3rd Quarter 2018 Market Commentary

Taxes, Tariffs, and Trade Wars

 “Our new Constitution is now established, and has an appearance that promises permanency; but in this world, nothing can be said to be certain, except death and taxes.”

It’s a quote that comes down to us from Benjamin Franklin, who uttered the phrase in 1789.

Taxes–federal, state, local, sales tax, property tax, gasoline tax, payroll tax, tolls, fees, taxes on capital gains, dividends and interest, gift tax, inheritance tax, and cigarettes and alcohol. There has even been a rising chorus that is calling for a special tax on junk food.

Yes, Ben Franklin nailed it. We can’t escape taxes.

Another term that has been popular this year is Tariffs. Now to most people tariffs are a four letter word. I wanted to take this time to write a little bit about tariffs and why they matter and what we think about how the Trump administration is handling this potential trade war.

On June 8, at the G7 summit in Quebec, President Donald Trump called for unfettered trade within the Group, announcing his desire for “No tariffs, no barriers. That’s the way it should be.” There was hope this sentiment would stand when only a few days later, Mr. Trump announced on his Twitter, “Sorry, we cannot let our friends, or enemies, take advantage of us on trade anymore,” However, on July 5 the Trump administration placed tariffs on $34 billion of Chinese imports and on July 10 it placed an additional $200B of tariffs on Chinese goods from clothes to refrigerators, showing that protectionism is apparently back in style.

With all the confusion and uncertainty surrounding Trump’s trade war, it’s important to explain the ramifications of the tariffs.  The situation has been rapidly changing over the past few months, and it’s understandable that many people don’t understand this complex issue. Also, considering all the drama and the sensationalized headlines that have been in the news, it makes sense that people have considerable concerns.

Here are 5 things to know about tariffs to cut through the noise

1. Why tariffs matter—a little history is in order

Historically, large tariffs have led to market decline because tariffs lift costs, cause shortages, and hurt corporate profits. This cycle dates as far back as at least 1929, when passage of the Smoot-Hawley Tariff was in the headlines. The Dow fell from 381 in September of 1929 to 41 in July 1932, a dramatic drop which precipitated the Great Depression. By 1934, global trade had decreased by more than 60%. As a result, economic nationalism grew, leading to World War II.

Almost 70 years later, in 2002, George W. Bush imposed steel and lumber tariffs, as well as crop subsidies. In the first year of these tariffs, the S&P 500 lost more than $2 trillion in market capitalization. In 2003, after realizing that European retaliatory tariffs would hurt the U.S. and bring a market decline of several thousand points, the tariffs were lifted and the stock market recovered.

Now, the Trump administration is favoring a protectionist stance, which hasn’t been done since WWII, in an attempt to further the “America First” policy and increase economic nationalism while decreasing reliance on foreign imports. Hurting the economy of a neighboring nation won’t help America, but instead brings both nations down, a lesson that Trump has yet to learn.

2. No one wins a trade war

Although Trump says that America will win a trade war, that’s just wrong. Most economists agree that everyone will lose. The U.S. and North America might be relative winners, according to Tom Lee, Head of Research at Fundstrat Global Advisors, but even then, the U.S. is not immune from the impact of a trade war. From countries who depend on imports and exports to the U.S. dollar, nothing and no one is immune to the repercussions of these tariffs.

Trade wars and trade hostility with China hurt world trade and global profitability. This means that “companies that operate globally are going to have disappointing earnings, and that is likely to have a negative effect on their financial market,” according to Byron Wien of the Blackstone Group.

Trump’s anger might come from the fact that America is more “open” than almost any other rich country. Looking at the World Trade Organization (WTO), America’s tariffs averaged 2.4% on a trade-weighted basis, while Japan’s were slightly lower at 2.1%, but Canada’s and the EU’s were both higher at 3.1% and 3.0% respectively. Mexico and China’s tariffs can exceed 4%. However, the numbers can be misleading. America may have lower tariffs than other countries, but the duties the U.S. does charge are typically higher. And trade-weighted averages can be deceiving, as goods with extremely high tariffs will typically have lower weights.

