Sunday's announcement by President Trump of an escalation of tariffs on China is a clear potential negative for both the industrials and materials sectors. In a sudden shift, President Trump announced that tariffs on the USD 200 billion tranche of imports from China would rise from 10% to 25% as soon as this Friday, and tariffs on the remainder of the imports from China (an additional USD 325 billion) would also be forthcoming "shortly" at a rate of 25%. The increase in tariffs to 25% has already been delayed twice as negotiations between the two sides appeared to be moving forward. The CIO base case remains for a negotiated trade settlement, with a 30% chance of a breakdown in negotiations.
This announcement marks a possible material escalation in the one-year trade battle between the US and China and increases the fear that the trade situation appears to be rapidly careening toward a worst-case scenario for the materials and industrials sectors. This is also a total surprise to the market and counter to recent White House comments that trade negotiations were going very well. It is not clear what has caused such an abrupt reversal by the US, but recent issues impeding the deal have been around enforcement verification, intellectual property protections, and the US wanting to maintain some tariffs as a check on Chinese compliance. In response, the Chinese government announced it is considering delaying any further trade negotiations set for this week. It is also very likely that the Chinese government would retaliate quickly against any higher tariffs from the US.
It is unclear how much of this is a negotiating tactic to get the Chinese to bend to a deal, but any rapid changes in trade policies could be destabilizing longer-term to both US trade partners and US corporations in trying to plan for the future. An acceleration in tariffs of this magnitude and any response from China would also make it increasingly less likely that the back-end nature of 2019 earnings forecasts by industrial and material companies will be achieved, as most companies were anticipating a trade resolution and virtually no one was anticipating a further increase of tariffs.
Higher tariffs would have a most negative impact on the industries that are directly impacted by the tariffs, more exposed to Chinese demand, and more cyclical. We would highlight the machinery industry as being most impacted within industrials, and the chemical and mining industries within materials. Within metals and mining, all the base metals will likely be negatively impacted as China accounts for some 50% of demand, but it is the most negative for copper given China is a net importer of that metal. Gold is likely to be a safe haven as it usually is in times of extreme uncertainty.
Areas relatively less impacted would be the more US-focused ones such as defense contractors, railroads, airlines, and waste management companies within industrials, and building materials and packaging companies within materials.
Bottom line, higher tariffs would be bad news for the industrials and materials sectors as it could hurt China's economy and global demand, raise prices across the supply chain, and potentially impair sourcing from China. Larger still is the more unquantifiable impact this uncertainty could have on business confidence and future capital spending. Hopefully for investors, this is more a negotiating tactic in line with the "art of the deal" rather than an eventual escalation.
Author:
Adam Scheiner, CFA, Industrial and Materials Analyst Americas, UBS Financial Services Inc. (UBS FS)
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