Protectionism and Investing

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 2, 2016 1:53:58 PM

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protectionismOne of the most unusual aspects of this presidential campaign is how both parties have lined up in opposition to free trade. No surprise there from the Democrats, who have substantial interest groups that have always been anti-free trade, but it’s a complete reversal for the Republicans.

You have to figure that when both parties agree on something, government action becomes significantly more likely. And that means we as investors should start thinking about what protectionism means for us.

This trend isn't just happening in the U.S., of course. I first wrote about rising protectionism back in 2012, and it has only intensified since then. Until recently, the U.S. had continued to press for free trade and worked on two major trade agreements, the Trans-Pacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (TTIP), as well as many smaller ones. Although other countries have typically been less enthusiastic, pressure from the U.S. has largely kept free trade moving forward. Now that the U.S. is pulling back, we can expect other countries to get even more restrictive.

Should we care? Yes, although perhaps not as much as you might think. Although there’s no doubt that this country (particularly consumers) has benefited from trade, the U.S. is less exposed to the rest of the world than any other major economy. That said, rising protectionism will certainly have an effect, both here and abroad.

The high costs of making things here

At base, protectionism means we make things in our country regardless of whether it is cheaper or more efficient to do so elsewhere. In general, costs would likely go up across the economy and efficiency would go down. The whole point of trade, after all, is to let the country that can do things best do it. Rising protectionism would likely mean lower growth everywhere as all economies become less efficient.

It would also mean higher prices. With costs rising, companies would have to charge more. For example, manufacturing a TV in the U.S. costs more, so TVs would be more expensive, as would a lot of other things. This would hit consumers who are used to cheap goods and possibly reduce their standard of living.

On the other hand, employment presumably would increase as manufacturers bring back jobs. But this positive effect would, in turn, be offset by declines in export-related jobs and very probably by mechanization of the returning manufacturing. Most job losses in that sector have come from technology, not trade, so protectionism wouldn’t necessarily reinstate them. The higher costs would be certain; the new jobs less so.

To envision what this might look like, consider rolling back many of the changes we’ve seen in the economy over the past 30 years. American cars might dominate again. There would be more blue-collar workers.

Yet, with many foreign auto plants here in the U.S., you could argue that U.S. companies would still be forced to compete. And, as I said, the workers would now be competing with machines, not the Chinese. Even in a best-case scenario, in which U.S. manufacturing comes back to life, there would be downsides, just as we saw in the 1950s and 1960s. Products would likely become more expensive (and might well be of lower quality) due to lack of competition.

Lower growth and higher costs could be damaging for both the economy and stocks. It could be particularly bad for consumers, particularly those who want to buy labor-intensive goods. This is why economists generally support free trade.

Which areas may fare best as protectionism rises?

From a macroeconomic standpoint, as an investor, you might want to focus on countries that are least subject to these negative effects—specifically:

  1. Large, integrated economies that can internalize a great deal of the comparative advantage that smaller countries can only obtain by trade
  2. Economies that depend relatively little on exports and are focused on domestic demand

Using these criteria, the U.S. seems like a good bet. It is a very large economy dominated by internal spending, with relatively little exposure to the rest of the world through exports. Looking at other areas, Europe and China satisfy criterion 1 but fail 2. Germany, in particular, would have a problem with 2, and as the most successful European economy, it could drag the whole continent down with it. Although China’s dependence on exports is lessening, it still remains at potentially damaging levels. Japan is somewhere in the middle—many of its largest companies depend on exports, but the economy as a whole is domestically focused.

All in all, the U.S. seems to be the economy best positioned to weather this trend.

The second layer of the investment process might be to focus, within the selected economies, on industries that could benefit from reduced competition. Here in the U.S., furniture is one such industry, and autos are another obvious example. Ford and GM, for instance, would stand to benefit from impediments to Toyota, Hyundai, and Mercedes. Even so, more detailed analysis would be needed, as Toyota, for example, has many U.S. plants, while Ford has plants abroad and a supply chain that depends on Mexico. Whether the gains for any particular company would offset the loss of export markets or the supply chain damage would depend on the company, but it’s something to consider.

For the economy, cons may outweigh pros

In short, protectionism offers few opportunities for either countries or companies that are not offset by significant disadvantages. As investors, we have to be aware that rising protectionism has the potential to do a great deal of economic damage, and investing around the trend will be primarily focused on mitigating that damage, at both the country and company level.

This is a threat that is likely to grow, and it’s something I will be keeping a close eye on as the election progresses.

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