Nobody Wins in a Trade War
July 27, 2018
Stocks were buffeted during the second quarter as investors reacted, in knee-jerk fashion, to each new headline about our brewing trade war. The choice to wage this battle on multiple fronts at the same time certainly complicated matters, as did the possibly misguided incentives for each side to exaggerate their negotiating postures. While the ultimate ramifications of these tit for tat maneuvers remain to be seen, we will spend most of this quarter’s newsletter discussing the newly implemented and still-threatened trade tariffs, along with their potential effects on businesses, consumers and investors.
But first, let’s review the markets. While the quarter was notable for heightened levels of uncertainty, stocks still managed to hold up during the quarter, with the global MSCI ACWI (All Country World Index) finishing up +0.5%. We saw significant regional differences, however. US stocks outperformed, returning +3.4%, as investors took shelter in companies they perceived to be less affected by a looming trade war. International stocks lagged, in part because their currencies depreciated, and also because investors started to price in some of the more extreme trade war possibilities.
Elsewhere, in fixed income markets, returns were negative for the quarter, with the Barclays Bloomberg Global Aggregate index declining by –2.8%. Bond prices were impacted by the same forces as were stocks. First, credit spreads widened owing to the increase in risk and uncertainty mentioned earlier. Second, foreign currency weakness was also a culprit here, causing losses on the international portions of the bond index.
While KCS’s overweight to international stocks hurt our stock portfolios this period (in contrast to 2017 when this overweight helped), we were able to partly offset this through sector and security selection. Meanwhile, we outperformed the fixed income index mainly as a result of our avoidance of low-yielding European and Japanese debt.
What Is a Trade War?
As of this writing, Trump’s trade war is heating up. Having already placed tariffs on steel and aluminum from many countries, including not only China but also the EU, Canada and other allies, tariffs on $34 billion of additional Chinese goods have recently gone into effect. Another $16 billion of Chinese products will soon be subject to tariffs as well, and on July 10, Trump threatened to levy yet another $200 billion of Chinese imports. China has already started to retaliate and has promised a much bigger response if these additional tariffs are implemented. While there is still time to negotiate in an effort to prevent these new tariffs from taking effect (e.g., the recent postponement of tariffs on auto imports from the EU), no meetings between the US and China are currently scheduled.
In conversations with clients and others, it seems that many people misunderstand the nature of “tariffs,” and so we thought we would take some time to explain them. Plain and simple, a tariff is a tax, specifically on imported items. Who pays this tax? Most of it is paid by the buyer of the imported item, with the seller shouldering some of the burden in the form of reduced profits. Think of a 25% tariff as a sales tax added to the price of purchased goods. Who receives this tax? The federal government. These additional taxes will offset some of the recent income tax cuts, resulting in higher overall federal taxes than we would have seen without the tariffs.
If all the threatened tariffs against China were to go into effect (25% on the first $50 billion and 10% on the next $200 billion), the US government would collect an additional $32.5 billion in taxes over a year, assuming no change in trade volume. While most of the estimated $213 billion in annual savings provided by the 2017 tax act goes to wealthy individuals and businesses, the tariffs will affect almost all consumers. As a result, many Americans would experience both higher prices for goods and higher taxes. This could increase inflation at the same time that consumers reduce their purchases of Chinese goods, a recipe for “stagflation.” (For those that don’t remember the 1970s, stagflation is the combination of higher inflation and slower economic growth.)
Wouldn’t consumers just buy the same goods from US manufacturers? Not likely. For starters, current US industrial capacity isn’t necessarily a match to many of these products, and adjusting that capacity (by building or modifying factories) takes time and money. Secondly, if the US were able to produce those goods as cheaply as China, it’s likely many of them would already be produced here; replacement goods made in the US would likely cost more than those from China, further adding to inflationary pressures.
This is how tariffs affect jobs: As you can see below, just the steel and aluminum tariffs already in place, while beneficial to the manufacturers of these metals, are expected to result in around 150,000 net job losses in the US as a result of higher prices for the businesses that use these metals.
China Has More Leverage Than Many Think
And let’s not forget the other side of the equation: tariffs on US exports to China. The US sends about $130 billion worth of goods to China each year (compared to $505 billion that the US imports from China). Chinese tariffs on US imports will result in higher prices on US goods to Chinese buyers, reducing demand for those goods and encouraging the Chinese to find substitutes. This will cause businesses that make these products financial strain, resulting in layoffs and potentially the bankruptcy of some smaller US companies.
