Trump, tariffs, trading

There’s no solid connection among the three topics above, but the title gives me the chance to write about three only-sort-of connected ideas in one post.

The crazy up-and-down pattern of recent stock market trading in the US is being triggered, I think, by Mr. Trump’s tweets about trade–and about tariffs in particular.  I think a lot of the action is being caused by computers trading on the President’s tweets themselves, or some derivative of them–likes, media mentions, reflexive response to stock movements (or a proxy like trading volume).

my thoughts

–it’s hard to know whether the misinformation Mr. Trump is spewing about tariffs is art or he simply doesn’t know/care.

Tariffs are paid to US Customs by the importer.   In some small number of instances, a Chinese exporter may have a US-based, US-incorporated subsidiary that imports items from the parent for distribution here.  In this case, a Chinese entity is paying tariffs on imported Chinese-made goods.  To that degree. Mr. Trump is correct.  Mostly, however, the entity that pays a tariff on Chinese goods is not itself Chinese.

This is not the end of the story, however.  The importer will attempt to recover the cost of the tariff through a higher price charged to the US consumer and/or through a discount received from the Chinese manufacturer.  In the case of washing machines, which I wrote about recently, for example, all US consumers ended up paying enough extra to cover the entire tariff  …and some paid more than 2x the levy.  The prime beneficiaries of this largesse were Korean companies Samsung and LG.

–one of the oddest parts of the current tariff saga is that Mr. Trump has decided not to work in concert with other consuming nations.  In fact, one of his first actions as president was to withdraw from the international coalition attempting to curb China’s theft of intellectual property worldwide.  The Trump tariffs are only bilateral, so there’s nothing to stop a Chinese company from shipping a partially assembled product to, say, Canada, do some modification there and reexport the now-Canadian item to the US.

The administration has been artful in selecting intermediates rather than consumer end products for its tariffs so far.  This makes it harder to trace price increases back to their source in Trump tariffs.  However, the fact that the administration has taken pains to cover its trail, so to speak, implies it understands that tariff costs will be disproportionately borne by Americans.

 

–in trading controlled by humans, a lot of tariff developments should have been baked in the cake a long time ago.  Continuing volatility implies to me that much of the reacting is being done by AI, which are learning as they go–and which, by the way, may never adopt the discounting conventions humans have employed for decades.

 

–I think it’s important to examine the trading of the past five days (including today as one of them) for clues to the direction in which the market will evolve.  Basically, I think the selling has been relatively indiscriminate.  The rebound, in contrast, has not been.  The S&P and NASDAQ, for example, are back at the highs of last Friday as I’m writing this in the early afternoon.  The Russell 2000, however, is not.  FB is (slightly) below its Friday high; Netflix is about even; Micron is down by 4%.  On the other hand, Microsoft and Disney are 1% higher than their Friday tops, Paycom is 2.5% up, Okta is 5% higher.

No one knows how long the pattern will last, and I’m not so sure about DIS, but I think there’s information about what the market wants to buy in these differences.   And periods of volatility are usually good times for tweaks–large and small–to portfolio strategy.  This is especially so in cases like this, where the movements seem to be excessive.

One thing to do is to confirm one’s conviction level in laggards.  Another is to check position size in winners.  In my case, my largest position at the moment is MSFT, which I’ve held since shortly after Steve Ballmer left (sorry, Clippers).   I’m not sure whether to reduce now.  I’d already trimmed PAYC and OKTA but if I hadn’t before I’d certainly be doing it today.  I’d be happiest finding areas away from tech, because I have a lot already.  On the other hand, I think Mr. Trump is doing considerable economic damage to American families of average or modest means, with no reward visible to me except for his wealthy backers.  Retail would otherwise be my preferred landing spot.

–Even if you do nothing with your holdings now, make some notes about what you might do to rearrange things and see how that would have worked out.  That will likely help you to decide whether to act the next time an AI-driven market decline occurs.

washing machine tariffs

I’m not an expert on washing machines.  I am fascinated by the local Baby Bubbles laundromat, though.  I know how to get tokens, put them in the machines and push the right buttons.

What prompts me to write this post is the release by the University of Chicago of research findings about the tariffs placed on imported washing machines by the administration in Washington last year in the name of national security (?).

background

The US washing machine market has three leading competitors, each with a market share of around 15%: Whirlpool, a US-based company, and LG and Samsung, two Korean firms.

