“Volatility scares enough people out of the market to generate superior returns for those who stay in.”
– Jeremy Siegel, Professor of Finance at The Wharton School
The year has started with volatility that we haven’t seen in the last two years, and it continues as I write this letter. There are two primary narratives driving current markets:
- A possible China/global trade war and,
- A broader technology stock selloff due to backlash over privacy/data lapses, and concerns over government regulation of the largest tech companies.
I will spend some time discussing both topics.
Global Trade
Over the course of the last month, the White House announced a series of tariffs beginning with imported Chinese steel and aluminum, and later expanded to a 25% tariff on some 1,300 products from China accounting for approximately $50B in annual imports. China responded days later with tariffs on 106 U.S. products worth up to $50B annually. Now there are rumblings of both the U.S. and China upping the ante by another $100B.
My thoughts on the announcements are thus:
- Trade imbalance does not equal “unfair” – Just because a country sells more to you than they buy, doesn’t mean that they have an advantage. It means that they have a lower cost base for certain products. And the products you are selling may be better suited for sale in other markets.
- Tariffs don’t fix trade deficits – Tariffs have been shown to reduce trade but they do not reduce the trade imbalance. There is just less being traded, which is likely a negative result.
- Tariffs are really a tax on consumers – Tariffs will raise the price of imported goods and it will influence consumers to buy domestic goods which are already more expensive. The net result of this price “inflation” could negate consumer gains from recent tax reform.
- Tariffs won’t reduce unemployment – Tariffs intended to protect domestic industries will support increased domestic production in the near term. But, in the longer term, prices will be higher, purchases will decline, and the companies in the protected industries will need to reduce costs somehow. Most likely in the form of job cuts.
- Adam Smith would roll in his grave – In his famous work, “An Inquiry into the Nature and Causes of the Wealth of Nations”, economist Smith writes
- “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. […] The value of [a country’s] annual produce is certainly more or less diminished when it is thus turned away from producing commodities evidently of more value than the commodity which it is directed to produce [by trade policies].
Roughly translated, tariffs on items such as steel and aluminum don’t make much sense. If we can’t produce and sell a product at a lower price point than our foreign competitors who have to manufacture and ship (across an ocean!) the same product to sell them here, then perhaps we shouldn’t be in the business of selling those products[1]?
- Protecting industries doesn’t help them in the long run – Protecting these industries allows our steel and aluminum manufacturers to avoid much needed investments in technology and process improvements which will make them more competitive in the long run. If these investments aren’t economically practical then, once again, we should stop producing those products except for what is needed for national security.
- It negates the value of our more profitable service industries – Steel and aluminum production is mildly profitable. Technology, entertainment, financial services, consulting, and many other services that the U.S. excels at, are very profitable. Profits are needed to support The U.S. business environment that mandates employee benefits and limits environmental emissions among other hurdles that Chinese businesses do not face.
In my September 2016 letter, I discussed the possible negative impacts of protectionist policies specifically as it related to what we learned from history and the Smoot–Hawley Tariff Act. The Act implemented trade policies that historians agree exacerbated the Great Depression. I continue to believe there are more astute and diplomatic ways to balance the trade equation. A true trade war would not be a positive development. Most major American exporters have long looked to China as a market for promising growth: Apple and other technology companies, General Motors, Boeing and of course, the movie and music industries.
“The most important thing in communication is hearing what isn’t said.” – Peter Drucker[2]
The stated motivation behind the tariffs is to protect American industries from unfair trade practices and improve employment in specific industries. But it’s clear that these actions are more political than economic. The President is demonstrating support for his base by “protecting” our heartland industries. China, being aware of these motivations, ensured that their tariffs on soybeans, corn, cars and planes are specific and targeted toward that same base:
(Fig. 1 – Counties where Trump increased the Republican Vote)
We export almost 25% of general agriculture production and 56% of soybean production to China.
(Fig. 2 – 2016 Soybean Production by County for Selected States)
(Fig. 3 – 2016 Corn for Grain Production by County for Selected States)
The tariffs haven’t been implemented yet. The U.S. has at least 180 days after the comment period to decide whether to impose the tariffs, leaving plenty of time for negotiations. Both the US and China will benefit from positive solutions that lower barriers and open markets. In the end, they need a solution that allows both sides to save face.
Technology
We have seen an acute selloff in the technology space. Facebook has been attacked for abusing customer data. (That statement is a bit of a misnomer because Facebook users are not the customers. Facebook users are actually the product!) But I would like to discuss a company that I have often praised, Amazon, who is under fire for seemingly abusing taxpayers, the U.S. Postal System, and small businesses.
Currently, state governments regulate the rules regarding the collection of Internet sales tax. In 2002, 40 states formed the Streamlined Sales and Use Tax Agreement (SSUTA) to simplify sales tax codes to make collection easier. In essence, if an online retailer has a physical presence (office or distribution center) in a state that charges sales tax, then items sold to customers in that state must be charged sales tax. Previously, Amazon had strategically placed distribution centers so that they did not have to collect sales taxes, thus creating the perception of lower priced merchandise. Competitors called foul, and pushed Amazon to fully comply with the agreement. Amazon astutely added sales tax for all appropriate states, but they also expanded their distribution centers to have a closer proximity to customers allowing them to reduce delivery times from days to hours.
If the US were to implement even stricter tax laws for e-commerce, the result would disproportionally hurt smaller businesses that would also have to comply. The likely result would be that these smaller retailers would seek partners to ease the compliance burden. The most likely partner for small businesses… Amazon.
Are they abusing the U.S. postal system? Not even close. The postal system has faced volume declines for many years as the bulk of communications has shifted from mailing letters and bills to emails, emoji filled text messages, and online bill pay. The post office lost $2.7B in 2017 with the one highlight for the year being strong growth in package delivery (up 11.7%) with much of that likely coming from Amazon.
Does Amazon hurt small businesses? No and yes. The Amazon Marketplace has been a savior to many retailers seeking broader distribution for their products. But Amazon continues to disrupt industries and displace many businesses small and large. This competitive destruction is part of the natural evolution that comes with business innovation and new business models. It leads to the eclipsing of aging and outdated businesses and brands. The net impact to consumers is cheaper prices and the convenience that comes with Amazon Prime and 2-day or 2-hour delivery.
During its growth years, Wal-Mart was frequently blamed for hurting small businesses as Sam Walton was notorious for keeping costs low and passing those savings on to customers. Many Mom and Pop stores did go out of business, but the world has benefitted from Wal-Mart’s low cost model. And where would the world be without The People Of Wal-Mart[3]?
I believe that Amazon will continue to deliver for our portfolio for many years to come. The threat of government regulation looms, but I don’t believe that would stop Amazon’s growth or innovation. I would compare Amazon’s current situation to the government’s regulation of tobacco companies. Beginning in the 1970s, the government placed increasing restrictions on the advertising of tobacco products. Tobacco companies realized that if they couldn’t advertise, then neither could their competitors. That freed up billions of dollars to invest in the business and return cash to shareholders!
Despite the volatility, our portfolios have performed well overall and we have outperformed the broader indices. What will happen next? I respond with a very confident, “I don’t know!” But I do know that the stock market doesn’t like uncertainty and everything looks bigger up close. While we are in the middle of this, it can at times feel like the sky is falling. But what is happening today seems much bigger and much more important than it will feel a year from now. The goal isn’t to make any reactive decisions, but to observe, monitor, and look for opportunities while others panic.
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