“You load sixteen tons, what do you get?
Another day older and deeper in debt
Saint Peter don’t you call me ’cause I can’t go
I owe my soul to the company store” – Sixteen Tons by Tennessee Ernie Ford
Shortly following Donald Trump’s election victory we penned a piece entitled Hoover’s Folly. In light of Trump’s introduction of tariffs on steel and other selected imports, we thought it wise to recap some of the key points made in that article and provide additional guidance.
While the media seems to treat Trump’s recent demands for tariffs as a hollow negotiating stance, investors are best advised to pay attention. At stake are not just more favorable trade terms on a few select products and possibly manufacturing jobs but the platform on which the global economic regime has operated for the last 50 years. So far it is unclear whether Trump’s rising intensity is political rhetoric or seriously foretelling actions that will bring meaningful change to the way the global economy works. Either as a direct result of policy and/or uncharacteristic retaliation to strong words, abrupt changes to trade, and therefore the role of the U.S. Dollar as the world’s reserve currency, has the potential to generate major shocks in the financial markets.
The following paragraphs are selected from Hoover’s Folly to provide a background.
In 1930, Herbert Hoover signed the Smoot-Hawley Tariff Act into law. As the world entered the early phases of the Great Depression, the measure was intended to protect American jobs and farmers. Ignoring warnings from global trade partners, the new law placed tariffs on goods imported into the U.S. which resulted in retaliatory tariffs on U.S. goods exported to other countries. By 1934, U.S. imports and exports were reduced by more than 50% and many Great Depression scholars have blamed the tariffs for playing a substantial role in amplifying the scope and duration of the Great Depression. The United States paid a steep price for trying to protect its workforce through short-sighted political expedience.
Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business-friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.
From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.
The Other Side of the Story
The President recently tweeted the following:
Regardless of political affiliation, most Americans agree with President Trump that international trade should be conducted on fair terms. The problem with assessing whether or not “trade wars are good” is that one must understand the other side of the story.
Persistent trade imbalances are the manifestation of explicit global trade agreements that have been around for decades and have historically received broad bi-partisan support. Those policies were sponsored by U.S. leaders under the guise of “free trade” from the North American Free Trade Agreement (NAFTA) to ushering China in to the World Trade Organization (WTO). During that time, American politicians and corporations did not just rollover and accept unfair trade terms; there was clearly something in it for them. They knew that in exchange for unequal trade terms and mounting trade deficits came an implicit arrangement that the countries which export goods to the U.S. would also fund that consumption. Said differently, foreign countries sold America their goods on credit. That construct enabled U.S. corporations, the chief lobbyists in favor of such agreements, to establish foreign production facilities in cheap labor markets for the sale of goods back into the United States.
The following bullet points show how making imports into the U.S. easier, via tariffs and trade pacts, has played out.
Bi-partisan support for easing multi-lateral trade agreements, especially with China
One-way tariffs or producer subsidies that favor foreign producers were generally not challenged
Those agreements, tariffs, and subsidies enable foreign competitors to employ cheap labor to make goods at prices that undercut U.S. producers
U.S. corporations moved production overseas to take advantage of cheap labor
Cheaper goods are then sold back to U.S. consumers creating a trade deficit
U.S. dollars received by foreign producers are used to buy U.S. Treasuries and other dollar-based corporate and securitized individuals liabilities
Foreign demand for U.S. Treasuries and other bonds lower U.S. interest rates
Lower U.S. interest rates encourage consumption and debt accumulation
U.S. economic growth increasingly centered on ever-increasing debt loads and declining interest rates to facilitate servicing the debt
Trade Deficits and Debt
These trade agreements subordinated traditional forms of production and manufacturing to the exporting of U.S. dollars. America relinquished its role as the world’s leading manufacturer in exchange for cheaper imported goods and services from other countries. The profits of U.S.-based manufacturing companies were enhanced with cheaper foreign labor, but the wages of U.S. employees were impaired, and jobs in the manufacturing sector were exported to foreign lands. This had the effect of hollowing out America’s industrial base while at the same time stoking foreign appetite for U.S. debt as they received U.S. dollars and sought to invest them. In return, debt-driven consumption soared in the U.S.
The trade deficit, also known as the current account balance, measures the net flow of goods and services in and out of a country. The graph below shows the correlation between the cumulative deterioration of the U.S. current account balance and manufacturing jobs.
