If you were wondering how the next stock market sell-off would take place, the answer is probably staring at you in your face with these tariffs that US President Trump has decided to put on Chinese imports. Some of you might think that these tariffs would bring manufacturing back to the US since China would lose its competitive advantage of producing “cheap” products. If you think this way, you are probably right, but it would take a long time to bring those jobs back.
So, what would happen soon after these tariffs go into effect? Most of the Chinese imports are going to be priced higher than before. This means that when you visit a car dealership to buy your new car, you’ll notice that the cars are a little more expensive since that “cheap” Chinese aluminum and steel used to build the car’s body is no longer “cheap”. You’ll notice that everything from seafood to toilet paper to your handbag will go up in price. Here is a list of Chinese goods that would be affected from the tariffs.
Once the prices of goods increase, inflation becomes evident. Inflation is the reason why a loaf of bread, which was 9 cent in 1930, is now $1.98. In other words, due to inflation, your $1 today is going to have a lot less buying power 10 years from now. So, we can agree that a tax on Chinese imports would increase the prices of goods, which translates to increase in inflation. If the US Federal reserve notices that inflation has grown past the 2% per year benchmark, it will start to aggressively hike interest rates. By increasing interest rates, the Feds are trying to keep inflation under control.
Let me digress here for a second. How does increasing interest rates taper off inflation? When the Federal Reserve increases interest rates, bond yields are going to increase proportionally. In other words, US government bonds start becoming an attractive investment option. Moreover, a rising yield is dollar bullish. This means that all the international investors want to invest in US bonds since it is a safe investment with a good return. In order for them to invest in US bonds, they have to convert their local country’s currency into US Dollar. As the demand for US Dollar increases, we can see US Dollar gain strength (if this is a bit too confusing for you, feel free to read my previous blog here, where I talk about how supply and demand affects currency price). As US Dollar gains strength, your $1 is going to be worth more than before. Let me give you an example. Assume that 100 Chinese handbags cost 500 Renminbi (CNY) to produce, and the foreign exchange rate is: 1 USD = 5 CNY (hypothetical). This means that 100 Chinese handbags cost 100 USD. Now, after the interest rate hike, the dollar gained strength. So, the current foreign exchange rate now is: 1 USD = 10 CNY. Consequently, those 100 Chinese handbags are now going to cost 50 USD. As you can see, the cost of those handbags was cut in half. This is exactly how inflation is curtailed. Products get cheaper. All made possible by Feds raising interest rates. In conclusion, rising interest rates are inherently deflationary. Alright, let’s get back on topic.
Now, we can all agree that in order to bring inflation under control, Feds raise the interest rates. As the interest rates increase, bond yields increase and bond prices drop. Let me give you an example. Assume that US government bonds carry a 3% coupon. This means that if you invested $1000, you would get a coupon payment (similar to dividend) of $30 at the end of the year. Now, the federal reserve decided to raise interest rates, which would translate to a coupon payment of 5% on new government bonds. This means that if you invest $1000 after the hike, you would get a coupon payment of $50 at the end of the year. Let’s say you were holding onto the US government bond that carried 3% coupon payment. After the Feds raised interest rates, new bonds are paying a 5% coupon payment. In order to sell your 3% coupon bond, you would have to offer your bond at a lower price (a discount) that would enable it to generate a 5% return to the new owner. From this example above, you can see how an increase in bond yields generates greater coupon payments and lowers the bond price (this concept is similar to dividend yield and stock price). It is this discount in bond prices that attracts investors to the bond market (here is an article from Wells Fargo where they do a good job at explaining the relationship between bonds and interest rates).
At this point, we can agree that as interest rates increase, bonds start looking more and more attractive. Imagine that you are invested in the stock market and are getting a 6% annual return on your portfolio. After the interest rate hikes, the US government bonds are giving you a 5% annual return on your investment. If you were to chose between stocks giving you a 6% return and bonds giving you a 5% return, what would you chose? How risk averse are you? Your answer is definitely going to vary with your age and the amount of money you have invested. If you are in your 20s with not a lot of money to lose, you are probably going to chase that extra 1% since you have a higher risk tolerance. If you are in your late 50s, getting close to retirement with a $1,000,000 stock portfolio, you are probably going to move all your money to government bonds since it’s the safest investment out there with a guaranteed return.
Hopefully, now, we can agree that as bond yields increase to an attractive level, significant amount of money would be moved from stocks to bonds. In other words, we could start seeing a sell off in the stock market; All we would need is fear inducing news that would make investors risk averse. That fuel of fear can be ignited by a spark coming from geo-political tension (war, political unrest, elections, terrorism, etc), rising unemployment, rising default levels (mortgage, student loans, auto loans, etc), overly hawkish Feds, etc. As the stock market begins to sell off, this is exactly when opportunities are created. As a value investor, this in when you begin investing in those companies that you like and that are now selling for a discounted price. It is difficult to invest when you are seeing an ocean of red tickers, but you have to be greedy when others are fearful.
So, are tariffs good for the US Economy? In the short term, not really. The tariffs on imports would increase the price of goods, which leads to inflation. The increase in inflation would incentivize Feds to raise interest rates (Note: Before raising interest rates, Federal Reserve looks at multiple indicators such as Personal Consumption Expenditure (PCE), unemployment rates, consumer sentiment, how the US economy is doing holistically, etc). Since we have been in a low interest rate environment for a long time, with low unemployment and positive economic growth, the Feds would aggressively hike interest rates as inflation gets above 2%. After all, by hiking interest rates, the Feds are indirectly preparing themselves for the next crash. As interest rates increase, bonds start looking more attractive than stocks. Risk averse investors would flock towards government bonds since bonds give a fair return and are safer than stocks. This is precisely how the stock market’s growth would trim. At this point a fear inducing news is all that is needed to start a full fledged stock market sell-off.
What do you think are the implications of tariffs on the US Economy? How are you going to position yourself as the Feds start hiking the interest rates? Are you a risk averse investor? Have you figured out which stocks you will be buying during the next market sell off?
Hope you learned a little and found this blog post helpful. We talked about tariffs, inflation, rising interest rates, bonds yield, bond price, and risk aversion. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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