Episode 18 – Investing and Tariffs

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Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is investing amid tariffs. And we’re going to be talking about, not the politics of tariffs, but rather how we respond to the reality of tariffs, what they mean for the economy, what they mean for us as investors. I’m Josh Zumbrun, I’m the director of External communications here at Mercer Advisors. And I’m joined today by Don Calcagni, our chief investment officer. Don, thanks so much for being here.

Josh, it’s great to be here. Thank you.

Tariffs have become a reality. When the Trump administration first started talking about tariffs in 2017, there was a lot of debate around it. But part of that debate is settled in a sense, because when the Biden administration came in, they changed a lot of things about Trump’s policies. But one thing they didn’t change were the tariffs on China.

So some level of tariffs are a reality. And we know that the Trump administration has made it very clear they want to use this tool more going forward. So it’s a good time to dive into this. So Don, to start us out, what’s the basics about tariffs that our listeners need to know?

I think it’s important to really understand what a tariff is. A tariff is really just a tax. A tariff is a tax that is assessed in theory on the non-US seller of a good who is choosing to sell that good in the United States. So that’s the whole idea of slapping tariffs on China, slapping tariffs on non-US companies, perhaps slapping tariffs on Colombia. These are taxes that are assessed at the point of entry into the United States.

Now the reality is, that pushes up prices. Because if I sell a product and the cost of me selling that product now goes up naturally, that’s going to push up the price. So at the end of the day, it does push up the price. And at the end of the day, the consumer, the American citizens are the ones who actually end up ultimately footing the bill for those tariffs.

So walk us through that a little bit. I mean I think there’s still some questions a lot of people have about how these tariffs work. But how do we come to the conclusion that just as an economic question, these tariffs cause a little bit of inflation?

Let’s just say, for example, I sell gasoline, and let’s say I am exporting gasoline to the United States. And let’s say for whatever reason, the United States wants to assess a tariff on the sale of non-US produced gasoline. Naturally, I need to recoup that expense. Otherwise, as a business, I’m going to sell my gasoline elsewhere. I’m going to sell it in other markets where I can maximize profits.

So if I have to pay a 10% or a 20% or 25% tariff on my good that I’m selling in the United States, naturally, I need to recover that somehow. And I’m going to either recover that either by raising the price for my good, for my product that I’m selling within the United States, or I’m going to altogether choose to stop selling my goods in the United States, and I’m instead going to take my business elsewhere and sell to other consumers in other countries.

And so that’s really how this works. I mean, if you think of the Trump tariffs from several years ago during the first Trump administration, those tariffs, it has been shown, tariffs on things like aluminum and steel have actually cost the average American household an additional $765 annually. And so there’s lots of good economic science, a lot of data to show that naturally these things are going to push prices higher.

And so this has an effect on not just the price directly, but also the supply of the good that’s coming into our economy.

Absolutely. So if you think about it, if I’m a business and I can sell my product anywhere on the planet, if I’m making less profits selling my goods in the United States, logically, I’m going to supply less quantity of my goods to consumers in the United States. And so you don’t need to be an economist to figure this out. If the supply goes down and the demand is still there, what happens?

Well, the price goes up. Just think of what happened during COVID. During COVID supply dried up. And so that naturally would impact prices.

So anytime you have a decline in supply and the demand is still constant, you should expect prices to rise.

And this really should be that controversial. I mean, we see that if you put taxes on cigarettes, there’s extensive taxes on cigarettes. That’s why they’re expensive. There’s states that have taxes on gas. The gas is more expensive than in the states that don’t have as much tax. It’s pretty clear what the first order effect of putting a tax on a specific good is going to be.

Absolutely. Just to give you a real-world example, I live in Pennsylvania, and in Pennsylvania we have a very, very high gasoline taxes. I think we have either the highest or the second highest gasoline taxes in the country. Now right across the border in New Jersey, gasoline prices are actually substantially lower. So a lot of consumers, a lot of us will just drive across the river to New Jersey and fill up our cars in New Jersey and avoid paying that tax.

