The stock market’s performance in 2017 was virtual perfection—above average gains and record low volatility. We believe a key catalyst was a supportive policy environment. On the fiscal front, a large tax cut and reform package was very well received by American business, as was the lighter regulatory touch of the Trump Administration relative to its predecessor. Meanwhile, the Federal Reserve took a leisurely approach to raising interest rates, which remained well below average.
Policy has taken a less constructive turn for financial markets so far in 2018. The new Fed Chairman appears to have subtly shifted priority toward inflation-fighting, raising the odds of four rate hikes this year rather than the three currently embedded in consensus expectations. We do not view that as a dramatic change, and in fact is consistent with our own forecast. However, at the margin, it is less constructive for stock and bond markets.
The recent news on trade policy is more consequential. During the 2016 campaign, Donald Trump expressed deep skepticism about free trade, believing that it has hurt American industry and negatively impacted the middle class. The Administration was largely silent on the issue during the President’s first year in office, but that has changed in recent weeks. First, the Administration imposed tariffs on imported washing machines and solar panels. On Thursday, President Trump signaled his intent to impose steep tariffs on steel and aluminum imports (reportedly 25% and 10%, respectively). Stock market reaction was swift and negative, contributing to an already volatile start to the year.
WHY ARE INVESTORS WORRIED ABOUT TRADE POLICY?
Classical economic theory is supportive of unfettered global trade as a way to bolster economic growth and productivity, thereby improving standards of living and the environment for financial assets. Not everyone believes this, but market participants generally do. Actions viewed as protectionist like tariffs or quotas are considered threats to the global trade regime.
Here are some of the potential risks raised by the trade news:
Raises the likelihood of retaliation and a “trade war”
The market worries have little to do with the impacted industries, which collectively are a small part of the U.S. economy. The bigger risk is that trade restrictions imposed by the U.S. will be met by retaliation from other countries against American products exported overseas, the U.S. will respond further, and a self-defeating trade war could ensue. We are a long way from a full blown trade war, but if the President follows through on his intentions investors should expect other countries to retaliate.
Tariffs are taxes and create more losers than winners.
There are about 80,000 U.S. employees working in metals manufacturing (i.e. aluminum and steel), and six million employees who work for the customers of steel and aluminum companies who may experience cost increases as a result.1 Looked at another way, on the day the President signaled his intention on these tariffs, U.S. Steel’s stock was up 4.7%. Two big consumers of steel and aluminum—General Motors and Boeing—were both down about 4%. The market capitalization of U.S. Steel is $7.7 billion, but GM is seven times that size and Boeing is bigger by a factor of twenty five.2
There may be more confrontational trade decisions coming soon.
The Administration is reportedly preparing a series of tariffs and other penalties on China for alleged theft of intellectual property. This would be a much bigger deal than the steel and aluminum tariffs, both in terms of dollar value and the optics of the world’s two biggest economies in a trade battle.
Not a good leading indicator for the NAFTA negotiations.
China is not the leading exporter of steel and aluminum to the U.S.—Canada is. Mexico is the fourth largest exporter of steel to the U.S.3 The President’s announcement on steel and aluminum occurred right in the middle of the current round of negotiations on re-working NAFTA. Needless to say, both countries were displeased. The NAFTA negotiations do not appear to have gone particularly well so far, and markets perceive that a more strident protectionist approach by the U.S. raises the risks of NAFTA falling apart. That would be a truly damaging “risk off” development for financial markets. However, it is also possible that after the hard line taken on steel and aluminum, the Administration has burnished its tough on trade image, and tacks to a more conciliatory approach on NAFTA.
ECONOMIC AND MARKET IMPLICATIONS
Any assessment of market fundamentals consists of a list of positives and negatives. We would place the current direction of trade policy squarely in the negative column. However, there remain some very supportive positive factors. Namely, we continue to see a solid year of growth for both the economy and corporate profits. Our stock market view for 2018 can be summed up as “the bull market continues, but with a lower return trajectory and more volatility than last year.” The trade issue feeds right into the volatility part of the story.
It is also important to remember how global trade tensions usually play out. Trade wars that cause the global flow of goods and services to seize up are bad for everyone—akin to economic mutually assured destruction. This historical lesson has meant that most trade disputes usually play out more as skirmishes than wars. We will be closely following developments related to China and NAFTA in the weeks ahead.
Dave Donabedian is chief investment officer of CIBC Atlantic Trust Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.
1 FTN Financial, 03.02.2018
2 Bloomberg, 03.02.2018
3 Evercore ISI, 03.02.2018.
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