Business

Trade War Or Mr. Market?

From the end of the trading day on November 9, 2016, after Donald Trump was elected President, to the beginning of February 2018, the stock market generally went up uninterrupted. We had 16 months of uneventful  happenings in the stock market. The key phrase in that sentence is “in the stock market.”

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The stock market is best thought of as being bi-polar, defined by the Oxford Dictionary as “having or relating to two poles or extremities.” Likely, you are familiar with bipolar disorder, a brain disorder that is characterized by wide swings in moods, energy, and activities levels. The stock market has a bipolar habit of swinging between extremes. It goes  through phases where it ignores all kinds of potentially bad news and instead focuses on the positive. Suddenly, it can turn around and fixate solely  on the negatives. At those times, it reacts to any small world event as if it’s a crisis or potential crisis.

My view is that very little actually changes. Only the mood of the stock market changes. Of course, occasionally, real events occur that have a meaningful impact, such as a recession, the late 1990s tech bubble, or the housing bubble. But they are few and far between.

To illustrate my point, here is a list of worrisome geo-political and economic events that the stock market ignored during its 16 months of euphoria. Any one of the events could have led to a stock market downturn but did not.

  1. Republicans attempted to repeal the Affordable Care Act (ACA) with no real replacement plan and threatened to completely upend the health care industry, which comprises almost 18% of our economy. Regardless of your views on ACA, when you are dealing with such a large chuck of our economy, it’s important to have a replacement plan and enough time for proper analysis and refinement before implementation.
  2. Although the UK voted to leave the EU (“Brexit”), it has and continues to make a complete hash of the effort. There is still no plan and not even a plan to have a plan.
  3. Greece is always in the news, usually because it needs another bailout. This past year and a half was no different. The new bailout may come with more austerity conditions, which will lead to more economic problems and more social unrest.
  4. Recent Italian elections gave the euro-skeptic Five Star Movement (M5S) party a majority in Parliament. Italians are upset at the continued austerity being imposed on EU countries, and M5S advocates leaving the EU as at least a possibility.
  5. We had escalating tensions with North Korea, including about a dozen ballistic missile tests and even a nuclear bomb test. You would think the increased specter of a major armed conflict that could engulf many of the largest nations on earth would have warranted a decent decline in the stock market.
  6. We have the continued mess in Syria, and the increased threat of confrontation between US and Russian forces. Just this past month, hundred(s) of Russian private military contractors from The Wagner Group were killed or severely injured during an attempted attack on a US military base. Why this was not a major news story, I’ll never know. The event was the first time since Vietnam that Russian and US forces engaged in direct combat. (Google “Deir Ezzor Wagner group attack,” if you want to learn more about the incident. With Russian efforts to cover up the disaster, and the US desirous not to escalate things, you’ll find very few details and a few different versions of what happened.)
  7. On the natural disaster front, we had three huge hurricanes in four weeks, wreaking havoc on parts of Texas and Florida and completely devastating Puerto Rico and other Caribbean islands. None of that, however, mattered to the market.

Now, all of a sudden, the stock market’s mood has swung to the opposite extreme. Every change in the geo-political and economic landscape is something for it to worry about. Right now, the big worry is a trade war, particularly with China. In my previous newsletter, I explained why I didn’t think that was something to fear. In this newsletter, I’ll elaborate a little bit more. A few tariffs and a trade war are two different things. I do think there will be an increase in tariffs, but I don’t think the situation will escalate.

Why? I think Trump cares more about appearances than substance when it comes to trade. Look at the steel and aluminum tariffs, for example. Trump announced he was going to enact a 25% tariff on steel and 10% on aluminum. What actually was put into place with steel tariffs was quite different, as you can see below.

Country Percent of US Steel Imports Status
Canada 16.7% Exempt
Brazil 13.2% Exempt
South Korea 9.7% Exempt
Mexico 9.4% Exempt
Russia 8.1%
Turkey 5.6%
Japan 4.9%
Germany 3.7% Exempt
Taiwan 3.2%
China 2.9%
Top 10 77.4%

In the end, we have tariffs on just 24.7 percentage points of the top 10 importers. It’s also worth noting that in addition to Germany being exempt, the rest of the EU is as well, as are countries like Australia and Argentina that do not appear on the top 10 table. In addition, the Administration encouraged other friendly countries to apply for exemptions, so it wouldn’t be surprising to find Japan and perhaps Turkey and Taiwan receiving concessions.

With China, the US announced 25% tariffs on $3B worth of goods and China retaliated in kind. Then the Trump administration announced they intended to enact 25% tariffs on an additional $50B of goods sometime in May unless China agreed to a “deal.” China, of course, announced a tit-for-tat 25% tariff on $50B of our imports. Then just yesterday Trump announced he wanted another $100B of goods subject to tariffs.

In the grand scheme of things, these numbers are relatively small. The US imported $505B worth of Chinese goods last year while exporting $130B. In the context of the international trade, the recently imposed and potential additional US tariffs amount to $12.5B in total increased costs (25% of $3B + 25% of $50B). That is a change of about 2.8% in the context of US imports from China. In the context of our economy, the effect is even smaller; $12.5B amounts only to seven hundredths of one percent (.07%) of our $19.7T economy.

Obviously, I’m not the first person to do this math and realize the actual effects are small. What the market is worried about is that this will somehow metastasize into a full blown trade war. I think what happened with the steel and aluminum tariffs gives us a good idea how the current trade dispute with China will ultimately end. A lot of tough talk, big announcements, lots of threats, and ultimately a deal that doesn’t change too much.

I also don’t view escalating trade tensions as very damaging to the market. Corporate earnings are growing at double digits, inflation is still low, and there is still slack in the labor market, which should keep wage cost pressure subdued.


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