Tit for Tat Trade Deals
When the two largest economies in the world go head-to-head on trade, no one should be surprised that financial markets don’t like it. As the snapshot of 2018’s trade events illustrate below, the announcement of trade tariffs between U.S. and China have escalated quickly. The measures are unsurprising given U.S. President Donald Trump campaigned on a protectionist agenda; however, the shift away from globalization creates a more nuanced and uncertain policy outlook, and introduces microeconomic costs such as loss of efficiency and productivity.
At this point, while the administration has released a proposed list of roughly 1,300 Chinese products subject to tariffs (and is exploring tariffs on $100 billion of additional products), no tariffs have actually been imposed and won’t be for at least a couple of months. Additional tariffs would likely take even longer to implement. This time period theoretically leaves the door open for the U.S. and China to negotiate a settlement that to make the trade relationship for reciprocal.
Recent U.S. negotiation tactics have followed a consistent pattern: headline announcements spooking markets, followed by compromise and narrow implementation (perhaps Trump’s latest version of the “Art of the Deal”). Approximately 65% of the world is now exempt from what were initially global steel and aluminum tariffs. U.S. President Donald Trump’s tariffs on Chinese goods triggered another bout of market volatility. Yet the order contained no immediate action and left the door open for talks. China has a few options that are available for making the trade relationship more reciprocal – a key U.S. demand – and helping trim the U.S. trade deficit. These include opening up service sector foreign ownership limits; reducing import taxes; loosening technology transfer requirements for direct investments; and increasing U.S. imports. Such measures may let the U.S. claim victory without hurting the global economy. Markets may breathe a sigh of relief and rally. Yet the path to such an outcome may be bumpy – and we see trade as both an upside and downside market risk.
It seems unlikely that the current administration will follow through with such a dramatic shift in trade policy - which would benefit few at the expense of many - at the risk of disrupting economic growth which benefit all as a rising tide in the form of economic growth lifts all ships. Escalating tariffs present a lose-lose scenario as it would lead to higher prices for consumers (whose spending account for approximately 70% of economic growth in the U.S.), a reduction in consumer spending given these higher prices and lower growth from reduced trade activity. Therefore, we are hopeful that cooler heads from both sides of the negotiating tables will prevail.
Economists Thoughts on Tariffs
Generally, economists think tariffs are a net detractor to economic growth. While there are arguments for and against tariffs, the vast majority of economists polled1 agree on that the retaliatory tariffs by China would have a negative impact of tariffs on the U.S. economy. Studies from the Organization for Economic Cooperation and Development2 (OECD) and the International Monetary Fund3 (IMF) go further, concluding that there are no winners in a trade war. They create an inefficient allocation of resources and block the free flow of goods. But economists are also aware that the effects are not uniformly bad. They can raise revenue for indebted governments and can protect industries from competition. They can be particularly beneficial in building competitive advantages in those industries. One question about the current U.S. tariffs is whether they are just meant as a negotiating tool to get other countries to open their markets.
While many countries impose thousands of “small tariffs” without incident, history has shown that large tariffs can be destructive. The Smoot-Hawley Tariffs (an extreme example that lead to a trade war in the 1930s) resulted in world trade dropping by 65%. In 2002, President Bush imposed steel tariffs up to 30% which resulted in over 200,000 Americans losing their jobs.4
Trade Wars & Investing
Benjamin Graham, one of the most influential investors of his time and widely known as the “father of value investing” once quoted, “in the short-term the stock market is a voting machine but in the long-run, it is a weighing machine.” What he meant by this is that short-term market moves are often emotionally driven, while long-term returns are more a function of underlying fundamentals. The volatility in the equity markets thus far in the year are an indication that the market has plenty to vote on; least of which are the threat of tariffs and escalating trade tensions between the U.S. and China. A focus on this issue is appropriate, as any escalation (i.e. trade war) would undoubtedly have a notable impact on the global economy and markets.
The past shows a wide range of reactions to tariff increases, and it is very difficult to draw any simple lessons. Moving into the early days of the second calendar quarter of 2018, markets are reeling from talk and action surrounding tariffs and trade wars. Markets abhor surprises, disruptions, and a perceived lack of vision in public policy. No one can predict the full economic implications of tariffs or trade wars, but early market reaction suggests concern. If there is a trade war, it would likely drive stocks down further. However, some industries and countries could benefit — such as those being protected at the expense of those being taxed. If there is an escalation of the dispute over intellectual property it could hurt technology companies, which are a likely target of retaliation. Additionally, looking at the S&P 500 Companies’ foreign exposure by sector may reveal the areas of the market that may be punished more than others should the current situation evolve into a trade war.
As it stands right now, the risk to equity investors relate less to ‘trade war’ and more so the impact on uncertainty and sentiment. The markets are conflicted between the benefits of tax reform that went in place this year and the turbulence of tariffs. At such time–and always, for that matter–the long-term fundamentals of seeking investments with attractive valuations, allocating to them in a globally diversified mix, and doing so through managers with a demonstrable competitive advantage are critical means by which investors can achieve their long-term goals. Investors should be careful not to overreact to unsettling headlines and be positioned to withstand volatility. A diversified portfolio may not be as glamorous as the idea of finding the top performing investment, but diversification provides a smoother path and helps avoid poor decisions that often run counter to one’s investment success.
1 Sarkar, S. “Economists United: Trump Tariffs Won’t Help the Economy.” Reuters, March 14, 2018.
2 Organisation for Economic Cooperation and Development. (2016). “OECD Economic Outlook”. Vol. 2016, No. 2.
3 Anderson, D. et al. (2013). “Getting to Know the GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Model.” International Monetary Fund.
4 U.S. Chamber of Commerce, Bureau of Labor Statistics, Bureau of Economic Analysis.