Impact of the Trade War

by Mark Bern, CFA

This week I want to attempt to explain what I expect to come, primarily in the relatively short term (6-12 months), from the tariffs implemented this past Friday by the U.S. and China.  Next week I intend to begin a series on how changes in technology will affect much of our lives and lead to disruptions in many industries.  So stayed tuned as it should be more fun to take a look into what the future could bring.

Initial Impact

The initial impact will probably take a few weeks before we, as consumers, begin to feel much difference.  Retailers will attempt to hold the line on prices as much as possible using some of the new found cash flow and profitability from tax reform to offset the costs of tariffs rather than pass it all on to consumers.  Ours is still a very competitive market, especially in retail, where Amazon is encroaching on the brick and mortar retailers with its purchase of Whole Foods giving it a physical presence in much of America.  Retailers are fighting back with beefed up online services and offerings.  The competition will remain fierce for some time to come and that should result in retailers of all stripes keeping prices as low as possible to retain or grow market share.

Additionally, the U.S. Trade Representative was very selective in the first round of items on which tariffs are now applied with only about 8% available at retail and likely to directly affect consumers’ pocketbooks.  China, on the other hand, is attempting to make its tariffs as painful as possible on U.S. businesses located in states that voted for Trump in the last election.  That means that American farmers will probably have lower revenues from their crops this year, especially soybean farmers.  But U.S. consumers should not feel that much pain as a result.  In fact, as ag prices fall consumers may pay less at the grocery store.  As far as exports go, soybeans and hogs will not rot in the fields and freezers.  When a major country like China changes suppliers it pays more for those products (mostly due to higher transport costs) and gives up a little on quality to make its point.  Brazil is likely to be a major beneficiary of the trade tantrums. 

But there is a finite amount of soybeans being grown in any given year so when China buys from Brazil instead of the U.S. those countries that had been buying from Brazil will need to purchase their soybeans elsewhere.  Since basically all the soybeans grown each year are used by somebody all that happens is that those countries that cannot buy from Brazil will be forced to turn to the U.S. for soybean supplies, or go without.  They may pay less but the majority of the soybeans that would have been exported will still be sold.  The same should hold true for hogs.  It takes at least a year to expand production to any significant degree, requires adequate rainfall or irrigation lines (or both), and sufficient soil nutrients to expand production.  So there are limited supplies in the short run. 

Other countries with the land and proper climate may hesitate to invest in much expansion until it becomes clear that the feud will endure long-term.  That is not clear yet, so I believe that any major increase in world production of soybeans will take at least two years. 

Pork production could be expanded somewhat faster but would require building herds, meaning lower production in the short term (and higher prices).  If hog farmers believe they can make more by expanding they probably will.  But they will need the grain and beans for feed.  Again, this would require expansion of global grain and bean production.  It is when the balance gets upset that the farmers get hurt the worst and most commercial farmers understand this so it will be interesting to see if they gamble or not and if so, when. 

Of course, everything will not be all roses as some inflation due to the tariffs will work its way through the supply chains to the consumers.  Anger of citizens from trade partner countries will probably hurt the U.S. tourism markets as many travelers from abroad decide to vacation (and spend their money) in destination other than the U.S.  So, hotels, domestic U.S. air lines, restaurants, car rentals, public and private local transportation, parks and other entertainment and tourist venues could see a reduction in traffic and revenues.  But many of the travel plans for this summer will probably go off as planned so much of the pain could be put off until next year.  Timing is everything. 

If the parties decide to resume negotiations prior to the next round of tariffs this whole fiasco could be over in less than a year.  There will undoubtedly be some pain on all sides.  The problem for China is that its economy appears more vulnerable right now than that of the U.S.  But both leaders seem to be digging in their respective heels. 

In the short term, there will be winners and losers, both in terms of countries and industries.  For now, I am staying with domestic investments as the strengthening USD (U.S. dollar) will probably continue to trend higher against other major currencies which will create translation losses on investments made in overseas assets.  Most other central banks have concluded to keep monetary policy relatively loose while the U.S. Fed is tightening.  The U.S. economy is growing more strongly than it has in almost ten years and inflation remains under control.  Global economic growth is beginning to slow and inflation is picking up in many countries.  Currency strength/weakness is all relative and right now (and for the foreseeable future) the USD has the deck stacked in its favor.  Until that changes, investing internationally could be painful for U.S. investors.

Bottom line: There will be some pain from the tariffs, but unless this trade war escalates and lasts more than a year the pain and any market corrections should be shallow and relatively short-lived.  Of course, if it does escalate and last more than a year at an escalated level the pain and market corrections could be severe.  But everyone knows that so I find it hard to fathom that neither side would relent.  China has much more to lose, in my opinion, so it becomes a matter of finding a way for Xi Jinping to save face while agreeing to a settlement that provides a more level playing field. 

I can understand the anger by our neighbors to the North and South in Canada and Mexico.  The primary reason that I can think of to involve such friendly allies in this dispute is that if our neighbors were excluded China would simply export everything it could to the U.S. through Canada and Mexico to avoid tariffs.  I am not happy with the current trajectory of trade matters, especially where it involves our allies, but the path to finding a way to convince China to level the playing field on trade matters (especially intellectual property rights) is complicated.  If the Trump Administration is successful then the rest of the developed world wins, too, but the U.S. will still be considered the big bad bully.  If not, the U.S. could be ostracized and made out to be the bad guy… again.  Even if we win we lose. 

But if nobody tries China will eventually control the global economy and everyone else, including our allies, would lose.  At least, that seems to be the thinking behind the Administrations actions.  In any event, the next year should be interesting and investing will become more difficult.  Selectivity will be more important than ever.  That should become even clearer when I explain what I see coming in the next few weeks.

Respectfully,

Mark Bern, CFA

Bern Factor LLC

540-241-1963 (new number)