Image: Shanghai, China (December 2016), Andrey Filippov
Stock markets in the US are slowly building in the prospect of retaliation (a “trade war”) from China, as a result of President Trump’s new tariffs. We maintain our view that the stock market has been frothy for some time, and the recent volatility may just be the beginning of a reversion to normalized valuations, with or without concerns about global trade.
By Brian Nelson, CFA
The market may be using concerns about a “trade war” as a reason to sell overpriced stock. According to Factset, as of March 16, the forward 12-month price-to-earnings ratio for the S&P 500 is still over 17 times, one turn more than the 5-year average and nearly 3 full turns above the 10-year average (each turn representing about 150-160 points in the S&P 500, which is hovering around the 2,700 mark at the time of this writing). We continue to be less concerned about the ramifications of any trade war than we do with respect to current forward valuations, which still seem frothy, even after factoring in the tax benefits for 2018.
The talk of a trade war still cannot be ignored, however, as there is a long line of history that suggests leaders can and do overreact to real or implied threats (economic or otherwise), particularly when “ego” is involved. We didn’t have two world wars during the 20th century because leaders of superpowers “got along” nicely. Bad things, sometimes, can and do happen, but in some respects, it’s actually a good thing that we’re talking about a trade war and not an actual military conflict…for now.
On the diplomatic front, things could be worse. Trump appears to have set up a time to meet with North Korean leader Kim Jong Un “at a place and time to be determined,” and while we’re happy the two leaders may yet talk, we think Kim Jong Un is probably more interested in unifying the Korean Peninsula under his rule than anything else, perhaps using de-nuclearization as a tactic to spread North Korean influence. If Trump balks at this, which he might, the US could look like the ones that aren’t meeting in the middle to prevent nuclear holocaust. Perhaps an exaggeration, but the globe might not be able to rest easy just yet.
Making true on his campaign promises, in any case, President Donald Trump’s latest foray is to go after China (FXI, MCHI) for “currency manipulation” and intellectual property theft, targeting tariffs on ~$50 billion worth of Chinese imports. These tariffs would be separate from those on steel (SLX) and aluminum, which actually appear more “watered down” than originally thought. It appears that the steel and aluminum tariffs will not be immediately imposed on Europe (EZU), Australia (EWA), South Korea (EWY), Argentina (ARGT), or Brazil (EWZ). However, messing with China can’t be a good thing, in any respect. For starters, China owns more US government bonds than any other sovereign, and the US debt continues to climb, now over $21 trillion.
Many are pointing to Boeing (BA) as the obvious company where China can retaliate, but we doubt that even China could derail the commercial aerospace giant’s long-term story. Boeing’s backlog is too full to experience any sort of disruption, and the replacement market plus the need for planes in emerging markets, absent China, is enough to keep Boeing’s deliveries very healthy for some time. China’s first narrow-body jetliner, the Comac C919, has for some time, been expected to enter commercial service some time in the next decade, so Boeing has already been dealing with looming competitive dynamics from a Chinese state-owned enterprise. We think the market is overreacting and selling Boeing to “play” the tariff trade.
The agricultural markets, particularly with respect to soybeans (SOYB), could be disrupted if China really amps up its retaliatory measures. Not only can agricultural equipment makers such as Caterpillar (CAT) and Deere (DE) face the heat from tariffs on steel and aluminum, but China is “the top importer of US soybeans and related products,” and should there be retaliation, American farmers could be hurt, regardless of efforts by the White House to mitigate the pain. Net farm incomes are critical to driving new equipment purchases, and ongoing uncertainty in the agricultural markets could prove to be an indirect headwind to the large equipment manufacturers, whether retaliation happens or not. In the already uncertain agricultural commodity markets, there may be no need for further uncertainty.
Some of the other companies, perhaps most exposed to retaliation, may be General Motors (GM), where it “sells 70% more cars in China than the US,” and Yum China (YUMC), the owner of the very popular KFC restaurant franchise in China. Both of these entities could face Chinese consumer backlash under a “Buy Chinese” fervor that could sweep the nation, much like “Buy American” has in the US. The aspirational goods makers could feel a pinch if Chinese consumers are turned off by American brands, with maybe Tiffany (TIF) or Michael Kors (KORS), feeling some weakness at the margin, but we don’t believe it’s worth overreacting to the news flow. Even the beverage makers, both non-alcoholic and alcoholic, may not be hurt that much, given the content costs of steel or aluminum, for example, as a percentage of end-product pricing. In a Campbell Soup (CPB) can, for example, “there are about 2.6 pennies worth of steel,” meaning even hefty tariffs would be practically negligible to the consumer.
All in, however, investors have been selling the news, and Boeing and perhaps Altria (MO)–the latter given its stake in alcoholic beverage giant, Anheuser-Busch Inbev (BUD)–feeling the most pain. Though uncertainty regarding trade wars may pass, now that it is no longer a foregone conclusion that economic policy in the US will avoid protectionism at all costs, the uncertainty with respect to long-term US gross domestic product expansion has only widened, pressuring equity valuations as investors seek to better understand long-term potential growth rates in a world where free trade may not proliferate. We’re not overreacting to the tariff news, of course, but we did remove Boeing from the simulated Dividend Growth Newsletter portfolio March 16, mostly for valuation and technical reasons, “Saying Good Bye to Boeing…For Now.” We’re waiting for Trump’s next move, but we think rhetoric will only intensify from here on out.
Agricultural Machinery: AGCO, CAT, CNHI, DE, HEES, MTW, RBA, TEX
Auto Manufacturers: F, GM, HMC, HOG, TM, TSLA
Beverages – Alcoholic: BF.B, BUD, SAM, BORN, CCU, STZ, DEO, FMX, TAP
Beverages – Nonalcoholic: CCE, KO, DPS, MNST, FIZZ, PEP, SODA
Chemicals – Agricultural: AGU, CF, CMP, IPI, MON, MOS, POT, SMG, TNH
Containers & Packaging: ATR, BLL, BMS, CCK, OI, PKG, SEE, SLGN, TUP
Luxury Goods – Established Brands: AVP, EL, LULU, NKE, PHG, PVH, REV, SIG, SNE, UA, VFC
Luxury Goods – Ultra & Aspirational: BID, CFRUY, CTHR, FOSL, KORS, LVMHF, RL, TIF, TPR
Metals & Mining – Aluminum: AA, ACH, ATI, CENX, KALU
Metals & Mining – Steel: AKS, GGB, MT, NUE, PKX, STLD, X
Truck Machinery: CMI, CVGI, NAV, OSK, PCAR, WNC
Related: ADM, BG, DWDP
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.