Tariffs have become one of the dominant topics in today’s financial news. The headline changes daily as tariffs are off, then on, then partially on (with concessions). Over the last three weeks, both the stock and bond markets seem to be anticipating a slowing economy. Interest rates are lower, and stock prices are down. Financial media points to tariff uncertainty as a cause of market weakness, although it is ironic that we now have the clearest view of potential tariff policies since the election.
Still, the question remains. What impacts could the outlined tariff policies deliver to the markets and economy? What can we expect?
Let’s start by looking at tariffs as a potential inflationary catalyst.
Tariffs As An inflationary Catalyst
Economic textbooks tell us that tariffs are a tax on goods that will lead to higher prices. Theoretically, the price increases are a “one time” increase and do not lead to a persistently higher inflation rate, but this is not the entire story. There are other factors involved.
Tariffs on Chinese goods in 2018 did not lead to materially higher prices. The depreciation of the Yuan currency value offset a large part of increased prices. U.S. importers absorbed another portion of the increased cost of imports. The last portion affecting consumers was significantly smaller than the gross tariff rate. To the extent that imported goods prices rise (and affect the average CPI index level) the last factor is consumer choice and substitution options. Ironically, a Honda built in Marysville, Ohio may change little while a Ford made in Mexico may suddenly cost 25% more.
Clearly, there are many factors that ultimately impact the final prices that consumers experience. It is important to remember the delicate and complex nature of global trade. This was made plain during the pandemic, where we saw global supply chains grind to a halt. The disruption had an immediate impact on inflation due to the scarcity of goods.
The globalization of production has been gradually developing over the last 40 years, and in general, has been a net positive for the everyday consumer’s quality of life. Global trade typically creates a competitive price environment. This trade not only leads to a greater variety of available goods, but it also allows for lower production prices.
All of this equates to your dollar going further. When global trade is disrupted, prices are raised (unless offset by other factors), overall consumption goes down, and GDP growth suffers.
For the past several years, we have held a contrarian (positive) view of the economy. While leading indicators and pundits have called for a recession, we’ve consistently pointed toward resilient strength in the consumer, which has been propped up by liquidity and rising wages, as a bastion for economic growth.
A tariff-related inflationary catalyst would weaken the consumer, hurt economic expansion, and likely introduce more volatility into the market. A market which is already extended by nearly every historical fundamental valuation measure.
A More Granular Look At How Tariffs Might Impact Segments Of The Market
Looking back at the factors that can soften the ultimate tariff-related impact on consumer prices, there are some obvious investing considerations.
First is a weakened currency for exporters. A weak currency negatively impacts the consumers in the exporting country as prices for their imports rise. This is a marginal negative impact on the growth and investment prospects within the exporting country and should influence allocation of international equity portfolios.
Second is the absorption factor for U.S. companies. To the extent that importers are not able to pass along their increased costs, their profits will be negatively impacted. A prime example would be a small company that needs highly specialized components, imports most of them, and has customers that can easily switch to another, cheaper source. If this small company is highly leveraged, it will have less flexibility to adjust its supply sources.
An example of a less affected company would be a U.S. electric or gas utility that sells power domestically, procures their plant and equipment from domestic sources, and is financially sound. Banks, Utilities, Real Estate, and Telecommunication companies should be least affected by tariffs, while retailers and small manufacturers will be most vulnerable.
What Do Tariffs Mean For Fundamentally-Rooted Portfolios?
For now, nothing.
As a fundamentally-rooted manager, we are not planning an overhaul of our sector weights. That is because the fundamental process does not hinge on speculation and market timing. Rather, the process is rooted in black and white statistics of market pricing and sector valuation. As policies become more concrete and impacts are evidenced in the market, we will monitor and assess the impacts to price and earnings data and allocated our portfolios accordingly.
It is in times of uncertainty that the fundamentals become so important. It’s a time-tested process that we will continue to follow.
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
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