The Trade War: Is the Damage Done?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 25, 2019 2:14:55 PM

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trade warOne of the topics I get a lot of questions about when speaking to clients is the trade war. They want to know what I think and whether whatever they’ve read in the latest headline will make a big difference. It has been a remarkably consistent question, through all the ups and downs, and the only difference is what exactly the latest headline is. My answer has also been consistent. I think the trade war is a big deal, but the latest headline doesn’t really matter. Why? Because the damage has already been done. It will just take a while to show up.

The global supply chain

To see what I mean, imagine you are Tim Cook, CEO of Apple. It could be any company with a global supply chain, but let’s use Apple. What was Cook’s reaction when he found out his whole supply chain, and thus his whole company, could be blown up with a tweet? Did he sit back and say with a sigh and perhaps a tear in his eye, “Well, that’s that. We had a good run here at Apple. Maybe I should try music again.” Or did he get his team into the room and say in no uncertain terms, “We have a problem here that we have to fix now. I want our supply chain as diversified and bulletproof to trade issues as we can get it, and I want it done as soon as possible.” I suspect the answer was the latter, and my answer to clients’ questions is based on the consequences of these types of decisions.

If you have a global supply chain, it means you have carefully selected your production facilities so that they are the most efficient, and likely cheapest, that you can find. You have centralized as much as you can to take advantage of scale and put them in areas where similar facilities are clustered. You have optimized everything as much as you possibly can and squeezed every penny and second out of the process. Your system is as efficient as you can make it.

Now, however, you must take this carefully designed system and break it. You have to find similar—but, by definition, less efficient (otherwise you would have already been using them)—facilities that are less exposed to political trade risks. You will become less efficient overall, and your costs will go up, because you have no choice. To insure against political risk, you have to become less economically optimal.

We're not talking about just Apple but every company with a global supply chain, which includes all the manufacturers, all the retailers, and so on. This forced decision will reverberate throughout the economy over the next several years as companies make these adjustments. The process will take time, and the effects will show up slowly. But show up they will.

Looking beyond the U.S.

This situation isn’t just about the U.S., either. Recent headlines have questioned whether China will continue to buy food from the U.S. This year, it may and probably will. But China now has a rock-bottom incentive to diversify its food sources away from the U.S. over time, even if it is more expensive. Brazil and Argentina, to name just two, are likely to get quite a bit more of China’s business over the next several years. Again, the effects will take time to show up—but they will.

This outcome is what I was talking about last year, at Commonwealth’s National Conference, and here on the blog. Politics is forcing a move away from economically optimal solutions, and there will be costs.

The damage is done

This shift helps explain why the headlines don’t matter, and why the damage is already done. Assume the U.S. and China come to some sort of an agreement. Would that change Apple’s decision, or China’s? No, because the risk remains. Just because a risk has subsided, it doesn’t mean it can be ignored.

When you think about the trade war and read the news, keep the real story in mind. That story is taking place in boardrooms around the world, as companies change their plans, not in meetings between government negotiators.

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