Why the trade tantrum is bad for stocks
by Raul Elizalde - 2018-03-28
The tariffs and penalties recently announced by the US represent a significant change in US relationships with its trade partners that creates uncertainty and stokes market volatility. Worse, they offer no outcome that would make the whole thing worthwhile. This is because the US has a lot to lose by alienating traditional partners who could help achieve its goals. This is not good for the stock market.
Let’s start with the botched attempt to impose steel and aluminum tariffs. The vast majority of economists opposed it and, in fact, Forbes did not find a single one who thought it was a good idea.
A tariff on goods imported into the US is a tax charged to US buyers. When a tariff is sufficiently high, the final price of the import becomes higher than the price of the same good produced domestically, which in theory should boost local production. This was the goal for the steel and aluminum tariffs announced in March.
All this may sound like a good idea. Yet, domestic buyers of those metals, who use them to make other things in the US, warned that they would have to raise prices for US consumers. Commerce Secretary Wilbur Ross argued tenaciously that the tariffs’ effect on local prices would be minimal (“less than six-tenths of one cent on a can of soda, less than half of one percent on a car”).
If what Secretary Ross says is true, then those particular tariffs served no purpose because such tiny price increases can be easily absorbed by consumers. Will anybody rush to deploy massive amounts of capital on new aluminum smelters or steel plants to replace imports? Most likely, any domestic substitution effect would come in the form of a small increase in capacity utilization.
The tariff gambit, in short, was ill-considered because it offered small potential upside compared to the possible downside of an escalation of tit-for-tat tariffs that could detonate a broader trade war. It is unsurprising that the administration eventually watered down the initial proposal as it also became clear that the main villain in its eyes, i.e. China, was unlikely to suffer much from tariffs on aluminum and steel.
The US then changed tack, announcing $60bn in tariffs and penalties specifically on Chinese imports, this time in response to US accusations of intellectual property theft.
The feeling that the US is itching for a confrontation with China is unmistakable. But the US has a lot to lose and the room for error is small.
The US is the largest exporter of goods and services in the world (China is larger just on goods) and therefore has the most at risk if a trade war unfolds. Additionally, foreigners hold 42% of all outstanding US Treasuries – 64% of which is held by governments. The fact that such a large proportion of US creditors are foreign is not a point of strength in negotiations.
More generally, a trade war could negatively affect the benign market outlook generated by other policies, such as the 2017 tax cut bill. While that bill created serious long-term problems (see How the tax bill made the next recession much more painful, 1.23.2018) there is no doubt that it gave stocks a short-term boost. A trade war, on the other hand, has no positive effects on the stock market.
A trade war will hurt US exports, corporate profits, and growth. US imports will also suffer, which will lead to higher inflation if cheap imports are substituted by more expensive local products.
While curbing intellectual property theft is a desirable goal, it is unlikely to be achieved through a trade war. Most experts agree that a coordinated approach by the US and other nations also affected by China’s actions would be more direct and have a higher chance of success.
For example, the US, Europe, and other allies could tighten restrictions on Chinese acquisitions of companies that own sensitive technology, or demand an easing on China’s regulations that force foreign companies to joint-venture with locals to establish a presence there. Alas, the US policy has so far been more directed at venting grievances with US allies over cars (Germany) or lumber (Canada), rather than convincing them to coalesce around common interests.
The US decision of abandoning the Trans-Pacific Partnership (TPP) also complicates the issue.
The TPP was advanced by the US to strengthen commercial and investment ties with much of the Pacific Rim. It excluded China, thus reining in its ambitions while reinforcing US influence on the region. When the US walked away from the TPP, China quickly moved in to revive talks on the competing, and far more advantageous (to China) Regional Comprehensive Economic Partnership, or RCEP. In addition, the US-less TPP’s successor – the Comprehensive Progressive Trans-Pacific Partnership, or CPTPP – now also includes China.
As the US surrenders influence in Asia, it cedes power to China. Pounding traditional partners over the head with tough rhetoric on trade simply drives them away, hurting US influence elsewhere. Meanwhile, confronting China’s ambitions in Southeast Asia is not made any easier by the rather inexplicable absence of a US ambassador to South Korea or the chaos in the State Department, which is currently awaiting the confirmation of a new Secretary of State after the sudden dismissal of Rex Tillerson.
In sum, the trade tantrum is not positive for the stock market. Since the bull run is already quite long in the tooth, some will see the trade issue as a possible catalyst for the rally’s end.
We believe that a full-on trade war is unlikely, but tensions need to be defused. The US must also formulate a coherent trade policy and refocus diplomacy on global cooperation favorable to US interests rather than confrontation with allies. Otherwise, the bull market could end soon.
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