During the Obama administration, Washington applied tariffs to washing machines made in Korea.  LG and Samsung countered by shifting production to China, which is a typical “country-hopping” response.  Ironically, this made the two even more competitive in the US, and consumer prices here continued to decline.  The Trump administration took a more heavy-handed approach, by applying a blanket tariff of (to keep the story simple) 20% to all washing machine imports.  LG and Samsung responded this time by accelerating the completion of US factories.

winners and losers

Basic economic theory says that increased costs will either be absorbed by the manufacturer or passed on to consumers, in proportions determined by who has market power.  In this case, however, all three firms raised washing machine prices by close to 12%   …and they raised the price of dryers, which were not subject to tariffs (but which are typically paired with washers when people buy) by the same.  That meant both Korean firms recovered the entire tariff plus a bunch.

The net effects:  consumers paid $1.5 billion more for washer/dryers in 2018; market shares for LG and Samsung remained unchanged; the government collected $82 million in tariffs; 1,800 new jobs were created (in a workforce of 150 million+).  The yearly cost to consumers for each of these new positions?  $815,000+.  

The winners:  LG, Samsung and Whirlpool (although analysts think Whirlpool’s 2019 earnings will remain below 2017 levels).

The losers:  the American public.

my take

This is the way protection typically works.  It sounds good but has perverse effects.  A domestic firm flexes its political muscle to prevent better/cheaper products from entering the country from abroad.  In theory, this is supposed to buy time for it to innovate.  Most often, however, the protected firm uses government action as a substitute for creating new, better products. The poster children in the US for this type of behavior–and its negative consequences for the economy–are the Big Three automakers of Detroit.

There is a pressing issue in the trade arena–preventing the theft of intellectual property in areas like computer software, advanced electronic manufacturing and biotech.   The current administration seems to have abandoned any effort to do so, however, in favor of protecting the income of industries of the past.  As an American, this is a worry.  As an investor, it argues that one should make a greater effort to explore opportunities in greater China and in Europe.

 

 

 

Trump and the Federal Reserve

dubious strategies…

I was thinking about last year’s Federal government shutdown the other day.  There are two million+ Federal workers.  They make an average salary of just above $90,000 a year, which is 50% more than the typical worker in the US.   Add in health insurance and pension benefits and their total compensation is double the national average.

On the surface, it seems odd to me that Federal workers began to run out of money almost the minute Mr. Trump laid them all off late last year.  On second thought, though, given their apparent job security and generous benefits, there’s arguably no urgent reason for them to build up savings.  Maybe they do live at what for others might be right on the edge.

That might explain the outsized negative impact laying Federal workers off en masse had on the economy, given that they represent only about 1.3% of the workforce?  If each consumes as much as two average workers, which I think is a reasonable guess, then the layoff does the same damage as 2.5% of the total American workforce becoming unemployed.

This is bigger than you might think.  A 2.5% rise in unemployment is what happens in a garden-variety recession.  No wonder the economy appeared to fall off a cliff in January.

 

Consider, too, the effect of the Trump decision to withdraw from international associations in favor of waging country-to-country trade warfare.  The resulting flurry of highly targeted tariffs and retaliatory counter-tariffs has made the US, at least for the moment, a uniquely bad place for new capital investment.  That’s even without considering the administration’s policy of restricting domestic firms’ ability to hire highly talented foreign technicians and executives–a policy that has made Toronto the fastest-growing tech city in North America.  Again, no surprise that new domestic capital additions sparked by tax cuts have fallen far below Washington estimates.  And, of course, tariff wars have lowered demand for US goods abroad and raised prices of foreign goods here.

My point is that–apart from the ultimate merits of administration goals–they are being pursued in a strikingly shoot-yourself-in-the-foot way.

…continue

Yes, Federal workers are back on the job.  I can’t imagine that they will resume their old spending habits, though, given the new employment uncertainty they are facing.  Last week the administration discussed disrupting the supply chains of American multinationals with operations in Mexico.  Yesterday, the talk was of a possible $11 billion in new tariffs on imports from the EU …and the retaliation that would surely follow.  Even if none of this materializes, their possibility alone will increase the reluctance of companies to operate inside the US.  The negative effect of all this may be much greater than the consensus thinks.

 

now the Federal Reserve

This central bank’s official role is to set monetary policy through its control of short-term interest rates.  Its unoffical role is to be a political whipping boy.  It takes the blame for (always) unpopular rises in interest rates that are needed to keep the economy from overheating, and on track to achieve maximum sustainable long-term GDP growth.