China has other ways to retaliate besides tariffs. They have already initiated a 7-day quarantine of US fruit imports, with the result that much of the fruit rots before reaching supermarket shelves. This is likely to cause Chinese supermarkets to avoid US fruit entirely, as rotten fruit doesn’t sell well. The list of other potential countermeasures is long, including restrictions on US-Chinese joint ventures, completely banning sales of specific goods (such as in the recent Chinese court case against Micron Technology), and “encouraging” their citizens to avoid US goods in favor of those from other countries. The Chinese have made similar moves in the past with often impressive results. Just last year, China state media called for consumers to boycott cars made by Hyundai in a dispute around deployment of a joint US-South Korean missile defense system. As a result, the automaker’s China sales plunged 64% in August 2017 compared with the prior year. Don’t put it past China to do the same to American companies.
The effect of such measures could be chilling to US manufacturers. While some believe that the combination of tariffs and income tax incentives to encourage US companies to concentrate their business in the US would also encourage many US multinationals to abandon China, this seems unlikely. For example, General Motors sold 4 million vehicles in China last year, but only 3 million in the US. For many US companies, China is too large a market to abandon or even cut back significantly. This gives China a lot more leverage in a trade war than many assume.
In addition, politics in China are obviously different from those in the US. In China, both central and local governments pretty much move in lockstep with the Communist Central Committee and its de facto leader, Xi Jinping. Companies, particularly the large state-owned enterprises, and to a lesser degree, consumers (as illustrated by the Hyundai example above), typically follow suit. Here in the US, the politics of democracy is a lot messier. While this is good for freedom, it makes it harder for the US to stay the course in a trade war that starts in the executive branch and isn’t also supported by the House and Senate. Already, we’re seeing intense lobbying by business groups who are opposed to the tariffs, and Congress is hearing them (see below).
The Chinese know this and have so far targeted most of their retaliatory tariffs toward Republican districts. They have studied the 2016 presidential electoral map down to the county level, and have primarily aimed their tariffs at companies in counties that voted for Trump and other Republicans. As companies in these counties feel the financial pressure from the tariffs, and consumers nationwide see higher prices on thousands of goods, the political pressure to back down in the trade war may become unbearable. (It’s likely that US trade negotiators backed down on auto tariffs against the EU at least in part because of pressure from Congress.) Despite potentially greater economic pain in China compared with the US, their government and citizens may be more united in their opposition to US tariffs and could outlast us politically.
US Politics Can Be Messy
We are already seeing early signs of pushback from Congress. On July 11, the Senate approved, by 88-11, a non-binding measure to give Congress a role in the President’s imposition of tariffs under Section 232 (the law that allows a President to impose tariffs for national security reasons). Though non-binding, this suggests that Republicans in Congress are becoming concerned, and if Trump’s tariffs start exacting real economic pain, we expect Congress to finally exert its legislative power to rein in the executive branch. We believe that in this trade fight the US, not China, will blink first and go back to the negotiating table.
You might reasonably ask what problem the tariffs are intended to solve. Is a large trade deficit, by itself, a problem? Ask almost any economist, and he or she will tell you that trade deficits really don’t matter. We buy more from many foreign countries than they buy from us. So what? Some of the dollars we send to them are used to buy US-made goods, while the rest are invested back here in stocks, bonds, businesses and real estate. The US dollars we pay them with don’t just disappear. The overall balance of payments remains balanced.
In the words of Ronald Reagan (11/26/88): “In recent years, the trade deficit led some misguided politicians to call for protectionism, warning that otherwise we would lose jobs. But they were wrong again. In fact, the United States not only didn’t lose jobs, we created more jobs than all the countries of Western Europe, Canada, and Japan combined. The record is clear that when America’s total trade has increased, American jobs have also increased. And when our total trade has declined, so have the number of jobs. Part of the difficulty in accepting the good news about trade is in our words. We too often talk about trade while using the vocabulary of war. In war, for one side to win, the other must lose. But commerce is not warfare. Trade is an economic alliance that benefits both countries. There are no losers, only winners. And trade helps strengthen the free world.”
In general, more trade is good for the economy and jobs, less trade is bad. Tariffs reduce trade, increase prices and threaten jobs. We agree with Reagan that a trade war is not the way to improve the lot of the American worker or consumer.
Are Other Countries Taking Advantage of the US?
Some have said that several trade deals with our trading partners, including allies, are unfavorable to the US, occasionally singling out specific tariffs that seem unusually high. But rather than focus on one or two products, the correct number to look at in evaluating a country’s protectionism is the “trade-weighted mean tariff rate on all products,” which is basically the average tariff levied on all goods. According to the World Bank, the US average is 1.7%, admittedly one of the lowest in the world. But Canada is even lower, at 1.6%, while the EU and UK are slightly higher at 2.0%. China is higher, at 3.5%, but still well below countries like Brazil at 8.0% and the Bahamas at 18.6%. President Trump seems to have the right endgame, that countries with higher tariffs than the US should lower theirs, but it’s unclear how raising our tariffs leads to this result.
