Jul 19, 2018
Talk of trade wars and tariff hikes dominate the financial news. It has become difficult to go through a day in which we aren’t sidetracked by headlines speaking of protectionism and the destruction of free trade.
Despite this negative overtone, the US economy is on track to perform better than it has since the early 2000’s. For instance, job openings are at historic highs and companies are scrambling to find and retain qualified talent. Manufacturers specifically are reporting that their growth opportunity is so strong that their performance is being throttled by a talent and labor shortage. We also hear the same challenges being echoed across construction, transportation, healthcare, and many other sectors.
These are signs of a rapidly growing economy, one that could easily hit 3.3% annualized GDP growth for the first time in more than 14 years, since well prior to the Great Recession.
However, many credit managers are concerned that trade disputes and the imposing of higher tariffs could derail economic growth. It’s probably a useful time to review the data to see if our fears are justified, to know what the macroeconomic impact of proposed and implemented tariff risk is.
The Numbers
US foreign trade in 2017 totaled $5.231 trillion ($2.3 trillion in exports and $2.9 trillion in imports) according to the US Census Bureau. This accounted for approximately 27% of the US economy’s GDP of $19.39 trillion in 2017.
The Tax Foundation assessed the total impact of 1) enacted tariff hikes to date and 2) ‘announced’ (speculative) tariffs and found that the long-run net negative impact to GDP would be approximately $117.66 billion.
“If all tariffs announced by both the United States and foreign jurisdictions thus far were fully enacted, U.S. GDP would fall by 0.47 percent ($117.66 billion) in the long run, effectively offsetting one-quarter of the long-run impact of the Tax Cuts and Jobs Act. Wages would fall by 0.33 percent and employment would fall by 364,786.” – Tax Foundation, 2018
Not to make light of trimming US GDP by $117.66 billion, but that’s .006% of total US annual GDP. If we just focused on the data lone, it would seem to make light of the overall risk of tariff hikes to the US economy.
And, proponents of tariff hikes will suggest that it helps safeguard and protect intellectual property rights that would eventually overcome and far exceed the $117 billion GDP impact.
Risk: It’s in the Rest of the Story
But, this isn’t the full story. In a rare moment (for those of you that know me), I’m going to go beyond the data and say that there’s another side to the current climate that creates real risk. And, there are two specific areas to focus on.
First, there is no doubt that some individual companies in secular industries are experiencing a much more difficult trade environment. Individual companies that are in industries that get caught up in the trade dispute crossfire are already seeing more difficult operating conditions.
Some are getting caught in raw material and input price ‘shocks’ (raw material prices have increased by as much as 25-30% for some commodities). In the latest Institute for Supply Management’s (ISM) Report on Business© for manufacturing, every commodity class in the study reported higher month-over-month price increases. But, only a small portion of these were due to tariff issues.
Some commodities were hit by trade war fears and companies stockpiled those raw materials throughout Q2, creating spot shortages in some of those categories.
The ISM reported that aluminum, capacitors, electrical and electronic components, freight services, resistors, steel-based products and hot rolled steel were all in short supply. All but two of those commodities have just recently shown up on the shortage list, suggesting that it is largely due to stockpiling activity because of tariff fears, and less about the actual tariffs themselves.
Steel, aluminum, and lumber are the exclusions in that list. Those are areas that have been directly impacted by changes in tariffs.
Moreover, the US economy has become far more competitive and consumers are able to more easily price shop than ever before. This factor can make it difficult (for companies with strong competition) to increase prices to offset higher production costs. Higher input prices, plus a ceiling on output prices, can strain operating income. That’s where the real risk surfaces.
It’s at this point that those companies with a diversified and dynamic supply chain can more easily flex, stretch, and divert sourcing to weather this trade tariff storm. Credit managers must think ahead and ask pertinent questions to understand how a particular customer or client is hedging their sourcing against secular tariff risk.
Answering a series of questions can help you in understanding risk that might not be showing up in the financials – at least not yet.
- How diversified is a company’s global sourcing strategy?
- Is the company in a highly competitive industry, or do they have product/service scarcity or uniqueness (which allows them to increase selling prices to offset higher operating costs)?
- Intuitively, how price sensitive is their customer base? Are there lower cost substitutes for the product or service that might create an impact in ‘share of wallet’?
- Is the company increasing obsolescence or cost of capital risk by stockpiling raw materials or finished products? This could ultimately lead to significant discounting or liquidity problems if sales aren’t strong enough to keep inventory turns within a reasonable range.
There are many other questions that could be important for your particular situation, but the idea is to ask questions that might lend themselves to understanding how exposed a company might be to tariff shocks.
Second on our list of items to watch is corporate executive sentiment. Many prominent figures in the financial community are warning that executives are beginning to allow negative outlooks on trade to affect their investment and spending plans. It’s fear. The risk of this fear spreading and becoming a contagion on companies that have no risk or exposure to trade tariffs is a much bigger risk.
Since the 1940’s, private domestic investment has been one of the primary drivers of global growth. Historically, when private investment dipped below zero year-over-year, it led to every recession since the 1940’s; and in nearly every case, preceded the recession.
Long before executives get directly impacted by trade tariff hikes, they could succumb to trade fears. Federal Reserve Chairman Jerome Powell mentioned that there is already anecdotal evidence of executives changing their investment plans because of trade risk fear.
Again, (turning to the data) FactSet reported in a recent Earnings Insights report that the percentage of S&P 500 executives mentioning tariff risk as having a negative impact on earnings in Q2 or in coming quarters was very low (granted it’s still early in earnings season at this time).
In order of importance, executives mentioned these as being the most worrisome factors for future earnings:
- Currency exchange and the value of the dollar
- Raw material costs and general inflation
- Transportation and freight costs
- Oil and gas prices
- Wage and labor costs
- Weather
- Europe
- Tariffs
There is no question that trade tariff risk is dominating the media. And at some point, this negative overtone could indeed have a significant impact on executive sentiment and would be responsible for creating heightened credit risk. It’s not showing yet in sentiment data, but anecdotes suggest that it’s a growing risk.
Based on economic data alone, the impact of higher tariffs is minimal at this time. And even in the long-run, the direct impact of tariff hikes has more of a secular impact on individual companies and industries; far more so than any macroeconomic impact.
Keep an eye on weekly developments on the trade front. It’s topical. It’s current. We can’t run from it. And, eliminating trade tariff risk could create just as many problems as hiking tariffs.
A great experiment just started as the EU and Japan signed an open, free trade agreement this month. Certain industries in both countries will see new competition unlike any in recent history as the borders open. Some believe that it will decimate and ruin certain domestic producers in several sectors. Time will tell if that approach works, and if it catches momentum among other global trade partners.
Ah, but that’s another article…
Keith Prather is a Managing Director of Armada Corporate Intelligence. If you want information on a weekly basis like the article above, Armada publishes the Black Owl Report, an executive intelligence briefing that focuses on corporate risk. The Black Owl Report is just $7 a month and more information can be found here: http://www.armada-intel.com/publications.