What Investors Should Know About the U.S./China Trade War

If you're curious how tariffs affect markets, if you're nervous what this trade war could do to your portfolio, or if you want to hear even more about the U.S./China trade war, you've come to the right place. In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool contributor Jim Mueller explain what investors need to know about the tariffs.

First, some context: what a tariff is, how we got here, what the U.S. and China are hoping to get out of this, and how far the tariffs reach. Then, the hosts explain what industries and companies are most affected by this -- from steel's boost to pressure for spice makers -- and what long-term investors need to know about investing through a wide-reaching tariff war. Click play to hear more.

A full transcript follows the video.

This video was recorded on Sept. 27, 2018.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, September 27th, and we're discussing tariffs. I'm your host, Nick Sciple, and today I'm joined in studio by Motley Fool analyst Jim Mueller. Jim, how are you doing today?

Jim Mueller: Hey, Nick! How are you? 

Sciple: I'm doing well! I'm really excited for this topic today! We spend a lot of time in the energy and industrials space talking about large macro events. We talk about global oil prices, we talk about commodity prices for metals worldwide, and we talk about worldwide shipping rates. All of these things, are large markets impacted by every single consumer in the world. We can think of each of these markets a little bit as a game, with global players moving pieces around the board, trading with one another. They're all making strategic decisions based on a common set of rules. If you've ever played Settlers of Catan, you might get a little bit of a basic idea of this resource trading between one another. 

Tariffs, what we're talking about today, really change those rules for everybody. Global prices change that increase the cost for a wide variety of goods and services. We've seen this year how changing rules can cause unusual and unexpected outcomes in the market. For example, the prospect of marijuana legalization in Canada has caused a whole new industry to pop up seemingly overnight, and valuation to skyrocket. U.S. sanctions against Iran have in part led oil to highs it hasn't seen in years. 

Today, we're going to try to put this latest rule change, these tariffs, into context to help investors better understand how these rule changes might affect them and their investments. 

I know tariffs have been in the news for the past six months or so, Jim, but for listeners who may not fully understand what exactly a tariff is and how it works, can you give them a rundown of what a tariff is and how it works?

Mueller: Sure. A tariff is a tax on something that's coming into a country that is being imported by a company inside the United States. That means that the exporting company or the country it's coming from is not the one paying the tax. These are not taxes paid by China or Chinese companies that are going to the U.S. Treasury. These are taxes paid by mostly U.S. companies on the import of the good, whatever it is. Those are going into the U.S. Treasury. 

The companies have a couple of ways of dealing with that extra cost on their goods. They can decide to eat the cost. That is, their profit margins are going to go down. Or, they can pass along the extra cost to the consumer. Whether it's a retailer like Walmart bringing in goods, so prices at Walmart are going to be raised, like they hinted at earlier this week; or whether manufacturers are going to have to pass along the costs to the consumers. The prices of everything goes up.

Sciple: Exactly. You want to nudge these domestic consumers to maybe switch their sourcing to United States products. Let's go ahead and jump into exactly what these tariffs are that came down this week, and the significance of them from a dollar point of view. 

Effective September 24th, President Trump announced a 10% tariff on $200 billion in Chinese imports. That tariff is currently 10%, but at the end of 2018, that's expected to rise to 25%. What's significant about this tariff, I know this has been in the news for a long time, this is the third round of tariffs, and it's the largest round of tariffs. Back in July, we had $34 billion worth of Chinese goods tariffed. Then, in August, we had a follow-on of $16 billion in tariffs. So, this is really a huge jump up of $200 billion.

This is affecting all kinds of goods. The list, if you look it up, is pages and pages long. Some significant things, pretty much any agricultural product is likely going to be tariffed, handbags, textiles. Some significant things that were not tariffed: smart watches, Apple made a specific plea to have those exempted, as well as some car seats, playpens, more child care type-products, those were exempted. Another thing that's significant about the size of these tariffs is this $250 billion aggregate tariff amount that we reach after these new tariffs were put in place is about half of U.S.-China trade.

Mueller: Yeah. U.S. brings in a little over $500 billion worth of goods from China. The $250 billion so far this year is roughly half, as you said. President Trump has also indicated that if things don't go as to what he wants to happen, he's going to do it on the rest of it.

Sciple: Exactly. President Trump has said that if China were to take retaliatory action on these tariffs, which they have, in fact, and I'll explain that here in a second, that he's going to put in place another $267 billion worth of imports. For all intents and purposes, that would put a tariff in place on 100% of U.S.-China trade.

Pivoting to China here, China also announced some tariffs on $60 billion worth of goods that also went into effect on September 24th. This is in addition to, China had also had previously announced tariffs of $50 billion. The total U.S.-China trade is about $130 billion dollars of imports of United States goods into China. This second round of Chinese tariffs is going to now cover $110 billion dollars of the $130 billion of U.S.-China trade -- again, almost 100% of the entire trading relationship. 

