Two Cheers For Trump's Tariffs

by: DoctoRx

The trade "wars" being fought by President Trump have received a Bronx cheer from the financial media and investors.

I offer a different perspective, which is that the positives may outweigh the negatives, but that the media have conditioned investors only for the negatives.

A move away from China as the world's go-to manufacturer would be fine with me, as would preservation or strengthening of America's industrial base.

Several specific stocks and investment themes relating to this point of view are discussed.

Introduction - How the media overdoes the negativity on tariffs

The drumbeat of attack from the mainstream financial media on "Trump's tariffs" - as Bloomberg News routinely calls them - is so one-sided that I have taken an opposite investment tack, despite the risks, which are real.

As an example, here is a news report from Reuters on June 3, before the US and Mexico agreed that Mexico would do more to prevent immigration into the US, thus delaying or preventing the tariffs:

Mexico draws red line on asylum as Trump tariff risk rises

A 5% tariff on imported goods from Mexico, which last year totaled $347 billion, according to U.S. data, would result in a potential tax increase on American businesses and consumers of $17 billion, the U.S. Chamber of Commerce estimated. It said the number would reach $86 billion should Trump's increase the duties to 25%, as threatened.

They are accentuating the negative. They ignore the income to the Federal government, which is running giant deficits.

Assuming the $347 B is accurate, and that due to substitution effects and possible price reductions, the going-forward number is perhaps $320 B, then the US government would take in $80 B income at the full 25% tariff rate. Ignoring the cost of collections, then if the annual Federal deficit were $1 T, this alone would lower it by 8%. In addition, at least some production would move either to the US or to other countries, and typically some price-cutting from Mexican exporters can be expected. Net-net, the flow of funds and jobs could be positive for the US, and the negatives would tend to be diffused.

Consider Chipotle (CMG) and this Barron's headline, also from June 3:

Chipotle Says Trump's Mexico Tariffs Could Cost It Millions and Raise Prices for Customers.

Headline aside, here's some of what the article says:

Chipotle... issued a statement saying that if tariffs on Mexican imports threatened by President Donald Trump are enacted, its profit margins could fall by 0.2 to 0.3 percentage point.

That's no big deal. But the story dissolves into triviality when Barron's also reports that:

If the tariffs become permanent, we would look to offset these costs through other margin improvement efforts already under way. We could also consider passing on these costs through a modest price increase, such as about a nickel on a burrito, which would cover the increased cost without impacting our strong value proposition."

So the "story" is more like a nothingburger.

The backdrop: "truly... a crisis"

When an Obama official agrees with this president, he may be right. From RealClearPolitics on March 29 (emphasis added):

Jeh Johnson, who served as President Obama's Department of Homeland Security Secretary said "we are truly in a crisis" at the Mexican border Thursday on MSNBC's Morning Joe.

... under 1,000 apprehensions the day before that was a relatively good number, and if it was above 1,000 it was a relatively bad number, and I was gonna be in a bad mood the whole day.""On Tuesday, there were 4,000 apprehensions. I know that a thousand overwhelms the system. I cannot begin to imagine what 4,000 a day looks like, so we are truly in a crisis," Johnson explained.

In other words, there is much more at play than economics.

Now let's move to a larger player than CMG.

Walmart (WMT) can handle tariffs

I saw WMT's CEO, Doug McMillon, on TV in early June. He said that WMT sources 2/3 of its merchandise in the US and plans to increase that. It has plans to diversify manufacturing from China, to Viet Nam and elsewhere. WMT will not disclose its mark-up on imports from China, but about nine years ago, I read China Shakes the World, by a British journalist, James Kynge. He reported that China complained that WMT and other large US importers were garnering massive profits by buying at prevailing Chinese prices, displacing US or other high-cost suppliers, but keeping retail prices more or less unchanged.

I cannot opine on today's margins or the veracity of those complaints from the Chinese side of the discussion, but something drove all the outsourcing to China, and there was no deflation at the time in the US to accompany lower product costs. Some companies made a lot of money by shifting production to China.

