Last night at midnight, the U.S. started collecting a 25% tariff on over 800 products from China, representing $34 Billion dollars of trade with the U.S. This follows other tariffs recently imposed on countries around the globe (particularly on steel and aluminum imports), with more tariffs pending.
The theory behind tariffs as an economic strategy is simple. If the U.S. imposes a 25% tax on imported goods, those goods become more expensive to buy in the U.S. The higher prices then enable domestic producers to make and sell the same product. This should lead to more domestic economic production and lower unemployment.
But international trade in a globalized economy isn’t that simple. Raw materials, parts, and finished products move back-and-forth across the globe at a dizzying rate following the principle of comparative advantage. Raw materials and parts are imported to a factory, a product is made, and then sold locally and exported around the world. If a 25% tax is imposed on both ends due to retaliatory tariffs, profitability and production will decline and may ultimately be moved to a different location to avoid the tariffs (Harley Davidson’s recent announcement may be an example).
Tariffs hurt manufacturers — at least in the short-run until they adjust to the new economic reality by amending their material sources, costs, jobs, and location as needed. The communities around these manufacturers may experience longer-term impacts, including the loss of jobs.
According to data from Quill Intelligence, the top 10 states with the greatest exposure to a trade war (based on the percentage of manufacturing in the state economy) are:
1. Indiana (28.6%)
2. Oregon (20.1%)
3. Louisiana (20.0%)
4. North Carolina (19.3%)
5. Michigan (19.2%)
6 through 10. Iowa, Kentucky, Wisconsin, Alabama, and South Carolina
The report goes on to describe how the trade tariffs impact both the sales and profits of US manufacturing, and ultimately jobs:
“The squeeze will be brutal. Higher tariffs on export sales will squeeze the top line while spiking steel and aluminum prices smoke bottom lines. What choice will (manufacturers) have but to go on the defensive and protect their balance sheets? How is this best accomplished? By cutting the biggest cost, of course. If you’ll allow a fill in the blank on your behalf: Labor costs are on the factory line.”
— Danielle DiMartino Booth, 7/4/2018
Last week, the makers of Jack Daniels announced price increases of 10% for buyers in their largest market, Europe, as a result of a 25% bourbon tariff announced by the European Union. This was in response to the U.S. announcement of tariffs on steel and aluminum imports from Europe. The result puts “Jack” in the tough position of raising prices by 10%, making their product less competitive, while their costs simultaneously increase by 25%. Tough decisions will have to be made to preserve their business. On the day of the announcement, the company’s stock price was down 18% from the prior month.
I was in Lynchburg, Tennessee, last month touring the historic Jack Daniels distillery with my brother (great tour, by the way!). If these tariffs remain in effect very long, that community will be one example of many to feel the negative economic impact of a trade war.
For decades, the Federal Reserve has been an economic backstop when trouble hits — lowering interest rates and infusing liquidity into the markets. Couldn’t they come to the rescue if a trade war hits the economy? Not likely:
“That’s because a trade war simultaneously risks pulling growth rates down while pushing prices up. Anything the Fed seeks to do to cushion the blow on one side of that equation would tend to make things worse on the other side. So if, for example, the Fed held off on further interest rate increases to cushion a slump in investment spending, it would be doing so just as inflation was accelerating above the 2 percent the Fed aims for.
Prices for washing machines, for example, have risen in recent months amid new tariffs on washing machine imports. Tariffs on steel and aluminum have already driven up domestic prices of the materials, which could flow through in the form of higher inflation even for American-made goods that use the metals.”
So where does this new global trade regime lead us in terms of investment opportunities? First, I believe there is a good chance that trade tensions will dissipate. If that occurs, I expect the markets to respond with a relief rally, further delaying the next market decline in a cycle that is already long-in-the-tooth.
However, if the trade war continues, we may see real investment opportunities sooner. Many stocks and asset classes are already down significantly and more will likely follow as the impact of the tariffs flow through the economy. For investors, there is no greater opportunity than the chance to buy productive assets and companies at low prices.
Precedent AM manages custom investment strategies targeted to our client’s time frames and lifetime income needs, and we are patiently positioned to capitalize on any “good news” rebound, while also holding sufficient cash and fixed income to withstand a downturn and buy assets at reduced prices — whether prompted by this trade war, a correlating recession, or whatever the next news cycle brings.
Our community is celebrating the 4th of July tomorrow — and with cooler weather! I hope you have a great weekend, and I look forward to connecting again next week. If you have any questions about this discussion of trade tariffs, or any other finance topic, please feel free to reach out to me.