A perspective from E*TRADE Capital Management, LLC
Economic protectionism on the rise
President Trump has made the inequities of global trade the centerpiece of his economic worldview, castigating China as a rogue trading partner that refuses to play by the rules.1 Recently, Trump has taken shots at the trading practices of America’s traditional allies as well. His solution is to impose punitive tariffs, no matter the collateral damage.
While like-minded protectionists applaud this kind of economic brinksmanship, many economists have discouraged increasing barriers to trade—based both on economic theory and the lessons of history. Former White House economic advisor Gary Cohn even resigned over the issue in March, expressing concerns that the US could become mired in a protracted trade war.
To understand the ramifications of protectionism, it’s instructive to look back in time.
Although economists don’t like tariffs…
A tariff is a tax levied on imported goods, designed to protect domestic producers by making foreign-made goods comparatively more expensive. Classical economic theory dictates that prohibitively high tariffs create economic waste by subsidizing inefficient producers and increasing manufacturing input costs, which are then passed onto consumers.
…they have long been bedrocks of US economic policy
The American colonies broke from Great Britain in part over opposition to tariffs. But that didn’t stop the US from putting up trade barriers as an independent nation. From the customs duties favored by US Treasury Secretary Alexander Hamilton to stiff tariffs imposed by President John Quincy Adams, tariffs were one of the United States’ largest sources of revenue before the advent of the federal income tax in 1913.2
Then there was the granddaddy of them all. In 1930, over the objections of most economists, newly elected President Herbert Hoover signed into law the Smoot-Hawley tariff, which increased import duties by as much as 50%. America’s major trading partners quickly retaliated, spiking import costs just as the country was sliding into recession. Did the Smoot-Hawley tariff cause the Great Depression? Opinion varies, but many historians maintain that, at the very least, it was poorly timed.
Free trade or giving away the store?
Supporters of free trade can look to recent history to make their case. The three decades following World War II coincided with a historic period of economic expansion—interrupted only by the effects of economic malaise and two oil shocks in the 1970s. This era of rising prosperity can be credited in part to reduced trade barriers among the major industrialized nations of the world.
Nonetheless, America’s share of global GDP fell from 40% in 1960 to 25% in 2016, with a significant volume of manufacturing offshored to lower-wage countries.3 Critics of globalization fault free-trade polices like the North American Free Trade Agreement for the decline in American industrial hegemony. These same economic nationalists cite unbalanced trade terms as justification for the resurgent brand of protectionism favored by the Trump administration.
Free-trade advocates counter that structural changes in the US economy are largely to blame for the decline in American manufacturing and that tariffs will hurt the people they are designed to protect—American workers, who will be forced to pay more for everyday household items.
Still, as recent headlines clearly indicate, tariffs retain their emotional appeal as a perceived tonic for all manner of economic ills.
What can investors do?
Recently, the markets have tended to frown on protectionist policies. So far in 2018, equities have consistently sold off following White House tariff threats, although the S&P 500® Index is still in positive territory year to date. If tariffs do indeed lead to a global trade war, investors should not be surprised to see heightened market volatility. Under this scenario, portfolios with higher-quality fixed income securities like investment-grade corporate bonds and Treasuries, may better withstand market turbulence. Within the equity space, small-cap stocks, while not immune from volatility, typically reflect companies that are not as export-dependent as larger companies, which may help mitigate the effects of a potential trade war.
Secondly, investors may wish to keep an eye on inflation if punitive tariffs become the norm. US manufacturers are dependent on China for many inputs that go into manufactured products. A recent study by the Peterson Institute for International Economics found that the majority of items targeted in the president’s $50 billion tariff plan are used in the manufacturing process.4
If inflation does become an issue, investors could evaluate the pros and cons of Treasury Inflation Protected Securities (TIPS). The principal of TIPS adjusts upward or downward with changes in the inflation rate, but TIPS typically yield less than equivalent government bonds without inflation protection. Commodities, too, have historically served as a hedge against inflation, owing to the positive correlation of certain commodities, such as crude oil and agricultural goods, to inflation.
Tariffs could also affect monetary policy, interest rates, and the economy as a whole. If trade wars ultimately slow economic growth or lead to inflationary pressures, the Fed would likely ease the pace of planned rate hikes. A deceleration in economic growth could pressure industrial stocks and financials, but boost the prospects for defensive sectors like health care and utilities.
These are broad issues to consider, but what happens in Washington, D.C., should not change an investor’s overarching strategy. Although adjustments to portfolio allocations are occasionally warranted, maintaining a diversified portfolio that aligns with an investor’s time horizon, risk tolerance, and financial goals is always a sound approach.
Trade wars may seem like the stuff of history books, but given the recent direction of US trade policy, everything old could soon be new again. Stay tuned.
1. “What You Need To Know About President Donald J. Trump’s Actions Responding To China’s Unfair Trade Practicies,” whitehouse.gov, April 6, 2018. https://www.whitehouse.gov/briefings-statements/need-know-president-donald-j-trumps-actions-responding-chinas-unfair-trade-practices/
2. Congressional Research Service, U.S. Federal Government Revenues: 1790 to the Present, congressionalresearch.com/RL33665/document.php?study=U.S.+Federal+Government+Revenues+1790+to+the+Present
3. The World Bank, data.worldbank.org/indicator/NY.GDP.MKTP.CD?end=2016&start=1960
4. Peterson Institute for International Economics, “Trump, China, and Tariffs: From Soybeans to Semiconductors,” piie.com/blogs/trade-investment-policy-watch/trump-china-and-tariffs-soybeans-semiconductors