June Newsletter: Taking Stock of the Trump Tradewar

Posted by Alex Frey (@alexhfrey )

With the S&P 500 still more than 100 points off its all-time high of earlier this year and international faring even worse, there are still considerable jitters in the financial world, despite a recovery in market performance since the beginning of the year. As we covered earlier this year, one of the things potentially making them jittery is the high valuations of stocks globally relative to their fundamentals (whether this is judged by earnings or more normalized measures).

There’s also a new reason for jitters: a trade-war seems to be heating up. As we haven’t covered this before, we thought this month would be a good time to take a look at what is going on and how concerned you should be.

You are probably familiar with the recent events. The U.S. fired the first round of a possible trade war when it announced a 10% tariff on aluminum and a 25% tariff on steel. The tariffs went into effect against China and India in March. On May 31st, they went into effect against Mexico, Canada, and the European Union. The U.S. justified these tariffs by claiming that they were needed for national security. Otherwise, they would violate World Trade Organization (WTO) rules that the U.S. has agreed to.

In response to the steel and aluminum tariffs, China announced tariffs on U.S. wine, pork, and other products. The U.S. continued the tit-for-tat by imposing tariffs on a long list of industrial products from China; in return China announced tariffs on U.S. soybeans, cars, and chemicals. Now the U.S. has threatened tariffs against an additional $200 billion worth of Chinese goods, but these haven’t been specified or enacted yet. The other affected nations have also announced retaliatory tariffs against the U.S.

Whether this tit-for-tat will continue or whether there will be a negotiated truce is uncertain, but assuming there is no truce, what are the likely effects on the economy and the stock market?

First, let’s start by saying that economists are pretty much unanimous in believing strongly that trade improves economies and living standards. A full discussion of the benefits and costs of trade is quite complex, but the basic argument in favor of trade is pretty simple. Trade allows nations to focus on what they do best and buy from other nations what they do best. It also increases competition and forces businesses to operate as efficiently as possible, which is beneficial to the whole economy.

One of the most fundamental but partly counter-intuitive findings of basic economics is that trade benefits even a hypothetical nation that is strictly inferior at everything compared to a trading partner. In extreme terms, you can image a two-nation world where, for instance, there are only two goods, corn and cars, and nation A is five times more efficient than nation B at building cars and three times more efficient at producing corn. You might think that there should be no way for nation B to ‘win’ at trade here, but it’s actually simple to show that if nation A specializes in producing cars and nation B specializes in producing corn and they trade, that BOTH nations will be able to consume more cars and corn then they otherwise would have. This is the notion that nation B has a “comparative advantage” in producing corn, even though in absolute terms it has a disadvantage. The important fact is that trade, as a general principle, is not zero-sum. That is there are not necessarily “winners” and “losers”, it can really make everyone better off. By a direct consequence, trade wars, therefore, do not necessarily have a winner. It is quite possible that both sides up 'losing', in the sense that consumers of both nations may end up worse off then they would have otherwise been had there not been a trade war. 

Of course, there are arguments for restricting trade, and some of them have some validity. National defense is one such argument. If a nation becomes dependent on trade for materials that are critical to defense, it might be significantly weakened in time of war. Also, a nation that is dependent on trade might become vulnerable to disruptions elsewhere in the world or to changing technology even if it is not at war. A more diversified economy might be a more resilient economy.

However, the argument that is usually used against trade is that it causes unemployment by eliminating jobs. That argument is invalid, at least in the longer term. If consumers can get products cheaper by buying foreign products, the money that they save gets spent on other things, and the production of these other things creates employment that offsets those lost to trade. This is why the unemployment rate in the United States is actually quite low today, even though many jobs have been “lost” overseas over the past thirty years. When production becomes more efficient, because of trade or for any other reason, in the long term everyone benefits. It is worth noting that even President Trump, while imposing tariffs, has said that he would like to see a world without tariffs.

The long-term aside, the question of immediate interest of course is how a trade war, if it develops, will affect corporate profits and the stock market. Obviously, there will be winners and losers. Short-term winners will be companies and workers who are directly protected by the tariffs. At this moment, this includes U.S. steel and aluminum producers. The benefit to them is fairly obvious, and for that reason the public may perceive more gains than losses, which may be one of the reasons why protectionist policies can be politically popular -- the few that benefit from them may be vociferous (and generous with their campaign contributions) since they will tend to benefit a lot, the many that will be hurt by them (anyone buying a car, say) might tend to be silent, since they will likely be hurt only a little.

That said, some losers will of course be more significant than others. The most obvious losers are U.S. exporters, such as Boeing, Caterpillar, and Harley Davidson, who will be subject to retaliatory tariffs and other retaliatory actions, as well as individual farmers who will be impacted directly or indirectly by tariffs on commodity exports like soybeans. China has already announced that they will cancel the purchase of Boeing aircraft, and the European Union has announced tariffs on U.S. made motorcycles. U.S. farmers are also net exporters and will also be losers. China has announced tariffs on U.S. soybeans, and price of soybeans has plunged since that announcement.

