Trump on trade

so far:

intellectual property…

One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.

…and metals

Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it.  His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table.  In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.

This action has prompted the imposition of retaliatory tariffs on imports from the US.

the effect of tariffs

–the industry being “protected’ by tariffs usually raises prices

–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think:  US pickup trucks, some of which still use engine technology from the 1940s)

–some producers will leave the market, meaning fewer choices for consumers;  certainly there will be fewer affordable choices

–overall economic growth slows.  The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot

is there a plan?

If so, Mr. Trump has been unable/unwilling to explain it in a coherent way.  In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.

automobiles next?

Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US.  This is a much bigger deal than what he has done to date.   How so?

–Yearly new car sales in the US exceed $500 billion in value, for one thing.  So tariffs that raise car prices stand to have important and widespread (negative) economic effects.

–For another, automobile manufacturing supply chains are complex:  many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.

–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China.  Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold.  It will send cars from Japan instead.  [Q: Who is the largest exporter of US-made cars to China?  A:  BMW  –illustrating the potential for unintended effects with automotive tariffs.]

 

More significant for the long term, the world is in a gradual transition toward electric vehicles.  They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.

This is an area where the US is now a world leader.  Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.

This has already happened once to the US auto industry during the heavily protected 1980s.  The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency.  The relative market position of the Big Three deteriorated a lot.  During that decade alone, GM lost a quarter of its market share, mostly to foreign brands.  Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles.  GM has been the poster child for this.  It controlled almost half the US car market in 1980; its current market share is about a third of that.

In sum, I think Mr. Trump is playing with fire with his tariff policy.  I’m not sure whether he understands just how much long-term damage he may inadvertently do.

stock market implications

One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.

Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit.  So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways.  They are:

–currency weakness and

–an emphasis on IT sector in the S&P 500.  Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products.  My guess is that if auto tariffs are put in place, this trend will intensify.  Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.

 

Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut.   This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.

 

 

Trumponomics to date

a plan?

It’s not clear to me whether Mr. Trump’s macroeconomic policy forms a coherent whole (so far it doesn’t seem to).  I’m not sure either whether, or how well, he understands the implications of the steps he’s taking.

The major thrusts:

income taxes

Late last year, the Trump administration passed an income tax bill.  It had three main parts:

–reduction in the top corporate tax rate from 35% (highest in the world) to 21% (about average).  This should have two beneficial effects:  it will stop tax inversions, the process of reincorporating in a foreign low-tax country by cash-rich firms; and it removes the rationale for transferring US-owned intellectual property to the same tax-shelter destinations so that royalties will also be lightly taxed.

–large tax cuts for the wealthiest US earners, continuing the tradition of “trickle down” economics (which posits that this advantage will somehow be transmitted to everyone else)

–failure to eliminate special interest tax breaks, or adopting any other means for offsetting revenue lost to the IRS from the first two items.

Because of this last, the tax bill is projected to add $1 trillion + to the national debt over time.  Also, since the reductions aren’t offset by additional taxes elsewhere, the tax cuts represent a substantial net stimulus to the US economy.

This might have been very useful in 2009, when the US was in dire need of stimulus.  Today, however, with the economy at full employment and expanding at or above its long-term potential, the extra boost to the economy is potentially a bad thing,  It ups the chances of overheating.  We need only look back to the terrible experience of runaway inflation the late 1979s to see the danger–something which would require a sharp increase in interest rates to curtail.

interest rates

Arguably, the new income tax regime gives the Fed extra confidence to continue to raise interest rates back up to out-of-intensive-care levels.  More than that, the tax cut bill seems to me to demand that the Fed continue to raise rates.  Oddly–and worryingly,  Mr. Trump has begun to jawbone the Fed not to do so.  That’s even though the current Fed Funds rate is still about 100 basis points below neutral, and maybe 150 bp below what would be appropriate for an economy as strong as this.  Again this raises the specter of the political climate of the 1970s, when over-easy money policy was used for short-term political advantage  …and of the 20%+ interest rates needed in the early 1980s to undo fiscal and monetary policy mistakes.

trade

This is a real head-scratcher.

“national security”

The Constitution gives Congress control over trade, not the executive branch of government.  One exception–Congress has delegated its power to the president to act in emergency cases where national security is threatened.  Mr. Trump argues (speciously, in my view) that there can be no national security if the economy is weak.  Therefore, every trade action is a case of national security.  In other words, this emergency power gives the president complete control over all trade matters.  What’s odd about this state of affairs is that so far Congress hasn’t complained.

 

More tomorrow.

 

 

the US and trade protection

tariffs and quotas

There are two main ways in which a country can shield a domestic industry from foreign competition.  Tariffs are taxes on imports, which make foreign goods more expensive for domestic purchasers.  Quotas are limits on the amount of a foreign good that can be imported over a specific time period.   The first controls the price of the foreign good, the second its availability.  Unless the quota is set at an wildly high level, tariffs and quotas have generally the same effect.

