The market’s recent pullback is driven by a familiar phenomenon: the trade war. The Trump administration’s attempt to increase tariffs from 10% to 25% has resulted in a brief market panic and a lot of yelling from both sides of the political aisle. It may be unsurprising that the Trump tariffs would result in political and partisan rancor, but the financial analyst’s job is to rise above such emotional fits and be rational and, well, analytical. So how can we do that with the Trump tariffs?
Essentially, this is a question of quantifying fear. There is fear that the tariffs will cause an economic slowdown, and the analyst’s job is to quantify exactly how much one should be afraid.
Doing so means relying on data, which is surprisingly not brought up very often in the political yelling match over what is essentially a simple numbers question. The typical debate goes like this: free-trade supporting moderates and those on the center-left decry the tariffs as being unproductive and causing market inefficiencies that will result in weaker economic growth. Protectionists on the right (and, it should be noted, on the far-left) say instead that China’s atrocious track record on stealing intellectual property, undercutting American firms, and dumping goods requires a response, even if the protectionists disagree among themselves on whether the tariffs are the right response.
The analyst, then, will want to address the center-left’s fear of an economic slowdown with math. The math is fortunately very easy, as soon as you get the numbers.
In July 2018, the U.S. Trade Representative proposed a 10% duty for about $200 billion worth of Chinese imports, which increased to 25% on May 10, 2019. In response, China will raise tariffs on $60 billion of U.S. goods to a range of values up to 25%.
Since we’re trying to quantify fear, we want the worst case scenario, even if it’s the wrong scenario. So let’s assume all $60 billion of U.S. exports will get a 25% tariff and add up the total tariffs being paid and assume that money will all be thrown in a furnace and burned up (this isn’t what happens, of course—that money becomes government revenue that can be spent on anything from social welfare to building roads). The total tariffs are themselves worth $65 billion dollars.
That number by itself is meaningless. We want to see how much these tariffs will drag on the economy, which is about $20 trillion in the U.S. for 2019. Simple math tells us that the $65 billion, if it was just burned up completely, would drag U.S. GDP growth by 0.325%.
That, by the way, is assuming that the U.S. suffers the entire brunt of the economic stress of the tariffs and China gets zero, and it’s also assuming that none of those tariff dollars are productive—that is, the money isn’t used to get a positive return by the U.S. government.
For equity analysts, the question now is to ask yourself whether the 2.8% downturn in the S&P 500 from its top is justified from a 0.325% destruction of GDP growth. Also keep in mind when asking yourself that question that the S&P 500 has seen $680 billion in market cap destroyed, which is more than ten times the total value of the tariffs in the worst case scenario we are constructing here.