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Have Tariffs Worked as Planned?

Written by Peter Cook | Aug, 8, 2018

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

For all the huffing and puffing by government leaders, and the financial media, on the emerging Trade War, the stock market appears uninterested.  On July 31 the White House floated the idea of increasing the tariff rate on $200 billion of Chinese imports, from 10% to 25%.  Commerce Secretary Ross reiterated the strategy on August 2, saying “We have to create a situation where it’s more painful for them to continue their bad practices than it is to reform.”  It is difficult to misinterpret that statement.

The Chinese responded by saying the U.S. leaders should “calm down,” and that pressure tactics will never produce an agreeable response.  Despite all the noise on tariffs, the S&P 500 rose 0.7% during that week.  Intense mudslinging over the ensuing weekend produced the unremarkable result of an unchanged open to trading on Monday, August 7.  The divergence between negative tariff news and positive price reaction is another textbook example of the futility of forecasting short-term stock price movements.

Threats of tariffs are one thing; actual tariffs are another.  In the steel sector, the Commerce Department issued a report on January 11, 2018, demonstrating a violation under Section 232, justifying 25% tariffs on U.S. steel and aluminum imports. The tariffs were clarified on February 14 and imposed on March 8.   These events provide a 7-month window through which to analyze the effect of actual tariffs, instead of threatened tariffs and other negotiating tactics.  Hence, the following analysis on the price of the targeted commodities (steel and aluminum), and the stock prices of steel producers and consumers.

The Wall Street Journal produced the statistics below, showing that the price of steel has risen from $600/ton to $900/ton, or 50%, since early 2018 when the threat of tariffs became a reality.  Aluminum prices have risen 20% over the same time frame. The graph below charts the increase in the price of steel and aluminum. The graph to their right is meant to help contemplate the question, when will price increases in the supply chain begin to affect consumer prices?

Regardless of whether one believes tariffs are good or bad for the overall economy, there should be no disagreement that tariffs are positive for producers in the targeted industry of the country levying the tariff.  In the short-run, before domestic supply can expand, prices should rise to reflect the new imbalance between existing supply and a higher level of demand. The whole point of tariffs is to protect a domestic industry from “unfair” foreign competition, spurring a rise in domestic prices, which has indeed occurred in the steel and aluminum industries.

Stock Market Reaction

Producers

How has the stock market reacted to the expected bonanza for steel and aluminum producers? As shown in the right-hand column below, the three steel companies are highly focused on the U.S. market, while Alcoa (aluminum) derives almost half its sales from the U.S.  So there is no question that the rise in domestic steel and aluminum prices has a direct and major impact on the overall profitability of the companies.

But each stock is down significantly since the close of trading on the day before the Commerce Department report on January 11 (between 6% and 32%, left-hand column).  The table also shows stock performance since February 8, which was the market low in the wake of the implosion of volatility-related ETFs.  The week of February 9-16 produced an enormous rally in steel stocks as word began to leak that the tariffs would indeed be implemented.  However, even measuring from the market low of February 8, three of the stocks (AA), (X), and (AKS) are down, while Nucor (NUE) is up 7%.  For comparison purposes, the performance statistics of SPX and the Russell 2000 Index (R2000) are shown over the same time horizons.  The steel stocks, which have domestic revenue concentration similar to the Russell 2000 index, are trailing that index by a large margin over the entire period.

Summarizing, steel and aluminum stocks are the beneficiaries of tariffs that should support their U.S.-focused businesses.  Yet they have been poor performers, whether measured on an absolute basis or relative to U.S. stock market indices.

Consumers

Next, let’s turn attention to the steel and aluminum consumers.  All other things equal, tariffs should place industrial consumers at a disadvantage, because they may not be able to pass rising costs along to their customers.   As shown below, the performance of the big three automakers and two large RV producers has been poor, on both an absolute basis, and relative to stock market indices.  The RV producers (Winnebago (WGO) and Thor (THO)) have taken the worst hit, presumably because their factories and sales are heavily concentrated in the U.S.  Also notable is that the stocks of these companies didn’t bounce very much during the week of February 9-16, when a spectacular stock market rally coincided with the anticipation and announcement of tariffs for the steel and aluminum industries.   This is a logical result; a sharp rise in input costs is clearly negative for industrial steel and aluminum consumers.

Conclusions

Mainstream economics long ago decided that the broad effects of tariffs are negative, even if they are positive for a specific sector.  In the case of tariffs imposed on the U.S. steel and aluminum markets in early 2018, one would expect that producers would benefit while industrial consumers and likely end users (customers) would be harmed.

However, judging by the price changes to the affected stocks, domestic steel consumers and producers have BOTH been harmed.  That fact suggests that either the stock market is wrong or the economic textbooks are wrong.  In a subsequent article, we will investigate the potential reasons for this anomalous result.


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Peter Cook, CFA, has worked as a leader in the global investment industry for almost 30 years. He is an expert in how business cycles interact with financial market cycles, and has applied that expertise across asset classes in both traditional and alternative portfolio management.

2018/08/08
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