So, this is pretty significant in that almost all the cards have been played here. If all the threats and allegations with regard to tariffs are followed through upon, all of U.S.-China trade is set to be under some kind of tariff barrier in 2018. So, this is a really important time to talk about the significance of these tariffs.

Mueller: Right. The first round of the Chinese tariffs was mostly on agricultural goods. The second round is more industrial goods -- small aircraft, computers, and textile see a 5% duty imposed on them. Bigger things like industrial chemicals meet some more agricultural -- frozen vegetables, for instance, see a 10%. But what's interesting is what's not been added to this list. That's primarily crude oil. China is a big importer of oil and they haven't yet put on a tariff on to what they import from the U.S. as far as that goes. 

They've also done something interesting in that, while they've increased the tariffs on American goods, they've lowered the tariffs on some of the other goods from other places. For instance, electrical equipment or machinery. That's an effort to try to drive their own consumers away from choosing U.S. products and choosing others. That's another way to try to hurt American companies and America.

Sciple: Exactly. This has really come to a head. We're speaking on September 27th. There had been plans for U.S.-China trade talks to take place today and tomorrow. But now, as a result of these new rounds of tariffs from the United States, China has stated that Washington is "putting a knife to China's neck and that China will not participate in the trade bully ism of the United States." What we're really seeing is, there's not a lot of signs that the two parties are going to come to the table and work something out here anytime soon. This is looking like it's going to be a protracted trade conflict between the countries that will cover the entirety of trade. 

Jim, why don't you talk about a little bit, what's the strategy behind these tariffs? What is the United States trying to accomplish? Conversely, with their tariffs, what is China trying to do? You mentioned a little bit pushing their consumers toward other countries' goods. But what's the strategy here?

Mueller: A country imposes a tariff basically for one or two reasons. In the past, it's been more the first reason than the second. The first reason is protectionism. That is trying to protect domestic industries. For instance, U.S. steelmakers, that's been a big reason touted in the media by the Administration. When steel is cheaper to import than it is to buy domestically, the domestic industry gets hurt. So, you put a tariff on that imported steel to try to help protect the local industry. 

That's part of what's going on here. But I think the bigger part is more punishment here. This is driven by the U.S.'s view that China has been engaging in... "unfair trade practices" is such a used phrase, but it's pretty much what's happening. The Chinese government is involved in so much of their industry that they can do things like subsidize the manufacturing of stuff like steel, and then China will export steel to the U.S. at a price that's lower than their own costs. That is not good for the U.S. for many reasons. Also, China has a habit of stealing a lot of IP, either directly through spies or indirectly by forcing American businesses who want to operate in China to share their IP as a condition for being allowed to operate there.

Sciple: Yesterday, there was a great article in The Wall Street Journal walking through the way some of those forced technology transfers take place. One of the facts they cited in there is that one in five members of the American Chamber of Commerce in Shanghai, China, have said that they've been pressured to transfer technology. And among those companies, 44% in aerospace and 41% in chemicals have said they face notable pressure. That Wall Street Journal article talked a little bit about something that Dow DuPont had gone through, a little bit of a forced transfer of their product. So, this is something that has been a significant negative impact to the United States, this forced technology transfer, that is trying to be remediated a little bit with these tariffs. 

Mueller: The danger there is, you want to operate in China because the market is so big there, and there's so much opportunity to sell stuff there. But do you want to give away all your secrets, and then five, 10 years down the line, see a Chinese company come up and make the exact same thing using your own secrets against you at a lower price, and there goes your market. So American companies are kind of in a bind. Do they want to operate in China today and risk such a future? Or should they not even try to make those extra profits in China? It's a real conundrum for American companies.

Sciple: Yeah. It's such an important market, but also, the consequences of operating in that market could be, over the long-term, meaningfully negative.

Mueller: Right. So, what the Administration is doing is trying to use these tariffs as a way to break that cycle, that pain point for American companies.

Sciple: Exactly. Let's move over to China's strategy. They're in a little bit of the same catch 22. They've been predominantly reactionary to the United States' tariffs. They have not been the aggressor in these.

China, we talked about, with the second round of tariffs, they're tariffing almost the entirety of their U.S. imports. Their back's against the wall a little bit. They're running out of products to penalize. China runs a risk, as well, that if they start to make other moves, if they start to target American businesses operating in China, and maybe discriminate against them, that's really going to give them an additional problem in that they really need foreign investment in their economy to drive the growth that they've had. If they were to start retaliating against international investors, that really could cause foreign capital to flee and put them in a dangerous situation. 

There's a lot of moving parts here for both countries. Like we're talking about with anything in the macroeconomic environment, there's a lot of moving parts.

