Tariffs and the possibility that regional disputes could turn into a full-scale global trade war are the biggest threat to the ongoing US bull market, according to M&G Investments’ John Weavers.
Whilst issues such as rising rates, inflation and regulation of the FAANGs – Facebook, Amazon, Apple, Netflix, and Google-parent Alphabet – pose potential risks to the earnings power of the US market, the manager of the four FE Crown-rated M&G North American Dividend fund said the biggest threats to the second-longest bull run US in history are tariffs and how the situation unfolds.
Weavers said: “At the moment, the focus of the tariff disputes and the area where we’ve seen the starkest developments is China. However, the tariff situation may extend well beyond this.”
Although there’s been a ceasefire with Europe, the manager believes it wouldn’t take much for the disputes to resume.
“With NAFTA [North American Free Trade Agreement] reform discussions ongoing, the prospect of a truly global trade war is by no means out of the question,” he pointed out.
When US president Donald Trump won the presidential elections in 2016, he made a promise to make NAFTA – the trilateral agreement between Canada, Mexico and the US – “a lot better” for the country.
After imposing duties on steel and aluminium from Canada and Mexico in June, the US administration has increased pressure on its neighbours, warning of potential tariffs on vehicles and auto parts.
According to Weavers, tariffs materially change the cost of doing business for US corporates. This can easily be seen in the effects of the first round of international tariffs announced in March.
“In March, steel and aluminium were the focal points and prices have already risen meaningfully,” he said. “Steel futures, for example, are up 30 per cent year-to-date and now stand at 10-year highs.”
Source: M&G
With the US the world’s largest steel importer, an increase in prices means higher input costs for many businesses, many of which are already trying to offset the additional cost by charging higher prices to the end-consumer.
This has been a theme of the current earnings season, with companies from Coca-Cola to Caterpillar announcing off-cycle price increases, the M&G manager pointed out.
Weavers, who is also a deputy manager of the £6.2bn M&G Global Dividend fund, said another area where the effect of higher prices has started to be seen is economic data.
“Last week we heard that core producer prices – which exclude the more volatile items like food and energy – in the US rose by 0.3 per cent in July, taking the overall year-on-year increase to 2.8 per cent. Economists have attributed this inflation directly to tariffs on imported Chinese goods,” he explained.
Although the economy seems to be strong enough to absorb those price increases, Weaver believes this may not be the case if the tariffs escalate further.
This is because every additional round of tariffs implemented will lead to higher cost in the system that will need to be recovered somehow, either through higher prices for customers or through lower profitability for companies.
All eyes now are on whether the US, which has already slapped 25 per cent tariffs on Chinese goods worth $34bn, implements an additional round of tariffs on China as, Weaver noted, if we reach a point where price increases can no longer be passed on, margins will have to “take a hit”.
US-China exposure Index
Source: M&G
Given the backdrop, the manager of M&G North American Dividend fund said the team is spending more time looking at which of the holdings in the £622m portfolio are most exposed to tariffs and which have the greatest pricing power.
“Our railroads holdings, for example, are major consumers of steel, and we are keenly examining the possible effects of tariffs on these stocks. They tend to have strong pricing power with limited demand destruction, meaning that the impact has so far been muted,” he said.
“Our other area of focus is on businesses that export to China and it’s no surprise that stocks with Chinese revenue exposure have sold-off meaningfully in recent months.”
With the most exported goods from the US to China including agricultural products, aircraft parts and automobiles, the M&G manager said some companies in those industries have been affected by the uncertainty in the recent earnings season.
An example, he said, is American car manufacturer Ford. The company lowered its earnings expectations at the end of July citing “their challenges in the China market” as the reason.
But the pressure from tariffs is not only being felt by direct exporters. Higher tariffs on products such as pork and chicken have led many products to stay in the US, depressing domestic prices.
According to Weavers, although great for consumers, this is “disastrous” for some companies like Tyson Foods, whose profitability comes from domestic sales.
However, Weavers noted that it is not all bad news, as some of the selling in China-exposed names has been indiscriminate and the team is starting to see opportunities to buy long-term winners “at a significant discount”.
“Yum China, the company that owns the KFC and Pizza Hut brands in China, strikes me as an example of a stock that has been exaggeratedly sold,” he said.
“The business has a long runway for growth ahead of it and has absolutely no export or import exposure to China, but its share price was down 20 per cent year-to-date at its low in July.
“The driver of the stock’s de-rating is the translational exposure of its earnings to the Chinese yuan which is currently approaching multi-year lows versus the dollar and we are considering it carefully in our analysis.”
Performance of fund over 3yrs
Source: FE Analytics
Over three years, M&G North American Dividend has delivered a 79.52 per cent total return compared with a 64.85 per cent gain for the average fund in the IA North America sector and a 74.04 per cent rise for the S&P 500 index.
The fund has an OCF of 0.91 per cent and a yield of 0.87 per cent.