The two instances where the Fed has succumbed to Washington arm-twisting–the late 1970s and the early 2000s–have created really disastrous outcomes, the big recessions in 1981 and 2008.

Despite this, Mr. Trump has apparently decided to offset the negative economic effects of his tax and trade policies, not by stopping doing what’s causing harm, but by forcing the Federal Reserve into an ill-advised reduction in interest rates.  His first step down this road will apparently be the nomination of two loyalists without economic credentials to fill open seats on the Fed’s board.

If the two, or similar individuals, are nominated and confirmed, the likely result will be a decline in the dollar, the start of a residential real estate bubble and a further shift of corporate expansion plans away from the US.  We may also see the beginnings of the kind of upward inflationary spiral that plagued us in the late 1970s.

 

investment implications

Replying to a comment on my MMT post, I wrote:

“Ultimately, though, the results would be a loss of confidence, both home and abroad, that lenders to the government would be paid back in full. That would show itself in some combination of currency weakness, accelerating inflation and higher interest rates. Typically, bonds and bond-like investments would fare the worst; investments in hard-currency assets or physical assets like real estate/minerals, or in companies with hard-currency revenues would fare the best. I think gold, bitcoin and other cryptocurrencies would go through the roof.”

I think the same applies to Mr. Trump gaining control over the Fed.

 

 

 

 

 

 

 

 

 

 

 

Modern Monetary Theory (MMT)

Simply put, MMT is the idea that for a country that issues government debt in its own currency budget deficits don’t matter.   The government can simply print more money if it wants to spend more than it collects in taxes.

Although the theory has been around for a while (the first Google result I got was a critical opinion piece from almost a decade ago), it’s been revived recently by “progressive” Democrats arguing for dramatically increasing social welfare spending.  For them, the answer to the question “What about the Federal deficit?,”  is “MMT,” the government can always issue more debt/print more money.

MMT reminds me a bit of Modern Portfolio Theory (MPT), which was crafted in the 1970s and “proved” that the wild gyrations going on in world stock markets in the late 1960s and the first half of the 1970s were impossible.

 

Four issues come to mind:

–20th century economic history–the UK, Greece, Italy, Korea, Thailand, Malaysia, lots of Latin America…   demonstrates that really bad things happen once government debt gets to the level where investors begin to suspect they won’t be repaid in full.

This has already happened three times in the US: during the Carter administration, when Washington was forced to issue Treasury bonds denominated in foreign currency; during the government debt crisis of 1987, which caused a bond market collapse that triggered, in turn, the Black Monday stock market swoon a few months later; and during the Great Bond Massacre of 1993-94.

In other words, as with MPT, the briefest glance outside through an ivory tower window would show the theory doesn’t describe reality very well

–the traditional case for gold–and, lately, for cryptocurrencies–is to hedge against the government tendency to repay debt in inflation-debased currency.  In other words, every investor’s checklist includes guarding against print-more-money governments

–excessive spending today is conventionally (and correctly, in my view) seen as leaving today’s banquet check to be picked up by one’s children or grandchildren.  In the contemporary cautionary tale of Japan, the tab in question has included massive loss of national wealth, a sharp drop in living standards and economic stagnation for a third of a century.  No wonder Japanese Millennials have a hard time dealing with their elders.

Why would the US be different?  Why are Millennial legislators, of all people, advocating this strategy?

–conventional wisdom is that the first indication that a government is losing its creditworthiness is that foreigners stop buying.  This is arguably not a big deal, since foreigners come and go; locals typically make up the heart of the market.  During the US bond market crisis of 1987, however, the biggest domestic bond market participants staged the buyers strike.  Something very similar happened in 1993-94.  I don’t see any reason to believe that the culture of the “bond vigilante” has disappeared.  So, in my opinion, the negative reaction to a policy of constant deficit spending in the US is likely to be severe and to come very quickly.

my take on Kraft Heinz Co (KHC)

Late last week, KHC reported 2Q18 earnings.  The figures were disappointing.  More importantly, the company announced it is:

–cutting the $.625/quarter dividend to $.40,

–writing down the value of its intangible assets by $15.4 billion (about 28% of the total) and

–involved in an SEC inquiry into the company’s accounting practices for determining cost of goods sold.  Apparently prompted by this, KHC boosted CoG for full-year 2018 by $25 million in 4Q18.

The stock declined by 27% on this news.

 

What’s going on?

broadly speaking…

KHC is controlled by famed investor Warren Buffett’s Berkshire Hathaway and by 3G, a group of investment bankers behind the consolidation success of beer maker Anheuser-Busch Inbev.

