Over the past month, we have had many clients concerned about tariffs, how they actually work and how they will impact the market. This topic has been a great ‘headliner’ for the media. However, let’s dig a little deeper to truly understand what this topic means to the US market.
Tariff – Below is an example of how a tariff may work for a fictitious US automaker making and selling cars in the US. (This is an illustrative example only.)
Let’s assume we have a 25% tariff on steel that directly impacts an automaker. Here is how the numbers break down.
- The average car uses about 2,000 pounds of steal.
- The average cost of steel is about $0.50 per pound
- The 25% tariff on steel represents about a $250 increase in the cost to produce a car.
- Roughly, the average margin on a new car is about $4,000
A $250 increase in production costs per car represents about a 6% decrease in margins, which is not so good when it is looked at this way, but this is only part the story. Today, we also need to look at the new tax law and commodity pricing to get the full picture.
Tax cut – The corporate tax rate went from 35% to 21% in 2018. This directly impacts US companies in a positive manner.
Let’s go back to our automaker example.
A decrease of 14% in corporate taxes on the original $4,000 profit results in this automaker recognizing an increased profit of $560.
If we take the $560 net profit increase due to the tax cuts for the automaker, and subtract the $250 increased cost of production due to tariffs, the automaker is still ahead about $300 per car today versus prior to the tariffs and tax cuts.
Again, this is still only part of the story…
Commodity pricing – This is a bigger item to watch today, and really impacted certain segments like farmers. Oil prices have hovered in the $60 range and pushed $70 for a short period. The increase in commodity pricing is being directly passed through to the consumer resulting in inflation… Several CEO’s on their recent conference call have directly noted that the increase in commodity pricing is a concern and being absorbed by the consumer.
US Dollar – The strength of the US dollar is another piece in play today. About 40% of the S&P 500’s revenues are derived from outside the US. A strong dollar will hurt these companies. If the dollar stays strong or strengthens, then a case can be made to shift some of our allocations from large US companies to smaller US companies. Small US companies are significantly less impacted by the strength of the US dollar, because of their lack of foreign exposure
While the amount of goods that are impacted by tariffs is large, it is a small piece of the overall global economy and only one factor of many that play into how the economy will respond. There are many other factors, in addition to the ones mentioned above, that must be considered when looking at the market as a whole.
No one really likes a tariff war, and though a protracted and/or escalated tariff war would hurt, currently it is not as big of a deal as the media makes it out to be. In fact, Pepsi said on their conference call recently that they were able to absorb the increase in production costs associated with the tariffs due to the tax cut and that they are more worried about the cost of oil on their profits.
At ISC, we are watching and reading about all of the market forces at play and discussing how we should be investing our client’s money.
Thanks for taking a look!
Tim Jaynes, AIF®
This article represents opinions of the authors and not those of their firm and are subject to change from time to time, and do not constitute a recommendation to purchase and sale any security nor to engage in any particular investment or legal strategy. The information contained here has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy.