What’s behind the rhetoric?
“Trade war is unlike real war in one crucial respect: the guns are pointed inward.”
Andrew Coyne, Journalist, National Post1
U.S. tariffs on steel and aluminum, a trade war between the United States and China, and the down-to-the-wire negotiation of the United States–Mexico–Canada Agreement (USMCA) – they’re certainly making headlines, but what do escalating global trade tensions mean for investors? Let’s start by looking at why tariffs exist in the first place.
What are tariffs meant to do?
Tariffs are simply a tax imposed on a set of imported goods or services. Governments often use them as a protectionist strategy to defend domestic producers. Charging tariffs on imported products makes them more expensive. This gives domestic producers a competitive advantage and greater incentive to jump into the market. Domestic producers may also seize the opportunity to boost profits by selling at an increased price – and that can be a challenge for everyone outside the protected industry.
As Megan Greene, Chief Economist at Manulife Asset Management, points out, the cost of a tariff is often passed on to consumers. “Tariffs benefit some and not others,” she explains. “In the end, if you add up who on balance wins and who loses from tariffs within your country, net-net there are always more losers than winners.”
The effect is sometimes complicated by global trade interdependencies. For example, when the United States imposed tariffs on imported steel, American steel producers got immediate protection for the steel they produced themselves. However, [U.S Steel Producers] now have to pay more for the steel they import from other countries – and that will be the case until the expiry of long-term contracts they signed before the tariffs were introduced.
“Eventually, they will work through those contracts and won’t sign any more because they are now more expensive,” says Greene. However, “In the short to medium term they are paying a higher cost.”
How can trade disputes affect the economy?
Uncertainty is often the most dangerous element of trade disputes. Greene explains that uncertainty can hold companies back from capital expenditure. Lower capital investment decreases productivity, which in turn decreases gross domestic product. That’s a real economic risk.
Trade disruptions have other implications for economic growth.“One thing that is really important to think about is the global supply chains that have developed because of globalization,” Greene says. “If we impose tariffs, then those global supply chains have to totally shift just because it gets needlessly expensive to keep them intact. So car manufacturers will have to build new plants somewhere else, for example. That can be done over time; it just takes a while.”
Greene points out that some global supply chains have already started to change to get around tariffs. For example, China has imposed tariffs on U.S. soy. U.S. farmers used to ship soybeans across the Pacific to China from the U.S. west coast. Now quite a lot are shipping to China via Brazil. Brazil hasn’t imposed tariffs on U.S. soy products, and China hasn’t imposed tariffs on Brazil’s soy products.
“It’s a bit more expensive because [U.S. farmers] are sending it through different countries, but there is a degree to which some of these tariffs will just never be paid because farms will work around them,” says Greene.
On the other hand, Greene isn’t concerned about the impact of tariffs on inflation. Historically, she says, tariffs haven’t led to significant inflation,2 and in today’s environment companies like Amazon are keeping inflation in check because they don’t feel they can increase their prices much without losing customers.
Are trade imbalances always a bad thing?
The U.S. administration has put forward the argument that other countries are taking advantage of the United States, treating it as the consumer of last resort instead of doing the hard work necessary to generate demand in their own countries.4 In this view, the U.S. has bilateral trade deficits with these countries because of bad trade policy. However, some economists contend that bilateral trade imbalances are to be expected. For example, some countries can grow bananas and other can’t. That’s natural and can’t be fixed by trade policy.
“Countries are supposed to produce things where they have a competitive advantage,” Greene says. In other words, not everything can be on an equal trade footing.
Meanwhile, within the United States, tariffs can create regional disparities. Auto tariffs may have a positive effect on states that produce lots of cars – which benefit from the extra protection – but may have a negative effect on states that buy lots of cars. Regional disparities can become electoral disparities and, Greene notes, “All of it affects competitiveness.”
Politics are a powerful motivator for tariffs even when there isn’t a strong economic case to be made, as with employment. Between 1965 and 2004, manufacturing declined from 53 per cent of the U.S. economy to below 10 per cent.4Between 1970 and today, manufacturing jobs declined from 25 per cent of all U.S. employment to around 10 per cent.5
“Tariffs are not going to bring manufacturing jobs back to the United States, in part because the majority of these jobs weren’t lost to outsourcing to other countries. They were lost to automation. So, economically speaking, the argument doesn’t make a lot of sense,” says Greene.
Can trade tensions create opportunities for investors?
In the shorter term, escalating U.S. and Chinese tariffs have without question had an impact on stock market performance. “Fears of an ongoing trade war … have boosted U.S. equity returns while depressing equity returns in international markets, including emerging markets,” says Philip Petursson, Chief Investment Strategist at Manulife Investments.
“Right now, the tariffs are the economic equivalent of a mosquito bite.”
Megan Greene, Chief Economist at Manulife Asset Management
According to Petursson, international market fundamentals remain solid, but performance hasn’t matched the team’s expectations. He attributes the mismatch to the tendency of investment markets to react to trade tensions based on a short-term view, and he agrees with Greene that the impact of the tariffs themselves isn’t likely to be lasting. In similar scenarios historically, he points out, “Investors would have been better off taking advantage of the market dislocations, which in today’s case would mean international equities and emerging markets.”
He also believes in staying invested in U.S. equities: “Given the fact that we continue to see a positive economic environment over the course of the next 12 months, … a positive earnings environment … and a market that is fairly valued (perhaps fully valued but not overvalued), we would continue to suggest to a full weight in U.S. equities within the context of a balanced portfolio.”
The bottom line is a message you’ve probably communicated to your clients countless times – but it bears repeating: “There seems to always be something in the geopolitical landscape that we can point to as a reason to sell out of the markets. That is often the wrong decision. It’s very rare that a geopolitical event has a meaningful and lasting impact on the market,” says Petursson. “Investors need to separate the fundamental truths of the equity markets, of the fixed income markets, and where are the opportunities therein, versus what is the interesting headline that might not have anything to do with investing at all.”
Those words apply to so much more than trade tensions, and they’re as true as ever.