A War Without Winners
William Heffernan
William Heffernan
Research Analyst

Markets have moved sideways since February despite solid earnings growth, strong economic growth and good underlying data. 2018 has seen a significant uptick in volatility with one of the major factors being a changing trade policy dynamic. Despite being elected on a platform that espoused protectionist policies, Donald Trump paid little attention to trade issues in 2017. However this year has seen a significant ramping up in actions and rhetoric, and financial markets have been roiled as a result. So what has been done so far and where is this likely to end?

Mr Trump gave some indication in late January that trade had moved to the top of the agenda with his implementation of washing machine and solar panel tariffs. The market did not pay much attention. However, tariff hawks were further emboldened by the resignation of Gary Cohn from his position as White House Chief Economic Advisor. Mr Cohn was firmly against any ramp up in tariffs and it had become a sore point. Both Mr Cohn’s replacement Larry Kudlow and other senior administration officials had already stated their support for raising import tariffs.

Two weeks after Mr Cohn’s departure, Mr Trump announced tariffs on steel (25%) and aluminium (10%) imports. At the time Mr Trump was attempting to force a favourable renegotiation of NAFTA (North American Free Trade Agreement) and these measures were assumed to be a tactic to incentivize Mexico and Canada to make a better deal. The Canadian and indeed world leaders’ response at a fractious G7 meeting was to counter with their own tariffs. Since then the US has also ratified imposing tariffs on $50bn worth of Chinese goods, $34bn of which came into effect on 6th July. The Chinese have responded in kind. Mr Trump has now directed his officials to draw up a list of a further $200bn of Chinese goods, which may be subject to import tariffs if China retaliates. He has also consistently mentioned tariffs on US auto imports and it’s likely his officials will seek to implement restrictions on Chinese investment in US companies over the next few weeks.

You may wonder what the US hopes to achieve through pursuing this dogma. Firstly it should be noted that some of the US complaints have a degree of legitimacy. The Chinese economy is structured to favour domestic Chinese companies. For example, the State-owned Assets Supervision and Administration Commission (SASAC) controls over half of the Chinese companies in the Fortune 500. It makes management decisions, allocates resources and deploys capital as it sees fit. Likewise in the financial sectors, Chinese banks are often used by government to deploy capital in preferential ways to certain industries and sectors. There are innumerable barriers to foreign owned companies when it comes to intellectual property, licensing and operational expansion. Mr Trump believes that the policies being pursued will ultimately lead to a more competitive and fair economy in China. However, this requires far greater structural reform.

Despite the issues laid out above, when looking at the overall picture, Mr Trump’s argument that the US economy is losing out at the expense of others does not hold up. It is far more complicated. WTO data shows the EU’s average trade weighted tariff is 3%. Canada’s is 3%, with the US at 2.4%. When it comes to the tariffs that US exporters have actually paid, it is 1.4% on non-agricultural goods sold in the EU and 2.1% on non-agricultural goods in Canada. EU exporters to the US paid an average weighted tariff of 1.6% while Canadians paid 1.3% on the equivalent goods. The EU has a 10% tariff on cars but only 15% of US autos shipped to the EU were subject to it as US autos that contained European parts were exempt. The US has a tariff of just 2.5% on auto imports but a 25% tariff remains on imported light trucks (pickups) since 1964. Certain companies in China are heavily subsidised but any major US public procurement program usually has the “Buy American” sticker attached. While Europe has a substantial trade surplus with the US, when you look at the service sector alone, it is the US that has the major surplus. One could surmise that it is no coincidence that US hegemony has been declining for the last two decades while other nations’ influence, most notably China has been increasing. The current administration may be attempting to stop what is a natural inevitability, and seeking to blame outside influences for what ultimately stems from US demographic, productivity and debt trends.

The most pertinent question of course is – where it goes from here? And of course we have to consider the incentives on each side. In the longer term tariffs tend to be a lose-lose game for both sides. Eventually, if it goes far enough, the biggest price paid is by the consumer and businesses in each country, at which point the incentives to continue down the tariff road are greatly diminished.

But in the shorter term, which is what White House policy appears to be driven by at the minute, there can be benefits. In advance of the midterm elections in November, a favourable NAFTA renegotiation or a hard stance on China may go down very well with the Republican electoral base. Likewise it is not necessarily a bad time to pursue this policy; US GDP is tracking above 3% and so far the measures outlined are minimal in magnitude (should shave 0.1% off annual GDP growth over the next 3 years). In fact, if there is no further escalation investors could remain reasonably assured. But that is a monumental if. Firstly, in order for one side to believe that the other is serious, tariffs will have to be implemented in some form. Secondly, it is in the interest of the White House to keep this political issue alive as it will keep voters engaged. This means that we will continue to see headlines and commentary from US officials on a regular basis. Thirdly, the current administration appears to be dominated by China hawks who sincerely believe that now is the time to curb China’s growing influence on the world. All of this means that, despite relatively small tariffs so far, it is the uncertainty that will affect equity markets the most. If it continues to drag on, investor and business sentiment will become more bearish, capital spending and investment plans may be postponed or cancelled with consumers becoming increasingly skittish.

So where does one look to invest in such a market? You only need to look at what has happened over the last few weeks. Small caps stocks, traditionally more focused on domestic markets, have outperformed the wider market. Defensive sectors such as Telecoms and Consumer Staples have enjoyed a substantial revival. Likewise US Treasuries and European core government bonds have proven a relatively safe haven. The same can be said of certain absolute return or market neutral strategies. While economic growth is strong and the tariffs implemented remain small in nature, one can expect those trades to continue to perform. However if for any reason both the rhetoric and the actual measures ramp up, either in magnitude or number, it is likely there will be few sectors or assets that escape unscathed.

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