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Q2 2019 Client Question: Tarrifs.

Client Questions |

Our Client Question(s) of the Month relates to tariffs. Tariffs have been front-page news over the last year and we have received a few clarification questions on the logistics and implications.


What is a tariff?


A tariff is a tax on imported goods or services. In general, tariffs are implemented to raise revenue for the federal government and/or to protect domestic industries.


What is the history of tariffs in the United States?


The US Constitution gives the federal government power to implement tariffs and to “regulate commerce with foreign nations.” After the Revolutionary War, the first US Congress passed the Tariff Act of 1789, which was designed to raise revenue, help pay down accumulated debt, and close the trade imbalance with England. The bill was sponsored by Congressman James Madison and signed into law by President George Washington. According to “Clashing Over Commerce: A History of US Trade Policy” tariffs produced 90% of US federal government revenue from 1790 to 1860. Tariffs remained a major source of government revenue until the permanent income tax was established in 1913.


The Smoot-Hawley law of 1930 currently holds the mantle as the most infamous tariff legislation in United States history. The law was passed shortly after the stock market crashed and the Great Depression started in 1929. The Smoot-Hawley act raised tariffs substantially on about 900 items, including many consumer products. Over the next two years the volume of US imports and exports dropped by about 40% as other countries responded with their own tariffs. The Smoot-Hawley act receives credit for spreading protectionism worldwide and exacerbating the Great Depression.
After World War II, the use of tariffs decreased substantially as the US moved toward free trade policies. The United States is now instrumental in the World Trade Organization (WTO) which aims to reduce tariffs and other trading barriers. In fiscal year 2018, tariffs only represented about 1% of government revenue.


What about Trump’s Tariffs?


President Trump has decided to use tariffs as a means to bring manufacturing jobs back to the US, retaliate against nations that place levies on US imports, close the trade deficit, and extract concessions on matters not directly related to trade. The Trump administration placed tariffs on imported washing machines and solar panels in January 2018. A few months later, the White House enacted tariffs on steel and aluminum imports from a variety of countries. Most recently, Trump threatened to implement 5% tariffs on all imports from Mexico effective on June 10th (the rate would have risen 5% every month thereafter until it reached 25%). The US and Mexico were able to reach a deal to address President Trump’s concerns and avert the tariffs. President Trump has also threatened 25% tariffs on autos imported from the European Union and Japan (a decision will likely be made before year end).


From an economic and market standpoint, the main concern with tariffs is the ongoing trade war between the US and China. The US began hitting China with tariffs in July 2018 with the goal of forcing an eventual deal that address the trade deficit, intellectual property rights, forced technology transfer, and currency manipulation. As of now, the US has implemented 25% tariffs on $250B worth of Chinese goods and China has placed 5-25% tariffs on $110B worth of US goods. The United States has also threatened to implement 25% tariffs on the remaining ~$300 billion worth of Chinese imports.

Who pays the tariffs? Who absorbs the cost of the tariffs?

There is a distinction between who pays the tariffs and who absorbs the cost of tariffs. The US importer of record pays the tariff when the product arrives in the United States. Importers usually pay the tariff within ten days of their goods clearing customs. While who pays the tariffs is clear (the importer), who absorbs the cost of the tariffs is an open debate between the Trump administration and many economists. The cost of tariffs can be absorbed in three main ways: 1) the supplier discounts the price of the product, 2) the importer absorbs the cost and accepts lower margins, or 3) the importer passes the cost to the consumer. President Trump argues that scenario 1 is occurring and foreign nations are absorbing the cost of tariffs by discounting prices. Many economists have argued that scenario 3 will ultimately occur with the consumer bearing the cost through higher prices and inflation. Tariffs have not been in place long enough for a definitive answer to the question, but we suspect that the longer the tariffs remain the more likely consumer prices will rise.


Who collects the tariffs?


The US Customs and Border Protection (CBP) agency collects the tariff revenue. The proceeds are then sent directly to the Treasury. According to the Department of Treasury’s Receipts and Outlays of the US Government report the total tariff revenue was $44.9 billion in fiscal year 2019 through the end of May. The Treasury expects to collect about $69.5 billion in tariff revenue in the entire current fiscal year.


Why should we care about tariffs?


Tariffs potentially have negative impacts on economic and corporate earnings growth. The Federal Reserve Bank of New York estimated that the current tariffs will cost the average US household $831 per year due to higher prices and reduced economic efficiency. The current consensus estimate for 2019 United States GDP growth is +2.5% Y/Y. Bloomberg estimates that the current tariffs will decrease US GDP growth by -0.2% (-0.5% if the US implements 25% tariffs on all Chinese goods.) The current consensus estimate for 2019 S&P 500 earnings growth is about +4% Y/Y. Goldman Sachs estimates that current tariffs will decrease S&P earnings growth by -2% (-6.0% if the US implements 25% tariffs on all Chinese goods). Several companies have also stated they will raise prices, accept lower margins, or shift their supply chains out of China in response to the increased tariffs.

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The MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe. With 445 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe. The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 322 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan. The MSCI India Index is designed to measure the performance of the large and mid cap segments of the Indian market. With 78 constituents, the index covers approximately 85% of the Indian equity universe. The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa. Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors. The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index. The Russell 3000 Growth Index is an unmanaged index comprised of those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index measures the performance of those Russell 3000 companies with lower price-to-book ratios and lower forecasted growth values. The MSCI China Index is constructed based on the integrated China equity universe included in the MSCI Emerging Markets Index, providing a standardized definition of the China equity opportunity set. The index aims to represent the performance of large- and mid-cap segments with H shares, B shares, red chips, P chips and foreign listings (e.g., ADRs) of Chinese stocks. China A shares will be partially included in this index, making it the de facto index for all of China. It can be used as a China benchmark for investors who use the MSCI ACWI Index or MSCI EM Index as their policy benchmark. The MSCI ACWI ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 26 Emerging Markets (EM) countries. With 2,206 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.

The MSCI United Kingdom Index is designed to measure the performance of the large and mid cap segments of the UK market. With 97 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the UK