- The opening of a new tariff war with Mexico dampens our expectations for risk assets.
- We question the assumption that U.S. equities will provide downside protection in a trade war as this premise is based on economic framing as opposed to market realities.
- While we have an inherent bias toward active management, we believe that this broadening tariff war makes it even more imperative to avoid a pure beta,1 basket approach to the equity markets. There will be clear winners and losers, something an index is not adept at sorting out.
We have noted in our past communications this year, that one of the risks to our forecast would be an escalation in the tariff war. It has been our belief that given the economic cost of a tariff war that the Trump administration would be hesitant to ramp up tariffs on multiple fronts in advance of election season. Given the latest tariff threat with Mexico - the U.S.’ second largest trading partner - it appears that we have misjudged President’s Trump’s resolve. Perceived economic strength, as implied by 3.1% GDP growth in the first quarter, may have created some false confidence. We question whether this type of resolve can be maintained as economic growth slows which is likely over the remainder of the year.
While we continue to believe that we will begin to see a de-escalation in the tariff war later this year, given recent events we need to consider the alternative. Since the creation of the NAFTA our manufacturing supply chains with Mexico have become deeply intertwined with many parts and products crossing the border numerous times. Placing tariffs on this complex system will create significant strains. Our largest imports from Mexico include motor vehicles, oil, electronics, machinery and fruit. This tariff threat also puts the new proposed tariff agreement (USMCA) in doubt and could even lead to the demise of NAFTA (something Trump campaigned on). More importantly it creates significant uncertainty for corporate America with respect to capital spending and hiring plans, important ingredients to future growth. We note with some concern that through April, layoff announcements have increased by 31% versus a year ago as reported by Challenger, Gray & Christmas, Inc.
On the China front we are seeing signs of further fraying of our relationship and it could be nearing a point of irreparable damage. In response to the Trump administration's Huawei ban, China has implied that it may limit U.S. access to China’s production of rare earths and has threatened to blacklist foreign enterprises, organizations and individuals. While we haven’t arrived at a point of no return, we need to begin considering its ramifications.
Certainly an escalating tariff war with our two largest trading partners is not a positive backdrop for risk assets. Equities, both U.S .and international, are likely to continue to sell off with each turn of the tariff screw. While our economy is less dependent upon trade, we believe this economic lens is not the correct way to frame the tariffs with respect to U.S. equities. Sales outside of the U.S. for corporate America is a much larger figure than what is counted in exports. Exports only count products that are delivered from the U.S. and do not count sales of foreign affiliates. For example, shipments of soybeans out of the U.S. are counted as exports, but sales of GM cars produced in China are not. GM sells more cars in China than any other market, though most of those sales are not counted as exports. While slowing sales of GM cars in China would have little to no impact on our economy, it would have a dramatic impact on GM. This economic lens has led some investors to believe that our equity market should provide cover from a tariff war. This has been true year-to-date, though we note that the performance gap has been rapidly narrowing just as the trade picture has become darker. Given late cycle conditions, all-time high profit margins, and higher relative valuations we would suggest that U.S. equities will provide little cushion if the tariff war escalates. We have been advocating a cautious approach to U.S. equities and continue to do so. We suggest investors consider shifting towards areas of unwarranted underperformance where stocks have underperformed while earnings have improved. These would include large cap value stocks and mid-cap stocks.
Positioning within the Emerging Markets has become even more important as the tariff war escalates. The distribution of returns by country, sector, and stock has been increasing, highlighting the importance of active positioning within this large and disparate universe. While we believe a tariff war diminishes the opportunity for the Emerging Markets index in an absolute return perspective, we continue to see opportunity within the index and on a relative basis versus domestic equities.
1 Beta is a measure of the volatility of a fund relative to its benchmark. The beta of a benchmark is 1.00.
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