U.S. equities have struggled to break out of a trading range in recent weeks, as investors alternate between optimism about economic momentum and concern about trade tensions. Bullish investors expect President Donald Trump to “declare victory” on trade before mid-term elections, clearing the way for U.S. equities to advance. Bearish investors are worried that escalating trade tensions will lead to economic and earnings disappointments, causing a sell-off in equities.
Trump’s trade threats frustrate many investors, economists and editorial page commentators. His well-chronicled beliefs about trade are contrary to conventional economic wisdom and historical experience.
However, Trump’s trade approach may be more influenced by politics than by economics. Three numbers illustrate the political dimension of trade policy: 90 percent, 5 percent and 80 percent. Trump has a 90 percent approval rating among Republicans, an approval rating helped by his anti-trade stance. In stark contrast, his approval rating among Democrats is 5 percent. The third key number is 80 percent, which represents the percentage of Congressional districts that are considered “safe seats” for one party.
[See: 7 Small-Cap ETFs to Help You Win a Trade War.]
The polarization of the electorate dramatically reduces incentives to seek bipartisan solutions on trade and other high-profile issues. In addition, losses from trade tend to be disproportionately concentrated among small but vocal constituencies while gains from trade tend to be spread more widely among larger groups. The longstanding shortcomings of government and private sector attempts to help those hurt by globalization makes populist solutions such as tariffs more appealing.
Trade discussions are often framed against a backdrop of misleading facts, half-truths and outright lies. According to the World Bank, weighted average tariff rates are higher in the U.S. than in Canada, a counterintuitive fact given presidential tweets complaining about unfair Canadian trade practices. Averages can tell an incomplete story, masking product-specific trade barriers or tariffs. For example, Canada imposes tariffs of 240 percent or more on dairy products such as fluid milk, cheese, butter and ice cream. Canada’s dairy tariffs protect farmers in Quebec, a concession intended to combat separatist sentiment in the restive province.
Canada isn’t the only country that utilizes tariffs or trade barriers for political or economic reasons, and U.S. trade policies often deviate from a “pure” free market approach. For example, the U.S. imposes import tariffs of 350 percent on tobacco and 160 percent on shelled peanuts. American tariffs of 25 percent on imports of light trucks are a particular source of frustration for the foreign automakers being threatened with new tariffs on autos and auto parts.
Trade tensions with China are a subset of what is likely to be a multi-decade competition for economic, political and military supremacy. There are legitimate grievances with China regarding intellectual property and market access, however trade hawks such as Peter Navarro offer simplistic solutions without addressing the potential cost of a trade war for U.S. investors and consumers.
China may theoretically have more to lose from a trade war than the U.S., but has ample tools to retaliate against the U.S. China’s retaliation will likely target the U.S. services trade surplus of more than $50 billion as well as the $200 billion worth of goods and services sold through Chinese subsidiaries of U.S. companies. China may also be less vulnerable to U.S. demands than other countries pressured by Trump, having considerable latitude to stimulate domestic demand in order to offset lost export demand.
Trade hawks point out that the direct economic impact of tariffs may be relatively low. Initial estimates are that tariffs and projected retaliatory moves could trim U.S. GDP growth by about 0.25 percent — not trivial but far from devastating.
[See: 16 Questions That Scare Investors, But Shouldn’t.]
However, the indirect but consequential impact on business and consumer sentiment could be far more harmful than the direct impact on economic growth. Washing machine prices rose in response to tariffs and import restrictions, but a relatively small number of consumers buy washing machines each year. Given the widespread reliance on globally integrated supply chains, the next set of tariffs may have a more profound effect on consumer prices. More than half of Asian exports are in intermediate goods — iPhones are a cross-border phenomenon in which South Korean screens and Taiwanese chips are used in a consumer product designed in America and assembled in China. The same dynamic is true for many automobiles that are manufactured under the NAFTA treaty. “Onshoring” of production may seem like a good idea in a tweet, but could lead to considerably higher consumer prices for many goods.
Retaliatory tariffs may create other unintended consequences. Harley-Davidson (ticker: HOG), already struggling with higher input prices because of steel and aluminum tariffs, is now facing retaliatory tariffs from the European Union. In response to the EU’s tariff plan, the company announced plans to scale back U.S. operations over the next 18 months in order to make more bikes overseas. Daimler, which sells a large number of U.S.-manufactured SUVs in China, may have to scale back manufacturing employment in the U.S. in response to Chinese tariffs. German automakers in total export 480,000 vehicles that are manufactured in the U.S.
It is also not a given that rising trade barriers will help create jobs. There is considerable doubt about how many steel jobs will return despite the imposition of tariffs on imported steel. The inconvenient fact is that U.S. steel jobs have fallen by about 80 percent since 1990 while production has stayed about the same. Steel tariffs may create jobs for robots rather than humans, while imposing higher prices for consumers.
The key question for investors to answer is tied to Trump’s long-term strategy for trade policy. The consensus earlier this year was that tariff threats were part of Trump’s “Art of the Deal” approach to governing, and that after some harsh rhetoric and extreme demands he would agree to a set of compromises on trade. The market is less convinced about that consensus today, given mixed signals from Washington and the ascendancy of trade hawks in the administration.
Insight may ultimately come from different numbers than approval ratings or “safe” seats in Congress. Trump often cites rising employment numbers and stock market gains as evidence that his policies are “winning.”
A slowdown in employment gains or decline in the stock market would be likely to curb his enthusiasm for a trade war. Ultimately, a series of deals on trade continues to be the most likely outcome of trade tensions, easing the path for U.S. equities to stage a final, late-stage rally.
[See: 7 Classic Inflation Hedges and Their Thorns.]
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How Trade Tension Affects Investors originally appeared on usnews.com
