Dear Valued Clients and Friends,
In the heat of the moment at the beginning of the week, I got to devote most of Monday’s Dividend Cafe to the here and now of what was happening with tariffs that day. And I stand by the commentary that Monday’s Dividend Cafe offered, intentionally limited in its scope as it was. But I have been wanting to do a deeper dive into the subject for a long time and I figured this week was as good as any to finally make that happen.
Now, this is still a pretty tricky thing to do in the context of what Dividend Cafe is here to do. The practical application of our discussion is supposed to be, “What does this mean for me as an investor?” A deeper dive into tariffs, trade policy, and some of the considerations around these matters is important and interesting, and I think it is paramount for those who want to have a more astute understanding of macroeconomics. But applying these things to this particular moment is not so simple when what is going on in this particular moment is not exactly easy to unpack. There is a very present tense relevance in the politics of the moment, but Lucy moves the football around a lot here, and that makes for a difficult time in having a coherent discussion about tariffs.
So what I am trying to do this week is, well, both. I want to get into the heart of the matter but not lose sight of what is (and is not) going on right now. Lucy may move the ball around some more, but I am going to keep my eyes where they belong. That is a useful perspective on the broad subject, tethered to real investment wisdom and application. If I fail in the objective, blame Lucy.
Let’s jump into the Dividend Cafe …
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Recap of the Week
The basic story for the week that was goes like this: Over the weekend, President Trump declared that 25% universal tariffs were going into effect at midnight Monday on all imports from Canada and Mexico (besides Canadian energy imports, which would be 10%), and a 10% universal tariff on all Chinese imports. Futures dropped a great deal Sunday night, and Monday markets swooned until word was out mid-day that, no, there would be no tariff imposition on Mexican imports as Mexico agreed to certain concessions around enforcing border security and aiding in efforts to stop fentanyl drug trafficking across the border. Shortly after the market closed on Monday, a similar announcement came from Canada.
Did President Trump achieve a political victory here? Well, sure, the narrative around “we used the threat of tariffs to secure a better deal with border security and drug enforcement” has resonated with something over 50% of the people. Were the concessions received as substantive as being claimed? Usually, these things get overstated in the world of politics (a bipartisan comment). Are these concessions nothing? No, of course not. So, as is usually the case, the truth is somewhere between the polarized claims that “this was a magical art of the deal moment” and “this is all pure nonsense.” You’ll be shocked to know that many people’s migration to one end of the spectrum or another is, well, connected to their view of the 47th President.
The basic problem in analyzing all of this from an apolitical, objective, markets perspective is this: How do you evaluate the impact of tariffs that never happen(ed)? The whole conversation is riddled with non-falsifiable claims. Two things are being said by the administration at once, and they do not easily co-exist for obvious reasons:
- Tariffs are beautiful, a source of revenue, make trade deals fair, bring money to the U.S. from other countries, and protect American jobs.
- Tariffs are a negotiating tool that we don’t want to use but will use to extract concessions from allies and adversaries alike, with the current focus being things like immigration and border security.
NEC Director Kevin Hassett directly said on CNBC Monday morning, “We are not looking for a trade war – this is about drug enforcement.”
So what exactly are market actors who are doing their best not to get caught in the politics of it all supposed to think of what happened this week? I would suggest four key takeaways that I hope you will find fair, objective, non-hysterical, and thoughtful:
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The indication thus far is clearly that, hyperbole, rhetoric, and audacity notwithstanding, the new administration favors the “tariffs as threats” approach – not the “tariffs as policy” approach
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Cosmetically, this approach has generated headlines – and yes, possibly real policy concessions – that President Trump loves (i.e., Colombia, Mexico, Canada, etc.).
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Market volatility skyrockets at the threat of tariffs and, more specifically, the uncertainty of tariffs.
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The President of the United States is as concerned with market response to tariffs as foreign countries are concerned with tariff impact on their economies.
Who is Paying Attention?
The major category of imports from China is computer and electronic products (30%), so it is not a surprise that that (rather expensive) area of the market has been most volatile around the uncertainty of where these things are going. Food is only 1% of imports from China, and even chemicals, rubber, metal, leather, and transportation are, all put together, not a significant component. Textile/apparel is 10% of the total, and electrical equipment is another 12%.
