By David R. Kotok
In a shooting war the guns are pointed at the enemy. In a trade-tariff war the guns are pointed inward. No one wins. This is the current state of U.S. trade policy towards China.
Western and American models of war favor brute force overwhelming the enemy. Asian martial arts turn an assailant’s force back on the attacker. The U.S. fired first against China trade with broad and brute force; China is answering with martial arts precision.
The U.S. is in a war and President Donald Trump and his trade adviser Peter Navarro put us there. The U.S. could have used precision tactics to counter IP theft or to improve 5G technology security. We didn’t. We picked on washing machines and flat-rolled steel. Trump was duped by Navarro’s argument that China would yield. Navarro has been proven wrong by subsequent events and outcomes.
China’s responses to the U.S. on trade are precisely targeted and scripted. The Chinese have planned for all contingent development options and for much higher levels of war with the U.S.; Trump and Navarro have forced them into that position. China will not yield, in my view. Time is on their side, the Chinese are patient, and their culture allows for both patience and precision.
Meanwhile, Trump is acting like a playground bully. Navarro owns the advisory role and the argument in favor of the present U.S. trade war policy. Trump owns the decisions. Together they are digging a hole , and that hole is getting deeper . Market agents know it. Farm-state voters know it. Financial agents know it.
Trump recently tweeted he wants the Federal Reserve to cut rates by 100 basis points . The result of such a move would be devastating to the U.S. economy. Sure, Trump’s real estate business ventures would have a 100 basis-point improvement thanks to lower borrowing costs, and the cost of financing Trump’s trillion-dollar federal deficit would be less as Treasury bill rates would fall.
But that would happen at the expense of every household in America. Every saver would suffer an income decline. Americans would witness a transfer from individuals and responsible businesses to profligate borrowers and the federal government. Call it a huge hidden tax on Americans.
Trump will either pivot and deal on China’s terms — or fail.
Trump has taken the tariffs level to a 30% threshold on some items. Apply 30% on all China trade and the total approaches $200 billion. This large amount functions as a direct consumer sales tax — imposed on Americans and collected by the U.S. Treasury as a revenue. A metaphor for a hit to consumers of this size would be a $2-per-gallon permanent hike in gasoline taxes. That is an appropriate way to view what a 30% tariff on all China trade would look like.
Trump’s rank-and-file political-base supporters haven’t felt this pain — yet. It’s coming and my expectation is weakened economic activity in certain U.S. swing states will get Trump’s attention as his 2020 re-election risk rises.
Then Trump will either pivot and deal on China’s terms — or fail.
What investors should do now
At this point, how should investors respond? We can’t believe anything the president says (tweets). So investors are better off ignoring his messages and looking at economic outcomes and market-based pricing.
Investors must think of this period as a hundred-year flood. Buy-and-hold strategies won’t work at this time. Investment portfolios must have a volatility component. In bonds that means duration shifts and “barbell” strategies. In stocks that means an active-management strategy and periodic cash-reserve usage. In credit that means emphasizing high-quality over junk.
Currently in the U.S., all bond yields are still positive. The barbell strategy goes heavy on short-term securities, with some exposure to the long-end. How you blend this duration determines your risk, but absolutely avoid intermediate-term bonds (which is why “laddered” bond portfolio is the worst thing to have right now).
Shadows of the 1930s
I’ve been in the investment business for a half-century and cannot recall anything like the present time. History books have few references , though one that is increasingly prominent is the Smoot-Hawley Tariff Act and its role in bringing about the Great Depression. In an article titled “The Smoot-Hawley Tariff and the Great Depression,” authors Theodore Phalan, Deema Yazigi, and Thomas Rustici assess the impact of this infamous U.S. trade-policy decision:
“In 1930, a large majority of economists believed the Smoot-Hawley Tariff Act would exacerbate the U.S. recession into a worldwide depression. On May 5 of that year, 1,028 members of the American Economic Association released a signed statement that vigorously opposed the Act.”
“The protest included five basic points. First, the tariff would raise the cost of living by ‘compelling the consumer to subsidize waste and inefficiency in [domestic] industry.’ Second, the farm sector would not be helped since ‘cotton, pork, lard, and wheat are export crops and sold in the world market’ and the price of farm equipment would rise. Third, ‘our export trade in general would suffer. Countries cannot buy from us unless they are permitted to sell to us.’ Fourth, the tariff would ‘inevitably provoke other countries to pay us back in kind against our goods.’ Finally, Americans with investments abroad would suffer since the tariff would make it ‘more difficult for their foreign debtors to pay them interest due them.’ Likewise, most of the empirical discussions of the downturn in world economic activity taking place in 1929–1933 put Smoot-Hawley at or near center stage.”
The late economist Allan Meltzer noted in his “A History of the Federal Reserve Volume 1: 1913-1951” that “Research suggesting a small effect [i.e., from tariffs] ignores the pronounced effect on farm exports, distress, bankruptcies, and bank failures in farm states.” Now check the rising bankruptcy statistics in U.S. farm states in 2019.
Responsibility for the U.S. economic slowdown and the financial volatility lands squarely in the lap of the president and his advisers.
The correlation between the Trump trade war and Americans’ rising financial distress is extremely high. In 2019, nearly every economist disagrees with the Navarro-advised Trump tariff policy. At our recent annual “Camp Kotok” gathering in Maine, for example, we polled the visiting group of economists, wealth managers and other investment industry veterans, who collectively represent about $2 trillion in assets under management. (Reflecting the investments of thousands of households, many hundreds of thousands of beneficiaries of retirement plans, and millions of investors and savers in the U.S.) Asked about Navarro, one supported him, 36 were opposed, and three were unsure. Asked about the Trump trade policy, about 75% of our group opposed it and saw it damaging the U.S.
No matter what Navarro says and whom Trump blames , the truth is that the responsibility for the U.S. economic slowdown and the financial volatility lands squarely in the lap of the president and his advisers. But Trump does not have the courage to admit an error. He avoids any self-blame. Instead, he constantly bashes the Fed since it (and Chairman Powell) is a convenient and distracting target.
There is a fitting adage here attributed to humorist Will Rogers: “If you find yourself in a hole, stop digging.”
Trump and Navarro are digging a deeper and deeper hole, for the U.S. and the world. Stop digging.
David R. Kotok is chairman and chief investment officer of Cumberland Advisors, a Sarasota, Fla.-based investment management firm.