Mueller: Right. One of the things that China's trying to do to protect themselves against that -- as you say, they need so much foreign investment -- is, they're trying to build more of a domestic investment supply, bring their population to be more consumer-driven than they currently are, and not as much savers but as buyers. That'll help them, but it's going to take a while. With this extra pressure against them, the clock is ticking.

Sciple: OK, Jim, now that we've talked about what's going on with these tariffs, what does this mean for the companies that might be affected? There's some non-tariff impacts, there's impacts to specific industries. Let's just jump in and talk about, who are the big industries that are being impacted? Obviously, we can't talk about everything. It's going to impact all of U.S.-China trade. But what are these big, major industries that might be affected? 

Mueller: So far, steel manufacturing here in the United States has been positively affected. Nucor, the biggest steelmaker in the country, for instance, has reported that the tariffs have helped push sales up for them in the first half of the year. They're quick to claim that, "We're doing alright anyway. We don't necessarily need the extra help. But it's nice to have, and we expect that to go forward."

But on the downside, that raises the costs for everyone who needs to use steel in whatever they're making, a big one being automakers, for example. This latest round of tariffs includes things like brake pads and cables and everything else you need to build an automobile. The automakers are going likely see a large increase in their costs for making those cars.

Sciple: Autos are an interesting industry here. They're going to get bit on both ends of these tariffs. There's a substantial number of auto parts manufactured in China, shipped to the United States, then assembled into vehicles here in the U.S. And, China is a massive market for U.S. automakers. GM, as a matter of fact, sells more vehicles in China than they do in the United States. Ford, their second biggest market is China. Their CEO Jim Hackett this week came out and said these tariffs on steel have taken away, they estimate, a billion dollars in profit from Ford. And that's only going to get worse. 

This isn't limited only to U.S. automakers. We think about this as a U.S.-China trade spat, this is only going to affect U.S. automakers. But think of a company like BMW. This is a German automaker, but this is really affecting them. They manufacture a lot of their popular SUVs -- for example, the BMW X5 is made in the United States, here in Spartanburg, South Carolina. They, again, are getting hit on both ends of this, from importing the auto parts to assemble into their vehicles and also getting hit on the back end importing their vehicles into China. 

Automakers are really going to be significantly impacted by these tariffs.

Mueller: Yeah. This has a secondary effect, too. That's the supply chain. The global economy has spent many, many years making the supply chain as efficient as possible. It's manufactured here, ships the goods there, it goes through customs real fast, it goes to the manufacturer here, and so on. Adding just a little bit of extra time or more friction is like throwing sand into the gear wheels of this very efficient supply chain. Matt Koppenheffer yesterday on Market Foolery mentioned that a British survey of supply chain manufacturers pointed out that adding even 20 or 30 minutes to this really efficient supply chain can have huge impacts down the road, even to the point of putting companies out of business because they run such a tight ship. 

Sciple: I mentioned earlier a survey from the American Chamber of Commerce in Shanghai, China. Another part of that survey, 52% of those companies reported that they are facing slower customs clearance, and increased inspections in bureaucratic procedures in China as a result of these tariffs. It ties in exactly with what you said. If you're having to deal with more robust bureaucratic red tape to get your products into the country, that's going to delay your imports, it's going to slow down your supply chain. That's really going to trickle down all the way to the bottom line of the business and their profits. There's a lot of moving parts to these tariffs, and they affect these companies in ways that might not be immediately apparent just from common sense.

Mueller: So, the companies have to respond somehow. One way, of course, is to pull in ahead a bunch of your inventory and try to get up a stock supply to try to have a supply of stuff that you need, as well as trying to get ahead of when the latest round on Monday's 10% jumps up to 25% by the end of the year. Companies are trying to get ahead of that, so they don't pay as much.

But also, they're going to have to start looking for other suppliers elsewhere in the world. For exporting, they need to look at other buyers around the world. That's not an easy task. The whole thing has taken years to build. It's going to take a while to figure things out, moving the supply chain around.

Another item that companies can do is to petition the U.S. government and ask for, "Hey, I'm buying something from China. It's made nowhere else in the world," which is one of the requirements of such a petition. "Because of that, if I don't get it, I can't sell what I sell." So, the government can look at that, and say, "Alright, this one is now exempt from the tariff." But it's a long process, takes several months, and it's not guaranteed, even if everything the company says is accurate.

Sciple: We mentioned earlier that Apple had success with this with the iWatch. There's some other companies that have been trying to do that. Jo-Ann Fabrics is looking at tariffs on fabric and yarn, how that's going to affect them. McCormick is talking about some of their spices that might be affected. 

Mueller: I thought that was one of the more amusing ones. [laughs] Garlic. Who thought garlic, right?