In other cases, the losses may be less obvious but nevertheless significant. Many companies have complicated relations with China and other nations that could be threatened by a trade war. The semiconductor-manufacturer Qualcomm is a case in point. It designs semiconductor chips in the U.S. and produces some of them in the U.S. and some in China. It both buys and sells chips to China. Complicated supply networks of this type will be hard to replicate and may create considerable cost for U.S. based companies. In Qualcomm’s case, it is also trying to buy a Netherlands based chip maker, NXP, and it needs Chinese anti-trust approval to do so. As a counter to U.S. tariffs, China may refuse to approve the deal.

U.S. automakers are another case in point. They ship auto parts to and from Mexico while assembling cars in both countries. Rebuilding supply networks such as this may be very expensive for many U.S. based companies and probably for some foreign based companies as well. Of course, U.S. consumers will also be hurt by tariffs because prices will rise. The Trump administration has tried to avoid direct tariffs on consumer products, but the cost of the tariffs will flow though to consumers.

Considering corporations overall, it is hard to quantify gains and losses across the economy, but we think there will be more corporate losers than winners, and we think the short-term effect on corporate profits and on the stock market will be negative. Perhaps the most detrimental factor will be uncertainty. In the long run, companies can probably adjust to tariffs or to free trade, but it’s hard for them to plan when they don’t know what the rules will be.

If tariffs eventually stabilize at a higher level than the present, the long-term effect on corporations will probably be tied to the performance of the whole economy. But how can we get a sense of what the size of the impact is likely to be? Here, we can look at some models that economics have built that have somewhat surprising results.

Steve Goldstein, of Market Watch, reported results that came from economists at Bank of America. They modeled a full-blown trade war where 10% tariffs were added across the board to all goods and services. The analysis indicated that gross domestic product (GDP) would be reduced 0.4% in the first year and 0.6% in the second. It is interesting that these are very modest effects, and the premise is far beyond anything that has happened to date.

Daniel Solomon, an economist at Euromonitor International, analyzed a case where bilateral tariffs between China and the U.S. increased by 15% to 25%. Over three years, he suggested that the U.S. GDP would decline (with respect to the baseline) by 1.0% to 1.5%, and the Chinese GDP would decline by 1.5% to 2.0%.

Economists at Penn-Wharton school of business analyzed the effect of an all-out trade war using the Penn Wharton Budget Model. They reported that that an all-out trade war would reduce U.S. GDP by 0.9% by 2027 and by 5.4% by 2040. It seems very unlikely that this trade war will last that long, so the practical effect would probably be much less.

Writing in a New York Times piece, Paul Krugman considered a trade war in which each country acted enacted an optimal tariff (from its own perspective, without considering what other countries would do). He suggested that the “optimal” tariffs would be in the range of 30% to 60%, considerably higher than the Trump tariffs. Assuming that tariffs would average 40%, Krugman made a rough back-of-the-envelope calculation and concluded that the U.S. would lose 2% to 3% in GDP, a rather small effect. However, Krugman also make it clear that this rough estimate did not include the effects of “disruption”. Disruption refers to the fact that workers in export related industries may have to move to new jobs. The U.S. may not lose a great many jobs, but many workers will have to move to new jobs, possibly in new locations. Although Krugman didn’t say this, disruption may also refer to the disruption of corporate supply lines and to the capital cost of building new supply lines.

While these models predict negative effects universally, this is not surprising given the argument above. What stands out is that in no case do the effects seem catastrophic. So if tariffs stabilize at a higher level than now, the long-term effects will probably be negative, but not cataclysmic.

This makes it somewhat easier in this case to answer our usual question: "so what should an investor do?" This is a clear case where we can say: probably nothing. Trying to pick specific winners and losers is difficult, and in any case the nature of the game is controlled by politics and could change at any time. Trump quickly pivoted from calling Kim Jong Un "rocket-man", saying he was the worst human-rights violator in the world, and threatening to wipe him out; only months later to strike a deal with him and sing his praises. So it's quite possible that the current trade war will come to be seen as a negotiating tactic or posturing, or, failing that, that Trump will simply change his mind (since it is him, and not the house or senate that is initiating the whole thing). If the trade war gets worse, there will be more losers than winners for sure, but the impact on the overall economy is unlikely to be ruinous in itself.

There are some extreme political risks out there no doubt, and we'll talk about more of those soon, but tariffs probably won’t snowball enough to make a really sizeable impact in themselves. We should all hope for some stability in the trade rules, but we probably shouldn’t alter our investment strategy in response to the daily news.


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By Alex Frey