McMillon was calm about the tariff situation.

What are the negatives, and how important are they?

There certainly are negatives for investors that may well not have been fully discounted by the mythical Mr. Market. Some of these include:

  • Business decisions freezing due to uncertainty
  • Short-term price increases disrupting economic equilibria
  • Reciprocal actions from China and Mexico to hurt the US economy
  • Greater uncertainty about the USMCA, which is pending ratification
  • Weathering an initial round of tariffs could lead to overdoing them subsequently

There are also political issues, both pro and con, that are beyond the scope of an investment-focused article.

All taxes have negatives, of course, and some have positives. I tilt toward the "two cheers" for the China and, if imposed, Mexico tariffs because...

The best reasons for low or no tariffs are not present here

A no-tariff situation makes political sense in a Europe devastated by two senseless, destructive wars. Voila: the Common Market, a predecessor today's EU.

Another obvious and more general reason not to tax imports comes from the concept of comparative advantage. Take three neighboring countries in a situation from the 1800s:

  • England has lots of iron and coal and produces lots of low-cost steel
  • France has the right climate and soil and produces lots of great wine
  • Switzerland develops a specialization in watch-making

Bilateral or triangular trade situations such as this may be desired so much, with no domestic industries to protect, that few governments would want to discourage trade by putting meaningful tariffs on imports from specialized producing countries.

Neither of these situations applies to the US and China/Mexico, where inexpensive, reliable labor drove outsourcing of production.

One historical point should be addressed.

Smoot-Hawley is not a great analogy

The US has been ranked with the nations with the lowest tariff barriers, with China much higher, i.e. more protectionist. See rankings from Index Mundi and Economics Help, for example. How these rankings would change if the full proposed China and Mexico tariffs are enacted is unclear.

Comparisons of current and proposed tariffs to the Great Depression and the Smoot-Hawley Tariff Act of 1930 have been made.

The situations are not especially analogous.

The US entered the crash of 1929 with very high tariff rates, which had been in effect since about 1922, and Smoot-Hawley was enacted in response to the ongoing economic downturn. Unlike the "Trump tariffs" - actual and proposed - Smoot-Hawley was not done with political motives against two specific countries; it was broad-based and involved adding meaningfully to an already protectionist US trade policy.

In fact, the very term "war" to describe the tariff situation is a tad overblown. The 1922 tariff act in the US took tariffs to the 40% range, after which the '20s "roared." A 25% tariff on imports from two countries is hardly "war" in that context.

Let's look at the data.

Import prices from China and elsewhere are dropping

The yoy trend in import prices from China is negative, down 1.4% in May versus May 2018. The yoy trend has been negative every month beginning last November. So the tariffs that went into effect last year have been associated with deflation, not inflation. In addition, the prices of all imports were down 1.5% yoy in May.

Why is this? Of course, there are many reasons. I would highlight the importance of access to the gigantic US market to exporters around the world. As I have said, this shows, or at least strongly suggests, that costs and prices are malleable as circumstances require.

The Reagan-era analogy

From an economic standpoint, bringing in revenue to the US government after the implementation of a large tax cut reminds me of the Reagan era. The tax cut that took effect in 1982 was followed by "revenue enhancements" every year, or almost every year, of the Reagan presidency. It was then followed by meaningful tax increases passed in 1990 and 1993.

Tariffs may be acting like the many revenue-raising measures that the government took after the budget-busting policies of the early Reagan years required adjustment. The difference with tariffs is that part of the cost is borne outside of the US. That's a positive for a US-based investor; "they" help keep the deficit lower than it otherwise would be.

The final two sections get to some investing specifics, beginning with top-down considerations.

The investment positives appear to outweigh the negatives; a top-down summary

I summarized the major negatives previously. Here are some positives that I see as an investor from Trump's tariffs, not necessarily in order of importance:

  • Media has overdone the negatives, which may provide a classic "buy the news" set-up
  • Deficit is reduced, helping to strengthen the USD
  • Lower deficits are anti-inflationary
  • Less economic reliance on China
  • Greater stability and growth potential for domestic US producers
  • Early data on Chinese and other tariffs does not show inflation
  • Targeted nature does not encourage domestic producers to get lazy
  • Helps achieve foreign policy objectives
  • A dramatic deal announcement could catalyze risk-on sentiment.

