Economic Report
Steven I. Dym
Analytical Capital
May 2019
Trade wars, the economy and stock prices
BACKGROUND
Let’s begin with a quick assessment of the investment environment: The unemployment rate, 3.6%, is at a 49-year(!) low (Bureau of Labor Statistics). Even when including “marginal” workers, those whom some policy makers have identified as not having gained from the strong labor market, the rate is dramatically low. Real GDP has expanded on average 3.25% over the past four quarters (Bureau of Economic Analysis), a marked improvement from previous years. Further, we are ten years into an expansion. Inflation is, may I say, shockingly low, given the length of the expansion. And interest rates, though up a bit, are far from being high enough to choke off any spending by households or businesses.
And that’s why the stock market has rallied. Sure, we had a correction near the turn of the year, as investors feared the Federal Reserve would withdraw the liquidity that propped up both the economy and the markets since the Great Recession. But, in recent testimony and public pronouncements, the central bank has seemed to have calmed those fears.
So here we are, a healthy economy, handsome corporate profits and few excesses that would prompt, on their own, a macro-economic downturn. In short, we believe, just the right foundation for equity investments.
THE CURRENT SITUATION
What happened during recent trading days to disrupt this? A trade war, or fear of one. Many point to a frighteningly similar situation in the 1930s, one which historians point to as having exacerbated, if not prompted, the world-wide Great Depression. In response to unemployment and a business downturn following the 1929 crash, politicians passed the Smoot-Hawley tariffs to protect American jobs. In retaliation, other nations introduced tariffs on American goods.
Why is a trade war bad? Basic economic theory says each country should produce according to its comparative advantage, and if trade is permitted to be free, all countries (subscribing to the free trade) will be better off. In plain English, if each country focuses its resources on producing what it is most efficient at, the net effect would be a higher standard of living for all countries. This holds even if one of the countries can make every item more efficiently than every other country – it still pays to outsource all production besides for what it is best at (its “comparative advantage”). Tariffs interfere with free trade, and so reduce world GDP. Plain and simple.
The above analysis is the long run (“efficiency”) benefit of comparative advantage and free trade and, conversely, the loss incurred by interfering with it. In the immediate aftermath of the tariff imposition industries are forced to adjust to the new situation, business is disrupted, unemployment results, and growth slows, sometimes markedly depending on the degree of the disruption. The stock market responds negatively to both the fundamental, long run factor, as it should, and to the immediate deleterious effect as well.
A MORE REALISTIC PERSPECTIVE
Does this mean President Trump is wrong? It sure sounds like it. But like all theory, the results hold true only if the assumptions underlying the theory – in this case, that of comparative advantage and the free trade that is necessary to make it work – hold. Here we have a problem. Free trade cannot be onesided. If it is, then the benefits accrue to only one side – the other side. What needs to be recognized is another, less well known, economic concept: “The Theory of the Second-Best.” That is, if one factor essential to the best course of action is missing, then it is not necessarily so that the second-best option should be taken – in this case that one country should avoid tariffs even if the other imposes them, as China has done for decades. (And we’re not even considering their technological theft, prohibitions against majority foreign ownership of “strategic” businesses, industrial espionage, etc.) Sure, disruptions hurt, but maybe it’s the price to pay to get the other side to play fair, so that we all benefit in the long run?
As an aside, there is an argument that, even in the context of comparative advantage and optimal global economic efficiency, developing countries should be allowed to impose tariffs on certain products – the so-called “Infant Industry” argument. The argument goes something like this: until an industry in a developing economy reaches an optimal scale, it should be protected in order to allow that industry to develop. But should this argument be applied to China? That depends on the definition of “developing” economy – it sure doesn’t seem so, given China’s massive military-industrial complex!
Our conclusion? Unless this trade spat gets out of hand, the economy, and the markets, should return to the fundamentals –-and the fundamentals, at least for now, are good.
All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC.
