Tariffs & Interest Rate Hikes - Does This Mean Doom & Gloom For Stocks?

March 6, 2018

Tariffs & Interest Rate Hikes – Does This Mean Doom & Gloom For Stocks?

  • Last week was an eventful week for stocks. Today, we’ll discuss the long term impact of what has been going on.



Introduction

So last week was another down week for the S&P 500 and from what’s going on, it looks like it’s something we should get accustomed to.

Figure 1: S&P 500 weekly decline started during Jerome Powell’s testimony and exploded after Trump’s statements. Source: CNN Money.

Last week started ok but then the FED chair gave his very upbeat testimony about the economy, business sentiment, and investments. This all should be positive for stocks, right?

Well, no, because a strong economy leads to a higher inflation rate and more tightening, or better to say, earlier normalization of financial markets. Also, a simulative fiscal policy should further spur inflation. The fiscal stimulus, which is a questionable thing to do when you constantly run budged deficits and are in the late part of the economic cycle—but more on that another time,—will further increase economic activity and expectations.

All of this increased the expectation that the FED might hike rates as many as 4 times in the next 12 months which pulls down asset prices because interest rates act on asset values like gravity, to quote Buffett.

Figure 2: Chances for 4 FED hikes in 2018. Source: WSJ – The Daily Shot.

All of the above wasn’t that impactful as strong economics counter higher interest rates and the FED is expected to balance it all out, but then Trump introduced tariffs. Now, I never go into politics and I will avoid doing that here, but I can talk about the macroeconomic part of the story which has two sides.

On Wednesday, President Trump said that the plan was to impose tariffs of 25% on steel and 10% on aluminum. Such tariffs might help U.S. steel producers in the short term and give Trump the votes he needs but at the same time, higher input costs might make U.S. products more expensive and less competitive while also further spurring inflation. The point is that there is no free lunch in economics. Nevertheless, tariffs aren’t necessarily a bad thing, especially for the U.S. in this environment.

However, Europe, Canada and others might impose countermeasures which could ignite a trade war which wouldn’t be good for anyone in the long term. The quality of our current lives can be thanked to global trade, not protectionism. But on the other hand, it looks like the U.S. is getting the shorter end of global trade dynamics and a renegotiation of trade deals won’t necessarily end badly.

I hope Trump will call full trade war a bluff and say that he won some deals with such a statement and that it won’t lead to a global contraction in trade. Nevertheless, let’s look at the U.S. balance of trade.

Figure 3: The U.S. balance of trade looks terrible. Source: Trading Economics.



From a broader perspective, the current account net income and direct payments looks even worse.

Figure 4: The U.S. current account. Source: Trading Economics.

This simply means that a country spends more than it produces and the economy is financed by debt. The more debt you have, the more you are dependent on others and under the influence of interest rates which can be set by the FED up to a point but can also be set by those who hold and repurchase those bonds and other debt instruments.

Also, other countries produce and improve their technologies while by focusing on imports, an economy renounces its productivity, production capacity, and competitiveness.

From such a perspective, Trump’s action plan might look favorable but this is a two edged sword. Higher import and input costs will make many products more expensive. Think of the same infrastructure projects Trump has been talking about – higher interest rates and higher raw material prices will weigh on that. On the other hand, more domestic labor might be used but where are you going to find additional labor when the unemployment rate is extremely low and the participation rate is stable? The conclusion is higher inflation, a faster path to interest rate normalization, and lower asset prices. If that isn’t managed well, all can lead to a recession and if foreign creditors lose confidence in U.S. debt, the debt party could be over quickly.

On the other hand, if all is managed well in the long term, it might end well and improve the position of the U.S. from a global perspective but will probably continue to have a short term negative impact on the markets.



What To Do

I’ve been warning about the risks of investing in stocks for a long time now. It’s unfortunate, but the markets and economies always work in cycles. The key is to have a strategy that will work best for you in all environments in relation to your financial and life goals.

As for timing the market, the best way is to think about it in a risk reward way where the best the markets can give over the next 10 years or 20 is a 5% to 6% return as this is what their earnings show. On the other hand, the risks have just been piling up, so I wouldn’t be surprised with a 50% drop. You make the call for how much exposure you want, the key is to sleep well in your whole investing life cycle.

Further, given how the market is structured and that the new age of things is here, stock picking might again see its place in the sun as ETFs will be forced to sell everything they own no matter the quality.