“Trade wars are good, and easy to win”
In an effort to protect domestic steel and aluminum producers, U.S. President Donald Trump recently announced his intention to impose tariffs on imports of the two materials. Trade wars are a contentious issue, so the pushback to the announcement was swift. In an attempt to defend his stance, Trump responded with the quote in our title.
Actually, we apologize. Calling trade wars a “contentious issue” is misleading. Let's rephrase that: trade wars are dumb. Or as the China Iron and Steel Association more eloquently put it, “stupid”.
We previously discussed the issue of tariffs and protectionism in our fourth quarter 2016 client letter. In this month’s market commentary we’re going to review some of the things we discussed in that letter, while updating those views in the context of the newly-proposed steel and aluminum tariffs.
What are Tariffs?
But before we do that, let’s make sure we’re all on the same page about what tariffs are. Let’s say you live in an apartment building that has a convenience store on the ground floor. This store does have food in stock, but the selection is limited and overpriced. So when it comes time to do your weekly grocery shopping, you don’t go to the convenience store. Instead, you go to the supermarket down the street.
But the manager of your apartment building really likes the owner of this convenience store. In fact, they’re often seen together socially. Frequently he has been overheard remarking, “IF YOU DON’T HAVE POTATO CHIPS, YOU DON’T HAVE AN APARTMENT BUILDING!”
We must protect our country and our workers. Our steel industry is in bad shape. IF YOU DON’T HAVE STEEL, YOU DON’T HAVE A COUNTRY!— Donald J. Trump (@realDonaldTrump) March 2, 2018
The building manager doesn’t like that you do your grocery shopping down the street. He wants you to do all of your shopping at his friend’s convenience store so that his friend doesn't risk going out of business and losing his job. So he hires a security guard that sits at the building’s entrance and inspects your grocery bags anytime you come back from shopping. If anything in those bags was bought at the supermarket down the street, he collects an extra 25% of what you spent in an effort to discourage you from shopping there. You complain about this additional tax, but the manager simply explains that it is Timely Assistance Rightfully Improving Friends' Fortunes or “tariff” for short.
Two Sides to Every Story
We don’t want to be accused of being flippant about people losing their jobs because of competitive pressures. As we previously wrote in our fourth quarter 2016 letter:
Tariffs can successfully protect domestic industries that face intense competition from foreign countries. But should any industry even be protected in the first place? In the client letter we continued with the following example that considered whether the U.S. automobile manufacturing industry should be protected from foreign competitors who sell lower-priced vehicles:
Protectionist trade policies also reek of an “us versus them” attitude. Far too often trade is incorrectly treated as a zero-sum game where foreigners have to lose if we want to win. But history has shown that isn’t the case. Not only can domestic consumers benefit from increased globalization, but it also helps alleviate poverty in developing countries:
As we discussed in our January market commentary, consequences have consequences. A country whose exports are suddenly subjected to tariffs is apt to retaliate with their own tariffs on imports. That’s why protectionist trade policies can escalate into full-blown trade wars. With respect to the proposed steel and aluminum tariffs, Canada has already responded by pointing out that we buy 50% of the United States’ steel exports; a tariff on these shipments is apt to negatively impact U.S. steel producers.
Back to our Q4 letter to see how tit-for-tat protectionism can unfold poorly:
Going back even further in history, the Hawley–Smoot Tariff Act of 1930 raised tariffs by as much as 50% on tens of thousands of goods imported into the U.S. Inevitably, U.S. trading partners retaliated. How did it all work out? We’ll let Ferris Bueller’s economics teacher explain:
How the Markets View Trade Wars
We aren’t alone in our distaste for trade protectionism. The S&P 500 index – the most prominent equity index in the U.S. – sold off almost 4% in the wake of President Trump’s tariff announcement.2 In other words, this suggests that investors believe these tariffs to be a net negative for the U.S economy.
Specifically, while the tariffs would be good news for domestic steel and aluminum producers in the U.S., it would be bad news for any company that uses those materials as an input. For example, tractor manufacturer Deere & Company (DE-NYSE) was down approximately 7% on the news, machinery manufacturer Caterpillar (CAT-NYSE) was down 9%, and electric car manufacturer Tesla (TSLA-NASDAQ) was down 6%. In turn, this suggests that farmers, construction workers, and environmentally-friendly drivers are all going to be footing the bill for these proposed tariffs.
We don’t own any equities in our portfolios that are as directly exposed to these tariffs. However, some of our holdings that export other goods to the U.S. did sell off. Investors seem to becoming increasingly concerned that more protectionist policies are coming from President Trump. We aren’t yet in that camp; we do believe that cooler heads will eventually prevail. They may not prevail in the next month, quarter, or year, but over a long-term horizon, we find it hard to believe that the world’s biggest economy and bastion of capitalism will wholeheartedly embrace trade wars.
2All index and stock return data from Bloomberg.