Taking Cover Amid a Potential Trade War
In early March, the Trump Administration announced tariffs on steel and aluminum from most U.S. trading partners after concluding that the imports pose a threat to national security.  The move surprised investors and triggered a steep equity market sell-off. While markets subsequently recovered and fundamentals remain stable, the threat of a trade war has exacerbated investor uncertainty about the long-term U.S. economic outlook and is likely to promote market volatility.

Shifting to a Mercantilist Regime

As a candidate, President Trump was vocal in his criticism of U.S. trade relations with China and agreements like the North American Free Trade Agreement (NAFTA) and the proposed Trans-Pacific Partnership (TPP), both of which he threatened to upend after taking office. When he won the election in November 2016, we began to evaluate the potential impacts of a shift in U.S. foreign trade. In particular, we looked at the tools through which the Administration could enact foreign trade policy, both on its own and in connection with Congress. We learned that the President has significant leeway to make unilateral trade decisions.

In the early months of the Trump Administration, the cabinet included a mix of free trade and protectionist voices, suggesting that a balanced trade policy could be maintained. This changed as the protectionist ideas gained traction and influential free trade advocates left the Administration or lost influence. After the initial March tariffs were announced, the most widely known proponent of free markets, former Goldman Sachs President Gary Cohn, left his post as Director of the White House National Economic Council. His departure removed a key check on the mercantilist views of Director of the Office of Trade and Manufacturing Policy, Peter Navarro, an economist and author of the book Death by China, Commerce Secretary Wilbur Ross, who made his fortune in the steel and manufacturing industries, and Robert Lighthizer, a veteran trade lawyer with protectionist views.  

Making Political Hay from Economic Policy

To a degree, President Trump’s position on trade during the election was calculated to appeal to voters in the states hardest hit by the decline of U.S. manufacturing. Many of these states, likely influenced by his protectionist rhetoric, helped carry him over the finish line in November 2016. After President Trump took office, the question was not whether he would seek to reward these states through the imposition of trade restrictions but rather when it would happen, and how far the policies would go.

This political angle was not lost on U.S. trading partners, and their response to the tariffs has been directed at these same states. China, for example, has imposed tariffs on several red-state agricultural exports, including soybeans, ginseng, and almonds. The European Union (EU) has adopted a similar approach, but aimed it more squarely at politicians. The EU imposed levies on items including Levi jeans, Harley Davidson motorcycles, and Kentucky bourbon, companies and industries headquartered in the districts and states of prominent House and Senate leaders.

A Lack of Clarity Breeds Volatility

The rollout of the steel and aluminum tariffs was notable for its ambiguity, which contributed to the subsequent market volatility.  While it’s impossible to determine the Administration’s next steps, it appears likely that the mercantilist perspective will continue to dominate. This could have negative, interrelated implications for financial markets.

Higher Volatility: Equity valuations are already elevated, and the new tariffs have increased uncertainty among investors. While the steel and aluminum tariffs are unlikely to derail the economy, protectionist policies have the potential to threaten global supply chains and raise costs for consumers. Further, counter tariffs from trading partners could negatively impact U.S. companies.

Lower Growth: Tariffs are taxes on imported goods and can threaten growth. When companies are forced to pay higher prices for goods, it can reduce profitability and, in turn, cause companies to pull back on investments. The first-order effects of the tariffs announced to date may not be significant, but the uncertainty about what’s ahead may cause a decline in the risk appetite of company managements, who may scale back plans or delay them as they monitor the situation.

Inflation and Higher Rates: Tariffs are by their nature inflationary because they increase the cost of goods sourced from other countries. The United States is already in a phase of monetary tightening, and an increase in inflation could be a catalyst for additional rate increases.

Investing in Uncertainty

Within our strategies, we’ve taken steps to mitigate our exposure to the uncertainty and potential impacts of protectionist policies. This has included taking long positions in companies with more domestic exposure, limiting and/or shorting companies with global exposure, for a variety of reasons, taking potential supply chain impacts into consideration, and positioning the portfolio for rising rates. We believe that heightened market uncertainty is likely to persist, and continue to seek opportunities to deliver risk-adjusted returns while limiting volatility.