Despite the return of volatility we’ve seen so far this year, it seems like the market really wants to try to shrug aside questions about inflation or rising interest rates. After plunging about 15% in just a few days in late January amid concerns that inflation could rise faster than expected, and so force the Fed to increase more than they have been forecasting, the market rebounded, reclaiming more than half of that initial drop by the last week of February. Some of the effects of the income tax cut that was passed in November of last year have begun to filter through, as a number of U.S. companies reported better-than-expected earnings in the most recent round of earnings reports, with tax savings an apparent common thread across just about sector. The economy is healthy, corporate profitability is improving, and Americans are paying less of their incomes in taxes, and the market looks poised to push near to its all-time highs. So everything should be good – full steam ahead, right?
Well, maybe, maybe not. At the end of last week, the Trump administration added a new element of uncertainty to the mix as it has threatened to use its executive power to impose tariffs on foreign imports of steel and aluminum. By itself, the protectionist rhetoric isn’t really out of character for this President – after all, he used the same kind of talk to get himself elected. I think the alarming part is the fact that the President wants to apply his tariffs to all steel and aluminum imports, regardless of where they come. It has also been very interesting over the last couple of days to see how corporate America, politicians in Washington, and economists in general have reacted. It makes me wonder if tariffs could represent the third leg of a strengthening bearish argument, or if this is ultimately just more smoke to obscure the overall picture.
As a general rule, political rhetoric and rumor can add short-term volatility to the market, as uncertainty can rattle or encourage investors from day to day, but it also doesn’t tend to contribute a lot to long-term, or even to intermediate term market momentum and movement. But that’s also relative and highly subjective, as sometimes political debate passes the point of rhetoric and bleeds into economic and monetary policy. I think that’s where the short-term impact on volatility is seen, because investors tend to get nervous when they think that government intervention is going to impose major changes on the economy or the marketplace. “No news is good news” tends to be the preferred mode of operation, because that means that the metrics and rules we’ve been using don’t have to change. So let’s take a few minutes and try to cut through the noise and rhetoric and think about what is at stake.
Tariffs as a political tool
The office of the president has considerable power delegated to him by Congress via several different acts over the last hundred years to impose tariffs in a variety of ways. Some are designed to give the president the ability to target specific nations and adversaries, some are limited in terms of size or duration, and some can be very broad and far-reaching. The broadest allowances come if the president can make a case that the U.S. is “at war”, and that is a term that has historically allowed for some incredibly loose interpretations; Richard Nixon cited the Korean War as a cause to justify tariffs nearly two decades after the fact in 1971.
Another allowance is when imports challenge “national security”, and if the experts and pundits are right, it looks like this may be the argument the White House is planning to use. As with the “at war” rationale, however, what exactly represents a threat to national security is uncertain, but this also gives the president fairly sweeping authority to impose unilateral restrictive tariffs without naming a specific target or set of targets.
Imposing tariffs on imports, theoretically at least, gives the U.S bargaining power with other countries. The U.S. remains the largest economy in the world, which means that businesses and governments all over the globe naturally will want to import their goods. Tariffs make it more expensive for those countries to send their goods here, which should also translate to an increase in the value of the same goods the tariffs target and which are produced within the U.S. This is a very protectionist move, and when the tariff is applied to materials, like steel and aluminum, that are used in a large range of other manufactured goods, it has a pretty large ripple effect, as tariffs increase cost on everything from cars and motorcycles to military aircraft and even canned foods and beverages. Reducing foreign imports on those materials puts a bigger burden on U.S. manufacturers, which by Trump’s reasoning is precisely the point; he has argued since before being elected that countries (China in particular) have cost the U.S. thousands of jobs in these sectors by pricing their exports to the U.S. below their actual cost.
Economic impact from tariffs
At first blush, an increase in America’s dependence on local materials could be a good thing; increased demand for U.S. steel and aluminum should mean more jobs in those industries, which could lead to important revitalization in parts of the country that have been the most dramatically affected by foreign imports. And the administration has argued that any actual increase in the price of those materials as a result of the tariff should be negligible since the actual percentage of those materials used for most finished goods is relatively small.
Let’s take a moment to put these potential tariffs in perspective as it relates to U.S. production of finished goods. Remember that steel and aluminum are basic materials that can be found in any number of different parts of life. As I write this, I can look at the chair I’m sitting in, the computer on which I’m writing, the desk the computer rests on, and the bookshelves leaning against my walls to think about just a few everyday items that include one or even both of these materials.
The United States uses domestic producers to meet about two-thirds of its steel needs, and so there is some logic to the argument that domestic steel prices may not see as much of an impact. Aluminum is another story, however since U.S. manufacturers currently purchase about 90% of the aluminum they need from outside the country. Either way, the combination of tariffs on both materials will generally mean that their cost is increased. The truth is that businesses won’t stop needing those materials, and if they can’t meet their needs domestically, they will have to look outside our borders, so it isn’t like these tariffs will stop imports. I think it is true that they should decrease them, but to what extent remains to be seen. Ultimately, though, businesses that needs these materials will be more likely to simply pass on the higher cost to their customers. That means that prices for everything from cars to refrigerators, from furniture to cans of soda and canned foods are likely to increase. That’s why I’ve seen some critics point out that any benefit from last November’s tax cut is about to get completely wiped out from a consumer standpoint.
