Stock market bulls argue that tariffs have been applied to gain the necessary leverage to rectify decades of trade imbalances, a feat that, if accomplished, would prove beneficial to the U.S. economy. Highly respected economist Mohamed El-Erian responded to the question of whether the trade war would go on indefinitely with, “My gut says that this will end in free and more fair trade.” (1)
Bears point to three challenges including cost, retaliation and unintended consequences. Tariffs were initially applied early this year to solar panels and washing machines. In June, the U.S. slapped a 25% tariff on steel and 10% tariff on aluminum imports. Even if that were the end of the story, those cost increases play into the manufacturing of airplanes, automobiles and buildings representing a tax.
Unfortunately, the story doesn’t end there. Europe, Canada, Mexico and China promptly retaliated by adding tariffs on key U.S. exports, apparently ignoring the metaphorical lesson from Gandhi who said, “An eye for an eye will only lead to a world of blindness”. Ironically, the world economy had been in a blissful state, marked by synchronized growth from most of the developed countries. Cornerstone Macro, an economic consulting firm recently reported that “A 10% tariff on an additional $200 billion worth of goods would effectively double the tax on the U.S. economy to 0.2%. While still manageable, this would offset almost half of the estimated boost from tax cuts in 2018.” (2)
Retaliations have directly targeted iconic U.S. brands, including Levi Jeans, Kentucky Bourbon, and Harley Davidson motorcycles. Through Harley we learn about these unintended consequences. European tariffs drove the cost of each motorcycle shipped from the U.S. up by approximately $2,200. (3) Harley responded by announcing plans to move some of their manufacturing outside of the U.S. which would result in a loss of jobs.
Despite the best intentions for the long run, the short-term impact of tariffs has been rising costs for U.S. consumers, loss of jobs, disruption of supply chains and a heightened sense of uncertainty. Martin Feldman, Professor of Economics at Harvard, former President of the National Bureau of Economic Research and former Chairman of Economic Advisers to Ronald Reagan wrote on July 6th, “Reducing Chinese exports to the U.S. would deny American consumers the low-cost products they buy from China while doing nothing to reduce the global U.S. trade deficit. That’s because the trade deficit reflects the reality that Americans consume more goods than we produce. To do that we must import the difference from the rest of the world.” (4)
Are interest rates rising? Perhaps the epitome of Yanny vs. Laurel. The yellow line in the graph below depicts U.S. Treasury yields from one year ago. (5) The colored lines show current yields. The big gap at the left captures rapidly rising short-term rates, directly attributable to Federal Reserve rate hikes. Unfortunately, interest costs to borrowers with variable rate mortgages, student loans and a substantial portion of commercial loans are all tied to Treasury Bills, LIBOR, or other short-term benchmarks. The convergence of all lines, at the far right, shows that long-term bond yields, driven by market expectations for inflation, have not budged in the past year.
“The dispersion between shorter-term and longer-term rates, known as the yield curve, is an indicator of sentiment about the prospects for economic growth. Investors monitor the curve because short-term rates have exceeded longer-term ones before each recession since at least 1975—a phenomenon known as an inverted yield curve. (6)
The Federal Reserve just announced intentions to raise interest rates twice this year, on top of the seven increases since December 2015. (7) This suggests their belief, at least for the time being, that tariffs do not represent a meaningful threat to the economy. The Conference Board, an organization that has published data on “leading”, “coincidental”, and “lagging” economic indicators for over 100 years, provides a three-dimensional view. Their latest release stated, “Leading Economic Indicators (LEI) for the U.S. increased 0.2 percent in May to 109.5 (2016 = 100), following a 0.4 percent increase in April, and a 0.4 percent increase in March. The U.S. LEI still points to solid growth but the current trend, which is moderating, indicates that economic activity is not likely to accelerate.” (8)
Perhaps the most compelling argument against a slowing economy comes from the just released employment report that indicats 213,000 new jobs created in June. “Economists surveyed by Reuters had expected nonfarm payrolls gain of 195,000 and the jobless rate to hold steady at 3.8 percent, which had been tied for the lowest since 1969.” (9) Of course, some readers of that news release might have focused instead on wage growth not meeting expectations.
And the markets’ interpretation…
Stay with stocks but, get out of the crosshairs of any trade war. How did they express this view? The Dow Jones stocks (blue) ran in place for the quarter (exporters such as Deere and Caterpillar would be big targets for any retaliations), while foreign stocks (green) stumbled because many (especially China) are highly dependent on exports. (10) The clear winner was small cap U.S. stocks (purple) reflecting the domestic nature of their markets and the implied immunity from trade wars.
At the risk of sounding cavalier, we’re more interested in the disparity of votes than the answer itself. This reminds us of Y2K or Brexit, with considerable capital being deployed thematically rather than fundamentally, believing it presents opportunities without having to place bets because:
- Volatility creates opportunities to rebalance portfolios, moving capital into areas that others have lost interest in.
- As the markets fret, prices, especially for large cap stocks, have flatlined. Meanwhile, earnings projections continue to grow, moving valuations back to more attractive levels.
- The nature of indexing has changed. In 1990, utilities, telecommunications and consumer staples (Think Consolidated Edison, AT&T, Procter and Gamble) comprised almost 30% of the S & P 500. Technology, by contrast, was only 6.34% of the index. Today tech represents 26% and the biggest positions (carrying the most weight) include names like Netflix, Facebook, Amazon and Alphabet. Of that group, Amazon has been publicly traded the longest; since 1997. (11) None were in the index in 1990. Conversely, that group of defensive sectors today adds up to less than 12% of the index. We believe that momentum investing (essentially following the herd) represents an expanded acceptance of risk today.
We are specifically targeting out of favor stocks that are less followed or recently dumped by the momentum crowd.
Yes, you heard that quiet confidence correctly.
- Interview by Fareed Zakaria on Zakaria GPS; July 8, 2018
- “Tariffs Toll on Trade”. Barron’s; June 22, 2018
- “Tariffs Send More Harley Assembly Abroad”. Wall St. Journal; June 26, 2018
- “The Use and Abuse of Tariffs”. Wall St. Journal; July 6, 2018
- The Yield Curve shows yields along the left column and maturities along the bottom. Typically, the longer the time period, the higher the yield. Source: Federal Reserve Bank of St. Louis
- “Behind the Flattening Yield Curve”, Wall St. Journal; July 5, 2018
- “Fed Minutes Reaffirm Gradual Rate Path as Trade Risks Rise”. Bloomberg; July 5, 2018
- www.Conference-board.org. June 21, 2018
- “US adds 213,000 jobs in June, better than expected, but wage growth is light”. CNBC; July 6, 2018
- Yahoo Finance
- Standard & Poor’s