The main impact is that both allow domestic producers to raise prices.  This is very good for those working in the protected industry, which will have higher profits than before.  It’s at least mildly bad for everyone else, who will have fewer choices and must pay more for what they need.

infant industries/developing countries

There can be a legitimate place for trade protection.  A developing country, for example, may want to establish a textile manufacturing industry.  In the early days, the infant industry may not have the technical skill or economies of scale to compete with more established foreign competitors.  So the home country government may limit foreign competition for a period of time to give the new endeavor a chance to get on its feet.  Tariffs/quotas may also guard against predatory pricing by foreign firms that want to keep the local industry from ever developing into a competitor by “dumping” product at below production cost.

effects of protection

There are several:

–overall GDP growth slows; domestic users of imported goods or their domestic substitutes now pay higher prices and are most likely worse off.  This economic loss may be hard to trace back to the protection, making the tactic more attractive to elected officials

–economic energy shifts to the protected industries, which raise prices and become more profitable.  In many instances, however, the protected industry doesn’t modernize but simply collects the extra revenue and continues its outmoded/inefficient practices.  So it falls progressively further behind world standards, with it and domestic consumers ending up worse off in the long run vs. having had no protection.  The domestic auto/light truck industry in the US during the 1980s is a prime example.

–affected parties figure out how to deal with tariffs.  In the case of the 25% US tariff on light trucks imported into the US, protection forced foreign automakers to establish plants in the US to serve the market.  In the case of current US tariffs on imported aluminum and steel, on the other hand, manufacturers who use these inputs have cancelled US expansion plans and have begun to shift production to other countries.

–we can see the negative long-term effects of protectionism around the world in the ossified telecom industry in the EU, the pickup truck business in the US, the semi-bankrupt state-owned industries in China or the senescent keiretsu structure in Japan.  Generally speaking, except for infant industries in developing countries, the state planning that tariffs exemplify seems to have worked out pretty badly just about everywhere in the OECD.

retaliation

When a country alters the trade status quo by applying a tariff or import quotas, the affected countries most often respond in a tit-for-tat fashion.  The original tariff is intended to help a politically important industry in the home country.  The response, called retaliation, has the aim of hurting a politically important industry in the home country.  If it also helps an industry in the original target, fine;  if not, also fine.  In this sense, retaliation is different from the initial tariff.

After the US placed tariffs on imported steel and aluminum, for example, the EU has responded with a retaliatory tariff on imports of Harley Davidson motorcycles (an early supporter of Mr. Trump) made in the US.  China has placed a similar retaliatory tariff on US soybeans.  HOG has since announced plans to move manufacturing of Harleys for export to the EU from the US to Thailand.  Chinese soybean buyers have shifted to Brazilian output, a loss that US farmers worry may end up being permanent.

 

Next time:  the Trump tariff plans, as far as I can figure out, and stock market implications

 

 

 

 

 

the administration, the economy and the stock market

I’m taking off my hat as an American and putting on my hat as an investor for this post.

That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.

My main concern is the effect of his economic policies on stocks.

the tax cut

The top corporate tax rate was reduced from 35% to 21% late last year.  In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.

The new 21% rate is about average for the rest of the world.  This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions.  The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions.  (An aside:  this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)

My view is that this development was fully discounted in share prices last year.

The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code.  It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal.  But he seems to have made no effort to do so.

Two important consequences of this last:

–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity.  That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.

–who pays for this?  The bill’s proponents claim that the tax cut will pay for itself through higher growth.  The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.

One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.

Two complications:  Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage.  Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.

 

Tomorrow: the messy trade arena

trade, tariffs and Harley Davidson (HOG)

Modern economics has been founded in study of what caused the Great Depression of the 1930s, with an eye to preventing a recurrence of this devastating period.  We know very clearly that tariffs and quotas are, generally speaking, bad things.  They reduce overall economic activity in the countries that apply them.  Yes, politically favored industries do often get a benefit, but the cost to everybody else is many times larger.  We also know that the use of tariffs and quotas can snowball into a storm of retaliation and counter-retaliation that can do widespread damage for a long time.

My point is that it’s inconceivable that high-ranking public officials in Washington don’t know this.

 

HOG motorcycles are Baby Boomer counterculture icon.  The company’s traditional domestic male customer base is aging, however, and losing the strength and sense of balance required to operate these heavy machines.  At the same time, HOG has had difficulty in attracting younger customers, or women or minority groups to its offerings.  So it’s an economically more fragile firm, I think, than the consensus realizes.

HOG has been damaged to some degree by the Trump tariffs on aluminum and steel, which are important raw materials.  (As I understand them, the tariffs are ostensibly to address Chinese theft of US intellectual property, although they are being levied principally against Japan and the EU.  ???)

