Tariffs have been at the forefront of economic headlines over the past year. If the market headlines do not include “United States Threatens to Impose New Tariffs” then it most likely includes “Markets rise on the hope of a Trade Deal”. This has been the never ending cycle for the last year. On May 10th, 2019 the Trump Administration announced that a 25% tariff would be placed on an additional $250 Billion worth of Chinese goods being imported to the US. This tariff levying once again shocked markets and sent them trading lower the following week. Although we follow these developments daily it is important to understand the impact that this political risk has on your investments.
Measuring The Effects Of The Trade War
Trade tensions, specifically tariffs, affect the economy and market in a number of different ways. Certain aspects of a ‘Trade War’ are relatively easy to quantify but most are difficult to predict exactly what the long term affects will be. One of the dynamics of tariffs that is relatively easy to quantify is the effect they have on corporate profit margins. According to Empirical Research Partners, the tariffs administered in 2018 decreased S&P profit margins by 2%. This number can be increased now that the amount of goods being penalized has increased. Profit margins are one of the most important factors affecting stock prices so any negative affects to profit margins will translate over to stock prices. Tariffs also affect GDP. The graph below provided by TD Bank illustrates the incremental effects that increasing the amount of goods subject to tariffs has on GDP. Although Q1 2019 GDP of 3.2% was strong, part of this could be contributed to rising inventories. One reason companies may be increasing inventories is to brace for an increase in the cost of imported goods.
The quantitative effect of tariffs might seam relatively small but arguably the more important aspect of the trade war is the uncertainty that it poses for companies. Investors, and thus the stock market, do not like uncertainty. Although at first the impacts of tariffs on a company might only appear to be a few basis points of profit margin, you start to realize the longer term effects to the supply chain, and capital allocation are where the real cost will be realized. For decades large US companies have been centered around globalism. Whole economies have been built on exporting goods to the US. Now the threat of a prolonged trade war makes companies have to second guess their operations and the costs that will be associated. The first graphic below shows the results of a survey administered by the Federal Reserve of Atlanta regarding how the trade tensions have impacted their capital expenditures. The second graphic is published by Deutsche Bank Research and shows the effects that the trade war is having on states most exposed to trade. As you can see, companies are starting to materially change their capital allocation decisions now that the trade war is looking like it will be prolonged.
Translation To Portfolio
Most companies will suffer in a trade war at least to some extent. The ones that will suffer the most damage are those that have the highest exposure to trade with China. These include companies in the Industrials, Materials, and to a lesser extent, Technology sector. Large Industrials that are exposed to global export and agriculture will be hit the hardest. On the flip side, these are also the companies that will benefit the most from a trade deal so it is important to keep some exposure to them. We are aware of the effects that trade disputes have on stocks and have taken/continue to take steps to shield portfolios from downside risk. Recently, we initiated a position in the Industrial HVAC/R distributor Watsco. Part of the investment thesis behind purchasing shares of Watsco is the domestic source of the company’s revenue stream. Primarily all of Watsco’s business is done in North America. This should insulate it to a trade war compared to a large conglomerate that does a lot of business overseas. In the Materials sector we added shares of specialty chemicals provider Ecolab. Because most of Ecolab’s products and services are mandated by laws/regulations, they are very “sticky”. This means that companies will cut expenses to many other areas before they stop buying Ecolab’s products. The other sector that is at the forefront of the trade war is the Technology sector. The impacts on this sector can be a bit trickier to assess because a lot of the issues come down to company specific intellectual property. If a company has their products/designs stolen by the Chinese it is obviously very detrimental to their stock price so it needs to be monitored closely. At the end of the day it is important to own proven companies with a strong balance sheet, strong management, and competitive advantages that can not only weather a trade war but take market share through one. We feel our investment philosophy of owning proven enterprises that not only pay dividends but also have the discipline of growing the dividend over time thrives in an environment such as this.