The other side of the coin comes in the way other countries react to such sweeping tariffs. Before we try to follow it through logically, though, let’s take a minute to talk about the kinds of goods and services that the U.S. exports. As the third-largest exporter in the world (behind China and the European Union), two-thirds of our exports come from goods – aircraft, automobiles, industrial machinery and supplies, semiconductors, telecommunications, medical equipment, chemicals, petroleum products, and so on. The other third is made up of services such as travel, computer, business, and financial services. In 2017, U.S. exports totaled around $2.9 trillion.
This morning the European Union made it clear they would respond in kind, with tariffs of their own on specific finished goods, like motorcycles, denim, and liquor. That is probably just the first warning shot; the truth is that if Trump’s steel and aluminum tariffs are as implement on such a sweeping, indiscriminate scale, we should expect to see the same from a lot of our trading neighbors, on any or all of the goods and services we just ran through. The implication is that we could be looking at the beginning of a trade war. Our biggest trading partners, in order, are the European Union, Canada, Mexico, and China – exactly the people Trump seems to be pointing his finger at and screaming the loudest about.
If this acts as a sudden trigger on inflation, the Fed would likely have to respond by increasing the scale and pace of rate increases even more than people already fear. It seems clear that the GOP fears a trade war just as much as Democrats; Senator Paul Ryan, who has been one of President Trump’s staunchest allies, has made public statements arguing against the sweeping tariffs the White House is proposing and urging a more surgical approach. A response-in-kind from all four of our largest trade partners wouldn’t be out of the question, and could result in significant decreases in revenues.That could restrict the flow of goods to such an extent that, combined with higher costs at home, the economy actually reverses from growth and healthy inflation to stagnation or even deflation – a scenario nobody wants to acknowledge or talk openly about.
If the politics of the day carry through as it appears they could, I think it is entirely possible tariffs could provide the third leg of the kind of “terrifying trio” of threats Dorothy and her companions were so afraid of in the Wizard of Oz. Giving the market a third leg to stand bearish concerns on could provide the tipping point for a new drop back to the lows seen last month, or worse, to drop below them. A break below that point would likely mark the beginning of new downward trend that could push the S&P 500 to levels not seen since April of last year, at around 2,350. That’s nearly 400 points below the index’ current level, which would mark a since the beginning of the year of more than 20%. That would shift market-speak away from terms like “correction” to legitimate “bear market,” which of course the provides the potential for an even longer, and more extended downturn.
What should investors do?
So what do we do as investors? I think the first key is to wait. Right now everything still appears to be mostly rhetoric; President Trump has ordered his administration to draw up the paperwork required to implement his tariffs, but that is a process that isn’t expected to be completed until the end of the week at the earliest. Opponents are trying to move quickly to persuade the administration to moderate its rhetoric and any actual tariff implementation.
I think it’s also important here to remember what kind of person the man in office is. Before he took public office, “the Donald” relished stirring the pot. As a businessman, I think he bought into the idea that “if they’re not talking about you, you’re doing something wrong.” You didn’t always like what he said, but he was always interesting – even if he claimed to believe or think something that later on he denied. Sometimes it seemed that he’d say or do something outlandish, uncomfortable or simply politically incorrect for no other reason than to see how people reacted to it. Later on, he might amend his statement, or “clarify” himself, claiming that what you heard wasn’t really what he meant. He seems to do the same thing now as President, and now I wonder if it isn’t just another tactic to gauge people’s reaction before he makes an adjustment.
President Trump has always enjoyed presenting himself as a notorious hard-line business negotiator, and I think he has clearly shown that as President, he wants to be seen in the same way. What usually happened in business, however, was that after presenting his “hard line,” or saying or doing something his opponent didn’t like, he would do as most smart businesspeople do – he’d negotiate. What that usually means is that “my way or the hard way” will bend people’s noses, and put him at odds with even the people working for him. Just today, for example his own senior economic advisor resigned due to his disagreement with the administration’s hard-line stance. Perhaps more importantly, it also means that he isn’t afraid to use the worst-case look of any particular scenario to spur discussion and negotiation. I’m not sure I agree with it, but if the immediate reaction is any indication, I think that it might actually be doing what he wants – get people off of the sidelines and trying to make a strong case for whatever their opinion is, or to come closer to where he actually wants them to be. That suggests that the worst-case really is a bargaining tactic, deliberately employed to motivate his opponents to deal in ways they may not otherwise be willing to do.
A lot of pundits will say that politics, and running a country isn’t nearly the same as running a business. I don’t think this president sees the distinction, and he doesn’t really care about trying to. If his business history is an indication, he isn’t afraid of making mistakes, even drastic ones. He rebuilt his business fortunes from ruins to multi-billion dollar operations more than once, after all, and I think those experiences are part of the reason he operates as he does today. He seems to be doing basically the same thing now as leader of the free world that he did to build a real estate empire. Will it work as he seems to believe it will? That remains to be seen.
The truth is that the market is going to keep reacting in knee-jerk fashion from one day to the next as the buzz shifts until we see some kind of actual result. If we get to the end of the week without the tariffs that are currently being threatened – or even just a moderated, targeted form of them – expect the market to shrug this off as just the latest round of short-term angst and uncertainty.