Data Courtesy: St. Louis Federal Reserve (NIPA)
Since 1983, there have only been two quarters in which the current account balance was positive. During the most recent economic expansion, the current account balance has averaged -$443 billion per year.
To further appreciate the ramifications of the reigning economic regime, consider that China gained full acceptance into the World Trade Organization (WTO) in 2001. The trade agreements that accompanied WTO status and allowed China easier access to U.S. markets have resulted in an approximate quintupling of the amount of exports from China to the U.S. Similarly, there has been a concurrent increase in the amount of credit that China has extended the U.S. government through their purchase of U.S. Treasury securities as shown below.
Data Courtesy: St. Louis Federal Reserve and U.S. Treasury Department
The Company Store
To further understand why the current economic regime is tricky to change, one must consider that the debts of years past have not been paid off. As such the U.S. Treasury regularly issues new debt that is used to pay for older debt that is maturing while at the same time issuing even more debt to fund current period deficits. Therefore, the important topic not being discussed is the United States’ (in)ability to reduce reliance on foreign funding that has proven essential in supporting the accumulated debt of consumption from years past.
Trump’s ideas are far more complicated than simply leveling the trade playing field and reviving our industrial base. If the United States decides to equalize terms of trade, then we are redefining long-held agreements introduced and reinforced by previous administrations. In breaking with that tradition of “we give you dollars, you give us cheap goods (cars, toys, lawnmowers, steel, etc.), we will most certainly also need to source alternative demand for our debt. In reality, new buyers will emerge but that likely implies an unfavorable adjustment to interest rates. The graph below compares the amount of U.S. Treasury debt that is funded abroad and the total amount of publicly traded U.S. debt. Consider further, foreigners have large holdings of U.S. corporate and securitized individual debt as well. (Importantly, also note that in recent years the Fed has bought over $2 trillion of Treasury securities through quantitative easing (QE), more than making up for the recent slowdown in foreign buying.)
Data Courtesy: St. Louis Federal Reserve
The bottom line is that, if Trump decides to put new tariffs on foreign goods, we must presume that foreign creditors will not be as generous lending money to the U.S. Accordingly, higher interest rates will be needed to attract new sources of capital. The problem, as we have discussed in numerous articles, is that higher interest rates put a severe burden on economic growth in a highly leveraged economy. In Hoover’s Folly we stated: Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.
It seems plausible that a trade war would result in potentially controversial intervention from the Federal Reserve. The economic cost of higher interest rates would likely be too high a price for the Fed to sit idly by and watch. Such policy would be controversial because it would further blur the lines between monetary and fiscal policy and potentially jeopardize the already tenuous independent status of the Fed.
Importantly, this is not purely a problem for the U.S. Still the world’s reserve currency, the global economy is dependent upon U.S. dollars and needs them to transact. Any disruption in economic activity as a result of rising U.S. interest rates, the risk-free benchmark for the entire world, would most certainly go viral. That said, for the godless Communist regimes of China and Russia, a moral barometer is not just absent, it is illegal. Game theory, considering those circumstances and actors, becomes infinitely more complex.
Investors concerned about the ramifications of a potential trade war should consider how higher interest rates would affect their portfolios. Further, given that the Fed would likely step in at some point if higher interest rates were meaningfully affecting the economy, they should also consider how QE or some other form of intervention might affect asset prices. While QE has a recent history of being supportive of asset prices, can we assume that to be true going forward? The efficacy of Fed actions will be more closely scrutinized if, for example, the dollar is substantially weaker and/or inflation higher.
There will be serious ramifications to changing a global trade regime that has been in place for several decades. It seems unlikely that Trump’s global trade proposals, if pursued and enacted, will result in more balanced trade without further aggravating problems for the U.S. fiscal circumstance. So far, the market response has been fidgety at worst and investors seem to be looking past these risks. The optimism is admirable but optimism is a poor substitute for prudence.
In closing, the summary from Hoover’s Folly a year ago remains valid:
It is premature to make investment decisions based on rhetoric and threats. It is also possible that much of this bluster could simply be the opening bid in what is a peaceful renegotiation of global trade agreements. To the extent that global growth and trade has been the beneficiary of years of asymmetries at the expense of the United States, then change is overdue. Our hope is that the Trump administration can impose the discipline of smart business with the tact of shrewd diplomacy to affect these changes in an orderly manner. Regardless, we must pay close attention to trade conflicts and their consequences can escalate quickly.