In high school, I once filled sandbags with my fellow students as we tried to minimize water damage from a coastal storm. I can vividly remember my frustration as I noticed a hole had formed in one of the bags. I attempted to fill it as quickly as I could, but the sand continued to leak out of the bottom. With no way to patch it, I knew most of the sand would eventually leave the bag.

The market seems to be in a similar position with trade talks. There's been a steady stream of trade headlines weighing on markets with no patch in sight — at least not yet. Let's take a look at what history tells us about tariffs, the potential impact current trade tensions are having on the economy, markets, and currencies, and how it's impacting our investment thinking.

Analyzing the Impact

While the risk of a severe trade war is always possible, it is not our base case. The recent trade tensions are bringing back memories of the 1930s and the passage of the Smoot–Hawley Act, a protectionist trade policy that enforced sweeping tariffs on all imported goods. Many economists believe this policy extended and exacerbated the Great Depression. Contrast this period in history with the fall of the Berlin Wall in 1989 and the opening of three decades of global trade that followed. That expansion of free trade led to country interdependency in the global supply chain, with individual parts made all over the world for a single end product manufactured in one country. Thus, it is understandable that investors are worried that a severe trade war might disrupt the global economy.

Tariffs can negatively impact economic growth, but to date these tariffs have been more than offset by the positive impact of fiscal stimulus from last December's tax legislation. According to Strategas Research Partners, the tax cuts are estimated to provide the U.S. economy with $800 billion of stimulus. Although tariffs will offset this stimulus to some degree, the estimated cost of $120 billion has yet to make a significant dent. However, as global leaders prolong this tit-for-tat retaliation, it has the potential to put additional strain on business and consumer confidence, and, eventually, the global economy.

Markets like free and fair trade, so uncertainty can rattle some markets more than others. So far, U.S. equities have been taking trade tensions in stride, while non-U.S. markets, especially emerging markets, have been under pressure given their reliance on trade. Areas such as domestic small cap and some technology companies have offered a place to hide from the volatility, given their minimal exposure to direct tariffs. But not all pockets of the market have fared so nicely. Exhibit 1 shows companies with large revenue exposure to China. It's clear that markets are starting to penalize those firms that may be most impacted. The same is true for firms that trade with one of our NAFTA partners, Mexico. These charts illustrate that markets are starting to pay attention and price in at least the possibility of a significant trade dispute.

Countermeasures Taken

China has already taken steps to mitigate a trade war impact on their own economy. They recently reduced bank reserve requirements by 100 basis points (1%), in essence freeing up more money for banks to lend in an effort to stimulate China's economy. They also allowed (or caused) their currency to weaken in order to help offset the prices paid by foreigners who purchase Chinese goods. The Mexican peso has also weakened against the U.S. dollar during the NAFTA negotiations. We would expect both of these currencies to reverse course should resolutions be reached and would expect further currency volatility the longer these disputes persist.

A Midterm Election Resolution?

Many strategists believe that Trump is posturing right now and intends to ultimately settle for concessions in October, just prior to U.S. midterm elections. While I can offer no specific insight into this thesis, it does point out that tariffs, and the threats for increasing them, can disappear with one man's change of heart. The recent meeting and agreement between President Trump and European Commission President Jean-Claude Juncker illustrates how quickly two sides seemingly at a stalemate can, instead, come together. While trade tensions with China show signs of escalating, the recent breakthrough with the EU shows the market what is possible.

Our Recommendation

The ongoing trade war rhetoric has not caused us to change our generally positive view of the global expansion and equity markets, especially domestic equities. However, we recently made the broad recommendation to reduce our exposure to U.S. small capitalization stocks. We did this for two reasons. First, many investors attempted to buffer themselves from the trade dispute by piling into small cap stocks, given their reliance on domestic revenue sources. In our view, this was an overreaction to the fear of a trade war escalation. Second, because the money rushing into small cap stocks pushed prices up, the risk/return trade-off no longer warranted a maximum overweight. Therefore, depending upon an individual client's situation, it may be prudent to realize some modest gains from small caps at this juncture.

Even after our recommended reduction in small cap stocks, we still maintain an overweight to equities and an underweight to fixed income. This allocation reflects our view that the most likely outcome is that the trade disputes will be resolved, allowing markets to move higher over time. We also recommend maintaining exposure to alternatives, or lower-correlated assets, in order to diversify the overall portfolio.

Conclusion

While escalating trade war rhetoric is a growing concern, investors would benefit from focusing on fundamentals, which remain very strong. Both earnings and economic growth continue to impress, with fiscal stimulus from the tax legislation proving to be powerful. The equity market remains resilient against this backdrop of uncertainty, although some areas have been negatively impacted. Because our base case is that an ultimate resolution should avoid a severe trade war, we continue to position our portfolios to take advantage of the strong economic backdrop. Tariff and trade issues remain fluid, but as we've seen in recent weeks the potential exists to patch up the holes in the trade sandbag. We will continue to monitor and evaluate this situation closely and stand ready to adjust portfolio positioning as necessary. In the end, we believe policymakers should be able to negotiate trade policies that will allow the global economy to continue expanding.

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