Market Musings Blog

Will Tariffs Sink the US Economy?

Aside from the Kavanaugh nomination and Hurricane Florence, the news lately has been dominated by ‘tit for tat’ on the trade front. Meanwhile, the stock market powers ahead. What gives? Isn’t it important to our economy if traded goods are more expensive and supply chains are disrupted? Won’t stocks eventually ‘wake up’ and fall because of trade policies?

To lay the groundwork, understanding how trade affects the US economy is critical. Our economy is actually relatively closed. About 12% of US GDP is associated with exports while imports make up another 15%. (Compare this to Germany, where 40% of GDP is exports; in Japan, it’s 17%.) The net of these two is a component of GDP calculation, and since the 1990s, we’ve run deficits consistently. If the US dollar were not the primary currency of trade, the US would have undergone an economic adjustment long ago to account for these persistent deficits, likely taking the form of a lower currency value, inflation, a difficult job market, or all of the above and then some. However, the station of the US currency is significant in this calculus, so we must think of this issue as the world is, rather than what it might be. As it is, we import capital to accommodate our consumption and we do not experience the kinds of dislocations that smaller less developed countries do.

A substantial portion of our goods and services are made and consumed in the US. The Chinese import US goods only to the tune of about 0.7% of our GDP. Exports from China to the US are about 4.1% of its GDP; when considering the effect of this number in China, remember that it does not capture local benefits from plant utilization in China by American manufacturers, such as employed Chinese workers.

Our two major trading partners are Canada and Mexico. There, NAFTA is in renegotiation. But despite tariffs, trade with Canada increased in the last few months, and Canada’s trade deficit narrowed. Through July, 2018, we were importing more from Mexico than in the last several years for the same period. Thus far, it’s pretty difficult to see any material impact on the economies in North America from trade talks.

At the consumer and industrial level, metals tariffs, much ballyhooed, have resulted in higher aluminum prices in the US for certain, but steel prices have barely budged. Stainless prices are up, but are at 61% of early 2012 values. Nickel alloy is at 82% of 2012 values. Lumber, nearly constantly subject to tariffs, has fallen in price dramatically since January. Soybeans, hit by Chinese tariffs, are down in price, but the other side of that coin is that consumers benefit from lower soy prices. At General Motors, costs of steel are on track to increase by $1 billion this fiscal year. But that’s 0.6% of GM’s latest annual revenue number. Looking at its cost of goods sold quarter over quarter for June, excluding depreciation and amortization, the number was DOWN, not up. The company’s conference call indicated that it was finding places to save even while bearing higher materials costs.

Meanwhile over in China, a decline in the yuan is ameliorating tariff impacts on the consumer. Ditto the Canadian dollar and the Mexican peso. So while taxes in the form of a tariff makes goods coming to the US cost more, the decline in source country currency values can offset that tax.

Tariffs are also happening in the context of a strong US economy where the Fed is still somewhat accommodative. Consequently, consumer demand has only grown stronger this summer. Of course, the threat of higher prices on imported goods may be front-loading demand into this quarter; time will tell. We tend to believe that strong employment bears the larger responsibility for solid demand figures.

Supply chain disruption is another common complaint around tariffs. But supply chains have been building in flexibility for years, in order to deal with wars, natural disasters, and of course, financial disruptions like tariffs. Companies can and do switch suppliers from country to country. It does take time, but it’s not impossible. We think GM, which should be particularly vulnerable to tariffs, is showing the results of supply chain maneuvers that will neutralize the effects of tariffs to a large extent. The much publicized plight of soybean farmers is overdone. There are only two major producers of soybeans in the world, and we are one of them. Our crop will be sold to countries that do not tariff it, and next spring, farmers can once again make a choice to plant grasses or corn instead of the bean.

That said, the latest round of tariffs does pose a threat on one front, and that’s inflation. The first set of goods taxed were business to business items, while this next round is nearly all consumer goods. We’re going to pay more at WalMart, no question about it. The effects of higher prices will probably become evident around the holiday season, but with tariffs so far set at just 10%, it remains to be seen how much of that will pass through.

We have discussed many of the commonly publicized negatives surrounding tariffs. But it’s conceivable that there will be positives. These might include manufacturing moving to the US; better trade agreements that then cause tariffs to be cancelled; or increased sales at US firms that become more competitive with imported goods. The Wall Street Journal wrote a story recently on Allen Edmonds, which makes shoes in the US and always has. Pricey, yes, but they last forever and the company will virtually rebuild your old pairs multiple times at no charge. This kind of service and product is overlooked in the US, but perhaps no more.

Considering all the possible points of pain from tariffs, our conclusion is that given their current extent, the effect on the US economy will be mild, with more extreme well-publicized disruptions here and there. Should the trade war worsen, we’ll have to revisit the subject, but for now, we conclude that the market is right to look past trade talk.