As I see it, Buffett’s principal investing idea continues to be that markets systematically undervalue “intangible assets,” accounted for as expenses, not assets–namely, successful firms’ brand-building through advertising/marketing and superior products/services.  This explains his preference for packaged goods companies and his odd tech choices like IBM and, only after all these many years of success, Apple.  All have well-known brand names cemented into public consciousness by decades of marketing expenditure.

3G believes, I think, that in most WWII-era companies a quarter to a third of employees do no useful work.  Therefore, acquiring them and trimming the outrageous levels of fat will pay large dividends.  Remaining workers, arguably, will figure out that performing well trumps office politics as a way of climbing the corporate ladder, so operations will continue to chug along after the initial cull.

These beliefs account for the partners’ interest in KHC.

 

My take here is that the investing world has long since incorporated Mr. Buffett’s once groundbreaking thinking into its operating procedures, so that appreciating the power of intangibles no longer gives much of an investing edge.  (Actually, KHC suggests reliance on the fact of intangibles may make one too complacent.)  As to G3, it’s hard for me to figure how companies fare after the dead wood is eliminated.

the quarter

The most startling, and worrying, thing to me about the quarter is the writedown of intangibles.  My (admittedly quick) look at the KHC balance sheet shows that total liabilities and tangible assets–working capital and plant/equipment–pretty much net each other out.  This means that shareholders equity (book value) pretty much consists solely in the intangibles that drive customers to buy KHC’s ketchup and processed cheese foods.  That number is now 28% lower than the last time the company looked at these factors.  Did all that decline happen in 2018?  Is this the last writedown, or are more in the offing?

The fall in the stock price seems to me to correspond closely to the writedown.  I’d expect the same to hold the in the future.  And it’s why I think the risk of further writedowns is a shareholder’s biggest worry.

 

–A dividend reduction is always a red flag, especially so in a case like this where the payout has been rising.  It suggests strongly that something has come out of the blue for the board of directors.  However, KHC appears to be indicating that cash cows are being divested and that loss of associated cash flow is behind the dividend cut.  I don’t know the company well enough to decide how cogent this explanation is, but it’s enough to put the dividend cut into second place on my list.

–an SEC inquiry is never a good sign.  In this case, though, it seems that only small amounts of money are at issue.  But, if nothing else, it points to weaknesses in management controls, supposedly 3G’s forte.

 

Final thoughts:

–Experience tells me the whole story isn’t out yet.  I’d want to know whether KHC is taking these actions on its own, or are the company’s lenders, its auditors or the SEC playing an important role?

–This case argues that the intangible economic “moats” that value investors often talk about have less protective value in the Internet/Millennial era than in earlier, slower-changing times.

 

 

 

 

the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

Trump on trade: unintended consequences?

A straightforward analysis of what Mr. Trump is doing would be:

–tariffs slow overall growth and rearrange it to favor protected industries.  There’s no reason I can see to believe something different might happen in the US

–apart from the third world, protected industries tend to have domestic political clout but to be in economic trouble.  In my experience, these woes come more from bad management than from foreigners’ actions

–the go-it-alone approach is a weak one, since it provides ample scope for a target country to shop tariffed goods through an intermediary

–the apparently arbitrary way the administration is acting will cause both domestic and foreign corporations to reconsider future capital investment in the US.

 

There are, however, two other issues that I think have long-term implications but which aren’t discussed much.

–tariffs may cause industries that have moved abroad to retain labor-intensive work practices (and continue to use dated industrial machinery) in a lower labor-cost environment to return to the home country.  If such firms come back to the US, it won’t be with the old machinery.  New operations will be very highly mechanized. In other words, one likely response to the Trump tariffs will be to accelerate the replacement of humans with robots in the US.

–as I see it, China is at the key stage of economic development where, to grow, it must leave behind labor-intensive work and develop higher value-added industries.  This is very hard to do.  The owners of low value-added enterprises have become very wealthy and powerful.  They employ lots of people.  They have considerable political influence.   And they strongly favor the status quo.  The result is typically that the economy in question plateaus as labor-intensive industries block progress.  In the case of China, however, the threat that the US will effectively deny such firms access to a major market will kickstart progress and deflect blame from Beijing.

 

If I’m correct, the effect of trying to restore WWII-era industry in the US will, ironically, achieve the opposite.  It will accelerate domestic change in the nature of work away from manual labor.  And it will run interference against the status quo in China, allowing Beijing’s efforts to become a cutting-edge industrial power to gather speed.