Trade talk may rattle markets, but negativity can provide opportunities

Written by Matthew Hoggarth, Head of Research, Thesis Asset Management

Global trade tensions have boiled to the surface in recent weeks after President Trump announced new tariffs on steel, certain aluminium products and Chinese goods, with China responding tit-for-tat with its own set of tariffs. This has led to speculation that the world may be on the verge of a trade war.

Trade is generally a good thing. Without it we would all struggle to be self-sufficient and produce everything we need to consume. With trade, we can focus on doing a job we are good at, and buy the other things we need from others who are comparatively better at producing them.

Allowing everyone to specialise in something that they are good at makes the overall output of the economy larger. The same is true on the global stage. Because of its financial service expertise, the UK is better off exporting investment management services to the rest of the world. One could argue similarly that America is better off exporting Hollywood films, large aircraft and so on, and importing steel from countries that can produce it more cheaply.

Of course, the issue for politicians is that the people who previously forged American steel are made worse off by this course of action. Even though the country as a whole is wealthier with free trade, the benefit is not spread evenly. President Trump has made the decision to make the US economy a little smaller in order to help certain industries. The risk is that other countries follow suit, and the cumulative effect is that the world economy becomes a lot smaller.

What effect does this have on investments?

Recent developments in India have exemplified the benefits of freer trade to investors.

Last year a common Goods and Services Tax (GST) was introduced throughout the country, but prior to this, every state levied its own indirect taxes and excise duties. There were checkpoints on the borders between states where lorries faced long queues waiting for shipments of goods to be checked and the correct taxes paid. As a result, companies tended to have warehouses and factories in multiple states to minimise the impact of the delays. Now that the checkpoints have gone, firms can reduce their overheads by consolidating their operations. These lower costs mean that the companies can make greater profits.

It is difficult to make generalisations when choosing investments, however. We live in a highly globalised world, which brings with it great complexity in terms of trading patterns. On the scale of an individual company, we need to understand the dynamics of the products it sells.

How mobile is the good or service which is being produced? Bulky or heavy but low-value items such as bricks may not be economical to transport over very long distances. Many services can only be consumed where they are produced, for example, haircuts. What is the company’s production cost relative to other producers worldwide once transport costs are taken into account? What are the barriers to entry of the industry? Are there economies of scale or network effects? Technology companies cluster in Silicon Valley partly because of the high concentration of suitably skilled staff. All of these factors contribute to our assessment of an equity.

Capitalising on trade pessimism

Most governments understand the benefits that trade brings, and will not want to retaliate against the new US restrictions in a fashion that risks an all-out trade war where countries raise tariffs and other barriers significantly. Risk to portfolios from trade restrictions is therefore small.

Negativity can provide opportunities, however. UK equities is one market to be optimistic about, it has been held back by uncertainty since the Brexit referendum in a way which does not accurately reflect the prospect of many companies. In the long run politicians and their decisions do not drive markets. Portfolio returns are fuelled to a much greater extent by choosing well-managed companies with strong fundamentals and buying them when they are trading at cheap levels relative to the rest of the market. 

Despite possible changes in trade patterns we are maintaining a substantial weighting to UK equities, including several relatively unloved companies which we think are trading too cheaply.

Matthew Hoggarth, Head of Research, Thesis Asset Management.

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