Stocks got a day of rest yesterday, closing mostly higher, as traders await the next big drop from the Trump transition team, who will head the Treasury. Builders were more optimistic than expected this month, but far less than in years past, according to the latest NAHB report.
The best things in life are free. The Motown classic, which was probably made most famous by the Beatles 1960s cover, got it almost right in at least two of the first three lines of lyrics. You see, EVERYTHING HAS COST, even… well, you know 🐦🐝. This is unarguably true when it comes to the economy. Even politicians know this, which is why the best politicians are skilled shell game artists. We all know this. At least once in all our lives we have experienced that spending hangover in the first week of January when the December credit card bill showed up. Thanks to NY real estate developer Seymour Durst, New Yorkers and possibly the World got a graphic representation of what the US’s national debt looked like way back in 1989 and it was scary for a minute. The national debt back then was about $2.8 trillion versus today’s almost $36 trillion, with great promises of growing that yet further in the nearest future as President-elect Trump prepares to make good on his campaign promises. There has been much discussion in Wall Street circles about that impending debt expansion. The possibility of the swelling debt has been a major driver of the higher bond yields that have been overhanging the capital markets and struggling housing market.
Let’s go a layer deeper than the blaringly obvious today and contemplate what downsides we might expect with some of Trump’s proposed policies. Let me start by saying that there is no doubt that his proposals are stimulatory, and with the Republicans controlling both chambers, there is a good probability that Trump will be able to bring some of his proposals to reality. Ok, down to the dirty work. Let’s start with the obvious, tariffs. I offered up proof last week that I was early to the party of hand raisers by reposting a hand-drawn picture from a note that I posted in 2018. The pencil-drawn chart showed how tariffs are inflationary. By now, we all know this to be a challenge. Universal tariff proposals range from 10% to 20% on all imported goods, and Chinese goods may be taxed as high as 60% to 100%. Let’s play that out for a moment. At the most basic level, a product which is manufactured in the EU may be taxed by an additional, let’s be conservative, 10%, will cost someone in the US, literally 10% more. Those already expensive gummy candies from Sweden or BMWs from Germany will cost NYC’s Instagram-famous BonBon, or your local BMW dealership an additional 10%. If the business owners are even somewhat rational, you will pay some, if not all of the additional cost. That, my dear friends, is inflation in its rawest form.
But let us delve into a not-so-obvious potential issue, maybe one step lower, and look at manufacturing. Let’s take Ford, for example. Of the company’s top ten suppliers, only three are domiciled in the US. Its third largest supplier, Magna International is a Canadian company which supplies Ford with some $5.1 billion worth of scrap aluminum per year. With a potential 10% tariff on Canadian aluminum, someone is going to have to come up with 518 million extra dollars from somewhere. Folks, I can spend a lifetime going down a list of just S&P500 companies who are heavily reliant on foreign producers of commodities, parts, and sub-assemblies, and the math is the same. Only 49% of mega-retailer Walmart’s suppliers are domiciled in the US, with some 21% coming from China and India alone. Apple’s supply chain is made up of only 23% US domiciled suppliers. Everyone’s favorite NVIDIA actually relies on around 42% of domestic suppliers. Still, 18% of NVIDIA’s suppliers facilities are in China. As mentioned earlier, someone is going to have to pay for these new tariffs, and I can assure you that some of these costs will ultimately find their way into yours and my shopping carts. You are probably thinking that Apple, as in the past, may decide to eat the cost in order to maintain market share. Ok, thanks Tim, but what about the stock’s value with lower margins? Do you own Apple stock? Probably, and that is how you will bear the cost. Ultimately, one cannot argue that tariffs are not inflationary.
I just want to briefly touch on one more issue relating to tariffs before I move on. Tariffed countries, as one might suspect, don’t take tariffs lightly. Remember the whole idea of tariffs is to discourage domestic consumers and companies from buying foreign products. China, for example, stands to lose a noticeable amount of GDP as a result of additional US tariffs. China is therefore likely to launch retaliatory tariffs on US products. What, you think the US doesn’t sell stuff to China? China buys agriculture commodities from the US. Do you recall that China imposed a 25% tariff on US-grown soybeans in the first Trump trade war in 2018? The increased cost to Chinese buyers causes them to seek cheaper sellers like Brazil, ultimately causing damage to not only US farmers, but all the products they may buy from companies like Deere, AGCO, ADM, Bunge, and Cargill. The list goes on. So, in summation, definitely inflationary, and without a doubt bad for domestic companies.
Let’s move on to the energy sector. This one is easier than you may think. We all start with the “drill, baby drill” thing. Ok, we get it, remove the shackles of regulation allowing US oil producers to do what they do best. That should, in theory, be great for the sector. But hold on. Remember nothing is free. Crude oil is a commodity and, as such, is governed strongly by the rules of supply and demand. More supply means lower prices. Did you know that it costs domestic shale producers about $65 per barrel to drill from a new well? For reference, WTI crude is around $67 this morning. Existing shale drills cost about $35 per barrel, which is more profitable, but declining prices will eat into energy producer profits. Gasoline costs may come down as a result of increased supply, but the companies that drill and refine will make… um, less profit. So, don’t be surprised if drill baby drill doesn't play out as you expect in your portfolio holdings.
