I’m often asked what I think poses the greatest threat to the current US bull market. Rising rates? Inflation? Regulation of the FAANGs? Whilst these all pose potential risks to the earnings power of the market, the issue that currently concerns me most is tariffs – and the prospect that what is currently a small-scale, regional spat could turn into a full-scale global trade war.
At the moment, the focus of the tariff disputes and the area where we’ve seen the starkest developments is China. However, the tariff situation may extend well beyond this. Although there has been a ceasefire with Europe, it would not take much for the disputes to resume. Indeed, with NAFTA reform discussions ongoing, the prospect of a truly global trade war is by no means out of the question.
Tariffs materially change the costs of doing business for US corporates. To see this, one only has to look at the effects of the first round of international tariffs announced in March. Steel and aluminium were the focal points and prices have already risen meaningfully. Steel futures, for example, are up 30% year-to-date and now stand at 10-year highs.
The US is the world’s largest importer of steel. Higher steel prices mean higher input costs for a lot of businesses, and many of these are trying to offset the additional costs with higher prices charged to the end customer. This has been a theme of the current earnings season, with companies from Coca-Cola to Caterpillar announcing off-cycle price increases.
We’re seeing the effect of higher prices in economic data too. Last week we heard that core producer prices (which exclude the more volatile items like food and energy) in the US rose by 0.3% in July, taking the overall year-on-year increase to 2.8%. Economists have attributed this inflation directly to tariffs on imported Chinese goods.
At the moment, it looks like the economy is strong enough to absorb these price increases, but this may not be the case if the tariffs escalate further. Every additional round of tariffs implemented will result in higher costs in the system that have to be recovered somehow – be that through higher prices to customers or lower profitability for companies. All eyes therefore are on the decision from the US this month on whether to implement an additional round of $200bn in tariffs on China.
If we reach a point where the price increases can no longer be passed on, margins will have to take a hit. We’re spending a lot of the time trying to understand which of our holdings are most exposed to the tariffs and also which of our holdings have the greatest pricing power. Our railroads holdings, for example, are major consumers of steel, and we are keenly examining the possible effects of tariffs on these stocks. They tend to have strong pricing power with limited demand destruction, meaning that the impact has so far been muted.
Our other area of focus is on businesses that export to China and it’s no surprise that stocks with Chinese revenue exposure have sold off meaningfully in recent months.
The most-exported goods from the US to China are agricultural products, aircraft parts and automobiles, and we’ve seen a number of companies in these industries affected in the recent earnings season. At the end of July, Ford lowered their earnings expectations, citing their “challenges in the China market” as the reason for this revision. These challenges were tariff-related, driven by “unfavourable market factors […] for imports into China and continued negative industry pricing.”
It’s not just direct exporters who are feeling the pressure from tariffs. Higher tariffs on pork and chicken have meant more product has stayed in the US, depressing domestic prices. This is great for consumers but disastrous for companies like Tyson Foods, which makes 90% of its profits selling domestically. As a result, the company revised its earnings expectations for the year downwards by over 10% last month.
But it’s not all bad news. Some of the selling in China-exposed names has been indiscriminate and we’re starting to see opportunities to buy long-term winners at a significant discount. Yum China, the company that owns the KFC and Pizza Hut brands in China, strikes me as an example of a stock that has been exaggeratedly sold. The business has a long runway for growth ahead of it and has absolutely no export or import exposure to China, but its share price was down 20% year-to-date at its low in July.
The driver of the stock’s de-rating is the translational exposure of its earnings to the Chinese Yuan which is currently approaching multi-year lows versus the dollar and we are considering it carefully in our analysis.
In all, there is little doubt that tariffs have the potential to meaningfully disrupt the US stockmarket. However, taking an approach that focuses on the long-term fundamentals will help to navigate the choppy waters and potentially turn threats into opportunities.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.