A Tale of the Unexpected

The ironies abound.

The president who touts his ability to make stocks rise, does one of the few things that a president can do to make them fall. The only president to hold a Wharton degree flouts the economics textbooks. The first presidential business magnate since Herbert Hoover upsets the business community. The president who has worked almost exclusively on his side of the aisle delights the opposing party and distresses his own. 

Even by the unusual standards of the Trump administration, last week's announcement that the U.S. would impose a 25% tariff on imported steel and 10% on imported aluminum was a shocker. So, too, was President Trump's tweet that he welcomed a trade war, because such wars are "easy to win." It is difficult to envision any other U.S. president making such a statement.

This column will skip the punditry, as much as is possible, and discuss instead the economic and investment issues. What does the academic research say about tariffs? If these tariffs do lead to counterattacks from other countries, what damage might a trade war inflict upon investors' portfolios?

Sizing Up Tariffs

Traditional conservatives, as represented by the business and political press, immediately denounced the president's announcement. The Wall Street Journal called it "folly." The National Review dismissed the tariffs as "crony capitalism for well-connected and politically sensitive firms and industries." Wrote Forbes, "In general, all tariffs hurt a country's economy."

The academic literature is more nuanced. The data do permit such grand proclamations. There are no control groups upon which to conduct a proper scientific study. There are no countries or time periods that are otherwise identical to other countries or time periods but have very different tariff policies. Thus, the studies consist of large multiple regressions, which are accurate only insofar as they include all relevant factors. Which they, invariably, never do.

Also, the evidence against tariffs is not as universal as the condemnations would suggest. Many countries, at many different times, have thrived after imposing tariffs. Some of these successes can be explained away; it is not that the tariffs were useful, but rather that they did not cause enough damage to impede that country's economic boom. Sometimes, however, tariffs appear to have been genuinely helpful. 

Those situations validate one of Alexander Hamilton's arguments. As Treasury secretary, Hamilton proposed that the United States levy stiff tariffs on certain manufactured goods, to protect nascent U.S. industries as they developed. The academic research--using updated examples, of course--suggests that is indeed a sound course, assuming that the country has good reason to think that it will enjoy a competitive advantage with that industry, once that industry has become capable of leaving the nest.

That logic might support U.S tariffs on solar energy (or not; I take no sides in that debate), but surely not for steel and aluminum. Thus, I must concur with traditional conservatives. These proposed tariffs do not make economic sense. They will assist two industries, at a cost to several others, and ultimately at some detriment to U.S. consumers.

Economic Warfare

With trade wars, I defer once again to Hamilton. Although he barked loudly at Britain while writing his Federalist Papers, suggesting that punitive trade restrictions would force the British to give the U.S. better trade terms, he bit not when serving as Treasury secretary. In that office, he talked down those who advocated brinkmanship. Brave words, prudent deeds.

Presumably, the president has operated similarly, by brandishing a big stick without planning to use it. Because it is difficult to see much good (if any) coming from a trade war. On that subject, I will defer to GMO's Ben Inker:

"As a general rule, when you add 'war' to your description of an event, it's a pretty strong suggestion that it is unlikely to be either good or easy. ... It can take years for companies to build out their global supply chains. With the stroke of a pen, political leaders can make those supply chains instantly far more expensive. But this does not make the process of building the domestic capability to replace foreign suppliers happen overnight. Such onshoring would necessarily take time."

Meanwhile, inflation will spike. How much damage might this cause to U.S. investments? Inker believes that a bout of unexpected inflation could lead to losses of up to 40% for balanced portfolios. (Down 40% in a balanced fund? Ouch.) Fortunately, a true trade war--as opposed to trade skirmish--remains far away. Even if the president decided to pursue such a course, he would need retaliation from other countries and probably congressional support (the executive branch having limited powers at enacting tariffs unilaterally) for such a battle to arise.

Wrapping Up

In summary:

1) The steel and aluminum tariffs will likely harm the overall U.S. economy, not help it.

2) Whatever damage is wrought should be modest. Although more manufacturers will lose than gain from the tariffs, they are the economy's tail, and are unlikely to wag the dog. Services account for 80% of the U.S. economy; healthcare alone far outstrips the GDP provided by all forms of manufacturing.

3) Thus, the stock market was (reasonably) rational with its reaction. It immediately tumbled upon hearing the tariff news, then rallied as the implications were digested. This event, in and of itself, is minor.

4) The next event, that of other countries' retaliation, would be more significant. Should that occur, it won't be with a bang. Trade wars are diplomatic affairs that unfold gradually, in stages.

5) Although that would seem to give investors the opportunity to become more defensive, that is not necessarily so. In such a case, the stock market would not wait until the bad news arrived; rather, it would decline once that news became reasonably clear on the horizon.