The main issue with China is not its modestly higher average tariff rate, but rather the stealing of US intellectual property. This theft covers a wide range of illicit behavior: counterfeiting American fashion designs, pirating movies and video games, patent infringement and stealing proprietary technology and software (including defense technology). It is estimated that intellectual property theft costs the US almost $600 billion per year, with China accounting for the lion’s share. This is clearly a big problem that needs to be addressed, and it is certainly not new. But previous administrations chose not to go down the tariff road, believing (rightly, we think) that this is not the best way to get the Chinese to cooperate in reducing intellectual property theft.
How best to encourage (cajole, force?) China to respect intellectual property rights? That is not an easy question, and one beyond the scope of this writing. However, we do believe that at a minimum, the US needs allies in this fight, most importantly the EU, and the issue will probably necessitate referral to the WTO (World Trade Organization) and perhaps other supra-national courts. But securing cooperation will not be easy after the US imposed steel and aluminum tariffs on the EU and is threatening more on products such as automobiles. A group effort and united front represent our best chance for success in this ongoing endeavor.
The KCS View Going Forward
The simmering trade war between the US and many other countries represents the only major dark cloud in an otherwise sunny economic horizon. Sure, there are other risks—such as a recent mild slowdown in Europe—but they pale in comparison to the damage a full-out trade war could inflict on the global economy. And even the softness in Europe seems to mostly result from reduced corporate and consumer confidence in light of the brewing trade conflict.
Higher short-term interest rates here in the US are another minor concern, but rates will continue to rise only if the economy remains strong and is not seriously impacted by a slowdown in trade. In other words, we probably don’t need to worry about both higher interest rates and economic harm from tariffs: it’s likely one or the other. We are keeping a watchful eye on these and other indicators for evidence that the economic climate is changing. For now, however, the outlook appears mostly fair with a small chance of thunderstorm let loose by trade tensions. We believe, however, that politics, not economics, will dictate the direction of this looming storm, especially with midterm elections only 3 months away. What politician in either party wants to hurt his or her constituents financially just as they are preparing to vote?
Global equity and bond markets will continue to be buffeted by trade winds, at least until we have some clarity on the size and direction of any looming storm. That suggests that the volatility that began in February of this year will continue, and another 10% correction is possible if trade tensions continue to build. However, we do not see a recession leading to a bear market on the immediate horizon, and still think the equity market has another year or two of meaningful gains ahead of it before the next recession. One way or another, we believe, the burgeoning trade war will be mostly over by the midterm elections, which could lay the foundation for a subsequent market rally.
KCS Portfolio Positioning
KCS continues to overweight foreign equities relative to the US, as they remain attractively priced on a relative basis (see our prior newsletters for more on this). While it is true that many foreign companies receive a significant portion of their revenue from exports to the US, we are not the only game in town, and trade deals that exclude the US continue to be struck. Also, though it takes time, companies can move the locations of their production to minimize the effects of tariffs.
More importantly, you should remember that markets tend to be very efficient, pricing in expectations almost immediately. This can be seen in the relative price moves of companies that may be negatively impacted by tariffs (e.g., German car manufacturers) compared with those that might benefit (e.g., domestic steel manufacturers) and those that will be relatively unaffected (companies that sell primarily in their own markets). As you might expect, the anticipated effects of tariffs have already been mostly priced into these companies’ stocks.
Thus, if the threatened tariffs are implemented, the short-term impact on stocks will likely be muted. On the other hand, if deals are struck that preserve the status quo or lower existing tariffs, stocks will likely rise strongly, with those already most beaten down rebounding the most. For this reason, we are not specifically avoiding foreign exporters in favor of less vulnerable companies, as many of them are now attractively priced even in the context of a trade war.
The markets always face risks, and 2018 is no exception. But known risks rarely drive the markets once they are priced in. The greatest damper on the equity market right now is uncertainty as to how the burgeoning trade war will play out. More certainty, even if the outcome is unwelcome, can paradoxically lead to a stock market rally.
In our view, only a global recession is likely to cause a major market decline. And since we don’t see one on the coming for at least another year or two, we remain invested in equities. A full-scale global trade war might change that view, but at this point such an outcome seems highly unlikely.
Dr. Ken Waltzer, MD, MPH, AIF®, CFA, CFP®
Managing Director, KCS Wealth Advisory
Laura Gilman, CFP®, PFP, MBA
Managing Director, KCS Wealth Advisory
Nick Nejad, CFA
Director of Investment Research, KCS Wealth Advisory
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