And so whether it’s gasoline, whether it’s cigarettes, I know folks who smoke cigarettes, who choose to buy their cigarettes in bulk on the Native American reservations because there’s no cigarette taxes on Native American reservations. So, yeah, whether it’s cigarettes, whether it’s gasoline, whether go to the airport and you wonder why you pay exorbitant prices at the airport. And that’s because the airport is assessing a concession fee on all the sellers, all the vendors that have space within the airport. So this is not a hard concept, Josh. It’s not controversial. Tariffs will push prices higher.

And the exception at the airport is the duty-free shop. And that’s what you’re getting for free. You’re avoiding the tariff. That’s why the duty-free shop has the deals.

That’s the benefit.

But now are there situations. Where tariffs are not inflationary or products where the tariffs might be less inflationary than others.

Yeah, there certainly could be. And it really depends on what we call this substitution effect. And so for example, just this past weekend, there was a news story that the Trump administration may hit Colombia with tariffs. And as a prolific coffee drinker, that certainly alarmed me.

But then I started to think, wait a minute. The United States actually imports lots of coffee from Brazil and other countries. And so it really comes down to whether or not there are other suppliers that are not subject to the tariff. Can they quickly enter the market and meet that demand that is there given the fact that one of the suppliers has been pushed out of the market?

So in commodities markets and certainly other types of markets where there’s lots of suppliers, if you remove just one supplier, in theory it’s not going to have a huge impact on the price. Now, those remaining suppliers generally will still increase their prices a little bit because now they have a bit of monopoly power, so they have more pricing power if you can remove one of their competitors from the landscape. So prices will typically still rise a little, but oftentimes, not that significantly.

Another situation would be where if the price of coffee went sky high and we as consumers said, that’s OK. We don’t need to drink coffee anymore. We’ll just drink more tea. And so if there’s another way to substitute, picking a different product, in those situations, typically, we can avoid a big impact to consumer prices.

So you have commodities on one end of the spectrum where it’s very easy to substitute one coffee bean for another. And then at the other end of the spectrum, you might have extremely specialized manufactured products where it’s very difficult to substitute. And if that product only comes from China or something, there might be little alternative, at least in the short term, where a company has no choice really but to eat the tariff when they import that item.

That’s absolutely right. In economics, we call it the elasticity of demand. The question is, how flexible are we as consumers? If it’s a highly specialized product and it gets slapped with a high tariff, we’re going to have no choice but to pay the higher prices in order to consume that particular good.

Commodity-type products–

we can easily substitute those, typically for something else.

So the takeaway there is that it can be really different from one product to the next. And obviously, if it’s different from one product to the next, it can be really different from one company to the next. So how do you invest in a situation like this? What are the investment implications of investing in this type of environment.

It’s interesting because I think that’s the million-dollar question. Everybody wants to know, hey, how can I game this? And what I’d argue you really can’t game this for a couple of reasons. Number one is the policy around tariffs could change in a New York second.

I think when I went to bed Sunday night, we were seriously going to be hitting Columbia with tariffs. I woke up Monday and now we’ve moved on. We’re not going to hit Colombia with tariffs. We came to an agreement.

And so these policies can change very, very quickly. And so you got to be careful. You don’t want to be turning over your portfolio constantly trying to shift things around only to have the governmental policy change in a second. That’s the first concern.

The second concern is let’s take Whirlpool as an example. But there are lots of companies that have very complex global supply chains. And so you may think, well, wait a minute. If we were to hit Chinese manufacturers with tariffs, isn’t that in theory good for US-based manufacturers? And so if you take the Whirlpool example from several years ago, when the Trump administration originally put tariffs in place on Chinese manufacturers, at the same time, they also put tariffs in place on aluminum and steel.

Well, what happened is that actually hurt Whirlpool. That actually hurt them. And actually the entire US manufacturing sector. Believe it or not, contrary to popular belief, actually contracted to the tune of several billion dollars in output, was actually lost between 2017 and 2020 just due to those tariffs. And so companies with very complex supply chains, you need to be careful there. In theory, you may think that you’re helping a US-based company, but in reality, you could ultimately end up hurting that company in the long run.

