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Don’t Trade (Tread) On Me

Wells Fargo Investment Institute - April 9, 2018

Key takeaways

  • Equity markets last week reacted negatively to the latest volley in tariff proposals between the U.S. and China.
  • Investors should keep in mind that just $3 billion in U.S. steel and aluminum tariffs have actually been implemented, while the larger total of $150 billion in U.S. tariffs on Chinese imports remains only proposed at this point.

What it may mean for investors

  • We would caution investors not to overreact to last week’s tariff proposals and still believe there is low probability of much of the $150 billion of Section 301 tariffs eventually being implemented.
  • Investors concerned about further tariff rounds may want to face the uncertainty with domestically oriented companies like small caps, which have outperformed since the trade rift heated up in early March

Download the report (PDF)

Last Thursday evening, President Trump instructed the U.S. Trade Representative to “consider” tariffs on an additional $100 billion of Chinese imports, as part of the intellectual property theft investigation being conducted under Section 301 of the Trade Act of 1974. Equity markets reacted negatively Friday to this latest volley of trade-conflict escalation, having their worst day in the last two weeks. Let’s put some context around the events of this past week: 

Where do we stand with tariffs implemented versus proposed?

This latest round of $100 billion in proposed tariffs would be in addition to steel and aluminum tariffs totaling $3 billion (under Section 232 of the Trade Expansion Act of 1962) and the initial $50 billion in Section 301 tariffs released on Tuesday, April 3. Therefore, a rather small total of $3 billion of Section 232 steel and aluminum tariffs has actually been implemented thus far, while the larger total of $150 billion of Section 301 tariffs remains only in a proposed state at this point.

What has been China’s response to these newly proposed tariffs?

China has already indicated a dollar-for-dollar reciprocal response on the initial $50 billion of tariff announcements. On Friday, following the announcement of the additional $100 billion of Section 301 tariffs, China stated it has “detailed countermeasures” and will fight “at any cost” to defend its trade and economic interests. China did not, however, reciprocate on Friday with a specific dollar amount of matching tariffs.

When could the newly proposed tariffs be implemented?

The earliest the newly proposed $150 billion in Section 301 tariffs could go into effect would be after May 22, 2018. To be clear, China and the U.S. continue to indicate publicly that negotiations will occur even as both posture with tough talk to appease their domestic constituents. These negotiations on the newly proposed tariffs likely will go on for months, giving markets an extended period of time to adequately assess real implementation risks.

How substantial are these proposed tariffs for both China and the U.S. relative to actual trade with each other?

According to the U.S. Census Bureau, imports into the U.S. from China were $506 billion in 2017. That would mean the newly proposed $150 billion of Section 301 tariffs—if implemented—would account for tariffs on approximately 30% of annual U.S. imports from China. On the other hand, the U.S. exported $130.4 billion of goods to China last year, amounting to 8.4% of overall U.S. exports. (China ranks third for total U.S. exports behind only Canada and Mexico.) Therefore, if China were to attempt to match the new proposed tariffs dollar for dollar on the entire $150 billion, it would effectively be putting some form of tariffs on all U.S. imported goods into China.

How should we interpret the market’s response?

We would caution investors not to overreact to last week’s trade and tariff proposals and still believe there is low probability of much of the $150 billion of Section 301 tariffs eventually being implemented. Even with U.S. equity markets now in full correction territory, any stress or contagion to other areas of the markets remains limited at this point. Bond yields are down slightly, credit spreads have remained well behaved while widening subtly, and there has been limited flight to traditional perceived safe havens like the U.S. dollar or gold.

Does this create an opportunity for investors?

The news has been unsettling for U.S. equity markets, dragging them back into the red for 2018 and erasing all the post-tax reform gains. Our base case continues to be an eventual negotiated outcome to the U.S.-China trade conflict even as the market has priced in continued downside risk. The combination of falling equity valuations and rising earnings has led to a marked repricing of multiples around the globe, causing most global markets and sectors to now trade toward the one-year low of their price/earnings ratios. Investors concerned about further tariff rounds may want to face the uncertainty with domestically oriented companies like small caps, which have outperformed since the trade rift heated up in early March. We believe U.S. Small Cap Equities would be a good asset class to take toward long-term target allocations.

We continue to favor cyclical sectors over defensive sectors within U.S. large cap stocks. Since the beginning of 2018, performance for all S&P 500 sectors is negative (except for Consumer Discretionary and Information Technology), but those that have weathered recent weakness best continue to be the four sectors in which we have maintained an overweight position—Industrials, Financials, Consumer Discretionary and Health Care. Meanwhile, the three sectors in which we have maintained an underweight position—Energy, Consumer Staples and Utilities—have underperformed the prior four, both in 2017 and through recent market weakness.