To say the market got a “reprieve” from trade frictions this week wouldn’t be entirely accurate. Rather, geopolitics and domestic political turmoil simply grabbed the limelight.
Donald Trump’s divisive U.N. speech brought “Iran risk” back to fore and the President’s shrill criticism of OPEC and allegations of election meddling by the Chinese lent credence to the notion that U.S. foreign policy will continue to be defined by antagonism.
Meanwhile, Brett Kavanaugh’s fraught Supreme Court nomination underscored the deep divisions within American society and the bitter bickering in the Senate Judiciary Committee provided further evidence to support the notion that the partisan divide is becoming too wide to bridge.
The incessant coverage of the Kavanaugh story, Trump’s laughable (literally) performance at the U.N. and the President’s wildest solo presser to date, drove the trade war to the back of the market’s mind, an ironic twist considering this was the week when “phase 2” of the China-Trump dispute officially went into effect.
Rest assured trade tensions will not be relegated to the proverbial backburner for long and while Trump’s lunatic plunge into late-cycle stimulus has so far served to insulate U.S. stocks from the global malaise (think: tax policy catalyzing buybacks and bolstering corporate bottom lines), it will be impossible to shield the U.S. corporate sector forever.
On Friday evening, Goldman was out with a new note that takes a straightforward approach to estimating the likely impact from a scenario where Trump “goes to $500 billion” or, more simply, moves to tax everything Chine ships to the U.S.
The bank has been over this before, but it’s worth highlighting their updated analysis because it assumes a kind of worst case scenario wherein Trump applies a 25% tariff rate to all Chinese imports and U.S. corporates are unable to diversify their supply chains and/or raise consumer prices.
“For a top-down tariff sensitivity analysis, we conservatively assume no substitution to other suppliers, no pass-through of costs to consumers, no boost to domestic revenues, and no change in economic activity”, the bank’s David Kostin writes, before delivering the bad news as follows:
Given those assumptions, a 25% tariff on all imports from China would lower our 2019 S&P 500 EPS estimate by roughly 7% to $159, flat vs. 2018. If forecast EPS drops to $159 and the forward P/E contracts by 5% to 16.4x, the S&P 500 would fall to roughly 2600 (-10% from current levels).
Got that? If Trump goes all in, S&P EPS growth flatlines.
The bank goes on to postulate that “if trade tensions spread significantly and a 10% tariff were implemented on all US imports, which would represent the highest rate since 1940s, our EPS estimate could fall by 15% to $145.”
These assessments rest on the common sense assumption that when the COGS rises for companies with globalized supply chains, margin pressure becomes a problem. With rising wages already threatening profitability and with margins already sitting at record highs, it’s difficult to imagine a scenario where that isn’t ultimately passed on to consumers. Here’s Goldman again:
Rising input costs force firms to raise prices or sacrifice profitability. In part due to the boost from corporate tax reform, S&P 500 net margins have surged to alltime highs (10.7%). However, earnings results and management commentary have underscored the challenge companies are facing to keep up with rising costs and the pressure this could eventually put on profit margins. The most recent National Association of Business Economics Survey showed a large share of respondents reporting rising material (48%) and wage costs (48%), and a much smaller share reporting rising prices charged to customers (20%). In the past, this dynamic has preceded declining S&P 500 EBIT margins.
But hey, this needn’t necessarily lead to lower equity prices, right? After all, investors in U.S. markets have been more than happy to drive multiples higher even when bottom line growth is to some extent artificial.
All it takes is a couple of idiots willing to pay a higher premium for every dollar of earnings to keep the momentum signals positive and it’s all “up”hill from there when it comes to climbing the wall of worry.
