Trade Wars

Trade Wars

I’ve mentioned before that reading of the quarterly letters of a select few fund managers and CEO’s can make for far more informative and revealing insights into what is going on behind the manipulative and exploitative headlines of the newspapers and the nonsense that passes for news on the internet…The fund managers and CEO's that I follow are actually out there investing in the real world, instead of just talking about it...The following is a good piece featuring one manager's take on the trade war hub bub that's plastered on the headlines everyday.

Experience—recent and longer-term—shows that Trump is rational when looked at from his perspective and what he is trying to accomplish. Ultimately, he wants a deal with China, the European Union and Canada on trade that will be a win for the U.S. and he has a strong hand for two reasons. Firstly, the U.S. is a huge market and it is running an $800 billion global trade deficit on goods. Secondly, China, the European Union and Canada do have some protectionist policies in place that the U.S. has always found to be unfair. However, compared to China, both other economies are relatively open and, even using U.S. data, Canada runs an overall current account deficit with the U.S, not a surplus. The balance with Canada is simply not a big deal in the total U.S. trade picture. However, we should not expect Trump to back down on his pressure tactics.

To understand Trump better, it is important to look closely at how he operates. An excellent analysis was recently written by Daniel Greenfield. It provides clear insights into the posture that Trump has always taken to get the deal he wants. Greenfield asserts that Trump follows five basic rules, and this applies to his negotiations on foreign policy:

Act, Don’t React

Try Everything

Chaos is Power

Never Show Your Hand

Don’t Be Afraid to be the Bad Guy^[1]

Trump always prefers to make the first move, giving others no choice but to respond. He counts on others’ need for a return to stability to create opportunities that he can exploit and is not afraid to fail and try something different. Unlike most leaders, he doesn’t care about looking like the bad guy. Bullying, lying, fake news and made-up data are all fair game. Anything to take the offence and make the other side uncomfortable enough to offer concessions. This is Greenfield’s assessment and we think he’s bang on. When viewed by others, Trump obviously appears thoroughly unlikable and comes across as ignorant of basic economics and the historic fundamentals and logic behind the complex web of global trade agreements and supply chains.

He is likely going to get some kind of win against China, the EU and Canada because they have more to lose than the U.S. However, because of the way Trump operates, it is not possible to say how things will play out with any certainty. He can and does change his mind in an instant, a master of the bait and switch. But the way he operates is very consistent and rational from his perspective. Further, his popularity has been rising in the U.S., indicating that a lot of Americans like what he is trying to do and admire the tough guy posturing. This provides him with positive feedback, so we can expect more of the same.

Canada does have a number of protectionist and non-free market policies. Supply management and marketing boards in the dairy industry, for example, have always been troublesome for the U.S. and not necessarily in the best interest of Canadians, who are forced to pay high prices to benefit a small number of farmers. However, it should be kept in mind that Canada’s dairy industry is only worth about $15 billion. The total dairy trade (imports and exports) is valued at about $1 billion. Canada’s dairy imports are four times its exports. The lumber industry is also a continuing contentious issue but that has to do primarily with the structure of the industry. The big point, however, is that, contrary to fake news generated in the U.S., Canada actually had an overall current account deficit with the U.S, not a surplus. For the 12 months ended March 2018, a U.S. surplus on services of $25.6 billion more than offset a deficit of $13.9 billion on traded goods. That U.S. deficit in goods dropped 10% from the previous 12 months and amounts to under 0.1% of U.S. GDP.

It is also worth pointing out that much of the total U.S. trade deficit in goods of $800 billion with the world (of which Canada’s portion is less than 2%) is caused by the U.S. fiscal deficit, which will be boosted sharply by Trump’s tax cuts. Fiddling with tariffs while the U.S. economy is already at full employment will not likely move the needle much on the U.S. trade deficit. Further, as protectionist pressure escalates, the U.S. dollar rises. Its trade-weighted value is up 8% since the end of January. In Canada’s case, our currency has fallen about the same amount against the U.S. dollar since September 2017. Devaluation of the Canadian dollar will benefit Canada’s trade by making our exports more competitive and making imports less competitive (i.e. more expensive). Thus, currency depreciation will provide an important offset to increased U.S. tariffs.

The bottom line is that even though the data shows that Canada is not the villain behind the U.S. trade deficit as Trump claims, we are still in his crosshairs. Uncertainty and risk have clearly risen but it is premature to get too bearish on the trade front alone. How things will play out is quite complex but there are important potential offsets if the U.S. persists with the imposition of higher tariffs on Canada or a detrimentally revised NAFTA agreement.

Conclusion

The problem for Canada is that we have no idea what a revised NAFTA agreement would look like, how long it could take to get a deal (Trump postponed negotiations until after the mid-term elections), whether we will ever get a deal and what sort of tariff and non-tariff agreements could finally be reached. In the meantime, economies, businesses and markets hate uncertainty, risk and particularly chaos. Given Trump’s modus operandi, which thrives on chaos and unpredictability, investors are having to live with this. The rational response for investors to take in the face of increased risk is to take a more conservative stance.

[1] Daniel Greenfield, “Trump’s 5 Rules for Ruling the World,” Frontpage Mag (June 15, 2018).

Resources

Stephen Takacsy

Lester Asset Management

2^nd Quarter Letter