How Will the Tariffs Play Out?
The stock market responded to the unexpectedly large imposition of tariffs with fear and loathing and negative imaginations ran amok. That’s not surprising, since investors often oscillate between euphoria and despondency. It remains to be seen whether our trading partners emphasize retribution or a willingness to collaborate and negotiate. We doubt the market’s worst fears will be realized. And we might even be pleasantly surprised.
The potential negative aspects of large tariff increases are easy to play out and articles abound on such possibilities. Higher tariffs will drive up consumer prices and drive down corporate profit margins, while consumer and business spending retrench, so the economy lurches into recession. It is a straightforward, but simplistic story. Reality is far more nuanced. Also, simple references to the Smoot-Hawley Act in 1930 are scary, but maybe irrelevant. Then, the U.S. was running huge trade surpluses, so large reductions in global trade hurt us. Now, we’re the one running large deficits, so reducing global trade may reduce our trade deficit, which could boost GDP. But let’s consider some examples.
Auto imports from Mexico and Canada have been largely exempted from these tariffs, but Japanese, South Korean, and German cars will be hit hard. So, U.S. buyers will face price increases and inflation will reflect that. But U.S. consumers do have options. Camrys are made in the U.S. Buyers also have the ability to choose American made vehicles, such as a Corvette instead of a Porsche or a Chevy instead of a VW. Domestic auto companies can boost production to capture the shift in demand. Liquor buyers can choose Napa wine or bourbon instead of Bordeaux or Moet. Such shifts can overcome the drag from higher costs for other products. We don’t produce many cell phones or laptops domestically, but the increase in cost of those tariff-affected products can be offset by modifying the replacement cycle from every three years to every four years. The worst-case scenario of prices rising across the board that induces an equally broad reduction in household spending is unrealistic. Consumers are very good at adapting in such ways.
Expectations of a weak economy have also spawned other market responses that will help offset some of the adverse effects. Crude oil prices have dropped around $10/barrel, which boosts disposable income. Lower interest rates will trigger a quick rise in housing purchases and will lead to a rise in mortgage applications within days or weeks and starts in short order.
The examples above should make clear that there are significant mitigating factors to offset the adverse effects of higher prices on imported goods. Moreover, the decline in imports will persuade at least some of our trading partners to seek some sort of accommodation with Trump to reverse the tariff hikes that apply to them. Neither Germany nor South Korea wish to see a sizable decline in vehicles exports to the U.S. Trump has stated publicly he’s open to negotiations. We know a few countries, including Vietnam and Israel, are already in such talks.
No doubt, economic growth will slow in the very short-run, since consumers and businesses must cope with an elevated level of uncertainty. We don’t know how these tariffs will play out, so some caution is to be expected. But there will certainly be some sense of urgency on the part of our trading partners to mitigate the tariffs on their exports before their domestic economy is seriously harmed, just as there should also be a desire of our government to limit the adverse effects on our economy. Supply chains simply cannot be adjusted quickly, so these tariffs will produce disruptions. Because the range of possible outcome is very wide, both parties should work to resolve the trade war quickly.
Negotiations will vary considerably, with some countries apt to move quickly, while others may be disinclined to do so. China is a particularly interesting case because that trade imbalance is so large, with China exporting far more than $4 in goods to the U.S. for each dollar of goods we export to them. So, our 52% tariff on Chinese goods (34% incremental) is vastly more damaging to them than their 34% tariff on our products, especially since they import lots of agricultural goods, which they need to feed their population. Nor will the Chinese find that they can easily replace U.S. customers with European ones. The Chinese have already stated that tariffs are bad for the global economy and both parties should work to lower trade barriers.
Not surprisingly, the market reacted very strongly to the new tariff regime, discounting some of its worst fears. It is premature to render judgment whether this will prove to be followed by more declines or is an overreaction. Much depends on how nations will respond. Some forecasters rushed to predict an impending recession, while others reduced their GDP projections by just a few tenths of a percent while raising their inflation forecasts by a similar amount. Since we prefer to avoid jumping to conclusions, we would be inclined to join the latter group, but of course, we will monitor developments closely to see how they play out.
The retreat is stock valuations does create great value, in our judgment, for those who can put more dollars to work at today’s reduced prices, although it is unclear how long they may need to wait to benefit from the rebound that will come in due course. Still, it makes sense to buy when stocks are on sale. And most importantly, investors should stick to their long-term plan. At ACM, we are acting to take advantage of mispricing, where we find it.
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