Putnam Perspectives

In early July, the Trump administration put into effect tariffs on $34 billion of imports from China, and China has retaliated. This is one piece of the administration’s efforts to revise agreements with major trading partners, including Canada, Mexico, the European Union, and other nations. While only a few tariffs have been implemented thus far — on items like aluminum, steel, solar panels, and washing machines — it seems likely that more are to come. An example is Trump’s proposed 25% tariff on imported autos, which has the potential to be devasting to the profitability of the U.S. and global auto industry.

The impact of tariffs is hard to predict, and there will be unintended consequences. Supply chains have been globalized, so while end products may be made in the United States, sub-components are from all over the globe, with many coming from China and Mexico. Tariffs disrupt this supply chain. As an example, the tariffs on steel have led to such a sharp increase in the U.S. spot price that it is already hurting the profitability of some U.S. manufacturers. And ironically, this higher price is serving to attract more U.S. steel imports.

At the same time, it is important to keep in mind that U.S. GDP is accelerating, as Q2 annualized growth was reported at 4.1%. The 2017 tax reform is having many positive effects for U.S.-based companies as well as overseas suppliers to U.S. companies. Interest rates are still low on a historical basis, even as the Federal Reserve is tightening policy.

Market implications

We believe that trade wars are significant events for global markets and for active investors. The impact of higher tariffs is similar to that of taxes. They make products more expensive, resulting in fewer purchases. They raise prices and reduce demand.

Tariffs will hit corporate earnings and are already starting to do so. For manufacturers, there are more potential losers than winners, as today’s high profit margins are vulnerable to cost increases. Globalization over the past 25 years helped to generally reduce costs, improve margins, and expand markets. Tariffs, on the other hand, are a form of de-globalization and have the opposite effects, namely they raise costs, squeeze profit margins, and shrink markets. In assessing the market impact of tariffs on manufactured goods, it is important to note that manufacturers play a much larger role in the S&P 500 — representing as much as 40% of the index market capitalization — than they play in the overall economy, where they account for just 10% of GDP.

Risks for U.S. companies in China

The goal of the Trump administration is unclear. It has an established pattern of employing tough rhetoric and policy announcements as a negotiating tactic in an attempt to “capture value” or increase geopolitical leverage more broadly. With China in particular, the objective may be to increase U.S. exports, protect U.S. technology, or make China more pliable on some other matter, such as security issues.

Also, the administration appears to be operating with an incomplete picture of the U.S.-China business relationship. It appears to assume that China will be motivated to meet U.S. demands because of its large trade surplus with the United States — $130 billion in the first six months of 2018 (Reuters). However, that excludes more than $300 billion in sales by U.S. companies operating in China. It also ignores the direct U.S. corporate investments in China, which are more than 3.5 times greater than Chinese companies have invested in the United States. Both China and the United States have much to lose.

The outlook for negotiations

Tariff negotiations will take longer to resolve than anticipated, in our view. President Trump has little incentive to agree to new trade deals before the November mid-term elections. Also, he has harped on the U.S. trade deficit for decades, suggesting he believes in reducing it, even though it has risen since he took office.

With regard to China, at least two of the U.S. demands are difficult for the Chinese government to acknowledge, let alone accept: stopping the theft of U.S. intellectual property and ending subsidies to industries that compete with U.S. companies. We think China’s response to the Trump administration will be guided by the government’s desire to avoid economic instability at all costs. China’s economy is highly levered, and policy makers are trying to gracefully deflate a large debt bubble. An intensified trade spat could derail this strategy and make the economic situation more volatile.

Regarding NAFTA, there may be a better chance that the U.S. reaches a new deal, as it would strengthen the U.S. negotiating position with China, but the odds are still below even, in our view.

Our best case scenario relies less on understanding the administration’s goals than recognizing President Trump’s proven desire to claim victories for the economy and the markets. This may be the path to moderation.

If it appears that the biggest trade threats are close to being enacted, markets could experience sharp price movements. It’s reasonable to expect that President Trump would then direct his trade advisors to settle for a compromise, and call it a victory. In the meantime, the market volatility and greater performance differentiation among equities would create an attractive environment for active investment management.