The Drums of Trade War, Redux

We wrote about trade war rhetoric back in April, and how the mere specter of it had rekindled recently dormant market volatility. Nearly three months later, these tensions have proved quite real and continue to dominate headlines. Market price volatility continues apace as well, affected by concerns not only about trade but also rising interest rates and energy prices. Ultimately the damaging impact of tariffs is economic slowdown, though; coupled with higher costs, that increases the risk of recession.

While the media’s coverage of back and forth threats is now focused on China, Trump began with an early tariff last November on Canadian lumber imports, exacerbating the cost of housing in the US.  Next came tariffs on washing machines and solar panels in January, and tariffs on steel and aluminum in late March. Those latter tariffs exempted Canada and Mexico, and eventually the European Union and others but as of June 1^st, they now apply to those close allies as well. Going into effect today are tariffs on $34 billion worth of imported Chinese machinery, auto parts, and medical devices. We have now arrived in a back and forth war of policy threats with allies and adversaries alike. While we can’t know the eventual outcome, let’s look at some of the tangible impacts we are monitoring most closely.

Jobs and wage growth are two key drivers of the market, not to mention elections. Moody’s recently pointed out that “tariff-driven increases in materials costs have compelled some companies to rein in employee compensation for the purpose of protecting profit margins. To the degree tariffs increase the cost of materials and inventories, businesses will tighten their control of other costs, the most prominent being employee compensation.” The irony being that trade policies presumably intended to bring manufacturing jobs back to the US may actually result in wage stagnation as materials costs increase. Look no further than Harley Davidson’s recent decisions to move certain export-focused production jobs and facilities to Europe.

Whether you need to fuel up your (currently) American made motorcycle or another vehicle, people pay close attention to the price of gas and energy. Rightly so since the US alone currently has more than 260 million registered vehicles[1].  Every summer people notice that there is a cyclical increase in gas prices due to higher levels of driving/vacations (and “summer-grade fuel” is actually more regulated and expensive to produce). Less visible to many people is that a significant portion of fuel demand is from the transportation industry, particularly the maritime sector and trucking industry. Both industries are directly tied to global trade and consumption. If global trade slows due to tariffs, then fewer goods are shipped, less fuel is demanded by these transportation sectors, and lower demand generally leads to lower prices. Lower prices might be welcomed at the gas station, but it also means fewer jobs and wage increases in the energy sector. In addition, tariffs on solar panels will impact expansion of solar installations, related jobs, and progress on modernizing our grid.

So, trade wars should be bad for oil prices, but what has actually happened? Until the last few weeks, oil has been one of the growth stories propelling markets higher. Rising global economic growth and trade both supported oil demand, with China and India starting this year on a strong note. These two countries accounted for nearly half of global demand growth in 2017. Cold weather in Europe and the US in the first two months of this year further increased demand for heating fuels.[2]

Oil prices are up 25% since mid-February and a whopping 64% since a year ago. Still, a slowing trade environment, with nationalist political parties gaining traction around the world, represents a risk for the energy sector domestically and internationally. Many mutual fund managers, including many in our portfolios, have been underweight energy due to this risk factor; some completely exclude the sector due to the negative environmental impacts of fossil fuel extraction. This divergence in allocation helped in 2017 when oil underperformed other sectors of the market but has been a headwind thus far in 2018, particularly in the second quarter.

The other side of the equation, ‘supply’, is equally complex. In this moment, more supply is coming into the markets and coupled with concerns about the trade war, has begun a declining trend in price. Supply increases come from two sources. First, US shale production – which is highly profitable with oil at nearly $80 a barrel – can expand. Second, OPEC producers have quietly started to exceed their quotas in order to make up for the shortfall caused by sanctions on Iran.[3]  Markets don’t always follow the rules laid out in economics textbooks, but if demand for oil falls while supply is being increased, we expect prices to decrease in the second half of the year. This relief will flow through to the gas pump but will be offset by the potential for inflation and higher borrowing costs for both businesses and individuals.

We expect politics to continue as a major market headline in the second half of the year including mid-term elections in the US and whether Congress becomes more balanced (read: gridlocked), any new negotiations with Iran that will impact global oil production, and trade wars calming or escalating with China and our NAFTA trading partners. Our strategy remains one of cautious growth. We will follow a path of diversified exposure, with an emphasis on short-term bonds that benefit from higher interest rates and allow us to buy the stocks of quality companies at low points in the market.

Even as we periodically adjust our sails, we remain confident in the long-term growth of the markets and the ability of the global economy to weather any intermediate-term weather. We welcome conversation with our clients, colleagues, or their networks, and appreciate the ongoing trust you put in us through these complex times.

[1] https://www.statista.com/statistics/183505/number-of-vehicles-in-the-united-states-since-1990/

[2] https://www.ft.com/content/595659f0-282b-11e8-b27e-cc62a39d57a0

[3] https://www.theguardian.com/business/2018/may/20/oil-prices-rising-but-set-to-fall-in-2019