Pick Your Poison: Tariffs or Tech

 

First Poison–Tariffs as a Tool

The headlines and much commentary on higher tariffs threatened against China, in our view, glosses over the importance of the underlying issue.  In reality, the higher tariffs represent a tool to deal with protecting U.S. corporate intellectual property and providing greater access to Chinese markets for U.S. corporations.

The Real Issue

Frequently, to access Chinese markets, U.S. corporations need to make mandatory transfer of their intellectual property rights to Chinese firms—many state owned.  A recent Goldman Sachs report noted that 136 of the 1,000 largest companies in the world are Chinese.  Of those 136 companies, 70 were state-owned.  Because mandatory technology transfer issues do not fall strictly under W.T.O. prevue, that organization lacks the power needed ultimately to resolve such disputes.   In addition to intellectual property transfer, China requires many U.S. companies to form joint ventures with Chinese firms in order to operate in China.

The U.S. Takes a Strong Stand

We suspect the lack of strong responses by prior administrations to rules limiting U.S. access to Chinese markets probably surprised Chinese government and business officials.  Therefore, the fact that the Chinese government opened bi-lateral talks with the U.S., despite our recent strong actions, should also not be surprising.

Dangers from a Tit-for-tat Response

This morning, hours after the U.S. announced 25% tariffs on $50 billion worth of Chinese products, China’s state council announced similar penalties on U.S. goods.  In the case of the U.S., our tariffs would cover 1,300 categories of goods.  For China, the category is more limited and includes passenger planes and soybeans.  According to IHS Markit, the largest U.S. exports to China included aircraft and aircraft parts totaling $16 billion.  These tit-for-tat announcements understandably rattled investors.  Obviously, concerns remain that both countries could lose control of this trade fight.  After the Chinese announcement, the Wall Street Journal quoted China’s finance vice minister Zhu Guangyao as saying “now it’s time for negotiations.”  Importantly, neither country will immediately institute these tariffs.

Will the Chinese Respond to Non-Tariff Issues?

Last Monday April 3rd, according to Reuters, Chinese premier Li Kequiang said that China would treat foreign and domestic firms equally, would not force foreign firms to transfer technology and would strengthen intellectual property rights.  Unfortunately, these also represent past promises.   Therefore, current bi-lateral negotiations will need to result in a written agreement with the U.S. to resolve these issues.

Bilateral Negotiations

If these issues can be resolved, then we would expect the U.S. and China to pull back on implementing higher tariffs.  Under current U.S. guidelines, some time exists before higher tariffs can be put in place.  A new round of tariff increases first requires our government to take comments from industry for 30 days.  Then, the government can take up to 6 months to decide whether to implement higher tariffs.  While headlines and comments will continue to focus primarily on the obvious dangers of higher tariffs, investors should also focus on the issues concerning protecting U.S. intellectual property and Chinese market access.

Poison 2 – Tech Industry Arrogance

From our years in the investment business, we noticed that equity markets seem ultimately to slap down those industries, companies, and individuals exhibiting enormous arrogance.  In our view, the tech industry met that standard of arrogance.  With that, equity markets took the tech industry stocks to the wood shed for punishment.  A fundamental reason always exists to cause that reaction, but the underlying problem usually results from the buildup of arrogance.

The Tech Industry Wakes up to its Arrogance

A recent headline from an article in Geek Wire shouted, “tech industry’s cavalier and arrogant attitude foments backlash but started long before trump, top execs say.”   Expedia and Zillow group co-founder said in that article, “I think we’ve behaved in quite an entitled and arrogant manner for quite some time.”  The tech backlash will not only show up in the financial markets but also in political capitals—Washington, London, and Brussels.   Investors will be watching closely to see if legislation and regulation result that could hamper growth.

Tech Fundamentals Remain Positive – Quarterly Earnings and Outlook Key

Despite the tech stock selloff, the overall fundamental outlook for the industry remains optimistic.  We expect both first quarter tech earnings and the earnings outlook that usually accompanies those announcements to be positive.  If so, the recent tech stock correction likely created some attractive investment valuations.

Investment Conclusions

The forthcoming first quarter earnings results and the accompanying earnings outlook for most companies, not just tech companies, should be positive and remind investors that economic growth remains strong.  If this outlook proves correct, then the recent decline in the equity markets should provide attractive valuations for these positive forecasts.

 

Andrew J. Melnick, CFA
Chief Investment Strategist

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