US businesses often imports their manufactured goods from China. This is because the cost of manufacturing products is much lower than in other places so they want to take advantage of this. The government makes money off this relationship by imposing tariffs on certain products coming into the US. President Trump announced on March 8, 2018 that the United States will begin imposing a tariff on steel and aluminum imported into the U.S. from countries other than Mexico and Canada.  The tariff on steel will be 25% and 10% on aluminum. There are two main questions that we will seek to answer in this article:

• What happened the last time the U.S. implemented trade tariffs?

• How will the stock market react to the new trade barriers?

What Is A Tariff?

First, let's do a quick recap on what a tariff is. A tariff is a special tax on goods that come into the United States. Tariffs are imposed to make select foreign goods more expensive in an effort to encourage the U.S. consumer to buy more American made goods. For example, if the government puts a 25% tariff on cars that are imported into the U.S., that BMW that was manufactured in Germany and shipped over to the U.S. and sold to you for $70,000 will now cost $87,500 for that same exact car due to the 25% tariff. As a consumer this may cause you not to buy that BMW and instead buy a Corvette that was manufactured in the U.S. and carries a lower price tag.

What Does History Tell Us?

It’s very clear from this chart that the U.S. has not imposed meaningful tariffs since the early 1900’s. Conclusion, it’s going to be very difficult to predict how these tariffs are going to impact the U.S. economy and global trade. Even though we have some historical references, the world is very different today compared to 1930. The “global economy” did not even really exist back then.

As you can see in the chart, the average import trade tariff in 1930 was about 20%. Since 1975, the average trade tariff on imports has been below 5%. More recently, between 2000 and 2016 the average tariff on imports was below 2%.

History Will Not Be A Useful Guide

As an investment manager, when a big financial event takes place, we start to scour through historical data to determine what happened in the past when a similar event took place. While we have had tariffs implemented in the past, many of those tariffs were implemented for reasons other than the ones that are driving the U.S. trade policy today.

Prior to 1914, tariffs were used primarily to generate revenue for the U.S. government. In 1850, tariffs represented 91% of the government’s total revenue mainly because there was no income tax back then. By 1900 that percentage had dropped to 41%. As many of us are well aware, over time, the main source of revenue for the government has shifted to the receipt of income and payroll taxes with tariff revenue only representing about 2% of the government’s total receipts.

During the Industrial Revolution (1760 – 1840), tariffs were used to protect the new U.S. industries that were in their infancy. Without tariffs it would have been very difficult for these new industries that were just starting in the U.S. colonies to compete with the price of goods coming from Europe. Tariffs were used to boost the domestic demand for steel, wool, and other goods that were being produced in the U.S. colonies. These trade policies helped the new industries get off the ground, expand the workforce, and led to a prosperous century of economic growth.

Today, tariffs are being used for a different reason. To protect our mature industries from the risk of extinction as a result of foreign competition. Since the 1950’s, the global economy has evolved and the trade policies of the U.S. have been largely in support of free trade. While this sounds like a positive approach, free trade policies have taken their toll on a number of industries here in the U.S. such as steel, automobiles, and electronics. Foreign countries like China have access to cheap labor and they are able to produce select goods and services at a much lower cost than here in the United States.

While this a good thing for the U.S. consumer because you can purchase a big screen TV made in China for a lot less than that same TV made in the U.S., there are negative side effects. First and foremost are the U.S. jobs that are lost when a company decides that it can produce the same product for a lot less over in China. We have seen this trend play out over the past 20 or 30 years. Tariffs can help protect some of those U.S. jobs because it makes products purchased from foreign manufactures more expensive and it increases the demand for U.S. goods. The downside to that is the consumer may be asked to pay more for those same products since at the end of the day it costs more to produce those products in the U.S.

In the announcement of the steel and aluminum tariffs yesterday, the White House also acknowledged the national security risk of certain industries facing extinction in the United States. Below is a chart of production of steel in the U.S. from 1970 – 2016.

