Yesterday’s announcement by President Trump of imminent tariffs on steel and aluminum imports was taken poorly by global stock markets. Perhaps in an attempt to convince investors this was an incorrect response, early this morning he tweeted that “trade wars are good, and easy to win.” He is wrong, and beyond the simple fact of his wrongness, a trade war is probably more dangerous for investors at this time than at any other time in recent history given the implications it would have for inflation, monetary policy, and economic growth. The only positive from the tariffs is that it is a windfall profit increase for U.S. producers of steel and aluminum, which is at least positive for them. It is unlikely to cause any material increase in U.S. capacity to produce steel and aluminum and therefore unlikely to lead to many additional jobs even in those sectors. The negatives are much more significant. I believe these tariffs on their own will push inflation higher, and higher inflation is a threat to the valuations of more or less all financial assets today (see GMO Quarterly Letter, 3Q 2017: “What Happened to Inflation? And What Happens If It Comes Back?”). But the greater threat is that this escalates into an actual trade war. A trade war would increase prices on a much broader array of goods and services, while simultaneously depressing aggregate global demand. This pushes us in the direction of not just inflation but stagflation, where both valuations and corporate cash flow would be under pressure. While there are scenarios that would be worse for financial markets—the proverbial asteroid on a collision path with Earth comes to mind—a trade war has the potential to be very bad for both the global economy and investor portfolios. As I wrote about last December, a significant inflation problem might well be the worst thing that could happen to a balanced portfolio, leading to losses on the order of 40%. A global trade war would be exactly the kind of economic event that could foreseeably lead to losses of that magnitude.
Trade Wars are Bad
As a general rule, when you add “war” to your description of an event, it’s a pretty strong suggestion that it is unlikely to be either good or easy. Wars are sometimes well intentioned (the war on drugs), occasionally necessary (World War II), but seldom good and more or less never easy to win. Even if you do “win” easily, the longer term implications are often more problematic than you thought (the second Iraq War). There is still some time for this particular war to be averted. But while it is our general contention that equity markets tend to overreact to political and economic events, this is not one of those times.
One obvious point about tariffs is that the entire purpose is to raise prices. Should these tariffs be imposed, higher steel and aluminum prices in the U.S. would not be an unwelcome side effect of the policy, but basically the entire point. If prices for steel and aluminum do not rise, there will be no U.S. jobs created or saved by U.S. based steel and aluminum companies. Furthermore, while U.S. companies would certainly benefit from a pricing advantage relative to their foreign competitors, I believe this is very unlikely to lead to a meaningful increase in domestic production any time soon. Looking at the production of steel and aluminum in the U.S. over time, there is no evidence that there exists a meaningful amount of spare capacity that could be easily and quickly turned on. Exhibit 1 shows the industrial production of steel in the U.S. against its 10 year moving average, and Exhibit 2 shows the same for aluminum.