22% of what China used to export came to the United States; that number is down to 15% now. China is the largest exporter to most other countries on earth, but not all. We bring in slightly more from Mexico than we do from China. But regardless, at 15% of their total export market, we are still a huge customer, but not as huge as we used to be.
Now, with Canada, 25% of our imports are oil and gas, and 18% are transportation equipment. Computer, electronic, and electrical categories are negligible. Mexico’s imports change further, still, with 34% being transportation (a lot in the automotive space) and a more diversified mix amongst electronics, machinery, metals, and agriculture.
Together, the three countries import 50% of our motor vehicle imports (parts, etc.). The automotive sector has a lot riding on all of this.
It is Mexican imports that are on the rise (from about 10% to 15% of our imports in the last decade or so), and Chinese imports are on the decline (from 20% to about 13%). China’s cost advantage has been disintermediated on the margins for years.
Interestingly, the Mag-7 names of the S&P 500 that represent such a massive concentration of the U.S. index have almost no exposure at all to revenue from Mexico or Canada but a massive exposure to China.
Trade War or Drug War
I believe Treasury Secretary Scott Bessent is essentially a free trader who knows in his heart and mind that tariffs are a cost on the U.S. economy paid by U.S. importers and, ultimately, consumers. I believe NEC chair Kevin Hassett knows this. I believe CEA chair Stephen Miran knows this. And while all three will, on occasion, have to say things that sound more economically nationalistic or protectionist at the moment, I believe they know the basic economics of how these things work and have an appreciation for the law of trade-offs.
What are trade-offs? They are the crux on which all of economics turns … The reality of scarcity means that we have to decide how we allocate resources and give a little here to get a little here. Economics is essentially the process of human action and reasoning around the allocation of scarcity decisions – that is, the implementation of trade-offs. If this was all you ever knew about economics, you would pretty much know enough, and you would know more than 90% of elected officials in the United States government know. The issue of tariffs involves trade-offs, and the President’s economic team knows this.
Do I think President Trump always understands all of this? Actually, I do. I don’t always agree with the way he applies it, and I doubt he thinks through it as analytically as he does emotively, but I think he has a general instinct for trade-offs. Do I think some of his advisors over the years have fallen on the side of trade-off decisions? I do—the Navarros, Lighthizers, and such – absolutely not.
But it just has to be said that no less than Pete Navarro himself said this week’s action was about drug policy. I think some believe we can implement $150 billion of tariffs and suffer no consequences. I think those people are intellectually disqualified from whatever it is they do for a living. I think others believe we can implement $150 billion of tariffs, and it will come at a cost, but it will be worth it. I vehemently disagree with those people, but they are more intellectually honest. And I think some believe those costs will not come because it will not get there. Those people appear to be leading the charge at the present moment.
Let’s Just Pretend
Back to my initial point. How do you critique tariffs that never happen or analyze the economic impact of a policy that is threatened but never implemented? Answer: You don’t.
But what about those who say we got a teaser of the tariff impact in 2018? Well, no, we didn’t. The amount of exceptions granted for the tariffs in 2018 was massive. This is, of course, a major policy concession – why would “beautiful” tariffs need to be exempted for some companies if there is no cost, impact, or damage?
And why did we pay tens of billions of dollars of subsidies to U.S. farmers if they were not paying the cost of the tariffs? Our agricultural exports dropped -76% due to retaliatory tariffs and we paid $27 billion in subsidies to offset. So again, no one appears to be denying that the tariffs, small, riddled with exemptions, targeted, and nowhere near the scope of what gets threatened now, did great damage to U.S. farmers. They paid the price, and then the taxpayers paid them. So, the idea that it made us wealthy is not something anyone is seriously saying.
Comparisons to the 2018 tariffs are disingenuous if the intent is to compare them to broad-based tariffs that people actually pay, not receive exemptions from, and that don’t just cover a sector here and a sector there. And comparisons are disingenuous if they do not acknowledge the subsidies paid to offset the costs (subsidies covered by the U.S. taxpayer).
But, if we pretend that the current tariff talk is all real, that we really are going to do this, that it is not for drug war concessions or border security, but rather that this is really going to happen, it is going to last, and it is going to be deep and wide, THEN can we come to any conclusion about what the cost would be?
