With ongoing NAFTA uncertainty and talk of global trade tariffs—either on the table or tweeted from U.S. President Donald Trump’s Twitter account—your clients might be wondering how global trade risks affect their portfolios.
To help you respond to clients, we asked industry experts to weigh in with their trade risk outlooks and tips for portfolio positioning.
How real is trade risk?
“Undeniably, protectionist risk has risen over the last month or so,” says Eric Lascelles, chief economist at RBC Asset Management in Toronto, noting that NAFTA risk, in particular, has ebbed and flowed with various deadlines.
“It’s now looking rather challenging to get a deal before the [Mexican] presidential election on July 1,” he says, and possibly before U.S. midterm elections in the fall. “It’s quite conceivable that no deal is struck.”
Speaking to Advisor.ca on June 12, he put the odds of a NAFTA deal at 50-50, a decrease from 55% the week before.
The increased risk should be put in perspective, however.
If NAFTA were shredded (a 25% chance, says Lascelles), the participating countries would, as World Trade Organization members, default to most favoured nation (MFN) tariff rates. One potential outcome: the countries would impose on each other a symmetric MFN tariff rate based on average MFN rates in the region—about 4%.
Referring to that relatively moderate rate, Lascelles says, “You’d need NAFTA to be killed and then the imposition of some big tariffs, in addition, to make that a serious problem.”
He adds that, for the U.S. economy, positives from U.S. tax reform outweigh negatives of protectionism.
“Don’t get me wrong: a full trade war could yet reverse that thinking,” he says. But so far, tariffs—both applied and threatened—represent “a more modest economic and market drag” compared to the boost from tax cuts.
Further, he says it’s difficult to find an economic model that shows protectionism results in extensive damage, unless extreme. Current protectionist measures would need to increase significantly to reach trade war status, he says.
In addition to tariffs already in place on steel and aluminum imports (25% and 10%, respectively, including Canada, Mexico and the EU), the U.S. has announced a 25% tariff on up to $50 billion of Chinese goods, effective July 6, with China retaliating. In total, Trump has threatened tariffs on up to $150 billion of Chinese goods.
In Canada, all eyes are on potential auto tariffs (potentially 25%), though they aren’t part of a base case scenario for Lascelles. Such tariffs would be “problematic to the U.S.,” he says, since it doesn’t have full auto capacity. Still, “the auto sector has taken on a symbolic importance in the eyes of President Trump. […] It seems to be a linchpin of NAFTA negotiations.”
Norman Levine, managing director at Portfolio Management Corporation in Toronto, says clients should be reminded of the rhetoric inherent in tough trade talk. For example, Trump has cultivated a brash negotiation style in private business, but markets don’t react to rhetoric, says Levine. “If that wasn’t the case, stocks like Magna wouldn’t be hitting recent highs.”
Likewise, Frank Holmes, CEO and CIO at U.S. Global Investors in San Antonio, Texas, notes that market response is increasingly sophisticated thanks to big data analysis. “Quant funds are downloading every filing of the U.S. government and going through […] Congressional studies” to make quality economic assessments, he says. “That the market grinds to higher highs would say that [trade talk] is a lot of short-term noise.”
To explain the ongoing rise in equities, in part, Holmes points to positive U.S. productivity data. For example, capital expenditure is surging in response to lower corporate taxes and higher salaries (firms spend on capex so workers can be more efficient). Bloomberg reports that capex increased 39% year over year in Q1 for reporting S&P 500 companies. ISM data for the U.S. is “strong and robust,” suggesting strong GDP growth, says Holmes. (The IMF forecasts U.S. GDP of 2.9% this year; the Bank of Canada, 2.7%.)
Further, Holmes cites the effect of the current strand of global populism—and its tendency to push back against regulation—on markets. “Cutting regulations is like a tax break,” which, historically, acts as a spending multiplier within the economy, he says.
David Fingold, vice-president and portfolio manager at Dynamic Funds in Toronto, downplays recent protectionist headlines, citing a laundry list of historical tariff threats. “This is all normal,” he says, referring to trade talk.
Levine says Canadian investors should have broadly diversified portfolios across companies, industries and regions—but not only because of trade risks. “Canada is 3% of world markets [and] very concentrated in resources and financials,” he says, “That helps protect your clients against something that may happen in Canada.”
Timeless (investing) style
If Levine’s suggestion sounds like business as usual, that’s because it is.
“We’re continuing on as usual, buying what we consider good, undervalued stocks,” he says. Plus, “We’re keeping more than half our money outside Canada, in the equity markets.” This includes international companies headquartered in Canada. “We’re not all that interested in owning too many only-domestic companies,” he says, referring again to the importance of diversification.
And because headlines worry clients, he makes an effort to explain the underlying rhetoric.
Regardless of protectionism, Fingold asks of every investment: What in the world could change? Changes include trade tariffs but also commodity prices, foreign exchange, interest rates, regulation, war, environmental disasters and so on. “It’s basic security analysis,” he says. A well-managed company has a plan for adapting to changed conditions.
Lascelles says no investor should be fully positioned for a trade war. “It’s a growing risk, but there’s no certainty that protectionism wipes out this cycle.” He suggests a probabilistic approach to investing as opposed to betting on a particular tail risk like protectionism.
As a result, he says the bank continues to be overweight equities, but less so than previously. “We’ve steadily ratcheted back our risk appetite over the last year-and-a-half or so,” he says. The move reflects protectionism risk but also the cycle’s end.
Holmes says that if trade woes come to fruition, tariffs will act as a form of regulation, with U.S. small caps positioned to benefit, including manufacturers and consumer products companies focused on domestic demand. Small caps are further set to benefit from big corporations’ capex, he adds. Levine and Lascelles will also be considering the small cap space.
But headlines will never replace investing fundamentals.
“Every day we try to invert the investor hypothesis,” says Fingold, giving a shout-out to Charlie Munger, longtime business partner of Warren Buffett. Munger suggests investors search for a reason not to own a company.
Says Fingold: “If you can’t find a reason, keep on owning it.”