The Great Emerging Markets Swindle

Unfortunately, the longer I practice as a portfolio manager, the more cynical I become regarding certain aspects of our business. The great push to include emerging markets funds in a ‘diversified’ portfolio has become my favorite annoyance lately. Granted there should be no doubt that I am reacting to the very poor performance of these funds lately, but this missive is about more than that.

In our industry, practitioners are taught that markets are efficient and diversification rules. I won’t go into the various problems with those theses – which are only that: theses, as they cannot be proven like the law of gravity is proven. Instead, we’ll lay groundwork by reminding readers that ‘diversification’ means including lots of different ‘asset classes’ in your portfolio to reduce risk. In the 1980s, policy wonks at a division of the World Bank came up with the idea of emerging markets. Later, Wall Street decided these constitute an asset class, and by the way, making these markets accessible to the average guy resulted in very high fees paid to these selfsame Wall Streeters. Industry academia jumped on the bandwagon, plotting ‘efficient frontiers’ including emerging markets funds, purportedly to show that a dollop of these investments added to a portfolio would reduce risk for only a small give-up in return.

The experience of the last few years must be disappointing to owners of these portfolios. In fact, the experience of the last ten years should be disappointing. Emerging markets funds as measured by Morningstar’s classification of rated funds have returned 1.95% per year over the last five years, versus 9% to 14% for the various categories of US stock funds. Using 10% as the return on US stocks (on the low side) and rounding up the emerging markets return of 1.95% to an even 2%, that’s a difference of almost $51,000 on a $100,000 investment over five years.  Even diversified bond funds had a better showing at 3.28%. Over ten years, the MSCI Emerging Markets ETF (EEM) returned just 3.26% per year. Worse, the long term variation in return (standard deviation) of emerging markets funds has been 22%, versus just 16% for the S&P 500. If you want to severely dilute your return to seek lower risk, bonds are a better choice than the riskiest stocks on the planet.

Aside from the horrific returns and high risk in emerging markets, I take issue with the underlying intellectual reasons given for utilizing these investments. Here’s why:

  1. Better growth in emerging markets and a larger slice of world GDP does not lead to high stock market returns. Consistently, evidence shows that economic growth is only slightly correlated with stock market returns. And good growth overseas comes with strings attached, such as lower political stability, uncertain effectiveness of financial controls in a US dollar dominated world, and expanding choices for investments in these economies. In other words, as economies grow, they offer more investment opportunities, which in turn cannibalizes funds from existing opportunities, restraining returns on all public companies. William Bernstein pointed out in 2009 that markets in low growth, stable countries performed best over the last 20 years, partly because the public-company opportunity set could expand so rapidly.
  2. In my lifetime, not one ‘emerging market’ has ever emerged. Markets that remain underdeveloped for decades are not attractive prospects.
  3. The rule of law is deteriorating worldwide, not improving. Property rights are unique to developed markets. China has no property rights. Africa has limited to no property rights; ditto many countries in the Middle East. Where property rights do not exist, high quality collateral does not exist, hampering large scale entrepreneurship. In the US, many small business owners get started by pledging their homes as collateral for a loan to expand. That alchemy is much more difficult if you don’t own property.
  4. Judicial processes, such as bankruptcy, are extremely inefficient and take a long time, preventing reallocation of capital to better uses. This goes for some developed countries as well, by the way. Italy is a notable example.
  5. Related to number 1, the opportunity set of public companies in emerging markets is undiversified. Many traded stocks are financial companies or extractive industries such as mining or energy. Few are consumer related. There is no place to run for cover should the stock market in Malaysia falter – except getting out of Malaysia. We won’t even get into the various accounting rules that dictate how earnings and sales are reported overseas – suffice to say there can be shocking disparity versus American rules.
  6. In some significant percentage (which varies according to whose numbers you use), participating in emerging markets means being a minority owner alongside countries’ governments. Governments are poor economic stewards. They are not innovative, they can prevent efficient capital allocation, they can insist on rules such as labor laws that are not in the interest of shareholders. Sometimes they can simply appropriate your asset without payment.
  7. Wall Street pundits have taken to saying that emerging markets are now ‘cheap’ – after years of sluggish returns. But we see this differently: perhaps they are cheap because investors are beginning to understand that the knocks against these markets are significant and not improving, making the entire asset class worthy of avoiding. Perhaps in fact, emerging markets should always trade cheaply.

As an alternative, we prefer accessing emerging markets exposure by owning companies headquartered in North America that sell to emerging markets customers. These companies are better managed, and still benefit from growth overseas. And if that’s just not enough for you, you can create an imbedded portfolio tilt by seeking only US companies that generate significant earnings from emerging markets. You will end up with a well diversified portfolio at a reasonable level of risk.

