published: March, 06th 2018
The markets experienced a turbulent conclusion to last week with the Dow down 1.7% percent on Thursday, and despite a rebound on Friday afternoon, the index closed down 3.05% week over week. The driver of market volatility was an indicated desire to impose tariffs of 25% on Steel and 10% on Aluminum for overseas producers. The Investment team wanted to provide a quick commentary on the potential short-term and long-term impacts of this policy.
The short-term direct impacts of this new policy are expected to be small. Currently, Steel and Aluminum account for just 1.6% of the United States' imports, and domestic production only accounts for 0.2% economic output. These numbers support the conclusion that these proposed policy changes will have minimal direct impact on economic growth.
That said, increased tariffs and the associated higher costs may have a significant impact on firms that consume and produce these metals. Domestic producers are expected to expand production to move closer to 80% capacity utilization, up from 75% percent for Steel production and 71% Aluminum production currently, and should be able to take advantage of higher domestic prices for both of these metals. It is expected that firms which consume these metals in their production processes (automakers, etc.) will absorb some of the cost increases in the form of lower margins, and pass some on to consumers, fueling inflation in both consumer and producer prices. Analogous historical precedence for this policy is George W. Bush's 2002 steel tariffs which resulted in an 8% swing in wholesale prices for primary metals in the U.S. (prices moved from 4% deflation to 4% inflation according to Labor Department data).
Markets responded to these factors and historical comparisons with large consumers of these metals experiencing sell-offs and domestic producers rallying. Overall the markets traded off as domestic producers are relatively small in number in contrast to consumers.
Beyond cost ramifications for consumers of these metals, the potential for retaliation from our trade partners could have a more substantial impact on the equity markets, which are currently pricing in a relatively small probability of a trade war. Donald Trump is using Section 232 of the Trade Expansion Act of 1962 with gives the president the authority to impose protectionist measures if the Commerce Department finds a national security threat. By using this mechanism, he essentially avoids conflicts in various international trade regulatory agencies, as the tariffs are justified under national security concerns. The issue is that our trade partners may respond with tariffs against US exports.
European officials have already discussed the potential for retaliatory tariffs against American jeans, bourbon, and motorcycles. Canadian officials have indicated that they may initiate retaliatory policies as well. The rhetorical response from the administration has been non-conciliatory, which is not unexpected. The question is, what does this rhetoric mean for portfolios going forward? Internally, we believe that a trade spat would adversely impact the current global economic expansion and subsequently, equities. Recent research supports this conclusion with the National Bureau of Economic Research concluding that " short to medium run the impacts of protectionist measures are akin to those of a negative supply-shock that contract output, increase price and have a combination of contrasting effects on the trade balance". While some industries may be unique beneficiaries of protectionist trade policies, overall economic growth is generally hampered by increased input prices and reduced profitability. Thus, a sustained "trade war" could be an event risk that was missing during much of the market correction in early February. We expect that, similar to the winners and losers in late last week’s turbulence, there will be specific sectors that are harmed and benefited by these types of policies, and investors will need to navigate these sector specific issues appropriately. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings. Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through RFG Advisory Group, a registered investment advisor. Reliance Financial Group and RFG Advisory Group are separate entities from LPL Financial.