Also, although Trump has complained about the 270% duty that Canada imposes on dairy products, the U.S. has its own ridiculously high tariffs, charging 168% on peanuts and 350% on tobacco. And here begins the downward spiral…. Other countries will also put retaliatory tariffs into place, as Mexico, Canada, and China have already done. This hurts companies like Husco International, a Wisconsin-based manufacturer that makes parts for companies like Ford, General Motors, Caterpillar and John Deere. Austin Ramirez, Husco International’s chief executive, said “the people it helps most of all are my competitors in Germany and Japan, who also have large parts of their supply chain in Asia but don’t have these tariffs.”

Economists also say that trade restrictions make the economy less efficient, as domestic companies lose incentive to increase efficiency or specialization, as competition from abroad is increased. And other countries like Malaysia, South Korea, and Taiwan will most likely suffer even more than the U.S., as they all depend on selling materials to China which are then made into goods and sold to the U.S.

3. U.S./Chinese conflict will likely benefit China

There is now some sort of disagreement between the U.S. and six out of the top seven of our export markets, which combined, account for 53% of all American-made exports. China is definitely still Trump’s main target, as the Trump administration has imposed tariffs on $50 billion of Chinese imports and is threatening to hit $450 billion more as Beijing retaliates. However, China might be the country that benefits most from these U.S. actions, as Xi Jinping is a big proponent of global trade and can capitalize on America’s fighting with its trade partners.

In addition, the trade war could help China internationalize the yuan, and hurt the dollar’s traditional role as the world’s reserve currency, a position that it has held for over 50 years. This is a shift that, once it occurs, will be difficult to undo, and would have disastrous consequences for U.S. trading abroad, according to Barron’s.

Increased American protectionism makes the dollar less appealing, and the yuan and euro are two potential substitutes, although many are not so confident in the euro as a result of the European debt crisis, Greece’s economic meltdown, and Brexit. This leaves the yuan in a prime position to become the new main reserve currency.

4. What does this mean for your investments?

It’s important to remember that the U.S. economy is strong enough to weather trade storms. According to J.P. Morgan, a worst case scenario involving tariffs on imports of $450 billion from China and $275 billion of auto and auto parts would mean that 27% of U.S. imports would be subject to these new tariffs.

Unfortunately, there’s no certain way to know the effects this would have on inflation and economic growth, as many factors are unknown, such as the extent to which customers feel the shift in pricing and how output would change are unknown. Therefore, J.P. Morgan believes that trade tensions are considered a cause of downside risk for growth and a source of volatility for markets, but the extent to which they change the U.S. economy is too early to call.

Steer away from risky short-term investments. Especially, since the true effects of Trump’s tariffs won’t fully be felt for another six to 12 months, and the consequences could be even more drastic depending on the strength of China’s future potential retaliations.

When there are tariffs, small and mid-caps could do better since they’re domestically based. Goldman Sachs told investors to consider domestic, consumer companies to avoid being caught up in the trade policies. Stocks with high domestic sales relative to export-oriented firms will benefit from issues with foreign trade, like the tariffs.

Look at companies that benefit from a weaker dollar. These can also be good stocks to invest in, according to Joe Duran, founding partner and chief executive officer of United Capital. Companies that have significant sales in Europe, like Johnson & Johnson, Procter & Gamble, and Microsoft, all benefit from a weaker dollar, as they will make great profits without having to change their prices, especially considering that the euro is currently strong.

Financials and technology are also good places to be. Technology is a big part of what’s driving the market today, and is unlikely to go away any time soon. In addition, Byron Wien of Blackstone Group expects that “the price of oil will go up, and energy is undervalued.” He also says that technology stocks, and in particular biotechnology stocks, are also undervalued.

