Tariffs for Boarder Security... probably not a good idea!

On Thursday, President Trump announced plans to impose tariffs on all imports from Mexico in an effort to stop migrants crossing into the U.S.  The tariff, effective June 10th, would begin at 5% and escalate at 5% intervals to a maximum of 25% in October.  The U.S. has never previously used blanket tariffs against another country; the President’s authority to do so is unclear.  The markets’ response was extremely negative; with all of the major indices declining for the week.  The Russell 2000® Index (-3.21%) led the markets lower followed by Dow Jones Industrial Average (-3.01%), S&P 500® Index (-2.62%) and Nasdaq (-2.41%).  The S&P 500® ended the week at 2752; analysts had considered 2800 the lower end of the trading range below which the Index could further deteriorate. 

Markets prefer predictability.  The break in U.S. and China negotiations; on-going tariff threats on European and Japanese autos and the latest threat of tariffs on imports from Mexico, our major trading partner, reinforce fears that tariffs will undermine global economic growth.  Equity and bond markets have long relied on stability in international trade policy; the latest move is, unsurprisingly, creating jitters as it also threatens passage of new NAFTA Agreement.  Meanwhile, in the absence of new developments in trade negotiations with China, investors are hopeful of framework discussions between Presidents Trump and Xi at next month’s G20 meeting.  The lengthy negotiations are prompting major corporations to reduce their reliance on China for supplies and products.  Clearly, these actions would negatively impact the Chinese economy; more generally, though, and despite the media posturing, both countries need a trade agreement.

We haven't been worried about a trade conflict with China, which has a long track record of pirating intellectual property and is a potential military rival in the (not too distant) future. The US has enormous leverage with China, given our trade deficit with the country and the ability of firms to shift supply chains toward alternatives, like Vietnam, Mexico, and India. 

However, we are more concerned about President Trump's recent tariff threat toward Mexico if they don't cooperate to stem the flow of migrants from Central America. Using tariffs to achieve policy goals outside of foreign trade makes it much more difficult for international companies to plan ahead. 

If the President imposes these tariffs, who knows what's next? Could he use tariffs to persuade NATO allies to spend more on their militaries? Could a future president use tariffs to try to get other countries to comply with stricter CO2 emissions standards? The range of outcomes quickly widens, which means businesses will have to allocate capital according to political calculations, which means less efficiently.

Before the most recent threat, we thought the odds a recession in the next year were about 10%. Now, we think they're more like 15 - 20%; still low, but higher enough to warrant some extra concern. As a result, we will be watching the data flow over the next couple of months even more closely than usual for signs of broad economic weakness. The economy grew 2.5% in 2017 and 3.0% in 2018 because of a combination of deregulation and tax cuts. Protectionism and added uncertainty could offset those positives. 

So far, we don't see signs of weakness; the economy keeps humming along. No deal with China and higher tariffs on Mexico (and perhaps others), doesn't mean recession, but instead a return to roughly 2.0% Plow Horse growth. We estimate that the impact of the tariffs net of the benefits of tax cuts and deregulation roughly equal the negative effects of President Obama's tax hikes and regulation.

Some are calling for the Federal Reserve to cut interest rates to offset this damage, but we don't think rates need to be lower to boost growth. Does anyone seriously think there are firms that are not investing because the Fed has lifted short-term rates to 2.375%? In addition, there are still $1.4 trillion in excess bank reserves.

We understand the fear of a wider trade war but don't think it will happen. We continue to believe markets will push policymakers in the right direction. However, a return to the Plow Horse economy is still possible. Remember, though, even then stocks rose substantially. Investors who stay calm while others panic will continue to be rewarded. 

The decline in oil prices, the largest in six months, is another economic story as Brent crude fell to $61.76 per barrel and West Texas fell to approximately $53 per barrel.  Fears of economic damage from trade disputes and increasing U.S. oil reserves from higher production weigh on the market.  Lower production in Russia and other countries have not eased oversupply concerns.  Commodity prices are typically volatile as traders respond to current assessments of supply and demand.  OPEC continues to support production cuts to rebalance the market while U.S., lenders and investors pressure oil companies for improved profitability.  Winter weather and spring flooding have also impacted the U.S. markets; analysts look to the summer driving season for a better assessment of U.S. inventories.

The market declines in May have eroded the gains following the December sell off.  Investors and companies are cautiously monitoring trade as well as looking for signs that the Federal Reserve may lower interest rates to support a weakening economy.  The Fed has indicated its vigilance to economic changes and willingness to reduce rates if necessary.  The markets will weather the storm; however, volatility is likely to remain elevated until tangible evidence of a breakthrough in trade policies emerges.

Source: Pacific Global Investment Management Company

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.


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