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By Gregory Woodhams - May 23, 2019
The trade war returned to the headlines and to earnings reports. Only a month ago, conventional wisdom held that the U.S.-China trade conflict would be resolved. Instead, the rhetoric is sharper and tariffs are higher. The tariffs on the initial wedge of $200 billion in Chinese goods rose from 10% to 25%. In addition, the Trump administration has proposed 25% tariffs on all remaining Chinese imports, including higher-profile consumer electronics, clothing and footwear. The timing of the tariffs on these final tranches would vary.
We believe this round of tariff hikes will have a bigger impact on consumers than the first round, as producers and retailers pass along higher costs. We also view the global move away from free trade as a risk to long-term inflation expectations.
More than just 15%. We're seeing retailers behave differently. With the initial 10% tariff, intermediate goods producers and retailers largely “ate” the cost of the hike to avoid passing it on to consumers. Some retailers managed this by being more productive, while others took a hit to their profit margins.
First quarter earnings conference calls for retailers, however, highlighted the need to balance the interests of both consumers and shareholders. Retailers are looking hard at price elasticity, implying a willingness to raise prices where they can.
The first round of tariffs had a modest effect on inflation. They coincided with slowing gross domestic product (GDP) growth, which could have been caused by tariff increases. For this second round, economists don't expect an increase to overall levels of inflation, given that the inflationary effect of higher tariffs could be largely offset by lower GDP—to the tune of about 0.20%-0.35% for each.
We believe the next step, extending the tariffs to all Chinese goods, would be far more damaging. We've seen estimates of as much as a 1% hit to GDP from such a move. Thus, recent volatility reflects not only concern about the incremental 15% rise in tariffs, but also the possibility of extending tariffs to all Chinese goods.
For example: U.S. Steel stock nearly doubled over the course of the Trump administration's initial implementation of higher steel tariffs. Even with tariffs, competition remained intense, and eventually the higher tariffs were eased. The stock has now given back all gains associated with protectionism and is trading near three-year lows.
U.S. farmers generally believed that trade tensions with China would ease before the current crop year and amassed historically large soybean inventories. Unfortunately for the farmers, that confidence was misplaced. They will now have to find markets beyond China to sell those soybeans—most likely at lower prices—even as the current year's crop is planted.
Predicting the exact timing of trade events is tricky without a crystal ball, so we rely on the strength of other market dynamics. When a company has trade exposure, we look to see if that effect can be offset with good management, such as the ability to identify where prices can be selectively increased. We also look for companies whose strengths are likely to extend beyond the current election cycle.
We've argued before that higher tariffs posed an inflationary risk, but that a vigilant Federal Reserve was likely to keep inflation in check. That certainly was true for the first round of tariffs, which represented higher risk to corporate profit margins than to general inflation.
Still, it's important to remember free trade has been a key reason we've experienced relatively low inflation since the 1990s. A global move away from free trade removes that deflationary benefit. Expectations are important for inflation. Therefore, we should interpret the willingness of retailers and intermediary goods producers to pass on higher costs to consumers as signal that inflation expectations are changing.
In our portfolios, we look through the prisms of competitive advantage and durable cash flows to analyze companies and the impact of tariffs. In general, this drives us toward companies whose positions are derived from durable scale or a defensible technological advantage rather than a governmental benefit or a perceived wage-cost advantage.
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October 24, 2018
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