Putting Trade Policy Risk in Perspective

Escalating trade tensions disrupted markets last week, particularly on Thursday and Friday when the S&P 500 Index lost about 5% over the two-day span, wiping out the index’s gains for the year. Here we summarize the latest developments and share our thoughts on the risk these actions might pose for markets:

What happened?

On March 22, 2018, President Trump announced approximately $50 billion in tariffs on Chinese goods, in response to China’s intellectual property thefts, to which he added that there is plenty more to come. China then retaliated with a smaller set of tariffs on U.S. imports valued at roughly $3 billion. The moves sparked fears of a broader trade conflict, although China’s trade actions came on the heels of several positive trade developments elsewhere, including some progress in NAFTA talks and additional exemptions for the recently announced steel and aluminum tariffs, notably the European Union.

What are the concerns?

It is clear that this trade battle is not over with the administration expected to announce additional actions to protect U.S. intellectual property, including restrictions on cross-border investments and immigration, e.g., student visa.

Though unlikely in our view, should the trade “tit-for-tat” escalate into a full blown trade war, we could see a significant reduction in trade between the United States and China, impaired economic growth, and higher costs of imported goods that translate into higher prices for consumers.

Scope Perspective

Chief Investment Strategist John Lynch explained, “With respect to the announced tariffs, we think it is important to put their size and scope into perspective relative to the size of the U.S. and Chinese economies. The announced tariffs cover less than 3% of all U.S. goods imports. So based on announced actions, the impact on the U.S. economy will be minimal. Furthermore, damage to China’s economy is likely to be minimal as well, with tariffs affecting about 10% of China’s exports to the United States, and much of this trade is likely to continue despite the tariffs because alternatives are limited. Capital Economics estimates just a 0.1% impact on Chinese gross domestic product (GDP) from the U.S. tariffs.”

It is also instructive to compare the size of these tariffs to the amount of stimulus that has been put in place in the United States as a result of the new tax laws and the latest federal spending bill. Between the two, including repatriation of overseas cash, an estimated $800 billion in stimulus (about 4% of U.S. GDP) has been put in place for 2018, according to Strategas Research Partners. In contrast, the two sets of tariffs just announced total less than $40 billion (the tariff percentages multiplied by the value of goods they are placed on).

Comparing the Size of Tariffs with Incremental Fiscal Policy, CY 2018

Is there good news?

The tariffs announced thus far are just not big enough to derail the solid growth path of the U.S. economy, in our view. That said, there are several more reasons for optimism:

  • There is a comment/implementation period that may allow time for negotiations with China, so tariffs could be watered down. This period could stretch into late May, giving ample time for lobbyists to be heard and negotiations to occur.
  • Comments from the Trump administration, and its handling of other issues, have suggested trade proposals may be moderated in negotiations. There are a number of examples when the administration has moderated initial proposals, including the border tax that was killed early in the tax reform negotiations last year.
  • There are indications China is willing to negotiate in good faith. The Chinese Premier recently offered concessions, at least verbally: pledging to open up their markets, to protect intellectual property of foreigners investing in their economy, and to stop forcing companies to transfer technology to domestic firms in doing so. These comments, plus the fact that the value of China’s retaliatory tariffs was small, suggest room for compromise.
  • Larry Kudlow could be a moderating influence. The newly appointed National Economic Council chief is a noted proponent of free trade. On the other hand, the moderating influences of Gary Cohn and Rex Tillerson are gone, so it is unclear if the personnel shift is necessarily moderating or not.
  • President Trump cares about the stock market, so the recent volatility has likely gotten his attention.

Investment implications

A series of potential protectionist announcements may weigh on investor sentiment in the coming months. When push comes to shove, we expect limited economic impact and manageable disruption to the supply chains of U.S. companies.

As this situation plays out, with broad economic and market fundamentals still solid, we are more likely to look for opportunities to buy dips rather than sell into weakness. We continue to market weight equities and maintain risk levels in portfolios at or slightly above benchmarks.

In terms of portfolio positioning, we suggest suitable investors consider opportunities to buy dips in small cap stocks, which have held up relatively well recently, due to their domestic focus. We would view trade-related weakness in emerging markets as an opportunity.

One of our favorite sectors, the export-focused industrials, is caught in the cross hairs of this dispute, but weakness in the sector has been narrow. The equal-weight industrials sector has performed much better than the market cap weighted industrials sector over the past several weeks, which we see as encouraging. We also think recent weakness in financials is overdone and continue to favor the sector.

 

 

IMPORTANT DISCLOSURES

The prices of small cap stocks are generally more volatile than large cap stocks.

Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.

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