Arguing Amongst Friends

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“We should beware of the demagogues who are ready to declare a trade war against our friends – weakening our economy, our national security, and the entire free world – all while cynically waving the American flag.” – Ronald Reagan (1988 national radio address)

Please understand that I do not highlight the above passage to argue for or against any particular global trade policy stance. Rather, I want to step back a bit and explore how we arrived at this moment in time.

The concept of trade is fundamental to the history of human civilization.

The first documented complex human societies were built around agricultural settlements. The most fortunate of these communities were able to generate enough food to feed their population and then some, which in turn freed up their resources to pursue other improvements to the group’s quality of life. Bartering with outsiders became the quickest path to obtaining needed supplies, services, or the latest technologies (not every society was blessed with a prehistoric Thomas Edison).

Trade was somewhat limited in its infancy to transactions between neighboring villages and/or nomadic clans. However, advancements in boat construction around 3000 BC allowed ambitious traders to travel long distances in a fraction of the time. And off we went.

The theoretical benefits of trade were as true back then as they are today.

If you have an excess amount of an item, you would be better off exchanging that item for something you do not have enough of. There are also production efficiencies to trade. If you have the ability to produce a product better than competitors, it makes sense for you to focus on making that product. You can always trade for the products that you cannot produce as efficiently.

So, trade is a no brainer, right? Well not exactly. As the adage goes there is no such thing as a free lunch.

By definition, trade requires two sides to come together to agree on a deal. Generally speaking parties will only willingly agree to deals that are in their self-interest. Thus, your trade counterpart is often benefitting as much from the transaction as you are and potentially more. This may not be strategically desirable if you are already the stronger of the two parties. Additionally, trade requires an element of trust. If your trade partner does not abide by the terms of the deal you could end up worse off then you were before.

Which brings us back to the words of Ronald Reagan. Trade with “friends” makes economic sense for everyone, but trade with bad actors that bend the rules to serve their own interests might not.

The United States and United Kingdom established the General Agreement on Tariffs and Trade (GATT) in 1947 in an effort to corral global nations into the “friends” camp following World War II. This accord eventually evolved into the formation of the World Trade Organization (WTO) in 1995. While not perfect, the WTO has been enormously successful in facilitating global trade. Today, 164-member nations accounting for 98% of global trade have been integrated into the WTO to some degree. Not coincidentally, the average global import tariff rate has declined from around 30% in the early 1980’s to close to 5% today.

Alas, it is likely unreasonable to expect that import tariffs and other trade barriers could be totally eliminated through negotiation. That is because at various points in a nation’s evolution they may find it strategically prudent to prioritize their long-term interests over the short-term economic benefits of freer trade.

The two most powerful global nations, the United States and China, are currently mulling whether today might be such a time.

The United States has evolved over the last century into a more services-driven economy with a growing expertise in advanced technologies. The cost of this evolution has been a reduction in domestic manufacturing jobs and the need to develop stronger defenses against intellectual property theft (the primary barrier to entry in the high-tech arena).

China on the other hand is out-growing its role as the low-cost producer of choice. The Chinese population has grown wealthier over time, which has allowed neighboring markets to undercut Chinese labor for lower-expertise work. Additionally, officials in China have grown increasingly concerned that an overreliance on the United States for critical, high-tech inputs could limit their ability to ascend to a stronger place in the global value chain.

Both countries are coming to the dispute from a rationale place, at least from their own perspectives, and the stakes are meaningful on both sides.

It is in both countries’ short-term interests to resolve the current stalemate. That is likely why the situation has not escalated to this point in the past. However, both sides have at least publicly indicated a willingness to bear short-term consequences in an effort to achieve long-term objectives.

There is no way to know how this dispute will resolve itself. The possibilities span the risk spectrum from “simply posturing” to “long-term economic cold war”. The truth as always is likely somewhere in the middle. We certainly hope the reality is closer to the “simply posturing” scenario and a deal is agreed upon in short order. We are mindful however that hoping alone does not constitute an investment strategy.

We have been hard at work digging into the weeds of the businesses that we own on your behalf to ensure that we have a good handle on their relative risk exposures to a bad outcome. The most dangerous risks of which are often in the less publicized supply chains of the various businesses. Where we feel appropriate, we are reducing exposure to the areas we expect to be most affected from an international trade perspective.

This approach may prove to be overly conservative should we get a swift, positive resolution to the current negotiating impasse. In that sense we hope that we will be wrong. We have investment ideas at the ready should the trade storm clouds dissipate. Until that time, we will proceed cautiously and try to limit our exposure to the particular risks a trade war could present.

We hope that in times such as these knowing that we are actively protecting your assets against potential risks will give you comfort. We take our fiduciary responsibility seriously and will always try to act in the most prudent fashion on your behalf. We know that there will likely be times where we are not fully rewarded for adopting a more cautious stance when we see potential problems. However, we trust that remaining disciplined will give us the best opportunity to provide value to you over the long-haul.

 

Matthew Haddad, CFA

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