Thus my view is that the reaction from the financial media to tariffs joins with a number of positives to create a more-bullish-than-bearish opportunity.

Translating this view to investing decisions

With a few exceptions, such as a longstanding position in Deere (DE), I have been investing heavily either in US-focused companies or multinationals that get little or no business from China.

What follows is a list of stocks or sectors I own and have discussed previously, put into the prism of trade issues. These are examples and not comprehensive.

Microsoft (MSFT): It has complained for years about losing billions of dollars a year to piracy of Windows/Office in China. Thus it has upside from a deal, and minimal if any further downside from the status quo.

Utilities (XLU): Deficit reduction from any source takes some of the pressure off interest rates, and an America first set of policies generates greater energy demand in the US. I have written several articles on the utility sector over the years and am long Con Ed (ED), NextEra Energy (NEE) and WEC Energy (WEC). Given today's bond yields, I think these stocks still have upside price potential in addition to secure dividends.

Biotechs (IBB): China has already become an important market for multinational biotechs and Big Pharma companies. I expect trade in medicines between Western companies and China to be unaffected by trade disputes, meaning I expect it to continue to grow. Meanwhile, no harm is done to the basic business of developing and marketing innovative products from trade wars.

Retailers (XRT) and restaurants: These are classic domestic plays.

I remain long TJX (TJX) and Ross Stores (ROST). TJX is primarily US-focused, with a significant presence in Canada and stores in Western Europe and elsewhere, but not China. ROST is entirely US-based. It appears from company comments that neither is being harmed much if at all by tariffs. I also remain long Home Depot (HD), which is managing through the tariff situation pretty well. HD sells primarily in the US and secondarily in Canada and Mexico, so any trade war that hurts Mexico would be a mild negative to it.

In the restaurant sector, I remain long Darden (DRI) as the cream of the crop in casual dining, and also The Cheesecake Factory (CAKE). CAKE has several growth drivers in early stages of roll-out and, with an aging founder, has what I estimate as 40-50% upside if it is acquired (possibly to DRI). Restaurants tend to be helped by disruptions in agricultural exports to China, which keep the domestic prices of foodstuffs down. CAKE has minimal exposure to China, but basically these are domestic plays.

Bonds (TLT): These are helped by bringing revenue into the Federal government. So far, the imposition of significant tariffs on imports from China has been associated with price decreases. Thus the trade war story has been a bit of a "Goldilocks" story for Treasuries and other bonds that are priced in relation to Treasuries.

Concluding comments

If the media favored the Trump program and were cheerleaders for tariffs and the like, I would be reacting differently as an investor. As matters stand, tariffs are primarily being used to A) change behavior of China and Mexico and B) secondarily to reduce the swollen Federal deficit. I've been trying to take advantage of the investment opportunities arising from those facts, the economic positives associated with them, and the one-sided media presentation of this complicated and ongoing story.

In practice, we are seeing price decreases from China, not the widely-expected inflation.

So far, the Goldilocks scenario (combined stock-bond bull market) is mostly on track. If the Fed finally bows to the fact that inflation is waning, and thus lowers rates before staring US recession threats in the eye, I think we could see a very nice rally in the S&P 500 (SPY) and the domestically-oriented Russell 2000 (IWM).

In conclusion, negativity regarding trade "wars" may have helped create a bullish set-up in the market. Risks exist, but I'm accentuating the positive in the US markets. Thus, based on matters as they now stand, as an investor I give two out of a possible three cheers for tariffs, and am hoping for it to rise to three of them.

Disclosure: I am/we are long CAKE, DE, DRI, ED, HD, MSFT, NEE, ROST, TJX, TLT, WEC. 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.

Additional disclosure: Not investment advice. I am not an investment adviser.