The answer is that, despite the entirely hypothetical nature of the question, the cost would be horrific. In fact, it is my belief that it would be so horrific that it would be self-correcting. In other words, one of the only ways to get past the non-falsifiable and theoretical dimension of this debate is to actually do this, allow the empirical results to be seen by all, and then see the Pavlovian lesson be implemented (that is, we won’t dare try it again).
In the meantime, we are debating against a fictional narrative. We are claiming things that have not happened (besides Smoot Hawley) and are not going to happen are benign, and there is no accountability for the claim because it is all conjecture.
What to Expect if Tariffs Happen
First, we have to expect a decline in the imports that are being taxed because when you tax more of something, you get less of it. Then, we have to expect prices to rise to make up for the impact. Then, we have to expect the currency of the country implementing the tariff to rise as the exporting country’s currency weakens to soften the impact. Then, we have to expect retaliatory tariffs that offset any benefit expected from the protection provided by the tariff to the special interest in question. Then, the economy has to price in the very complex and multi-dimensional consequences of declining orders, uncertainty, newly allocated resources, and other questions about production and consumption that a new tax to the system represents.
And when all is said and done, there will be no winner – just a decline in total exchange, which is to say, a decline in total production. Rinse and repeat.
So, are You Petrified?
No, because I do not believe those things will ultimately happen, and if they did, I believe the course correction would be quick. Maybe not as quick as the ten minutes it took Monday, but it was quick. It is not without risk. And it is not without uncertainty.
Would stocks drop? Sure. How much? You tell me how much the currency adjusts first, and I’ll tell you how much stocks drop second. There is a complex, uncomfortable, not-going-to-make-the-news part of this that is embedded in currency exchange rates, and the impact on earnings starts with forex, so how the dollar moves (and the corresponding currency of the counter-party country) is highly relevant to the total macroeconomic impact. A U.S. dollar appreciation hurts the competitiveness of U.S. exporters, and that cost then gets priced in, as well. Dominoes are involved from all directions.
Tariff policy threats to drive better cooperation with allies do not scare me, though I have to suspect it will eventually lose its efficacy. How many times can you threaten to kill the hostage before someone begins to suspect there are no bullets in the gun? But I freely confess here, what do I know? I am not exactly a tough negotiator.
Tariffs to try and protect U.S. industries scare me because they don’t work, or they come at a cost that tends to be ignored or missed. They fall into the classic category of “visible” effects vs. “invisible.” They wrongly assume exporting more than we import is good (it is not). And they generate losses for some domestic economic actors while they generate gains for others. Foreigners spending less money on U.S. exports hurts U.S. manufacturers and agriculturalists who export, even if we believe domestic industries visibly benefit.
Tariffs to affect other more complex national security objectives are a separate matter. A national policy framework that avoids dependency on global supply chain actors who are untrustworthy when it comes to vital pharmaceutical and technological products is sensible. I see little space for tariffs there, and I believe we can diversify and protect our supply chain with the seriousness of purpose – with the will to do so – without universal tariffs that put downward pressure on total economic activity.
Conclusion
Which of the above tariffs are really on the table right now? The answer seems to be none. But that can change in a day, a week, or a month. Markets are the great mediator, for now, and the President cares about markets. There is no reason to believe the noise is over or the volatility is softening from here. Lots of considerations remain unknown, and there are enough competing policy voices in the President’s ear that I would take nothing for granted.
But I am serious when I say that the worst-case outcome is, to me, a generational lesson that would ultimately be good. Societies get wealthier when they freely exchange more, and those who disagree with that have the privilege of not having to see their theory of the case tested in the real world. Thank God.
Chart of the Week
I ran it Monday in the Dividend Cafe, but it needs to be run again:
Quote of the Week
“Capital will always go where it’s welcome and stay where it’s well treated…Capital is not just money. It’s also talent and ideas. They, too, will go where they’re welcome and stay where they are well treated.”
~ Walter Bigelow Wriston
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I am aware of a lot of follow-up questions that will come up after this piece. “What about unfair trade deals?” “What about IP theft?” “Didn’t our founding fathers like tariffs?” “Aren’t tariffs better than an income tax?” I really do believe that we need to organize our questions around tariffs so that the conversation stays focused, and this week’s market commentary was on (1) What actually happened this week and (2) What would happen if we ever had universal, broad tariffs. The questions in this paragraph are all separate from the focus of this week’s commentary but warrant more discussion. I feel a part two coming!
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
