In our last post, we took a brief look at the drivers of growth and inflation in the United States. Noting that economic indicators seem to suggest mid- to late-stage dynamics, we think that while growth still has some room to continue, inflation is at risk of overshooting expectations. The main “known unknown”, so to speak, in our considerations is the impact of trade tariffs and the escalating trade war. Inflation is particularly vulnerable to the effect of trade tariffs, as imports become more expensive and US businesses raise prices to pass costs through to consumers.
In order to evaluate the early impact of the tariffs, it can be illustrative to read through earnings transcripts. Public company executives issue forward guidance in earnings calls and sometimes offer their perspectives on global macroeconomic forces. In aggregate, these perspectives can form a pointillist picture of economic developments. As such, we explore a few quotes below (all emphasis is ours).
In particular, we are finding that public companies may be able to stave off tariffs at least briefly, but the combination of late cycle dynamics and higher retail prices from tariffs will negatively impact consumer spending.
Selected Earnings Call Quotes
La-Z-Boy (furniture, consumer goods), August 2018
- “The retaliatory tariff that went into effect from Canada on July 1 is a 10% across the board. All finished goods going from the U.S. up to Canada carry the 10% tariff… The big one is … a tariff on anything in the furniture business coming in from China, and it’s on fabrics, it’s on leather, it’s on finished goods. And what really has the industry perplexed is… there is very minimal supply of fabrics and leathers in this country that the industry can buy and most of it comes from China, and there is no offset to do anything different. So, the first two are not insurmountable. The third one is going to have the price of furniture across the board be challenged… third tariff one is the big unknown at this point.”
Samsonite International (luggage brand), August 2018
- “So the reality is… it will have an impact to cost, and it will impact the entire industry within North America. And so you should assume that we will be pushing enough of that increase through to kind of maintain the margins of our business. And we won’t be alone in that space. So the shame of that is consumers kind of lose out on that front, but we will be doing everything we can to maintain the margins.”
Home Depot (home improvement retail), September 2018
- “I think we are managing through fairly well. And I think our size and scale gives us an advantage… It’s not a one-to-one relationship in terms of where you may take some cost in and how that shows up in the retail price.”
- “Certainly, when you have tariffs in place, some of that flows through to the customer.”
Caterpillar (global industrials, machinery company), July 2018
- “Based on the current situation, we’ve assumed incremental tariff-related costs of $100 million to $200 million for the rest of the year. Even with these new costs, we are raising our 2018 outlook. We are confident that our strategy positions us to capitalize on current market opportunities and manage through dynamic environments.”
Commercial Vehicle Group (cabs, trucks, military equipment), August 2018
- “Based on the enacted tariffs to-date, the direct impact to our company on an annual basis is minimal so far. However, there is an indirect impact in that U.S. hot-rolled steel prices have risen about 40% in the first half of 2018. Another consideration is the still materializing impact to our extended supply chain.”
Hewlett-Packard (computer hardware, software), August 2018
- “I don’t think it has had a material impact on our business to date… But our supply chain team and our go-to-market team and all areas of our business, including our broad ecosystem of suppliers, customers and partners work together to take any change and turn it to opportunity.”
Commentary
Curiously, it seems that the tariffs have yet to materially impact the economy. Most companies reporting don’t seem particularly fazed by the trade war as it has panned out thus far, and seem quite confident in their ability to mitigate the anticipated effects. There are pockets of the economy, mainly retail-facing industries, that are more apprehensive than others, while for example, industrials and tech companies seem fairly sanguine. Even then, only fabrics seem to be particularly at risk, per La-Z-Boy’s comments.
This seems to clash with some of our intuitions about how trade wars unfold. For one, nearly all economists agree that the tariffs will not be positive for the economy. Secondly, the media is reporting that many companies have been directly hurt by the tariffs. One possibility for this is that large, public companies have the resources to mitigate the direct impact to their bottom line, as many are diversified enough in revenue and suppliers to withstand the tariffs. On the other hand, smaller companies do not have these luxuries. So it is possible that the equity market may be spared yet.
Still, though large public companies may be able to protect their bottom line in the short-term, the prognosis is still not good for the shifting macroeconomic landscape. In our view, there are a few possibilities for how the tariffs may unfold, and how growth and inflation will be impacted as a result. Either the effects of the trade war will unfold slowly or quickly, depending on how companies are able to cope. If the trade war unfolds slowly — i.e., if public companies are able to mitigate the effects to margin — then it is likely that any negative effects to growth will flow through with a lag, starting with SMEs and spreading to consumers broadly. Small- to medium- sized enterprises (SMEs) are already strained; it is just a matter of time before there is a material hit to SME employees’ incomes and SME revenues, which, combined with higher retail prices, will negatively impact consumer spending. It is worth noting that in this scenario, there may be a divergence between public companies that can stave off harm and smaller enterprises that cannot, further fueling inequality and social tensions.
If companies are unable to mitigate the impact of the tariffs, a sudden flow-through of the tariffs would force SMEs and public companies alike to either absorb the costs of materials or pass them on as higher prices to consumers. If they are absorbed, then equities would suffer abruptly as increases in costs reduces profits. Among many second-order consequences, an equity correction would flow through to consumers, creating a negative wealth effect that further stymies spending. If the costs are passed on to consumers, there would be a mechanical bump to inflation, which would trigger spikes in bond yields and deter consumer spending, both of which would be negative for growth and the equity market broadly.
We will be monitoring these developments closely, and will report again after next earnings season.
