Examining the Impact of Tariffs

by FS

Markets are rebounding today after yesterday’s precipitous fall, in which the S&P 500 and Dow Jones Industrials both experienced their worst day in four months. But make no mistake – the short-term trend remains down.

S&P 500 May 2019
Source: Stockcharts.com. Note: Past performance is no guarantee of future results

Yesterday’s decline halted at a key technical spot – the 2810 level that marked prior resistance from October through March. That signals to me that much of today’s move is a technical, trader driven bounce. These are common as the market slowly adjusts to a new narrative (renewed trade tensions).

Before we get into the meat of today’s article, I want to briefly point out that we are now at the beginning of the market’s seasonally weak period, encapsulated by the old adage, “Sell in May and go away.”

While this seems like a silly, superfluous way to guide investment behavior, it must be noted that there is a substantial amount of merit to this idea. The table below, from Bespoke Investment Group, demonstrates the significant outperformance seen during the November to April period each year.

S&P 500 sell in may returns
Note: Past performance is no guarantee of future results

This doesn’t mean that you should always exit the market from May to October (the long-term returns are positive, after all) but it does mean you should temper your expectations and perhaps err on the side of caution. When you consider that valuations have run up considerably from the December 24thlow, and that profit growth is essentially flat, it adds to the concern.

Speaking of profits, let’s check in quickly to see how this earnings season is holding up.

As of last Friday, 90% of the S&P 500 had reported, with 76% of those companies reporting better than expected earnings. The first quarter blended earnings growth (including actual results for those companies who have reported and estimates for those that haven’t) stands at -0.5%. This is better than was initially estimated, but still represents no growth.

On the revenue side, the blended revenue growth rate for the first quarter stands at 5.3%. This is the lowest revenue growth rate since Q2 2017, but at least we’re seeing some top line growth. The culprit for rising revenue but flat earnings is of course declining margins, which we discussed two weeks ago.

The last item worth noting regarding earnings is the continued discrepancy between domestic vs. internationally oriented firms. Those companies that get the majority of their revenue from overseas are being hurt by the strong dollar, slower global economic growth and trade tensions. You can see the effect of this in the chart below (courtesy of FactSet).

earnings growth

In case the chart is difficult to read, the blue bars represent companies that get the majority of their revenue from inside the U.S., while the green bars represent those firms that receive the bulk of their revenue from overseas. The left set of bars represent earnings growth, while the right set of bars depict revenue growth.

Alright, now let’s tackle the topic that’s currently driving the market – trade tensions.

I want to begin by clarifying something that seems like common knowledge, but based on the media’s reaction in recent days, apparently isn’t. It has to do with who pays the cost of tariffs.

Over the past year, Trump has repeatedly espoused his love for tariffs, suggesting over and over again that China pays the tariffs. This, like a lot of other stuff he says (see this fact checker site for more) is not exactly true.

When tariffs are imposed on a foreign country’s goods or services, those additional costs are paid by the companies who are importing those goods – namely, American companies. Those costs are then either absorbed by the firms themselves (resulting in lower margins, as we’re seeing), or they’re passed along to the consumer, resulting in higher prices (which we’re not really seeing yet – at least not in aggregate).

The damage to the foreign country’s economy comes not from having to actually pay the tariffs themselves, but from the reduced demand for their goods and services that comes from OUR firms having to pay the tariffs. The premise is that American importers will attempt to maximize profits and shareholder value by sourcing those goods elsewhere (either domestically or from a different country).

It’s the same when China applies tariffs to American goods – Chinese firms will pay that cost, but our companies must figure out a way to manage the reduction in demand.

For most of you, this is probably very basic, but it took a conversation between Larry Kudlow – Trump’s chief economic advisor, and Chris Wallace on Sunday to seemingly get this out into the public sphere. Since then, it’s drawn an inordinate amount of media attention.

One particular line of reasoning this has sparked is that the additional proposed tariffs could cause inflation to rise substantially, which would then lead to the Fed having to tighten monetary policy – thus potentially forcing the economy into recession.

While I would never rule out the possibility of the Fed overtightening and causing a recession (they’re quite good at that), I highly doubt this sequence of events will play out. This is due to how the Fed’s overall approach is shifting.

First, in recent post-FOMC meeting press conferences, Fed chairman Jerome Powell has repeatedly emphasized the notion of “transitory factors” as justification for why the Fed has not lowered interest rates in response to declining inflationary pressure. Their willingness to look past these temporary price events suggests that a bump in inflation as a result of tariffs would be viewed in the same light – as being temporary.

In addition, the Fed is looking for, and indeed wants, higher inflation than we have currently. As discussed previously, recent Fed discussions have involved the possible adoption of a new inflation targeting framework. Rather than simply trying to keep inflation near 2% at all times, the Fed is considering a policy framework that involves looking at inflation over longer periods of time, such as the entire business cycle. In this type of framework, inflation would be allowed to run hot (over 2%) to compensate for the many years we’ve had in which inflation was below that target.

Together, these two factors, in addition to Mr. Powell’s willingness to listen to the markets, suggests to me that we don’t have to worry about tariffs forcing the Fed’s hand.

That said, I do think it’s worth pointing out that the logic behind tariffs raising overall consumer prices is not flawed. Indeed, we’re already seeing that to some extent. The chart below was created by Goldman Sachs and breaks changes in the Consumer Price Index (CPI) into two categories: tariff-impacted, and all other goods.

tariffs inflation

As you can see, there has, in fact, been a substantial increase in the prices of tariff-impacted goods. It’s just that this increase has been diluted by the price changes of non-impacted goods, which have continued to fall. (On a side note, this means that inflation would actually be even further below the Fed’s target if these tariffs were not in place.)

Current estimates suggest that consumer goods account for roughly 25% of the items that currently have tariffs. However, consumer goods make up about 60% of what’s left of imports from China that could become subject to tariffs. This means that if those additional tariffs are enacted, and if they hang around for long enough, we’ll need to begin monitoring inflation more closely.

But for now, I think it’s still too early to get our panties in a wad. This is a very fluid environment and things could change quickly.

Getting back to the markets, I’ve suggested in recent months that we most likely remain in a range-bound type of environment, as there are few catalysts in my mind to push markets significantly higher (corporate profit growth is lackluster, multiples have already risen significantly and global growth remains weak) or lower (immediate recession risk remains low).

I still think that’s an accurate characterization and that a moderate position in stocks is warranted. I’ve also mentioned the benefits of trading around a core position during periods like this, in order to try and generate some returns while the market moves sideways.

With this current correction in its initial phase, I think we could see the market head lower over the next couple of weeks. I’d be surprised if the S&P didn’t at least touch its 200-day MA, or fall below it. That’s where my interest would begin to pique as a buyer. Keep in mind, however, that we remain in a headline driven environment and that news, particularly around trade, could cause some sharp swings in either direction.

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