Sciple: That's the thing about these tariffs, they touch products that you might never think about coming from across the world, but are being affected by this. Industries that you don't think about when you think about these big metal tariffs. Automakers are top of mind immediately. But you wouldn't think about McCormick, a spice maker, being somebody that's really being affected by this.

One other thing, we're talking about these supply chains, and how these tariff impacts, just slowing down a little bit is going to affect them. I think an important thing to point out is, these supply chains were built over years and decades. To change these supply chains will take years and decades. As long as these barriers remain in place, this is going to be affecting businesses over the long-term. There's going to be a lot of friction to try to move around to fit this new dichotomy. 

Jim, let's talk a little bit about, where does this go long-term? If we're looking out 18 months from now, where do we think we're going to be looking at with tariffs? What are the things we'll see develop to play this out?

Mueller: Probably, we'll have the last $250-260 billion worth of Chinese imports under tariff as well, I don't expect China to cave in at the first sign of trouble. Actually, I don't expect China to cave. They might come to a negotiate a settlement, but that'll be difficult, especially if one side or the other is trying to do a win-or-lose situation and nothing in the middle. That'd be difficult. We could probably expect these kinds of things to last for a while.

One of our expectations is that China has the motivation to liberalize its economy and bring more of a free market economy to the country. But what we might not have realized is that the Chinese Communist Party is still in very much firm control inside China. That has to play into any calculus on thinking forward.

Sciple: Right. I think there are a few signs of some cracks in the clouds, not directly related to China. This Monday, the Administration announced a deal with South Korea to expand the ability for the U.S. manufacturers to import their products into South Korea. We saw a deal just yesterday between President Trump and Japanese Prime Minister Shinzō Abe with the relation to starting some trade talks, and in exchange for that, holding off on some potential tariffs on Japanese automakers. We're seeing some cooperation between the United States, the European Union, and Japan to try to start pushing, changing some WTO rules to limit China's ability to use state subsidies and forced technology transfers, like we discussed earlier. 

In the near-term, I don't think there's any expectation that these things are going to go away.

Mueller: I don't think so.

Sciple: For China to get nudged to back off from this position, it's really going to take a village, it's going to take the United States, our European allies, Japan to really work together. 

We've talked about the macro environment here. If you're an investor in any of these companies affected by tariffs, how should you think about these things and allocating your portfolio? Is this a buying opportunity? Is this something to avoid until things play out? What is your assessment of that, Jim? 

Mueller: Yeah, let's bring it back to the investors. [laughs] We're investing advice, right?

Sciple: Yes, sir!

Mueller: In the short or medium-term, you can take advantage of some of this. You can buy shares of companies that will benefit from tariffs. I've mentioned Nucor, maybe U.S. Steel. Whirlpool, of all people, might be a decent investment. Some of the things on the list are finished appliances, like finished refrigerators and finished freezers. In fact, Whirlpool made a petition to the government not to exclude something, but to add something.

I can't remember what it is off the top of my head, though. Anyway, you could move some of your money to some of these companies. You might lower your exposure to some of the other companies, such as the automakers, or big retail, like Walmart or Target or somebody like that. 

But in the long-term, companies will adjust somehow. That's how they stay in business. They adjust to changing circumstances all the time. I would expect profit margins to come back down a little bit if they have to eat those costs. I might also expect inflation to tick up a little bit if they have to pass on those costs. For the long-term, I wouldn't be making massive changes inside my portfolio, but a tweak here and a tweak there, probably.

Sciple: Those are definitely things to take into account. The last thing I want to say for investors is, the prices that you're going to pay at retail as a result of these tariffs are going to go up. Even if you're not going to change your investing allocations based on this -- and you probably shouldn't. When we're thinking as true long-term investors, five, 10 years down the line, these businesses, while they're going to be affected in the near-term, it's not going to fundamentally change their investing thesis.

I do want to encourage our listeners and investors to be prepared to see a little bit of a bump in the prices you're paying at retail. I know Walmart mentioned that you might see as much as a 20% bump up in what you're paying for some retail products as a result of this. You may want to take a little bit of that into account when it comes to your financial planning. Maybe give yourself a little bit more wiggle room when it comes to your saving plan to account for that. But when it comes to long-term investing, your theses will not change as a result of this. It's just something to take into account, and something that's going to play out over months going forward.

Mueller: Even years. Yeah, I agree with that. 

Sciple: Jim, I enjoyed having you on the show! I really hope we were able to simplify this issue for our listeners and communicate the important information having to do with these tariffs. This is something that's going to play on, as we mentioned, over months and possibly years. It may be something we revisit down the line to give our listeners some updates. 

Thanks for coming on!

Mueller: Thanks, Nick! It's been a pleasure!

Sciple: Thanks so much, Jim! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Jim Mueller, I'm Nick Sciple. Thanks for listening and Fool on!