As you can see in the chart, our economy has grown dramatically over this time period but we are producing half the amount of steel in the U.S. that we were 47 years ago. If everything stayed the same, this reduction in the U.S. production of steel would probably continue. It begs the question, what happens 50 years from now if there is a global conflict and we are unable to build tanks, jets, and ships because we import 100% of our steel from China and they decide to shut off the supply? There are definitely certain industries that we will always need to protect here in the U.S. even though they may be “cheaper” to buy somewhere else.

There is also monopoly risk. Once we have to import 100% of a particular good or service, those producers have 100% pricing power over us. While I would be less concerned over TV’s and electronics, I would be more concerned over items like cars, foods, building materials, and other items that many of us consider a necessity to our everyday lives.

Free or Fair?

While we have had “free” trade policies over the past few decades, have they been “fair”? Elon Musk, the CEO of Tesla, recently highlighted that “China isn’t playing fair in the car trade with the U.S.” He goes on to point out that China puts a 25% import tariff on American cars sold to China but the U.S. only has a 2.5% import tariff on cars that are manufactured in China and sold in the U.S.

In response to this, Trump mentioned in his speech that the U.S. will be pursuing “reciprocal” or “mirror” trade policies. Meaning, if a country puts a 25% tariff on U.S. goods imported into their country, the U.S. would put a 25% tariff on those same goods that are imported from their country into the U.S.

Trade Wars

While the reciprocal trade policies seem fair on the surface and it also makes sense to protect industries that are vital to our national security, the greatest risk of transitioning from a “free trade” policy to “protectionism” policy is trade wars. We just put a 25% tariff on all of the steel that is imported from China, how is China going to respond to that? Remember, the U.S. is part of a global economy and trade is important. How important? When you look at the gross revenue of all of the companies that make up the S&P 500 Index, over 50% of their revenue now comes from outside the U.S. If all of a sudden, foreign countries start putting tariffs on U.S. goods sold aboard, that could have a big negative impact on the corporate earnings of our big multinational corporations in the United States. In addition, when you listen to the quarterly earnings calls from companies like Apple, Nike, Pepsi, and Ford, the future growth of those companies are relying heavily on their ability to sell their products to the growing consumer base in the emerging market. Countries like China, India, Russia, and Brazil.

I go back to my initial point, that history will not be a great guide for us here. We have not used tariffs in a very long period of time and the reason why we are using tariffs now is different than it was in the past. Plus the world has changed. There is no clear way to know at this point if these new tariffs are going to help or hurt the U.S. economy over the next year because a lot depends on how these foreign countries respond to the United States moving away from the long standing era of free trade.

Canada & Mexico Exempt

The White House announced yesterday that Canada and Mexico would be exempt from the new tariffs. Why? This is my guess and it's only guess, the U.S. is currently in the process of negotiating the NAFTA terms with Canada and Mexico. NAFTA stands for the North American Free Trade Agreement. Trump has made it clear that if we cannot obtain favorable trade terms, the U.S. will exit the NAFTA agreement. The U.S. may use the recent tariff announcement as a negotiation tool in the talks with Canada and Mexico on NAFTA. "Listen, we gave you an exemption but if you don't give us favorable trade terms, all deals are off."

Coin Flip

While tax reform seems like a clear win for U.S. corporations, only history will tell us whether or not these new trade policies will help or harm the U.S. economy. If we are able to protect more U.S. jobs, protect industries vital to the growth and protection of the U.S., and negotiate better trade deals with our trading partners, we may look back and realize this was the right move at the right time.On the flip side of the coin, if trade wars break out that could lead to a decrease in the demand for U.S. goods around the globe that may cause the U.S. to lose more jobs than it is trying to protect. As a result, that could put downward pressure on corporate earnings and in turn send stock prices lower in the U.S. Only time will tell.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.