The Drums of Trade War

The first three months of the year have been marked by a return of volatility to the stock market. We are getting questions from friends in casual conversations and clients in meetings, which means the newspapers and the talking heads on TV are covering it. The problem is that this coverage often lacks proper context.

Like the ebb and flow of the tide, we saw markets rush upward in January only to see them retreat back in February and March. On the smaller scale of day to day trading, we have seen a few historically large single-day declines that created unnerving headlines, only to see a big rebound a few days later. The primary reason given for this volatility has been broad concern about tariffs and a looming trade war with China. What does this mean for markets going forward, and for investment portfolios?

To understand the ripple effects that are concerning the markets we must first understand what a tariff is. Simply put, a tariff is a tax on specific goods that are being imported or exported from a country.

The tariff, or tax on these goods, must be paid by someone. Sometimes the company importing these goods – such as Coca-Cola importing aluminum for their cans, or GM importing steel to manufacture new cars – might absorb this cost and lower their profit margin. Alternately, they could cut costs elsewhere such as labor (read: layoffs).  More often, these tariff costs are passed along to consumers in the form of higher prices on goods, which creates or exacerbates inflation.

A single set of tariffs does not constitute a trade war, but it can signal a change in policy away from free trade and toward an actualization of President Trump’s rhetoric on protectionism that could have broad negative impacts for the global economy and corporate profits. At this point, markets are still optimistically assuming that the trade threats are part of the president’s “art of the deal” and will be negotiated to more reasonable terms. Yesterday’s announcement that Trump is reconsidering entering the Trans-Pacific Partnership is yet another unexpected twist in those negotiations, and it is difficult to predict the ultimate outcome. That said, the opening threats have had a real impact, with the S&P down 10.1% from its peak in late January until the end of the quarter, and the EAFE declining 7.4% over that same time period. Markets don’t like patent uncertainty.

This highlights another consideration we have talked about in recent commentaries:  at present, the US equity market is highly priced from a historical perspective. The CAPE ratio (a common measure of how much investors pay for earnings, averaged over 10 years and adjusted for inflation) is near 31 at the moment, a level the market has only reached twice before – in 1929 and 1999. There is no single metric that explains the market, so we’ll be clear in saying that we aren’t predicting any imminent crash – but we do think current price levels make the market vulnerable to economic surprises and less resilient than it might be otherwise.

The reference to 1929 brings up another comparison as well, since tariffs enacted by the 1930 Smoot-Hawley Tariff Act are widely credited with worsening the Great Depression.  Again, we aren’t anticipating a comparable decline in today’s markets based on the information we currently have, but that gives context to the price gyrations we are seeing in response to daily news reports of trade policy tit-for-tat. In the 1930’s, the Smoot-Hawley Tariff Act put in place effective tariffs of just under 20%; current policies would increase U.S. effective tariffs to approximately only 3.1%.

Trade war concerns are the current headline de jour, but the reality is that volatility is a normal part of the market.  The last few years have experienced low volatility, in part due to artificially low interest rates, and that has lulled investors into a false sense of comfort.  In fact, from 1979 to 2017 there was a market correction of at least 10% from the yearly peak in 22 of those years or 55% of the time.[1]  For now, we don’t expect any major changes to your portfolio unless we see further declines, in which case an opportunity to buy stocks at attractive prices for the long-term may present itself.

In addition to market volatility, we also pay attention to portfolio volatility. Our portfolios are intentionally designed to be less volatile than the stock market. As Warren Buffet said in our opening quote, “a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.” If our portfolios experience downside volatility equal to the market, it leaves no opportunity to take advantage of those irrationally low prices that allow for long-term growth.

Significant volatility on the downside can also lead we oh-so-fallible human beings to make emotional decisions to reduce risk at any cost. Sometimes we have seen clients do this in their portfolios – insisting on selling a portion or all of their stock allocation in order to reduce their discomfort. Other times we watch them buy insurance they don’t need, spend significantly to refinance debt at a high cost, or forego personally meaningful spending – all in the spirit of bringing their risk to a point they can tolerate.  We want to limit the likelihood that you feel the need to make those kinds of decisions.

Our portfolio design intends to keep that downside distress to a manageable level, allowing discipline to a long-term strategy and avoiding short-sighted decisions with the sole goal of reducing stress.

Regarding the trade war, the fact is that China needs the U.S.  We are their biggest market. The U.S. imported more than $500 billion in Chinese products in 2017[2], which represents 18% of their total exports[3]. Going the other direction, the U.S. provides one-third of China’s massive soybean imports, and slapping a tax on those won’t be positive for the Chinese economy. A true trade war isn’t good for either country and in the long term we think it more likely that the global economy will continue to evolve in the direction of free trade.

[1] https://insight.factset.com/a-historical-perspective-of-market-corrections

[2] https://www.census.gov/foreign-trade/balance/c5700.html

[3] https://ustr.gov/countries-regions/china-mongolia-taiwan/peoples-republic-china