Through the Looking Glass: The Effect of Tariffs on International Stocks

Much has been written about the potential impact of tariffs on the U.S. economy and financial markets, and almost as much about the impact of 25% tariffs on countries with which the U.S. has large trade deficits, Canada and Mexico. But far less has been written about the effect of tariffs on international markets, where firms like Baird's global and international asset management arm, Chautauqua Capital Management, deploy the bulk of their investors’ money – China, Europe and Asia. I had an opportunity to sit down with Chautauqua Portfolio Managers Haicheng Li and Jesse Flores to discuss what the confusing, shape-shifting Trump administration tariff policy looks like from overseas.

Haicheng:
Obviously, this is an area of tremendous concern for leaders abroad, particularly in Europe and Asia, because higher tariffs will likely reduce demand for their exports. In addition, this is a period of confusion – and, for certain companies, chaos – as U.S. tariff policy seems to be a moving target. During the presidential campaign, the starting salvo seemed to be universal tariffs, but then it morphed into country- and sector-specific tariffs. Without clear tariff policies, companies that import goods don’t have the information they need to set prices.

Starting in 2018, the first Trump administration imposed duties on steel and aluminum from many countries and tariffs on goods imported from China, a strategic competitor of the U.S., with the purpose of containing China’s rise. The trade deficit with China sank, but companies responded by routing goods into the U.S. through back-door countries like Vietnam and Mexico.

For Trump, tariffs seem to be about:

• raising revenue for the extension of the Tax Cuts and Jobs Act
• paying debt service on higher interest costs
• fulfilling the campaign promise of “making America great again” by helping its industries
• reducing the trade deficit, particularly with China, Mexico and Canada – the three countries with whom we have the largest trades. 

Distinctions have been made between “transactional” tariffs – those the Trump administration is wielding for negotiating purposes – and “structural” tariffs – revenue-raising tariffs that are likely to be around for the long term. Is that distinction valid? 

Haicheng:
While a big part of Trump’s tariffs is about negotiating, he does believe that some level of tariffs is good because modest tariffs can reduce demand, which can lower prices on imported goods and thus improve consumers’ welfare. Therefore, “structural” tariffs are becoming more probable.

The current tit-for-tat ratcheting up of tariffs has been described as a “trade war on steroids.” What do you expect will be the impact on the global economy? 

Jesse:
Overall, in the global economy, inflation is going to go up and growth rates will be lower, though not by that much. Only 17% of the global economy is manufacturing.

The single most important international market is China. What will be the impact of the latest tariff proposals on China?

Haicheng:
The Chautauqua International Growth strategy is invested in several Chinese and Hong Kong companies that we believe are undervalued and offer clear advantages. Many of our portfolio companies have no or de minimus direct exposure to U.S. tariffs. For example, Alibaba, Tencent and KE are mostly reliant on Chinese domestic demand and earn revenue from Chinese domestic sources. BeiGene manufactures its key drug Brukinsa in the U.S. WuXi Biologics earns a significant revenue stream from the sale of services, which are not subject to tariffs, and otherwise has manufacturing capabilities in its facilities in the U.S., Ireland, Germany and Singapore. Hong Kong Exchanges earns revenues directly from the trading activity of financial assets in Hong Kong and China.

However, new tariffs on Chinese goods are likely to negatively impact China’s GDP growth. At an additional 10% tariff, the Peterson Institute for International Economics projects China’s GDP growth to be -0.15% to -0.20%. Lower GDP growth is likely to impact holdings in Alibaba, Tencent, KE and Hong Kong Exchanges through lower revenue growth.  

As an international equities manager, how are the administration’s tariff proposals affecting your investment process? 

Jesse:
Tariffs don’t impact our investment process. We invest in the best companies – long-term secular winners with strong competitive positioning and big moats around them. One-of-a-kind businesses, demand for whose products is largely non-elastic. The companies we invest in are tariff-resilient and will find ways to withstand shocks. Tariffs are a shock, but so was the pandemic – and frankly, the pandemic was a much bigger shock.

How do you see all of this playing out over the months and years ahead?

Haicheng:
It’s hard to predict the future. If you look at what the administration is trying to do, they want to solve the problem of the revenue side, because of the size of the fiscal deficit and higher-for-longer interest rates. We are in uncharted waters.

Consider this chart, starting before Trump took office. For the past at least five years, the U.S. stock market has done better than international markets. That is because of technology and U.S. dollar strength. The U.S. has been a leader in technology, and the U.S. dollar tends to be strong when there is more uncertainty elsewhere. For the last year, the performance of the two indices was pretty tight … until late September/early October, when there was evidence that Trump was more likely to win and the market started to anticipate how Trump’s America First policy might be negative for international markets. However, this year international stocks have begun to outpace U.S. stocks. This change is partly due to attractive valuations in international markets and partly due to uncertainties related to tariffs and government spending cuts.

And you think that is due to tariffs?

Haicheng:
Yes, I think so. Tariffs play a big part here because people began to anticipate more tariffs, less global trade and a higher U.S. dollar.

Valuations for U.S. stocks have gone up. If you look at the end of January, the CAPE ratio (which assesses a company’s long-term financial performance) in the U.S. was 37.6 – close to its 2021 high. By comparison, international valuations are a lot lower and haven’t changed much: Europe is at 21.3, for example, and China is at 13.1. So based on valuations alone, expected future returns in international markets are likely to be higher.

Jesse:
To sum up: In our view, tariffs are being pushed by Trump as being pro-America. But the reality is that trade wars and retaliatory tariffs only have losers. It’s a misconception that tariffs only hurt exporting countries shipping goods into the U.S – it also hurts the U.S. because prices of goods go up. Consumers are going to pay those higher prices, and that's going to impact inflation and U.S. GDP growth as well.

As international investors, it's important to highlight that the portfolios we've constructed through a bottom-up investment process – looking for companies that have sustainable competitive advantages – are actually tariff-resilient and able to withstand price increases. Companies that carry strong profit margins, have great balance sheets and are able to generate cash throughout the economic cycle. Their products are difficult to replace, and they therefore have more ability to pass through price increases. 

U.S. equity market valuations are really expensive right now, and the international markets are just way, way cheaper. So, as a starting point for future returns, we think that there's a greater likelihood that a tariff war will hurt the expensive U.S. market more than the cheaper international markets.

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