The current trade policy focuses on tariffs very much. What is a tariff? Let’s start with that. Tariff is essentially an import tax. 

For example, if there is a 15% tariff on Chinese goods, that means that when an American business imports a shipment of products from China, it has to pay the US government a tax that is 15% of the value of that order. The American importer is going to have to certainly negotiate with the Chinese exporter to determine who pays the tariff. If the Chinese exporter pays, then the consumer may not see a price increase at all. Generally speaking though, the tariff is paid by the importer and the extra cost of the tariff gets passed along to the consumer. So why would anyone, much less the President, seemingly intentionally raise prices when people are basically hoping he is going to end inflation and stop price rises.  

That is because tariffs can have an amazing side effect that you are not hearing much about. Tariffs were a really important part of American economic history back in the late 1800s and early 1900s. Here is why American Presidents were making foreign products much more expensive with tariffs in order to protect the wages of American workers. For example, let’s say an American made T-shirt costs $20 because American workers wages add up to $5 per T-shirt. A company in China sees America as a huge market. So they put in a textile mill in China and they hire really cheap Chinese labor that only costs 10 cents per T-shirt. Now because of their extremely poor standard of living, the really long working hours, low wages, the Chinese business can sell T-shirts in America for a dollar each. Now, if there is no protective tariff, the American T-shirt company necessarily will go out of business. Now, obviously we can think it’s great for the American consumer to buy a T-shirt for a buck until we realize that by buying cheap goods made overseas with low prices every day that we are putting American companies out of business and essentially without meaning to do so. 

American consumers have been killing their own jobs. This has been going on for decades but just between 1999 and 2011 for example, lower priced foreign goods eliminated almost 2.5 million high paying manufacturing jobs in the US. This is a phenomenon called “Beggar Thy Neighbor.”  

We get a cheap T-shirt for us, but our neighbor loses $100,000 per year manufacturing jobs, when their T-shirt company folds up. Now, the main function of the President’s tariff is to help out and keep American workers in high paying jobs. The impact of that particular function is that the American consumer will have more money to spend and the price of T-shirt and a lot of other stuff is going to go up a lot. Both of those things. 

So what is the current landscape of the tariffs? Overall there is lot going on. Everyone is making a lot of noise to show toughness and fearlessness and to give their local press red meat to chew on. But this is not a trade war. These are skirmishes. They are testing boundaries and positions. A trade war may come but this is not it. In short the situation is fluid. It is highly unpredictable and this has created substantial volatility in global markets and for the long term value focused investors. What this does is, raise a really important question. How do these rapidly changing tariff negotiations actually and ultimately affect us. Well. Let us take a look.

How tariffs affect the Stock Market?

There are four key points.

Margin Compression

Industries that rely heavily on imported goods like automotive, semiconductors, consumer products and manufacturing are going to face higher input costs because of importing stuff that they put into their products. This will cause two things. Number one, higher prices to the consumer and in the short term a squeeze on profit margins. Let us take US automakers like Ford and GM which rely on imported parts, many from Mexico. If tariffs are imposed and maintained on Mexican imports then their costs go up as they pay the tariff when importing the car parts into America. At that point, they have two choices, one absorb the extra cost which reduces their profitability. That is margin compression. Or else pass it on to customers which could lead to higher prices and lower sales. So the first big point for investors is that shrinking margins are likely and that is going to cause P/E ratios to shrink as well, perhaps back to the historical norm of 15 or so from where it has been lately in the 20s. Now that will result in a major market reset downward or there is going to be a flat market for years to absorb those import duties. Either way, investors should look for many more opportunities to buy great companies at fair prices. So, it is kind of good news. In the long run, protecting American wages with tariffs could make life better for the middle class even while things get more expensive. As that happens, margins are going to recover and even expand. Margin compression will not last long, so investors should take advantage of the margin of safety prices when available. 

Inflation

The second thing tariffs can contribute to is inflation for sure, especially in the short run. When import prices rise, companies tend to pass on those additional costs, meaning we consumers end up paying more for everyday goods. If wages do not keep up with rising prices, this by definition is inflation. We are going to get a lot less stuff for the same money. As time goes along, this stuff is more likely to be American made which also means higher wages to match those higher prices.

Trade Retaliation

One another consideration is the potential for other countries to fight back and play tariffs on the US to the degree that each side feels the tariffs to be unfair. These skirmishes will turn into a full blown trade war. Trade retaliation risks are especially concerning for those big American multinational businesses. 41% of the S&P 500 total earnings now come from foreign markets. American goods could become more expensive in foreign markets leading to fewer sales. On the other hand, negotiating with tariffs could and should open up markets to American products that are now closed. We don’t sell a lot of Fords in Japan, Korea and China. Well may be we will start. So it is not the doom and gloom the press likes to foretell. They love negativity. But keep in mind that the press only produces negativity because it sells press. Lot of good things can happen and are happening but you will not hear about that in the news. Positive things takes time to develop. Negative things happen fast. It takes a while to build a house. It will not make the front page, but if it burns down in an evening, it is front page news. 

Never Bet Against America in the Long Run

Now, the last consideration for investors is that you do not want to bet against America in the long run. It might be bumpy. We might have some great opportunities because of that. Remember we like volatility because it increases the chances that great companies on our watch list drop to a price that gives us a margin of safety.

Tariffs can create volatility and that is the real opportunity for us. Volatility brings mis-pricing and mis-pricing is where we find our margin of safety. If a great business gets temporarily beaten up by the headlines that could be your moment.

Courtesy: Rule 1 Investing