Risks associated with trade and tariffs are the top concern of institutional investors, according to a recent survey by RBC Capital Markets. They far outweigh worries about inflation, interest rates, Fed policy, and the economy overall, among many other issues.
Amid the uncertainties, there is a lot of confusion about the trade disputes, especially after a myriad of tariff threats and counter-threats have been lobbed back and forth in recent weeks. Neither the U.S. nor its major trading partners seem willing to back down anytime soon.
In an attempt to cut through the noise, we answer some frequently asked questions:
Markets largely ignored trade tensions for months. Why have they reacted recently?
Perhaps this has to do with President Trump’s unorthodox communications style. For much of his presidency markets have been in “show me” mode—less focused on rhetoric and more focused on actual outcomes.
For example, markets were slow to price in the historic U.S. tax cuts and associated increase in earnings estimates. The reaction to tariff rhetoric has been similar—most markets were mostly unaffected by the war of words until the prospects of multiple tit-for-tat tariffs became nearly assured. This is unusual behavior for equity markets, which normally price in events well in advance.
It’s now clear the U.S. administration isn’t completely bluffing and there is more to this than just tough rhetoric. What were trade “threats” months ago have begun to turn into actual policies. Steel and aluminum tariffs have been implemented by the U.S. and counter-tariffs are forthcoming from many trading partners. Also, the first round of U.S.-China tariffs is nearing the implementation phase. We think the additional tariff threats lobbed in the past few weeks by all sides now seem more credible in the eyes of markets.
What is the potential economic impact of tariffs?
The trade disputes are being fought on four different fronts: (1) steel and aluminum, which impact many countries; (2) automobiles, which impact auto-producing nations; (3) the U.S. versus China; and (4) the U.S. versus NAFTA partners Canada and Mexico.
Our economists believe there is a very low probability that all of these fronts will ignite at once into an all-out global trade war. They anticipate the parties will ultimately negotiate trade deals for most if not all of these because it is in the economic interests of all countries involved, including the U.S. If a full-on trade war is avoided, the economic damage should be manageable.
That being said, our economists have evaluated some harsh scenarios. For example, if the U.S. and China were to levy 25 percent tariffs on all imports from each country and China were to include additional non-tariff barriers so as to match the total U.S. tariffs, RBC Capital Markets estimates it would subtract a little more than one-half of a percentage point from annual U.S. GDP growth (the economy would grow 2.4 percent rather than 2.9 percent, for example). Keep in mind, the U.S. and China tariff threats currently on the table are much lower than this (25 percent on the first US$50B in goods, followed by a 10 percent tariff on the equivalent of $400B more in goods).
In another scenario, if the U.S. were to levy a hefty 20 percent tariff on imports from China, Mexico, and Canada, and each country countered, RBC Global Asset Management’s economist estimates it would subtract 4.8 percent from Mexico’s GDP growth (admittedly, a big number), 2.4 percent from Canada, 1.9 percent from the U.S., and 0.9 percent from China. The probability of this occurring is very low, in our view.
Which U.S. sectors are most vulnerable to tariffs?
Theoretically, the U.S. sectors with the highest levels of international revenues—Technology, Materials, Energy, and Industrials—would have the most to lose in a global trade war on goods and services. But that’s not what is being threatened and this issue is not cut and dried.
Thus far, the tariff threats have focused on goods, not services. The distinction matters because many Tech firms, including internet and some software companies, are services providers. They manufacture nothing so their risk is low. Within Tech, semiconductor and hardware companies are manufacturers and have significant revenues from overseas, so they are much more exposed to tariff risks.
Another key point: it’s difficult to break down the risks by regions or countries. Many S&P 500 companies don’t detail the sources of their international revenues.
In general, internationally oriented semiconductor, tech hardware, materials, and industrial firms have the most exposure, and some consumer goods companies are vulnerable as well.
What could hasten the end of the trade disputes?
A meaningful deterioration in U.S. and global economic indicators and a more pronounced selloff in equity markets could certainly grab the attention of elected officials and push sparring parties to resolve their trade differences. But we don’t think it has to get that bad for deals to take place.
Corporate pressure could go a long way toward bringing an end to the trade disputes. A non-trivial share of major trade relationships—whether between the U.S. and China, the U.S. and the EU, or NAFTA members—is business-to-business and involves complex global supply chains with interdependencies that are often misunderstood or underappreciated by government officials. Some tariffs could tie global supply chains in knots. We don’t doubt businesses of all sizes in all countries involved will warn governments about this, which could encourage positive movement toward trade deals.
Two U.S. automotive industry groups have already sounded alarms about auto tariffs. ExxonMobil and Chevron warned of the damaging effects of tariffs on steel, which they use for infrastructure maintenance and expansion. High-profile European companies, Daimler and car lights supplier Osram, warned that rising trade tensions could weaken their profit outlooks. Any cautionary comments by U.S. companies during the upcoming Q2 earnings reporting season would likely catch the attention of the free trade advocates in the U.S. administration (Steven Mnuchin, Larry Kudlow). While additional warnings could rattle equity markets, they may also jolt trade negotiators into action.
Cooler heads should ultimately prevail
All sides of the trade disputes have economic incentives to resolve their differences, and we think this will eventually occur. In the meantime there could be more heated rhetoric and additional tariffs implemented that could keep equity markets off balance over the near term.