGHOUT HISTORY HAVE EVER SUFFERED BEFORE. WE ARE NO LONGER A COUNTRY THAT WILL STAND FOR YOUR DEMENTED WORDS OF VIOLENCE & DEATH. BE CAUTIOUS!11:24 PM - Jul 22, 2018
Military conflict with Iran by the United States could be particularly costly as the major NATO allies may be very reluctant to participate and could even deny the US use of bases and airspace, due to their outrage over President Trump's decision not to certify Iran's compliance with the Nuclear Agreement and other recent statements and actions by Trump. Not only would oil from Iran be shut off. Twenty-five percent of oil traded worldwide moves by tanker through the Strait of Hormuz, the world's most important petroleum transit choke point. A single artillery piece could block the Strait of Hormuz at its narrowest point. No insurance company would insure any oil tankers that could be subject to visually directed gunfire. Any military conflict involving Iran could thus drastically reduce supply and spike oil prices.
How Might Markets React to Much Worse Protectionism?
There is a real risk that President Trump could escalate protectionism, particularly with regard to China and possibly a withdrawal from NAFTA or even the World Trade Organization. These actions would shift aggregate supply curves to the left worldwide and thus reduce economic activity. While standards of living of the populations in the USA and other countries could decline severely, the impact on financial markets might not be as severe. Reduced economic activity, especially if it reaches recessionary proportions, could cause the Federal Reserve and possibly other central banks to lower interest rates or engage in quantitative easing. That could support securities markets in ways described in A Depression With Benefits: The Macro Case For mREITs.
Individual market sectors, companies and commodities could experience widely disparate outcomes from an escalation of protectionism and the inevitable retaliation. One possible Chinese response could be to greatly expand soybean and corn production worldwide by providing subsidized credit and capital to areas such as South America and Africa that could be used for expanding soybean and corn production. During the colonial era there were many very large farms owned mostly by Europeans in sub-Sahara Africa. Today, risk/reward profit maximizing investors would tend to avoid investing in large capital-intensive agricultural operations that could be subject to expropriation or the whims of warlords, as was the ultimately case with many of the large farms that had been established during the colonial era.
China could easily decide, either for retaliatory or food security reasons, to have its state controlled or influenced entities to advance the funds needed to develop large efficient capital-intensive farms. There are many areas in the world in addition to South America and Africa that could be used for expanding soybean and corn production, if the money for modern irrigation and advanced farm equipment was made available on very favorable terms by the Chinese.
Russia has recently made available an additional 2.5 million acres of farmland eligible for foreign investment. Russian officials said that they expect most of the farmland to be bought by the Chinese. Chinese officials have also suggested that American farmers would never regain market share lost in a trade war.
Were this to occur, American soybean and corn farmers and the areas that depend on them would be depressed for many years. Industries that sell equipment and other goods to farmers would suffer. Many point to the depression in American agriculture in the 1920s that preceded the great depression as a precipitating factor. Even before any new crops from these Chinese agricultural investments came online, the prospect of the gluts they might cause would depress prices of farmland and sales of farm equipment. This could result in defaults and credit problems as well as depressing securities of entities that depend on a healthy agriculture sector.
China also could retaliate by imposing taxes or restrictions on America's largest "export" which is securities such as bonds and stocks. This also could hurt China as the value of their vast holdings of American securities might decline. However, the whole point of a trade war is to harm the other side even if it hurts you. The United States federal government is well on the way to its first $2 trillion deficit, as is described more fully in the article "A Reality Check On The Budget Outlook." Chinese retaliation such as taxing American securities, that makes it difficult to finance the American deficits, could harm the economy and securities markets.
Summary and Conclusion
The risks that protectionism could shift the aggregate supply curve to the left and significantly reduce economic activity are real. There are various scenarios that could occur, some of which could be favorable for the securities markets. Unlike, Britain where there does not seem to be any serious chance to hold a new vote to reverse Brexit, there may be some paths to avoiding protectionism. These positive outcomes could result from Trump declaring victory and ending the tariffs or from Trump being replaced relatively soon by a pro-free trade President Pence. There are also scenarios where real GDP declines due to protectionism, but certain interest rate sensitive securities do better.
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.