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Markets follow a well-worn pattern after Donald Trump’s pronouncements, a pattern followed by tax, North Korea and trade. There is a sharp reaction—up or down—on the first news, fading as doubts that the president is willing to follow through set in. Then there is another panic on the realization that he is serious, and finally the market prices in the details of whatever compromise he settles on.
The Trump trade war briefly reached the realization phase on Tuesday, but markets are still waking up to the idea that trade battles are more than a sideshow. Investors who think China won’t back down still have plenty of opportunity to get out. They also have a problem: get out of what, exactly?
It is exceptionally hard to work out how to price in a prolonged trade fight. So far investors have turned to simple rules of thumb, but ignoring the complexities won’t make them go away. The basic rule is to avoid companies with big Chinese exposure, particularly those that could also make handy high-profile targets for foreign retaliation.
So far that has meant selling shares in Caterpillar and Boeing, preferring smaller stocks to bigger ones, and preferring the U.S. to emerging markets, especially China and big trading partners such as South Korea.
“There were a lot of assumptions that these tariffs were simply negotiating tactics and we would come up with some sort of agreement and they wouldn’t be put in place,” said Robert Baur, chief global economist at Principal Global Investors in Des Moines, Iowa. “That’s clearly not right, but how far it is going to go we don’t know.”
The first corporate information knocked shares in German car maker Daimler down 4% on Thursday. It said profits would be hurt as China’s retaliatory tariffs on U.S. light trucks hit Mercedes SUV exports from its Alabama factory. But information about other companies is sparse, partly because supply chains are so complex.
Tuesday’s price drops showed that China-related stocks in the U.S. are sensitive to trade fears. All but one of the 14 S&P 500 members that make more than a quarter of their revenue from China fell by more than the index.
Yet, the same stocks suggest that trade war fears haven’t sunk in properly, with six of them up and seven down since the day before the announcement of tariffs on the first $50 billion of Chinese goods in March. Caterpillar and Boeing tell the same story, with their shares falling hard this month but being dominated by other issues until then.
This makes sense. It is hard to price in something you don’t understand, and the implications of a trade battle are obscure, at best. Not only do we not know precisely which products will be targeted in the next round, or how long the tariffs will last, but we have little understanding of complex corporate supply chains.
Measures of revenue exposure to China—or of Chinese corporate exposure to the U.S.—don’t capture the complexity of modern manufacturing, either. U.S. company Qualcomm has microchips made for it in Taiwan, before they are sold into China to make mobile phones and shipped abroad. Even if China extended tariffs to U.S. chips, those made in Taiwan wouldn’t be covered.
On the other hand, if the U.S. extends tariffs to consumer goods, then the suppliers to imported phones, including Apple ’s iPhone, could be hit. Ironically, a successful U.S. company is more exposed to possible U.S. tariffs on China than it is to Chinese tariffs on the U.S. Even worse is for chip makers who do produce in the U.S. and sell to China, as they might be hit twice, once if China levies a tariff on their chips, and once if the U.S. charges a tariff on the phone imported back from China.
UBS strategists who tried to isolate Asian stocks embedded in global supply chains also found little effect, until very recently.
The biggest effect has instead been on wider markets and currencies. There has been no link between how much of an Asian company’s sales come from the U.S. and its stock performance in local currency terms, according to data from S&P Global Market Intelligence. But include the effect of currency moves, and U.S.-exposed Asian stocks have underperformed by about 10 percentage points, UBS found.
The simple rules of thumb—sell China, sell Korea, sell emerging markets, prefer smaller to larger U.S. stocks and buy the safe-haven dollar and bonds—have been working better than detailed analysis so far, in part because the prospects for a trade war are still so uncertain. If it becomes clear that new trade barriers are here to stay, understanding both the details of which companies will be hit and the knock-on effects on the economy will matter more.
Copyright The Wall Street Journal 2018