TARIFFIC

There has been a lot of discussion in the financial press about the effects of our new international trade policy on the markets. While there has been a lot said in the mainstream press about the effectiveness or lack thereof of utilizing tariffs to increase domestic production, the financial markets seem to be relatively unaffected so far.

The first thing to understand about the current state of international trade is that most countries, including the US, use tariffs to protect specific domestic industries. This has been true since before the current administration took office. As an example, the European Union (EU) currently charges a 10% tariff on US car (sedan) imports, while the US charges a 2% tariff on EU car imports. However, the US charges a 25% tariff on trucks and pick-ups imported from the EU, while the EU charges 15% on imports of trucks and pick-ups from the US. We can see that the US is trying to protect its production of trucks and pick-ups, while the EU is trying to protect its production of sedans.

The next question is why the current administration is trying to renegotiate the existing set of international trade contracts into which the US entered. This requires a bit of understanding about the make-up and backgrounds of the current administration. In general, the Republican Party favors free trade. The background of the current administration leans heavily toward private business (rather than politics and policy), with members such as Treasury Secretary Mnuchin, Commerce Secretary Ross, Secretary of State Pompeo, and of course President Trump having significant management experience in the private sector. And businessmen tend to be even more free trade oriented. So it would appear that the escalation of tariffs by the current administration is probably a negotiating tactic to move the US more toward truly free trade. Indeed, President Trump said as much in a recent tweet, “I have an idea for them. Both the U.S. and the E.U. Drop all Tariffs, Barriers, and Subsidies! That would finally be called Free Market and Free Fair Trade!”

The financial markets also appear to be treating the ramp-up of tariffs by the US as just a negotiating tactic, expecting the US and its major trading partners (China, Japan, EU, Canada Mexico) to have revised trade agreements in place with lower tariffs. While the markets dipped when the administration first started talking about tariffs, they now do not react at all to talk of substantial tariff increases on China and the EU.

If substantial tariff increases occurred and were permanent, it would likely be a huge negative blow to equity markets. Tariffs work exactly like taxes on consumers of goods, so tariffs would act as a drag on US domestic economic activity. Furthermore, tariffs would likely have an even bigger drag on the economies of the trading partners of the US. For this reason, it does not make sense to have direct exposure to foreign currencies and non-dollar equities. With dollar exposure, a maintained “convexity” hedge on US equities by holding certain proportions of US Treasury instruments can be done. If new trade agreements get finalized between the US and its trading partners, exposure to non-dollar equities, especially those in growth sectors, and a decrease in dollar fixed income exposures might make sense.