Trade Wars — July 2018

July 25, 2018

Dow Jones Average: 25,242
S&P 500 Index: 2,820

Trade Wars

The first quarter of 2018 marked the beginning of a broad trade war, as the Trump administration announced that the U.S. was going to levy tariffs on upwards of $60 billion in imported goods from China. China quickly responded in kind, and the President answered by seeking to triple the amount of Chinese goods covered. This is one feud among many involving the United States and its trading partners. Tariffs have been applied to imported steel and aluminum from Canada and the European Union, while the EU members have responded with tariffs on iconic American products such as whiskey, motorcycles, and blue jeans. In recent months there have been a dizzying number of threats between the U.S. and the rest of the world. The largest came last week, when the administration announced its readiness to tax essentially all Chinese imports: a half trillion dollars worth of goods.

A tariff is simply a tax on an imported item. For much of U.S. history there were large tariffs on nearly all goods, applied relatively uniformly and consistently. It was the primary way that the Federal Government raised revenue before the income tax was established. History has shown that tariffs on their own, when applied in a uniform and telegraphed manner, are not necessarily damaging to investors. Trade wars are an entirely different situation. They often bring about the chaos and collateral damage of real wars, but in economic terms. That unpredictability seems ever more heightened given the President leading this particular charge. He defends his desire to overhaul the global trade system with a consistent refrain, that the United States has gotten the short end of the stick, with the trade deficit as evidence. However, there is an enormous flaw in this argument which is clear when looking at trade with China.

The United States imports more goods than it exports, and thus has a trade deficit with the world. That imbalance is most pronounced with China, with much of the imbalance in computers and electronics. Products such as cell phones are often assembled in China for a few dollars per device, but such items include many hundreds of dollars of parts made in a number of countries. All the other components made in other countries are rolled up into the final manufactured price when it arrives on U.S. soil, and that final price determines the trade deficit with China. Thus, an iPhone bought in the U.S. contributes around $300-$400 apiece to the growing deficit with China, even though the Chinese assembler is only making around $8-10 per phone for putting the various pieces together. Apple, having done all the design work and engineering and written much of the software, receives hundreds of dollars per device, but that does not factor into the trade deficit math. Apple employs about 50,000 people in the U.S., many of them highly-paid engineers, and is the most valuable company in the world. However, if one only looks at the trade balance figures, Apple is perhaps the primary example of how we are “losing” to China. Physical goods flow from China to the United States, while we export research, engineering, and software into products that span the globe. This aspect of globalization has been beneficial to our economy, yet contributes to our trade deficit. There may be deficiencies to be remedied within global trade and certain inequities that could be rectified. However, the Trump administration is using a blunt tool to fix particular imbalances that do not need to be corrected.

Current Strategy

The brewing trade war did not sink the market in the 2nd quarter. One possible reason for this is that investors see the President as someone who negotiates from the extreme and arrives at a more modest position eventually. But as more tariffs are enforced, and the economic toll on corporate profits grows, this is a less tenable hypothesis. Another explanation emerges when digging into the price movement of stocks a bit deeper. Several large companies that performed well in the latest quarter were Netflix, Facebook, Google, and Mastercard. These companies share business models that are built on intangible assets. A trade war could erupt, ensnaring physical goods from steel to soybeans, and it would have little initial effect on the largest capitalization companies. On the other hand, the industrial sector of the Standard & Poor’s Index is directly impacted by a trade war on physical goods, and that sector declined by 6.5% in the past quarter. This list of forty-six companies includes American icons such as 3M, Boeing, and Caterpillar, but all forty-six companies combined carry less value in the stock market than just Mastercard, Facebook, Google, and Netflix. The most highly valued companies are largely based on intangible assets, which makes it possible to engage in a trade war and still have a calm stock market in the aggregate.

There is a danger underlying this benign stock market. More investors are concentrating their money in fewer large and favored companies. This lack of diversification is not typically a wise approach, and valuations are becoming quite stretched in many technology companies. Expectations for the group are high entering the second half of the year. Some companies will meet or surpass these expectations, but those that do not will likely be soundly punished. This is a dangerous setup for investors in these shares, at least in the short-term. For much of the year, we have been slowly pivoting away from technology companies, either by looking elsewhere for new investments or paring back on existing successful positions. It has been a contrarian bet for the time being, but we are more comfortable owning shares in companies where expectations are lower and the possibility of a positive surprise is higher. Despite the headwinds some companies may face from a trade war, it is important to remember that good companies are being managed with an eye toward the future. Any responsible executive and investor will contemplate the current political climate, but also look past it in trying to make intelligent, long-term decisions.

The bond market paused during the period. After falling early in the year, bond prices stabilized as geopolitical tensions increased and global economic readings worsened ever so slightly. Nervous investors generally gravitate towards the safe haven of government bonds, and the trade war did make many investors nervous. Weaker economic readings generally persuade the Federal Reserve to pause its tightening or even reverse course and lower rates, which is a good thing for longer-dated bond holders. In our fixed income portfolio we continued to focus on shorter-term bonds. The difference in yield is negligible over various time periods and we prefer to remain agnostic on the direction for bonds, while content to capture as much short-term income as possible.

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