Does global money have Trump outrage fatigue?

It is hard work to maintain the rage.

One week into the Trump presidency (just 207 more weeks to go!) and every day has a new headline to be outraged over.

Last week I spoke about the difficulty of being even-handed: yes, Trump say and does outrageous things, but the media coverage of him tries to manufacture outrage over everything he does which makes it hard for investors to distinguish between what is truly dangerous and what the act of a “typical Republican President”.

The key for financial markets is whether Trump is still likely to manufacture a boom. And the answer would appear to still be yes.

Markets have largely shrugged (much to the chagrin of the media manufacturing the outrage), continuing to hit new highs while the Vix index (which is a good proxy for “fear” – the price investors will pay for insurance) continues to be bumping along the bottom of its 10-year range:

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Is the market overly complacent? Yep. There is still a big danger of a trade war, and the Vix probably should be higher. Markets are taking Trump’s anti-trade rhetoric as being simply a negotiating tactic. Goldman is typical:

Despite President Trump’s anti-globalization stance, share price performance suggests that US and global equity investors assign low risk to trade conflict. Last week our Asia-Pacific strategists estimated that a 5% decline in US imports could lead to an 8% drop in the MXAPJ index over 3 months, with the greatest impact in Korea, China and Taiwan. Despite trade risk, the index has risen by 2% post-election and 6% YTD. They also identified a group of Asian stocks with direct US sales exposure that would be most directly affected by trade restrictions. Although these firms sold off sharply immediately following the election, they have since recovered.

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David Kelly, Chief Global Strategist, JP Morgan Asset Management also runs through the various protectionist tax options mooted by Trump since his inauguration:

To understand why Trump’s trade policy is such a hot issue, just note that last year the U.S. ran a current account trade deficit of roughly $500 billion or 2.7% of our GDP.  This was a key issue in the Presidential election as it was alleged by both the left and the right that this trade deficit was just a manifestation of “unfair” trade deals, such as NAFTA, which have allegedly decimated U.S. manufacturing.  As an example of this argument, in the first presidential debate, when discussing NAFTA, Mr. Trump said:  “When we sell into Mexico, there’s a tax…..- an automatic 16% approximately – when they sell to us, there’s no tax.  It’s a defective agreement”.   The 16% he mentioned was presumably, Mexico’s 16% value-added tax or VAT – a subject to which we will return.

In prescribing policy remedies for our trade deficit, the President has argued in favor of tariffs on China in retaliation for alleged currency manipulation.  In addition, the new Administration has speculated on whether a tariff on Mexico could “pay” for a wall on the U.S. border with Mexico.  The President has separately proposed leaving the current corporate tax structure in place but dramatically cutting the tax rate and allowing for an even lower rate on repatriated foreign profits.

As an alternative, House Speaker Paul Ryan has proposed achieving the goals of both tariffs and corporate tax reform by replacing the current corporate tax system with a tax on corporate cash-flow with border adjustments which, for simplicity, we can call a Border Adjustment Tax or BAT.

In order to consider which policy might be adopted and what it might mean for investors, it is crucial to understand the difference between a tariff, a VAT and a BAT.

So let’s start with a tariff.

A tariff is simply a tax on imports which could raise substantial revenue for the government.  Indeed, the President’s press secretary has suggested that a 20% tariff on Mexican goods and services would be one way to force Mexico to “pay” for the cost of building the wall.  It should be noted that, in 2015, the U.S. imported $316 billion in goods and services from Mexico and exported $267 billion to Mexico, thus running a trade deficit with Mexico of $49 billion.  A 20% tariff on goods and services imported from Mexico would, in theory, raise roughly $62 billion, far more than the total cost of the wall, assuming that the volume of U.S. imports from Mexico was roughly unchanged.  Even if the volume of imports from Mexico fell, the revenue raised would be substantial.

However, economists generally regard tariffs as a terrible idea.  The first result of such a policy is that U.S. consumers would have to pay more for Mexican imports, making them worse off.  They would presumably also buy fewer of these imports, leading to layoffs among Mexican workers.  The second result of such a policy is that Mexico would very likely retaliate with tariffs of its own, hurting Mexican consumers and U.S. workers.  The volume of trade would be lower, consumers and workers would be worse off on both sides of the border and Mexican and U.S. government revenue would be higher.  In short, a tariff for a tariff makes the whole world poor.

But what about the President’s charge that current U.S.-Mexico trade relations are grossly unfair because Mexico taxes our exports at the border and we don’t tax theirs?

To adjudicate this, it’s crucial to understand that this isn’t a Mexican tariff on U.S. goods and services.  There have been virtually no Mexican tariffs on imports from the U.S. or vice-versa since 1994 when NAFTA was implemented.  Rather this is the impact of Mexico’s VAT.

