The Truth about Tariffs

Tariffs are generally bad. They are taxes, paid directly to the government. When added to the cost of goods, tariffs make everything more expensive for the consumer. Most importantly, free trade has been essential to the great prosperity America has enjoyed over the last 200 years, since our first trade war in 1807.

In 1807 the English and French were involved in war and Jefferson, not wanting to incite either and get into the war, simply closed our ports. Our ships were being boarded at sea, and U.S. sailors were being impressed into the English and French navies. This ultimately led to the War of 1812, which, for the first time in our history, established the United States as a power to be dealt with, economically and militarily.

No trade wars are “won”, as they are fought at the expense of the consuming public. However, a drain of a country’s capital outflowing to any one particular trading partner is really a transfer of wealth from one country to another. At some point it must stop, or be reversed. As large chunks of wealth are transferred to another country, their power increases at the expense of ours. This is what happened to the United States and the European powers in the 19th and early 20th centuries. So many more U.S. goods were shipped to Europe, than European goods were shipped to America, causing U.S. wealth to grow disproportionately compared to European wealth during that time.

Many of us will recall a similar problem existed in the 1980s with Japan. Like China today, Japan was pretty much a closed market until the U.S. forced the issue. The result ended with the Japanese building multiple manufacturing plants in America, providing jobs for Americans to whom they were selling their products. It is this administration’s plan to bring about a significant amount of change in the balance of trade with China to make it fairer for Americans so we can keep wealth here in this country.

US/China Trade Deficit (Billions)
U.S.
Year	Exports	Imports	Trade Deficit
1987	$3.5B	$6.3B	$2.8B
1997	12.9	62.6	49.7
2007	62.9	321.0	259.0
2017	$130.0B	$505.0B	$375.0B

Question: President Trump said, “Trade wars are good, and easy to win”. If that’s true, why don’t trade wars exist all the time?
Answer: Trade wars are not “easy” to win. We think the President meant America simply happens to be in a better position than any other country in the world to become involved in a trade war. Very little of our economy is exported as a percent of our GDP. That is not true of our major trading partners including China, Japan and Germany. We purchased, in 2017, $505 billion worth of product from China, or 2.6% of the U.S. GPD. While it is disruptive, and while it causes purchasing agents to scramble for alternate suppliers, 2.6% of our GDP is small enough to replace and overcome.

Question: Looking at the chart, the growth of business with China has been an economic miracle for both countries. How can $505 billion worth of business be replaced, even though it’s only 2.6% of our GDP?
Answer: Notice that this administration has been courting North Korea. While that was developing as a difficult relationship, Secretary Pompano has been visiting with Indonesia and Vietnamese trade representatives, and plans to become more involved in India. Those countries have the skill, and labor, to do for the U.S. economy what our relationship with China has done. India has the second largest population in the world, and Indonesia is the forth.

Question: Why would the United States try to work with North Korea when India, Indonesia and Vietnam appear to be more cooperative governments?
Answer: The U.S. is well established in South Korea. If North Korea was cooperative, the U. S already has a huge infrastructure in place that could be used to enable and promote business with North Korea. Many people do not realize the South Korean economy is the 11th largest in the world, larger than Russia, which has only the 12thlargest GDP in the world.

Question: It is said that trade wars lead to shooting wars. Does that possibility exist?
Answer: Probably not. People don’t realize the economic and military power of the free world. China and Russia make a lot of military noise in their hemisphere, but the reality is that neither one of them is in a position to become involved in anything other than a regional war. 52% of Russia’s GDP comes from oil and gas they inefficiently recover from huge Russian reserves. The average Russian family income has been going down the last two years creating additional problems. China has a large population they need to keep employed, and busy, as huge underlying potential revolts exist all over the country. Furthermore, it takes money to fight wars. The GDP of the top 12 economies in 2017 was $57 trillion. Russia and China represented only 24% of the GDP of the top 12 economies, vs. the free world’s 76%. How are China and/or Russia going to compete militarily with the free world when their cash flow is less than a third of their enemies?

Question: Why is the market hitting new highs when news is dominated by the harm that will be done by this tariff war? Isn’t the market supposed to “see ahead”?
Answer: The market is comprised of millions of bits of information that compress themselves into statistical averages. These bits of information are what is called “discounted” in the market, which means that all of the information pertaining to each stock in the market has worked its way into the thinking of investors. Investors have taken into account all the news that is available on tariffs, as well as interest rate hikes, labor news, earnings estimates and so forth. This market continues to rise because the bad news has been “discounted” as not important enough to overcome the momentum of the current market, primarily due to record corporate earnings, and an excellent future earnings outlook, in spite of the Fed’s interest rate hike last week.

Question: Market Watch does not seem to be bothered by tariffs. Is the U.S. tariff proof?
Answer: The U.S. is not tariff proof, but we are a self-sufficient economy. Only 9.4% of our GDP depends upon export business. Germany, China, and Japan’s exports represent 46%, 20%, and 16% of their GDP, respectively. The U.S. is the largest customer of each of those countries.

Summary

This market is going to continue to set records. Every economic indicator is up, including foreign trade, which was up last year and is up significantly this year, regardless of tariffs.

The reason the market continues to set records is because of investor sentiment. We can point to all of the statistics in the world, but unless people are buying stock, the market will not move. Investor sentiment, like a lot of other indices, continues to remain at all time highs.

Up until tariffs dominated the news early in the summer, much of the run-up in the stock market was because tariffs and interest rate increases had already been discounted. Then the market sold off strongly on tariff news. It’s returned to a record posture because of rising projections on future earnings. To continue to set records, the market needs strong earnings and dividend growth. Such performance is the one single indicator that can keep investor sentiment at these levels.

The market is ruled by fear on the downside and greed on the upside. We are now in a greedy phase. Investors are buying and returning to the market. 52% of Americans own stocks, down from 65% in 2007. This is the lowest ownership of stocks since the trend was followed 20 years ago. As investors return to the market, added pressure on upside prices will exist, thereby increasing the level of stocks.

Look for continued strong stock market performances.

Carpe Diem.

George Rauch
September 28, 2018

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