Q3 started out with several very positive days in the equity markets, due to the seeming “Goldilocks” economy (solid growth, low inflation, best employment market in 50 years), likely in anticipation of continued 20%+ earnings reports (the tailwind of tax reduction), and, at least in the early days of July, from a lack of any significant moves on the tariff and trade front. That all ended on July 11th when the Trump Administration threatened 10% duties on an additional $200 billion of Chinese goods if agreement isn’t reached by the end of August. And, markets are now gyrating up or down depending on the day’s assessment of the “trade war’s” impact on long-term growth. Volatile, to say the least.
Tariffs to Date: Little Impact
The Q2 data that we will be getting in the weeks ahead will mainly be devoid of any negative trade and tariff impacts on consumers. There have been some on businesses who must now pay higher prices for steel, aluminum, and lumber, and price increases are starting to show up in Q3. Nevertheless, the near-term data releases are Q2 based, and profit margins, so far, appear to have absorbed the current tariffs. That is likely to change going forward. On the positive side, a record export of soybeans in April/May which preempted China’s tariff retaliation, will have a large positive impact on Q2’s GDP growth rate. But, note, that was demand pull-forward. So, Q3’s growth rate will suffer.
Why Have Tariffs?
From a pure economic point of view, prices are lowest and resources are most efficiently allocated when there is free trade (no tariffs, no subsidies). Consumer prices rise, and/or corporate profits fall, when tariffs are levied. Tariffs are equivalent to a sales tax. Then, why are they there? Two reasons:
• Self-Sufficiency: In an uncertain and increasingly dangerous world (nuclear arms, jihad, etc.), a major power like the U.S. needs to be self-sufficient with regard to some critical defense items. Imagine if the U.S. had no steel/aluminum making capacity and China had 100% of it!
• Jobs: This is a political football. By placing tariffs on imports, a country can protect jobs that would otherwise go elsewhere. At the same time, a country can subsidize an industry (like Canada does to its lumber industry or the U.S. does its agriculture space) to keep prices low enough so no one else can effectively compete. In the case of tariffs, the country keeps the jobs, but that country’s consumers pay more for the product or for the goods in which that product is a part. In effect, the consumer subsidizes the protected industry. For the most part, consumers do not know they are subsidizing. But, it is clear to those who get to keep their jobs that those tariffs are effective, and they are beholden to the politicians who impose/support them.
In my last writing, I said that the best growth for the remainder of this cycle would be in Q2. My reasons: 1) Fed tightening and the rising cost of money; 2) the fiscal stimulus of the tax cuts fades over time; 3) slowing world growth and, in particular, a recognized slowdown in China; and 4) the rising cost of gasoline.
Models: Tariffs Have Small Impacts
Highly respected economists have indicated that tariffs will have small impacts on U.S. GDP. One model says that only 4% of trade with our largest four trading partners has, so far, been impacted by tariffs, and that, at most, would equate to about a 0.5% impact on GDP’s growth rate. But, this has now escalated to the point where tariffs are becoming significant (steel, aluminum, lumber, potentially imported autos and parts, specific Chinese goods, and, in the opposite direction, agricultural commodities (even ketchup!)). There is no doubt that consumer prices will rise as a result, and this could impact as much as 40% of imported goods and up to 5% of GDP. So, it could be a significant issue, and thus, the equity markets’ reaction.
As noted above, economic “models” indicate that, so far, the impact on the economy of today’s “trade wars” is likely to be less than 0.5%. Those “models” are based on historical data measuring how the economy reacted to various stimuli in the past. The biggest mistake here is to think that today’s economy, powered by today’s technology, demographics, and attitudes, will react like the economy of 50, 40, 30 or even 10 years ago. But, “data” from these eras are the basic ingredient of those models. Don’t put a lot of faith in them.
Reality: Tariffs Bite
While it appears that we are in the early stages of the “trade wars,” it is clear that they are already having a significant impact on business in the form of uncertainty and unwillingness to invest. In May’s Fed minutes, “some” businesses were concerned about tariffs and were “thinking about” reducing capital expenditures. In June’s Fed minutes, “some” became “many,” and “thinking about” was becoming reality. The fact is, today’s supply chains are significantly more “global” than they have ever been. Historical data in those econometric models are likely to produce estimates that are much more muted than today’s reality. An example of such “surprise” was Harley Davidson’s announcement that it would move some of its production overseas to avoid the retaliatory European tariffs. Such a reaction was not in any of the “conventional wisdom” or models regarding the tariff and trade issues.
China Can Retaliate
While it appears at the outset that the U.S. has a big advantage in these “trade wars” (latest data show that we imported $505 billion from China while they purchased $130 billion from us, a $375 billion gap), there are other levers that China can pull. China has a great deal of influence on N. Korea, and perhaps the N. Korean characterization of Secretary Pompeo as using “gangster like tactics” in his visit there the weekend of July 7th and 8th may have been a part of China’s reaction strategy. China’s currency has also lost 3.5% of its value over the past month which acts as an offset to U.S. tariffs.
In addition, many American companies do business directly in China, and the government has been loosening foreign investment requirements over the past few years. Nevertheless, China can make their business life more difficult via heightened regulations. China is also a very large holder of U.S. Treasury securities. And a large-scale sale may impact U.S. interest rates. At this writing, there is no evidence that China has, or will, resort to either of these last two actions.
Conclusion: The Tariff Issue is not Fully Priced
The conclusion for investors is that the “trade and tariff” issue is a serious one. No one wins in a trade war. I am not taking sides on the tariff issue. After all, it is clear that other countries subsidize exports, and have other unfair trade practices. But, the U.S. isn’t an innocent lamb in these matters either. What I am saying is that what is occurring on the trade front is almost certain to have a larger negative consequence on economic growth than is currently recognized or priced into equities.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.