Covenant Weekly Market Synopsis for June 22, 2018

June 25, 2018

Last Week Today (market-moving events): President Trump quadrupled-down on China, threatening tariffs on $200 billion more Chinese imports, on top of the $50 billion already announced; China announced they intend to reciprocate with tariffs on goods imported from the US; Trump threatened 20% tariffs on European automobiles. | OPEC’s members agreed to increase crude production by 600,000 barrels per day.

In a week dominated by trade concerns, global equity markets failed to gain traction and the MSCI ACWI declined by a modest -0.6%. The domestic benchmark S&P 500 fared slightly worse, falling -0.9%. In a rare win for value investors, the Russell 1000 Value Index outperformed its companion Growth Index -0.6% vs. -1.1%. One week is not a pattern, but a broad swath of active managers would welcome consistent outperformance of value over growth stocks. Meanwhile, emerging market and frontier market stocks took it on the chin, falling more than 2% for the week, led by China’s 3.7% decline (China’s Shenzhen 300 Index is now down nearly 10% YTD). Developing-nation stocks are suffering from both the threat of reduced trade and a stronger US dollar (+2.6% YTD). In fixed income investments, all eyes remain on the yield curve as it continues to flatten. The spread between the yield on 10-year and 2-year treasuries tightened again, such that investors in bonds maturing in 10 years earn only 0.35% more per year than those investing in 2-year bonds (2.89% vs. 2.54%). Within commodities, Dr. Copper (so called because it is an indicator of global economic growth) fell 3.7% and is now down 8.3% YTD. WTI Crude oil rose (5.4% to $68.58 per barrel) on news of the OPEC production increase, which was a) in line with expectations and b) an indication that the cartel is not splintering apart, as some had feared.

For detail on weekly, month-to-date and year-to-date asset class performance, please click here.

This Week Today: This week’s knowable potential market-moving events are mostly tied to economic data releases, including New Home Sales (May), Consumer Confidence (June), Durable Goods Orders (May), and Personal Consumption Expenditures (May). Of course, it is often the unexpected that moves markets, so we’ll see what this week brings along with everyone else.

Tariffs and Global Economic Growth

As noted above, headlines about actual and threatened tariffs continue to buffet financial markets. The consensus is tariffs are bad (unless you happen to work in an industry that “benefits” from the tariffs), but why? In this short piece, we review how tariffs affect economic growth, beginning with economic theory and ending with practical implications.

One cannot explore the economics of tariffs, without first considering the theory of comparative advantage. Introduced by eighteenth-century economist David Ricardo, the theory of comparative advantage posits that a country can experience its highest potential growth by focusing on the industry (or industries) in which it can produce goods or services with the lowest opportunity cost.

A comparative advantage differs from an absolute advantage, a concept with which most of us are familiar. As a refresher, absolute advantage is anything a country does more efficiently than other countries. An absolute advantage can be achieved in various ways, including cheaper labor, abundant resources, or superior technology. Whereas an absolute advantage considers only the relative competitiveness of a country’s ability to produce a product or a service, a comparative advantage considers the opportunity cost to a country of producing Product A vs. Product B. Indeed, a country can have an absolute advantage in producing multiple products, yet only have a comparative advantage in a subset of those products.

To demonstrate the difference between the concepts of comparative and absolute advantages, consider a hypothetical scenario including an attorney (Pam) and a secretary (Ann). Pam is an excellent attorney and a proficient typist (60 words per minute). Ann is not an attorney, but she can type well, averaging 50 words per minute. As such, Pam has an absolute advantage over Ann in both legal and typing skills. Let us further assume that Pam can charge $150 per hour for her legal services, but the market value of her typing skills is only $25. Pam can maximize the profitability of her practice (or GDP output if Pam were a country) by hiring Ann, even though Ann is a less-skilled typist. Pam’s profit maximization comes from focusing on the higher value legal work as her opportunity cost of typing is $125 per hour.

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Source: Market Business News

This simple example provides a baseline for understanding how the theory of comparative advantage applies to global commerce. Technological advances have given rise to globalization, allowing companies to procure components (or services) from suppliers around the world. The suppliers of these products and services offer companies an alternative to using local suppliers if they provide products/services that are more efficient – either due to price, quality, or a tradeoff between the two.  In other words, globalization allows companies to source products/services from countries with the greatest comparative advantage, whether it be from their own country or from another country.

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Source: Our World in Data

As this chart illustrates, global trade was limited through the early 1800’s, never surpassing 10% of global GDP. Improved technology, primarily in the form of communications and transoceanic shipping, led to the first wave of globalization in the late 1800’s. However, the globalization trend reversed during the World War era (the blue lines in the chart) when enemy countries ceased trading, and international liberalism gave way to nationalism. Following World War II, countries reopened trading channels, international commerce accelerated (the orange line in the chart), and global economic growth along with it.

Today international commerce is once again threatened by nationalist tendencies. This statement is not intended to suggest that the currently proposed tariffs will reduce trade to World War-era levels. Yet, tariffs artificially inflate the cost of international commerce and, in so doing, reduce the efficiencies otherwise available from maximizing comparative advantages.

When companies are unable to source goods/services at price levels set by countries with the greatest comparative advantage, the global economy is less efficient and productivity declines in each affected country. For example, if President Trump’s threatened tariffs on $250 billion of Chinese imports were implemented, the domestic GDP growth rate would be “taxed” by approximately 0.2% (Source: Cornerstone Macro). While unlikely to plunge the economy into a recession, at that level tariffs would offset nearly half of the economic growth from the recently enacted tax cuts.

The expansion of global trade has created winners and losers both between countries and for different groups of citizens within countries. But, in the aggregate, expanding global trade has generated a higher standard of living through greater global economic growth. Moreover, global trade facilitates efficient production and resource utilization as there is a ready market for the products/services supplied by countries pursuing their comparative advantage(s). Global trade and comparative advantage are critical aspects of capitalism, which thrives on the efficient allocation of resources.

Capitalism is most effective when governments allow companies to make decisions unfettered by politically motivated taxes designed to curry favor with constituents – this applies internationally as much as it does domestically. In this respect, tariffs are the enemy of capitalism and global economic growth. Indeed, during the recent G7 summit President Trump (in direct contradiction to his actions) shocked our trading partners by suggesting that everyone agree to eliminate all tariffs, trade barriers, and subsidies to promote free trade. President Trump’s casual suggestion to level the playing field for international commerce is the optimal solution to maximize global growth and the benefits that come from it.

Be well,

Justin