Most global consumers are very familiar with value-added taxes since roughly 160 countries have them, although the U.S. does not.  Essentially, it’s like a national sales tax with one key difference.  In the U.S., sales tax is only charged once, when the consumer buys it from the retailer.  With a VAT, every importer, manufacturer, wholesaler and retailer has to charge VAT on the value they added to the process.

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It’s worth going through an example to see how this works.

Suppose I buy a mop at the store and there is a 10% sales tax on mops.  The manufacturer makes the mop in the U.S. using $20 worth of imported components, sells it to a distributor for $30, who sells it on to a retailer for $40, who sells it to me for $66, including $6 in sales tax.

Now suppose the government imposes a 10% value-added tax, or VAT, instead.

The importer pays the government 10% VAT on his $20 of imported components (i.e. $2) which he adds to the price he charges the manufacturer. The manufacturer pays the government 10% VAT on his $10 of value added (i.e. $1) and adds this to the price he charges the distributor.  The distributor pays the government 10% VAT on his $10 of value added (i.e. $1) and adds this to the price he charges the retailer.  Finally the retailer pays the government 10% VAT on his $20 of value added (i.e. $2) and adds this to the price he charges me.  I still end up paying $66 and the government still gets $6 – it’s just that they get four different checks along the way.

Alternatively, suppose the government tries to get its $6 with a cash-flow border-adjustment tax or BAT.  If we assume in our example that U.S. manufacturers, distributors and retailers spend half their total value added on wages and interest which they can deduct from the tax calculation, then a BAT rate of 15% will do the job.  The importer pays 15% on $20, or $3.00, while the manufacturer, distributor and retailer pay 15% tax on half their value added, amounting to $0.75, $0.75 and $1.50 respectively.  The government still gets $6 in tax and I still pay $66 for the mop.

But notice one important difference.  Under a VAT, both domestic content and imported content face the same tax – 10%.  Under the BAT, because domestic producers are able to deduct half their value added, the effective tax rate on imported content is 15% and the effective tax rate on domestic content is 7.5%.

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OK, back to the real world.

Mexico does charge a 16% VAT and that is imposed on imports from the U.S. and everywhere else for that matter.  However, this does not put U.S. goods and services at any disadvantage relative to Mexican goods and services because they also incur 16% VAT.  Because of this, the Mexican VAT is not judged to be a trade barrier by the World Trade Organization (WTO).  Mexico is not discriminating against imports.

However, a BAT would discriminate against imports and so would likely eventually be ruled as being in violation of WTO rules.  In the meantime, our trading partners could reasonably decide that a tariff by any other name stinks as sour and impose retaliatory tariffs on us.

There is actually, a solid argument for eliminating our corporate income tax altogether and replacing it with a VAT.  The U.S. has relatively high income taxes (including the corporate income tax) and relatively low consumption taxes.  Compared to almost all of our trading partners, our tax system favors consumption over production.  One natural result of this is that, as a nation, we tend to overconsume and underproduce, resulting in a trade deficit.  However, it hardly seems reasonable to demand that the rest of the world adopt our system or face tariffs.  It seems more sensible to just change ours.

So what’s likely to happen?  The politics are tangled to say the least.  However, the President would likely have a harder time getting Congress to approve of broad tariffs than a more opaque corporate tax reform that achieves the same result.  For his part, the House Speaker will want to achieve a victory on his pet project.  Congress will run into opposition from retailers, oil refiners and other industries that will argue that this amounts to a major tax increase on them which they will have to pass on to consumers.  Nor are they likely to be assuaged by the very dubious claim that the dollar will immediately appreciate enough in response to such a tax as to negate its effects on import prices.

However, the way out of this dilemma for both the Congress and the President is simply to abandon all pretense of revenue neutrality and cut the rate to a low enough level as to make the pain reasonable, particularly in return for an abolition of the corporate income tax.

In summary, while the political chess match will be complicated, a replacement of the corporate income tax with a low-rate cash-flow tax with border adjustments seems the most likely outcome.  If this occurs, it could boost after-tax operating earnings and the budget deficit.  However, it would also add to inflation, potentially increasing interest rates.  It would finally, likely increase the value of the dollar.  In combination, these changes would favor U.S. stocks over bonds and U.S. stocks over international and particularly EM stocks.

Something to consider at the start of just the second full week of the Trump Presidency.

If Trump’s anti-trade tactic turns out not to be a negotiating tactic but rather a core belief, prices will unwind quickly.

However, in the meantime markets have taken the view (similar to my own) that the likelihood that Trump manufactures a debt-fuelled economic boom is greater than the likelihood that Trump creates a trade war.

So, I’m keeping portfolio allocations ready for a boom (and am buying the dips) but have the “trade war” allocations ready, hoping that I don’t have cause to use them.

Damien Klassen is Chief Investment Officer at the MB Fund launching in April 2017. Register your interest now (if you haven’t already):

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