There’s relatively few companies that are purely US in their entire supply chain. There’s raw materials that most companies use that are going to come from somewhere internationally.

That’s absolutely true. I mean, the economy, the global economy, especially is infinitely complex. And so the challenge with tariffs that we have learned many times throughout economic history, going all the way back to something called the Smoot-Hawley Tariff Act from the Great Depression, we have learned time and time again that the economy is very complex. And so assessing a tariff, for example, on Chinese-manufactured goods is more likely than not going to come back and hurt consumers in some way, shape, or form.

And that doesn’t even take into account the fact, Josh, that when you hit a country with tariffs, the reality is they’re going to retaliate. They’re naturally going to hit us with tariffs. And the United States is a major supplier of goods and services to the rest of the world. So again, these cause and effect relationships throughout the global economy are very complex. And it’s very likely that putting tariffs in place on one particular good or one particular country, it’s not going to end there. There’s going to be a very unpredictable domino effect that ultimately can come back and hit consumers.

How should we think about the risk to international investments in this type of environment? Most of us, if we’re investors with diversified portfolios, we have an allocation to international stocks. To what extent should we be reevaluating that in this tariff environment?

Again, I don’t think the tariff environment necessarily forces us to reevaluate, for example, a portfolio allocation to non-US companies. And let me give you a real concrete example why. Let’s just go back to the coffee example. The United States imports 24% of the coffee that we consume from Colombia, and 35% from Brazil. And so in theory, if we were to hit Colombia with tariffs, what it means is that Brazilian producers would actually benefit from that. And so if you have a diversified portfolio consisting of non-US equities, the reality remains that part of your portfolio would benefit, part of your portfolio would suffer from that particular tariff decision.

Interestingly the US part of your portfolio might actually suffer from that tariff decision as well. Consumers may purchase less coffee from Starbucks or Dunkin’ Donuts. And so at the end of the day, that could also hurt your US portfolio. So again, back to my point. Trying to draw very simplistic cause and effect relationships is very difficult.

And so the tariff environment–

the reality is I don’t think that forces you necessarily to reevaluate a non-US allocation. I think what it does do is it forces you to reevaluate what’s the level of diversification in the portfolio? How much fixed income do I have? Which countries do I have exposure to?

Am I broadly diversified enough so that I can weather any potential economic storm that might come about as a result of tariffs?

When the Trump administration has talked about tariffs, they’ve often talked about three goals. One is to use them to raise revenue. Another is to encourage companies to bring their supply chains back to the United States because to the extent you’re making things more in the United States, there’s less tariff on it if you can bring everything back into the United States.

The third reason that they’ve cited is to use the tariffs to generate leverage in negotiations. That’s what we saw with Colombia. They threatened tariffs because Colombia wasn’t accepting US airplanes, wasn’t allowing them to land. Columbia said, we’ll let the airplanes land.

And so the US said, well, we’re going to back off from the tariffs. So it’s just a negotiating tactic in that situation. But I want to talk just a second about this idea of bringing back US manufacturing. What should we as investors watch out for in terms of a return of US manufacturing capabilities?

Again, I think that’s a very simplistic conclusion to draw from putting tariffs in place. So for example, if you were to hit China with tariffs, in theory, you would think, OK, well, that’s going to now incentivize those manufacturers onshore to move back to the United States from China in theory. Well, in a world where there’s only two countries, that would make sense, but there’s manufacturers in China could simply move to Vietnam, they could move to Mexico. In fact, I read a recent study that Mexico has actually been the biggest beneficiary of the first Trump administration’s tariffs because many manufacturing companies are moving to Mexico.

So the reality is you would have to hit the entire world with tariffs to force US companies to return back to the United States. And I don’t have an opinion on that. I mean, I grew up in a factory town that has really fallen on hard times. The mill shut down many, many years ago, and I have felt that.

So I feel that emotionally, Josh. There’s part of me that really agrees with trying to bring US manufacturing back to the United States. So I don’t want our audience to misunderstand. I’m just trying to give our audience an assessment of the economic impact here.