Look to protected industries. The tariffs will also help protect U.S.-based companies in robotics and automation, so such companies are going to be better bets in the coming months according to Arthur Dong, a professor at Georgetown University’s McDonough School of Business.

Most of all, don’t overreact.  Markets are strong and resilient. And yes, although stock market valuations may be rich and therefore more vulnerable to headline risk, we also know that there are many investments that clients can be steered toward to reduce any potential fallout from volatility in the stock market.  If you are truly concerned, consider domestically focused companies, and in particular, small and mid-sized companies, leaving a way to avoid some of the uncertainty that comes with the trade war.

5. What if there’s a full-blown trade war?

Right now, much is uncertain. Based on Trump’s past it is not out of the realm of possibility that all of this tariff talk is a negotiating tactic.  What we do know is that the Trump administration is not making any steps toward reconciliation with China, so a full-blown trade war could be in our economic future. If there is a full-blown trade war—which now seems more likely than ever—that could bring higher inflation, slower growth, and even tip us into a recession. Hopefully such a disaster scenario will be averted, and certainly warning signs would be present, but it is something to keep an eye out for, particularly since we are in the tenth year of the bull market.

In an extreme situation like this, all of the traditional defensive measures would make sense. But again, it is too soon to trigger the danger alarm, despite the recent bold moves of the Trump administration. The coming months will hopefully bring clarity to the situation, but be sure to stay on the lookout for signs that a full-blown trade war, and then possible recession, is coming, and take preventive measures so that your clients are protected.


Shorter term, I believe the market is trying to push higher. The tech-heavy NASDAQ Composite, and key measures of mid-sized and small companies touched new highs in June (MarketWatch data).

Much of the underlying momentum can be traced to faster economic growth, rising corporate profits, and still-low interest rates.

Another factor that lends support–S&P 500 companies repurchased a record $189.1 billion of their own shares in the first quarter, according to S&P Dow Jones Indexes Senior Analyst Howard Silverblatt. He expects buybacks to remain strong through the rest of 2018.

But the Dow Jones Industrials and the S&P 500 Index failed to recapture their January highs. These indexes are made up of the nation’s largest companies, some of which derive a significant share of sales from overseas.

Though not far from the January highs, a strong dollar may be putting modest pressure on these stocks. Moderation in overseas growth may also be a factor.

I believe much of the uncertainty stems from escalating trade tensions between the U.S. and its major trading partners.

Free trade/fair trade–it’s a very complex issue that’s being fought with simple soundbites. The President believes America has not been treated fairly, and he is using his authority to selectively levy tariffs against offending nations.

It’s a risky strategy that may eventually break down barriers. Or, it could escalate into a series of retaliatory measures that impede the U.S. and global economy.

But a quick review of the economic data strongly suggests the noise from the trade headlines isn’t affecting the U.S. economy, and GDP growth in the second quarter appears poised to surpass 4%.

You may agree or disagree with the President’s actions. But the market, which is collectively made up of millions of large and small investors, hates heightened uncertainty. Tit-for-tat levies increase short-term economic uncertainty.

Currently, it has injected volatility and uncertainty into the headline-grabbing major averages. Like many obstacles that will crop up, I believe this will eventually pass.

Table 1: Key Index Returns

MTD % YTD % 3-year* %
Dow Jones Industrial Average -0.6 -1.8 11.3
NASDAQ Composite 0.9 8.8 14.8
S&P 500 Index 0.5 1.7 9.7
Russell 2000 Index 0.6 7.0 9.6
MSCI World ex-USA** -1.3 -4.5 2.1
MSCI Emerging Markets** -4.6 -7.7 3.2

Bloomberg Barclays US

Aggregate Bond TR

-0.1 -1.6 1.7

Source: Wall Street Journal, MSCI.com, MarketWatch, Morningstar

MTD returns: May 31, 2018-Jun 29, 2018

YTD returns: Dec 29, 2017-Jun 29, 2018


**in US dollars