How can global equity investors incorporate the impact of tariffs into fundamental analysis of companies?
Trade wars are in the headlines again, with the US imposing new tariffs on an array of Chinese products. Policy moves like this create headaches for investors seeking to develop return forecasts based on a company’s long-term outlook and require special consideration in research processes.
President Joe Biden announced on May 14 that the US will raise tariffs affecting about $18 billion of imported Chinese goods, including electric vehicles (EVs) and solar cells. The move was a sign of escalating trade tensions between the world’s two largest economies, and a tangible example of geopolitical risk driven by deglobalization.
Tariffs change the relative cost of products, which influences supply and demand and can have a big effect on a business. Since policy decisions are often difficult to predict, investment analysts may struggle to plug them into financial forecasts. But we can map out some principles and parameters to constructively gauge the evolving environment.
Understanding the Political Circumstances
The first step is to study the underlying political circumstances. For example, US restrictions on semiconductor sales are part of a broader reversal of globalization related to protecting technology and securing supply chains. In the US, this position has had broad bipartisan support for years, so the trend toward tariffs is likely to continue.
Next, investors should identify companies at risk and potential beneficiaries. Analysts can then evaluate a company’s geographical and product exposure to tariffs, to inform an appropriate response. That doesn’t only mean selling down positions at risk; in some cases, we might take advantage of temporary dislocations triggered by the headlines in companies that look likely to benefit from changing price dynamics.
Avoid the Most Acute Risks
Sometimes, the risks warrant more caution. Tariffs on EV manufacturers are a case in point, because they add uncertainty to an already shaky industry dynamic. China is selling relatively cheap EVs across US and European markets, while US and European automakers are staking their future on a shift toward high-quality, relatively expensive EVs. Murky market and political dynamics make it very hard for equity investors to develop conviction in EV manufacturers, in our view.
However, the global structural shift from traditional internal combustion engines to electric-powered vehicles is unlikely to be derailed by policy moves. As a result, investors seeking to capture EV growth potential while avoiding trade war fallout can focus on companies that provide essential components to the EV manufacturers, such as semiconductors or batteries. We think EV enablers are likely to enjoy continued demand, even in a tougher industry and political environment.
Distinguish Between Structural Change and Policy Challenges
EVs aren’t the only example of a structural shift taking place in an uncertain policy environment. Consider the energy transition and the quest for energy security. In the US, the Inflation Reduction Act is a big driver of spending on the energy transition. Yet nobody can predict the outcome of the US election in November or how it might affect the incentives currently offered to companies participating in the energy transition.
With or without policy support, we think the energy transition is likely to continue because it’s being driven by improving economics in such areas as industrial electrification, which is currently undergoing a long-term transformation. So investors can look for companies that are beneficiaries and enablers of the energy transition with quality businesses that can deliver earnings growth regardless of subsidies. If the incentives remain in place, companies like these would enjoy a free bonus.
Find Businesses That Can Overcome Tariffs
Similarly, in some cases, product demand can overcome tariff pressure over time. Chinese tariffs on European cognac and brandy are a good example. In early May, talks between France and China suggested that anticipated Chinese tariffs on the alcoholic beverages might not happen. In this case, investors cannot really forecast the timing of potential tariffs or how much it will rock the balance of imports and exports.
However, tariffs on cognac have tended to ebb and flow over the years. In our view, investors with a long-term horizon of at least three to five years can develop a business analysis of select luxury goods companies capable of delivering attractive earnings growth regardless of the fluid tariff environment.
Develop a Range of Outcomes
To be sure, trade wars and tariffs widen the range of potential outcomes for companies and investors. If the risks are too severe, investors should step out of the way and avoid an industry or a company that’s in the direct line of fire of unpredictable trade moves.
In other cases, investors can integrate the risks into security analysis. If a company is vulnerable to tariffs but has an otherwise solid business, we can apply suitable discount rates that reflect a risk-aware valuation. Then, we can gauge whether the long-term reward potential compensates for those risks. Position sizes in a portfolio can also be adjusted to reflect a company’s susceptibility to tariff moves.
Trade wars are just one aspect of geopolitical risk, which is clearly increasing on many fronts. Equity investors with a thoughtful approach to addressing these risks will be well equipped to cope with an erratic policy environment and to capitalize on the structural growth trends that are likely to overcome political hurdles over time.