The reality is, even if those companies were to return to the United States, the reality is in the United States, we have a higher cost of doing business. We have higher labor costs. We have environmental regulations. All of these things, I could argue are good, but they do push up the cost of doing business in the United States.

And so what does that mean? Well, it means if you choose to return to the United States to manufacture your goods in the United States, the costs are going to be higher, which means the prices are going to be higher. And so that’s just a reality. So back to your earlier question.

To what degree are tariffs inflationary? Well, look, if we’re going to push up the cost of doing business, the reality is that’s going to generally push up the price of goods and services.

Yeah, I think back to the example of cigarettes. There’s no question that they’re more expensive because of the tax imposed on them. But it’s a political question or maybe a public health question whether or not that’s a good policy. I mean, maybe that’s what you exactly want the policy to do. It’s not to say what’s the right or wrong thing, it’s just to say what the actual effect of it is.

Absolutely. Another rationale given for tariffs is really national security reasons. And I can totally understand that and certainly support it as a political policy. But that does not change the economics, the economics of tariffs, whether that be on advanced computer chips, whether that be on coffee, or whether that be on aluminum or steel, the economics of tariffs ultimately work together to push prices higher.

Now, how should we think about–

we mentioned this a second ago that these tariffs are often a negotiating tactic. Sometimes they have gone into effect. Very significant tariffs have been put in place against China. They stayed in place throughout the Biden administration.

But other times they’ve been threatened and never came into effect. The auto industry is an example where in the first administration, they threatened large tariffs on all imported automobiles, but never carried through with that threat. What’s the takeaway for navigating that aspect of tariffs?

Well, I mean, the reality is the United States remains the world’s largest economy. And all of the forecasts at this point suggest that it will in perpetuity, remain the world’s largest economy. There was some concern that China may eclipse the US economy in size, but there are lots of evidence recently that suggests, no, that’s not going to happen. And China’s economy is a very closed economy, very difficult to get permission to do business in China given the new policies of Xi Jinping. So the United States is a very lucrative market for businesses to transact in. And so it is a very powerful negotiating tool.

I can totally understand why President Trump wants to wield this tool as weapon, as a negotiating tool, because I do think it is very powerful. Now, the challenge is, though, is and you’re right, there’s been many times when it was walked back and ultimately, we found some sort of negotiated agreement. But the reality remains is the minute you put it in place, other countries are also going to retaliate. And the minute you put that in place back to what we’ve been discussing thus far on this particular podcast, there are first and second order economic effects that will certainly hurt consumers.

And so my view is, how do you navigate this from an investment perspective? Like I’ve said before, trying to draw very simplistic cause and effect relationships, I would argue that’s a fool’s errand. So what do you do given that information? You would want to build a highly diversified portfolio, both public and private markets, if you qualify for investing in private markets. You’d want to make sure that you have a proper asset allocation between stocks, bonds, real estate, and so on, and so forth. So that’s really the best way to navigate it is to stay broadly diversified.

As a consumer, that’s a whole other topic. But budget management, things like that. If you’re looking at making a large purchase of Colombian coffee, you may want to do that now and perhaps not wait three weeks. Although at the moment, it sounds like we have an agreement.

It’s a significant economic policy. But for us as investors, there’s a lot of wisdom in still staying the course.

There really is. There’s danger, as investors, in trying to derive an investment thesis from what’s happening in the political environment. Very dangerous. And remember, when we make changes in our portfolios, those aren’t free. Those come at a cost, especially for taxable investors. And so to move out of diversified portfolio right now that has massive capital gains, untaxed capital gains, I think there’s one or two producers of coffee in Hawaii to try to buy those companies, I think would be very foolish. So the turnover expenses, the opportunity costs that come along with making portfolio changes, all based on really what’s happening in the political environment, I think is a very dangerous approach to managing the portfolio.

Well, I think that’s a great piece of advice to leave this discussion with. Don, thank you so much for your insights here today.

Thank you.

If you’re already a Mercer Advisors client, feel free to reach out to your advisor with any questions about your portfolio. And if you’re not a client but would like to learn more, visit our website. merceradvisors.com, set up a phone call with our team. Until next time, this is Market Perspectives.

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