U.S. trade conflicts have entered a new phase. President Trump has demonstrated his tariff threats are real, individual companies can be blacklisted and his rationale for new tariffs can extend beyond trade balances to include immigration. This new phase has alarmed investors, forced economists to reduce growth estimates and precipitated a 5% selloff in global stock markets during May.
President Trump enacted the tariffs in an effort to bring jobs back to the U.S. and to ensure fair trade. We agree there is a lot of room to improve trade in the U.S., to make it more fair and better support displaced workers. However, as investors, Crestwood believes tariffs are bad policy and will hurt U.S. GDP growth as they disrupt companies’ supply chains, weaken companies’ margins and create uncertainty.
Mind the Rhetoric
Investors and markets need to take President Trump’s tariff threats seriously. Clearly, he is willing to disrupt global supply chains, decrease companies’ earnings and threaten global growth to pursue his U.S first agenda. Throughout most of 2019, markets anticipated a constructive trade agreement between the U.S. and China, where China agrees to protect U.S. property rights and increase purchases of agricultural products, and the U.S. agrees to reduce tariffs. This optimism was dashed in May when President Trump surprised markets with a tweet threatening to raise the tariff rate from the current 10% to 25% on the $200b in goods and floated a 25% tariff on the remaining $325b in goods imported from China. President Trump increased tariffs after China backtracked on previously agreed upon concessions and talks stalled.
The unravelling of trade talks and escalation of tariffs surprised global stock markets which generally fell more than 5% in May. President Trump showed that his trade tweets are not just posturing and he is willing to enact his proposals. He is not concerned with supply chains and believes tariffs will prompt companies to relocate production to the U.S.
Targeting Individual Companies
When President Trump banned Huawei, a Chinese consumer electronic and technology company, from selling in the U.S., he demonstrated a willingness to further escalate the trade war with China. In this case, the U.S. banned Huawei’s products due to concerns Huawei was using their telecom infrastructure equipment to spy on the U.S. While this is a legitimate concern, singling out a single company has appeared to strengthen Chinese nationalistic pride and elicit a tit-for-tat response from China. The U.S. could have banned only Huawei’s telecomm infrastructure equipment but instead banned all the company’s goods including phones and PCs from being sold in the U.S. The government took the further step to also ban U.S. companies from selling products and software to Huawei (who purchased more than $11b in chips from the U.S. last year). While, some countries, like Japan and Australia, have chosen to follow the U.S. ban on Huawei others, like the UK and Germany, have not. President Trump has linked Huawei’s ban to a trade deal, so it is unclear if the ban on Huawei is due to security concerns or an attempt to force the Chinese to meet U.S. trade demands. This policy of banning companies can easily be reciprocated by the Chinese to U.S. companies. This past week, China considered restricting exports of rare earth minerals, investigating FedEx and even warned Chinese travelers in the U.S. of “risks” associated with visiting the U.S.
Tariffs as a Policy Stick
As talks with China fell apart, President Trump expanded the rationale for use of tariffs with Mexico to include immigration. On May 30th, he announced a 5% tariff on all goods from Mexico (to take effect on June 10th), which would increase 5% each month up to 25% until Mexico stems the tide of illegal immigration into the U.S. The President justified the steel and aluminum tariffs as a national security concern and perhaps immigration fits that description, too. However, historically tariffs have been used to protect domestic industries from competition deemed to be unfair. In this case, President Trump wants to punish Mexico until they help reduce people flowing into the U.S. Unfortunately, it was unclear exactly how the administration would measure Mexico’s efforts to comply, especially given the extremely short period of time before tariffs take effect. These tariffs placed the ratification of the new-NAFTA, USMCA, agreement at risk, which would ironically prevent tariff increases just like the one Trump announced. Thankfully, it seems that Mexico has agreed to some form of “immigration deal” and Trump has suspended plans for these tariffs.
Ultimately, tariffs will reduce U.S. GDP growth and have an even larger effect on S&P 500 earnings. We expect the enacted tariffs (not including Mexico threats and China increases) will reduce GDP by -0.5% and corporate earnings by as much as -5.0%. These estimates do not include possible secondary effects like a reduction in consumer or business confidence which could exacerbate the tariffs’ effect. Tariffs create both short and long term business uncertainty, even farmers are not sure which crops to plant.
We expect countries that export to the U.S., like China, to see a greater reduction in GDP growth. However, some countries could benefit as production and exports shift to countries that do not face tariffs. In the first quarter, the U.S. trade deficit with China shrank a little, but the trade deficit with Asia did not change much as production shifted to other areas like Vietnam.
“If goods don’t cross borders, soldiers will” Frederic Bastiat (1801-1850)
More broadly, the current post World War II trade system is under fire as tariffs and company bans threaten to sever supply chains and interconnections between countries. Trade fosters stronger relationships and studies have shown that strong trading partners are peaceful partners¹. Trade creates international goodwill, provides economic incentive to avoid war while protectionism promotes hostility. Countries who are in the top 10% of the least protectionist are 70% less likely to go to war than the 10% most protectionist countries. Certainly, we are not expecting any military conflict in the near future, but the dismantling of the global trade system could have longer term implications for global stability.
We are concerned that President Trump’s willingness to follow through on trade threats, ban companies and expanded justification for tariffs has shifted the trade ‘conflict’ to an entrenched trade ‘war’. The U.S. has set high bars for both China and Mexico to meet demands and the likelihood of a compromise seems more and more remote. Tariffs are here to stay. We see a high chance of increased market volatility and increasing headwinds for corporate earnings and GDP growth. Importantly, we are not forecasting a recession and the U.S. economy remains healthy with strong employment and healthy consumption. We continue believe it is important to focus on diversification and high quality businesses which are best positioned to weathering challenging market conditions.
¹“Peace through trade or free trade?” Patrick McDonald The Journal of Conflict Resolution 2004