Tariffs Come to Main Street
Consumer Research Analyst Joshua Cummings explains what really spooked markets about the recent escalation of the U.S.-China trade conflict.
- Rather than the total dollar amount of new tariffs, we believe the market sell-off was a reaction to further evidence of an entrenched trade battle between the world’s two most important economies.
- This round of tariffs will most directly affect consumers and thus may weigh on confidence. That may ultimately hurt economic growth given the large share of gross domestic product attributable to personal consumption.
- Many companies must likely choose between accepting lower margins or passing along higher costs to customers. We believe strong brands are well positioned, as are companies whose supply chains do not run through China.
Markets reacted negatively – and for good reason – to last week’s news that the Trump administration would introduce tariffs on most of the Chinese exports not already included in earlier rounds of the trade dispute. This latest round consists of products catering most directly to consumers and, given that personal consumption comprises roughly 70% of the U.S. economy, this one may hurt.
While there is likely never an opportune time to throw sand in the wheels of the global supply chain, this escalation of the trade war carries numerous risks that may impact consumers’ wallets, corporate income statements and the U.S. economy alike. To be sure, the ultimate cost of these new tariffs – 10% on an additional $300 billion of goods – is very much absorbable in an economy the size of the U.S. As such, we believe this week’s market reaction was due to additional evidence that the world’s two most important economies are locked in a protracted trade – and broader geopolitical – battle. That’s bad for risk taking on the part of management teams, capital formation and ultimately corporate earnings.
This intensification comes at a time when other concerns about global growth are brewing. The global economy is in an extended business cycle, gross domestic product slowed during the second quarter and wages have yet to break out of their just-above-3% range. Given this backdrop, we expect there to be knock-on effects from these tariffs as price-sensitive consumers may be forced to alter their purchasing decisions to account for potentially higher prices.
The Wrong Kind of Inflation
For the past decade, the Federal Reserve has tried to push inflation toward its 2.0% target. While higher import prices would be inflationary, it’s not the kind of inflation that the economy needs. Welcome inflation would come more in the form of higher labor costs as workers in a robust economy gain leverage in demanding high wages, which, in turn, increases their purchasing power. By contrast, moderate wage gains and imported inflation only act to decrease consumers’ real purchasing power. Under this scenario, we would not be surprised to see consumer confidence slip and households either approach their discretionary purchases more judiciously – often seeking cheaper alternatives – or circling the wagons altogether. We must also consider that a tariff is one of the most regressive forms of taxation, hitting all families with the same rate, thus disproportionately impacting those lower on the income scale.
Prudent inventory management is a key discipline for retailers, especially in the waning days of summer as companies ramp up for the holiday buying season. At present, inventories at many retailers are already high from a seasonal perspective, thus limiting their ability to horde additional stock. Presenting a logistical challenge is the roughly two-week journey from China to the U.S. leaving only a couple of weeks for companies to place orders and get freight on board in order to beat the September 1 commencement of tariffs. Most vulnerable to these inventory challenges, in our view, are apparel, toys, footwear and electronics companies.
Who Loses. Who Loses More
In addition to consumers lower on the economic scale, select vendors and retailers may be in for a stretch of acute pain. Much of this will come down to who is willing – or forced to – suffer the margin compression or risk losing market share by passing along higher prices to consumers. The nation’s largest retailers may have sufficient leverage to extract concessions from vendors that source their products from China, but other companies may not. Regardless of size or region, retailers’ margins have been only mediocre for the past several years. An increasing cost of goods sold will only exacerbate that pressure.
We believe that the only vendors well positioned to pass along higher costs to consumers are those whose products are high quality and sought after. More fungible products not benefiting from a renowned brand will likely come under significant stress.
The Parable of the Dishwasher
There is the chance that any shock on Main Street may prove ephemeral. Evidence of that can be viewed in an earlier round of tariffs that covered appliances. While initially higher prices resulted in immediate demand destruction, sales eventually recovered.
At the same time, many appliances and other bulky items such as home-building materials are produced either domestically or elsewhere in North America. Companies whose supply chains – regardless of the product – run through countries other than China will be more insulated, while off-price retailers could benefit from taking advantage of inventory dislocations in other chains.