Completely predictably, the EU is retaliating against the tariffs.  In particular, it is levying its own 25% tariff on HOG motorcycles imported from the US.  This affects about 20% of Harley’s output.  HOG says the levy will cost it $100 million a year in lost income, implying that all of the EU-bound Harleys are now made in the US.  HOGs response is to shift production targeted for the EU to its overseas plants.  My guess is that this will take 1000+ jobs out of the US.

In contrast to the job loss from this one company, public reports indicate the total job gain from the steel/aluminum tariffs to be about 800 workers being recalled to previously idle steel/aluminum plants.

 

Mr. Trump’s response to the HOG announcement was to threaten punitive tariffs on any imports of foreign-made Harleys–a move that could threaten the viability of HOG’s network of around 700 independent dealerships.  7000 jobs at risk?

The stock market declined sharply on the day of the HOG announcement.  I think that’s because the HOG story is a shorthand illustration of how tariffs, and quotas, cause net losses to the country as a whole, although they may bring benefits to a politically favored few.

 

A second negative effect of trade protection is a long-term one.  My experience is that most often the protected industry, relieved of immediate competitive pressure, ceases to evolve.  After a few years, consumers become willing to pay the increased price to get a (better) imported product.  In my mind, General Motors is the poster child for this.

 

Stock market implications?  …avoid Industrials.  The obvious beneficiary of Washington’s ill-thought out trade policy is IT.  For the moment, however, I think that this group is expensive enough that Consumer Discretionary and Energy are better areas to pick through.

 

 

a new government in Italy

Italy has long been the weakest link among the three major continental European economies in the euro.  Its economy has deep structural flaws.  Pre-euro it had long been papering them over through heavy government borrowing.  That allowed it to live beyond its means, protecting industries of the past and giving short shrift to future possibilities.  Periodic devaluations of the lira let it continue this strategy by paying lenders back in debased coin.

Despite this checkered history, Italy became a founding member of the euro in 1999.  It got in by the skin of its teeth–and that only after enacting a violence-wracked series of important reforms just in advance of the deadline.  The hope back then was that once in the common currency Italy would continue down the reform path. Instead, however, it has used the privilege of issuing euro-denominated debt to resume a less aggressive version of its bad old ways.  The result has been a domestic economy laden with debt, that has shown almost no real economic growth over the past decade.

 

The leaders of a nativist political coalition formed after recent elections have been speaking about their economic plans.  Their idea is apparently to “solve” Italy’s problems by repudiating a portion of the national debt and withdrawing from the euro, presumably in order to substantially devalue a new currency.

…sounds a little like Greece, only ten times the size.

This development is, I think, the main reason the euro has been falling against the US$ since early April.

 

my thoughts

–although the new government hasn’t announced official policy, I think that what it ultimately says will be at best a watered-down version of what leaders have already been saying unofficially to their supporters.  If so, we’re in early days of a looming crisis

–to the degree that professional investors hold Italian stocks, I think their reaction will be to seek safety elsewhere

–it wouldn’t be surprising to see official policy end up being something resembling Abenomics in Japan in its broad outlines.  This implies the folliwing end result:  a substantial loss of national wealth, a higher cost of living for ordinary citizens and protection of traditional industry/established elites from negative effects.  There’s no reason to think Italy would end up any different

–it’s probably also worth noting that “protect sunset industries/stunt the future/lower living standards” summarizes the Trump economic playbook for the US, to the extent there is one.  This means we can already see in Japan/Italy the trailer of a future disaster movie for the US

–What to do in the stock market?  I think Italy has restored the safe haven character of the dollar for the moment.  Given the distinct policy negatives in the US, EU and Japan, China is looking a lot better.  Secular growth (i.e., IT) anywhere is probably safer than economic sensitivity

 

a US market milestone, of sorts

rising interest rates

Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%).  Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.

What does this mean?

For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds.  No less, but also no more.

The reality is, of course, much more nuanced.  Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds.  For example:

–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class.  So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.

–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination.  In those days, listed companies either expanded or bought rivals for cash rather than paid dividends.  So stock yields were low.

three important questions

dividend yield vs. earnings yield

During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks.  For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.

Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-).  If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%.  This would imply that the stock market (next year?) should be trading at 25x earnings.

At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x  2019 eps.  To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year.  If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.

stocks vs. cash

This is a more subjective issue.  At what point does a money market fund offer competition for stocks?  Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now.  Is this enough to cause equity holders to reallocate away from stocks?   Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash.  Maybe I’d also stop reinvesting dividends.

I doubt this kind of thinking is enough to make stocks decline.  But it would tend to slow their advance.

currency

Since the inauguration last year, the dollar has been in a steady, unusually steep, decline.  That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).

The dollar has stabilized over the past few weeks.  The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners.  Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation.  Either could be bad for stocks.

my thoughts:  I don’t think that current developments in fixed income pose a threat to stocks.

My guess is that cash will be a viable alternative to equities sooner than bonds.

Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets.  At this point, though, I think the odds are for slow further drift downward rather than plunge.