Tariffs: What’s the Big Deal?May 2019
A tariff war could have a meaningfully negative impact on global
trade and, as a consequence, the U.S. stock market.
We believe an agreement on trade is in everyone’s interest and are hopeful for a
compromise. However, until an agreement is reached, we would not be surprised to see elevated
market volatility. With a watchful eye on current events, we are focused on the long-term and our
thinking, outlined in our recently-published first quarter 2019 Economic and Market Commentary,
Recall that in our fourth quarter, 2018 Economic and Market Commentary, we attributed a
meaningful portion of the late 2018 stock market sell-off to the growing risk of a trade war between
China and the U.S. Just a short time later, in our Q1 2019 Commentary, we attributed a meaningful
portion of the early 2019 stock market strength to dissipating trade risks, as it appeared the world’s
two superpowers would reach an agreement. Today, barely a month and a few tweets later, with
painfully slow progress towards a deal, we find ourselves re-visiting these risks. As such, we thought
it might be helpful to share a few thoughts.
What’s going on?
The U.S. imposed tariffs on a variety of Chinese imports beginning in July of 2018, and is now
considering expanding the tariffs. In a vacuum, reducing the U.S. trade deficit and striving for more
“fair” trade and international relations might make sense. However, we don’t live in a vacuum and
China responded to U.S. actions in a similar fashion: tariffs on U.S. imports. This is where the U.S.
stock market comes into play.
Why do tariffs matter so much to the stock market?
At first glance, they shouldn’t matter. At face value, the dollar magnitude of the tariffs, as of
February 2019, represents less than 0.5% of US GDP, less than 1% of US consumer spending, and
under 3% of earnings for the S&P 500 stock market index. However, upon closer inspection, the
impact of tariffs appears far more severe for key areas of the stock market because the U.S. imports
a large amount of Chinese products that are used to provide key services and/or make finished
goods. For instance, according to data from the Census Bureau and Empirical Research Partners,
roughly half of U.S. imports from China are high-tech products and inputs into capital goods
(mechanical equipment, engines, machinery, etc.). In such instances, tariffs could have a very
meaningful impact on some public company earnings, as evidenced by the chart below.
Source: Empirical Research Partners
Given the importance of technology sector earnings and, as outlined below, manufacturing sector
profit margins on the U.S. stock market, tariffs could matter a lot. Profit margin expansion has been
a key driver of earnings growth, and therefore the U.S. stock market, over the last few
decades. The manufacturing sector has been a key contributor to this margin expansion, helped by
increasing globalization, outsourcing to geographies with lower labor costs (e.g. China) and stable
prices on goods imported from emerging markets, especially China.
Source: Empirical Research Partners
With U.S. economic growth decelerating more than ten years into an economic recovery, continued
margin stability appears important to further, meaningful appreciation in U.S. stock prices. Would
U.S. firms respond to higher input costs (via Chinese tariffs) by raising prices or seeing lower profit
margins? Both options carry risk, and could accelerate a slowdown in the U.S. economy.
Is the U.S. administration posturing to get a better, faster deal? Or will it walk away North Koreastyle?
It would seem obvious to all players and most (all?) global economies that a deal is in
everyone’s interest. We believe cooler heads will prevail and that the U.S. and China will reach an
agreement. However, we would not be surprised to see more posturing, and therefore more stock
price volatility, in the ensuing days, weeks, and (hopefully not) months. In the meantime, while we
are monitoring these events, we remain focused on the long-term outlook.