This brings us to a touchy topic, mass deportation of illegal migrants. Actually, it is not so touchy when you look at it purely from an economic perspective. Let’s do it that way and avoid the ideological debate. Let’s be really clear, agriculture, construction, food services, hospitality, manufacturing, and home healthcare, to name just a few, all rely heavily on undocumented laborers. If suddenly every illegal, but working migrant were to suddenly disappear, just think about the significant and negative impact that it would have on the domestic supply chain. Stepping back, imagine that all those producers would have to backfill open positions with domestic, legal laborers. The labor market is also governed by supply and demand. The higher demand to fill vacancies will cause labor costs to spike. Oh, and lest we forget, supply of laborers will also decline with the deportations. This will have a pretty seriously negative impact on all industries that rely on these workers today. This is, without a doubt, also inflationary. Don’t believe me? Think back to the pandemic when the labor market was tight. It was one of the key catalysts of the spate of post-pandemic inflation. Correspondingly, throw in the likely supply chain disruptions which will cause supply outages to consumers; also, inflationary. Jumping to the supper high-level view, let’s not forget that illegal immigrants are also consumers. Consumption makes up… 66% of GDP, and less of those 66% will suddenly be present to – well, consume. Expect an impact on consumption and GDP.
Finally, we must talk about another uncomfortable topic. Stimulus. Do you want to pay less taxes? Of course. Who doesn’t want more of their hard-earned money in their pocket? More money to spend is awesome, and it is also a very good way to increase overall consumption. This is the golden fleece sought by all politicians. And for good reason, statistics show that a flourishing economy gets politicians elected. The economy was the top consideration for voters in this past election, at least according to exit polls. It, therefore, seems like an easy low-hanging-fruit win for politicians to cut taxes, make voters richer, and stimulate the economy. I would love to end this right now with a “…and they lived happily ever after,” but I can’t because… well, there is a cost to all of this. No, I am not going to bring up the increased deficit, we already covered that. All that extra spending and INCREASED CONSUMER DEMAND LEADS TO INFLATION. Remember that? Please don’t get me wrong, I love me a good tax cut, but I also know that there will be a price to pay somewhere, at some point. I also want to make a quick mention that not all tax cuts are the same. Cutting personal income tax on things like tips, overtime, and social security are one thing, but cutting the corporate tax rate (or keeping it at the current rate) is completely another. Lowering corporate taxes can be stimulatory to the economy and certainly stimulatory to our portfolios without being inflationary. Additionally, while income tax cuts will have a big impact on the national debt, corporate tax represents less than 10% of the Treasury’s income as opposed to the roughly 50% in receipts from individual income tax. So, a corporate tax cut can be stimulatory with less of a burden on the deficit and debt load.
In summation, while it is clear that there are many potentially positive benefits from Trump’s proposed policies, there are costs as well. Tariffs may be a stick to bring production to US soil and gain trade advantages over US trade partners, but they are without a doubt, inflationary. Additionally, trade wars can have all sorts of nasty and negative effects on the global supply chain. While deportation of undocumented workers may create more opportunities for documented workers and will reduce burdens of state and local budgets and infrastructure, it is also, without a doubt, inflationary as a tighter labor market will cause labor costs to rise. Deregulation in the energy sector may appear on the surface to be beneficial for energy producers and consumers, but it is likely to have a negative impact on the former as declining prices will burden corporate margins. And last but not least, tax cuts, loved by all are, indeed, stimulatory but ultimately, inflationary. Considering that the economy, though healthy, is still very much on tenterhooks with the labor market and the sticky remnants of post-pandemic inflation, caution must be taken. Recalling how inflation began with supply chain disruptions, tight labor markets, and stimulus, one cannot but wonder if we might find ourselves back where we were in 2021.
So, here we are, already making predictions on legislation not yet even proposed by an administration who has not even gotten the keys to castle. We are assuming that a Trump 2.0 administration did not learn from the mistakes of the Trump 1.0 administration, all proposed tariffs will be permanently and instantly instituted, all tax cuts taken to the extreme, etc. It should be clear that all these costs which I have just outlined could have some painful impacts on not only our wallets but also the markets and our portfolios. Knowing that President-elect Trump likes to use the market as a scorecard for his success, one would expect that the administration will take a measured approach in policy rollout. One final note, I promise. Increasing the deficit is not bad if the returns on that investment are acceptable. Growth, through careful, well thought out strategy can indeed be really positive, and by the way the debt clock still exists in New York, though it has been moved from its original location… and a lot more zeros have been added to accommodate the growing national debt.
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