Oregon vs Washington: Should I Move Across the River to Save Taxes?

Residents of Portland, Oregon are only a matter of a handful of miles across the Columbia River from a completely different tax regime, in Washington. Does it make any sense to move to Washington for retirement or when selling a business, to save on taxes? We have spent some time on this notion and here are some differences that could compel a decision one way or another:

Washington:

No income tax

Property tax rates range from about 1.10% of RMV in Clark Co to 1% if you move into King Co where Seattle is

Sales taxes in Clark Co are roughly 7.4% to 8.4% depending on where in the Co you live, with some exclusions for food, drugs, and so forth

Car registration fees are substantial, and based on value of vehicle; a $25,000 car registered in 2016 cost about $550 in addition to the regular registration fee of around $30.

Health care costs can be substantial if you must use the Obamacare exchanges as Washington has had a difficult time generating participation by insurance companies. We don’t have exact numbers here, but be certain to check these costs before you move across the River.

Inheritance taxes start at $2,193,000.

If you are moving a business to Washington, be sure to check licensing fees and the business and occupation tax, which is based on gross receipts.

Oregon:

Hefty income tax, with a top rate of 9.9%. Social Security is exempt, and there is a small credit for taxes on pension income.

Property tax rates are similar to Washington, slightly higher in Multnomah County at 1.13%.

No sales tax.

Car registration is a flat fee for licensing, in the $100-$200 range depending on the plates you want.

Inheritance taxes start at only $1 million.

If your business in Oregon is a C-corp or an LLC treated as a corporation, you will pay an excise tax of 6.6% to 7.6% in Oregon on income.

Given these differences, it appears that owners of large estates or those who may be subject to substantial required minimum distributions from pension or IRA accounts could profit from a move to Washington state, thereby sheltering income and assets from these taxes. There may be other situations when a move could make sense; but consult with your tax advisor!

 

Stocks Behaving Badly vs Your Plans

We often advise clients about short term investments, such as how to save for the imminent purchase of a home or for a child soon to enter college. In the midst of a bull market, it seems tempting to buy a stock fund to sock away that cash. However, that’s a bit of a roll of the dice. Stock market history since 1926 contains 9 decades in which returns were 3% or less per year, slightly more than 11% of the decades we measured. Four of those periods showed negative returns – that is, an investor in stocks lost money for ten years. These examples were clustered around some of the most notable bear markets in US history – the Great Depression, the crash of ’73-’74, and the Great Recession.

Saving for a short term objective by utilizing an investment where good results tend to require a long term commitment is a risky strategy, particularly from a viewpoint near the top of the multi-year bull market that we are experiencing. We call this ‘liability mismatch’: the moment you must write tuition checks comes before the best years of your investment returns.

Even if you have an investment program in place for your retirement – which would likely be a long horizon plan – recognize that when you need to fund a short term objective, your time horizon on that portion of your portfolio has shortened, and it might pay to raise cash or use short term bonds to fund it, rather than staying put. Otherwise, that tuition check could coincide with a nasty market decline, forcing sales at low prices.

Puerto Rico Causes Municipal Debt Tremors

Even since the Great Recession, municipal bonds have seen more trouble than is normal for this usually super-safe segment of the bond market. Several municipalities in California filed for bankruptcy (Stockton, Vallejo, San Bernardino), then there was Detroit, and now we have the Mother of them all, Puerto Rico.

I won’t bore you with the myriad interesting things about Puerto Rico’s bankruptcy, which is truly special in so many ways – except for this one ominous item. Judge Laura Taylor Swain, who is overseeing the bankruptcy of PR, ruled in mid May that revenue bonds backed by revenues could not, in fact, be paid by those revenues in bankruptcy situations until relief is granted from the automatic stay triggered by the filing itself. This was quite a surprise to participants.

Revenue bonds were heretofore assumed to have a direct lien on revenues that are generated by projects financed by the bonds, such that they stood above the fray in a bankruptcy filing. That meant that so long as the revenues were still being generated, the bonds would be paid. This is how Vallejo worked, for instance; Vallejo taught us that in fact GO bonds were vulnerable. GO bonds had always been thought to be of the highest quality, since their repayment could simply be secured by raising taxes. Instead, Vallejo’s revenue bonds turned into the champs, as revenues kept coming in, for electricity payments, sewer and water payments, and so forth. Meanwhile, everyone has found out that a bankrupt municipality can rarely raise taxes.

So now, derived from the PR proceedings, we have now been told in no uncertain terms that the court will decide the disposition of every iota of cash, not relevant bankruptcy code.

Of course this will go to appeal. However, it’s a very interesting development for municipal bond holders, who have just been reminded that if your bond issuer ends up in court, you might as well throw out the debenture. You’ll just have to wait for the courts to give you what crumbs can be spared.