Strubel Investment Management commentary for the month of November 2024, A Special Election Edition.
Dear Investors,
Now that Donald Trump has won the election, what are the biggest changes we can expect from a new administration? How should investors prepare?
We know from his past administration that tariffs will likely play a prominent role in economic policy. Some type of tax cut package to replace and extend the Tax Cuts and Jobs Act (TCJA) from the first term is almost certain. So, let’s look at both.
Tariffs can be enacted by the Executive branch unilaterally without Congress. They are a form of tax on products imported into the US from abroad. When a product is imported, the entity that is the importer pays the tariff (or tax). How that tax ultimately plays out for consumers and the markets, however, depends on what happens and what changes are made.
Let’s look at a hypothetical new 10% tariff on a hypothetical product manufactured in China. Let’s call the product Ultra Widgets and say they cost $100 and that ABC Company retails them to consumers for $120 (a $20 profit margin). There are several different scenarios with different economic impacts for how that tariff could play out.
Consumer or Importer Ultimately Pays the Tax
The simplest and most straightforward example is that ABC Company imports the widget from China for $100 and pays the 10% tariff, meaning the widget’s final cost to ABC Company is $110. If the market for widgets supports a $20 profit margin, then ABC Company can raise its prices. It will retail the widget for $130. The end consumer ends up bearing the full burden of the 10% tariff.
Now, let’s suppose the market for widgets is extremely competitive. Maybe there are lots of retailers of widgets, and even more companies are entering the market all the time to compete with ABC Company. ABC will import the widget and pay the tariff just as before, but now the company may feel it can’t pass on the tariff costs to consumers. If it does, it risks losing out on market share to all the numerous competitors. In this case, consumers are still paying $120 for their widgets, but ABC Company has born the full cost of the tariff and is now only making $10 in profit per widget instead of $20. This might be a win for consumers but the company is earning less profit. So, if you’re a stock market investor invested in the company now earning less profit it would be a loss.
Source from Different Country
The first and easiest way to get around tariffs is simply to import the product from a different country. Let’s say that there is a manufacturer in India that also makes Ultra Widgets. Instead of paying $110 to buy them from China ($100 plus the $10 tariff) ABC Company can buy them for $100 with no added tariff from India. Of course, in the real world, things are often more complicated than a simple substitution. Some products may only be manufactured in a select few countries. There may not be enough capacity in those other countries to meet the entire new demand. For example, ABC Company may need to import one million widgets a year, but it can only get a maximum of 250,000 from India because of manufacturing capacity constraint. It has no choice but to continue buying at least 750,000 from China and paying the tariff. Manufacturing costs might be higher in other countries as well. Perhaps the widgets are also made in Germany, but cost $110 because of higher labor costs. Then ABC Company’s choice is either to buy from China for $100 plus a $10 tariff for a total of $110 or from Germany for the same $110. Or perhaps the cost of making the widgets rises high enough that it now makes sense for ABC Company to manufacture them in the US.
Cheat (Legally or Illegally)
The second option, and perhaps one of the most popular that we saw during the first Trump term was simply cheating (either legally or illegally) to avoid tariffs. One of the most common mostly legal schemes was to import semi-finished goods from China to Mexico perform some minor assembly and then import them into the US. In some cases, companies didn’t even bother with that charade and just mislabeled them as “made in Mexico.” After that, ABC Company could import its widgets tariff-free from Mexico into the US. Another popular workaround for manufacturers was to move goods from China to neighboring Vietnam. Then they could import them into the US as “made in Vietnam” and avoid the tariff. Of course, doing this adds extra shipping and other minor costs. Who ultimately pays the shipping costs? The end consumer or the company as before.
Substitute Goods
If a similar good that isn’t subject to tariffs is available, then that could be an option. Maybe there is a product called Super Widgets that is very similar to Ultra Widgets and isn’t subject to tariffs. Instead of paying $110 for an Ultra Widget, consumers might just decide to buy the now cheaper Super Widgets instead.
Foreign Exchange
Another way tariffs can be “paid” is through changes in foreign exchange rates. If something costs $100 to import from China, but the dollar rises in value against the renminbi (or Chinese yuan) that item may now cost only $90 to import. Add on a 10% tariff of $9 and ABC Company is back to the pre-tariff price of $100 (well, actually $99).
Which scenario is most likely? Probably a combination of all of them, all at once. Consumers won’t pay higher prices if they don’t have to, and so they will substitute goods where possible. Businesses want to keep their sales and profits high, so they will try to do whatever they can to avoid tariffs, both by sourcing from non-tariffed countries or gaming the system by moving shipments around. In most end markets, tariffs will be passed on to consumers. But in hyper-competitive markets, you may see companies choosing to eat all or some of the tariffs and sacrifice profits to keep sales up. Countries that depend on exports may also try to keep the value of their currency low compared to the dollar, so foreign exchange movement could also blunt some of the impact of tariffs. (It’s probably worth noting that large moves in foreign exchange markets that would completely blunt tariffs are rare. While a strong dollar could help counter import costs, it would conversely hurt US exports, so foreign exchange changes aren’t a panacea.)
Expect Some Type of Tax Cut Package
The other major campaign plank Trump ran on was lowering taxes. Everything we mentioned about the effects of tariffs might all come to naught when we zoom out and look at the whole economy. As we saw tariffs are a tax that the importer pays to import a good into this country, which can sometimes be bypassed or mitigated. Who ultimately pays the tax depends on how competitive the end market is and if it’s possible to pass a price increase on to the consumer. (In most cases, it is passed on.) With the Republicans having control of the Senate and projected to have control of the House, expect some type of tax cut package to be passed.
Indeed, some provisions of the 2017 TCJA from Trump’s first presidency expire next fiscal year, and the entire act expires in 2028. Everyone from low income households to high income households to businesses will see their taxes rise. That means everyone, Democrats and Republicans, are incentivized to get some type of replacement bill passed. (It’s a safe bet that there will be strenuous disagreements about what should be in a replacement bill!)
To follow up on our discussion of possible tariffs, let’s say an across the board tariff of 10% is enacted on everything imported into the US and 60% on imports from China. (This is one of the scenarios Trump has mentioned.) The consensus (by just working through the math) is that it will cost the average household somewhere around $1,700 to $2,000 more per year. (As we saw with our walkthrough of tariff scenarios, this number isn’t set in stone. But let’s go with it for now since it’s the best estimate we have.) All we need is a tax cut package that gives the average household an extra $1,700 to $2,000 per year, and all of a sudden, the entire net effect of everything is … nothing. It all evens out. Tariffs are simply one type of federal tax. Federal income taxes are another type of tax. If you simply switch where the government gets its tax revenue in a way that nets out to no major economic impact on the average household, then not much will change.
What can we expect from the new administration? You will likely hear a lot about both tariffs and potential tax cut plans and proposals over the coming months and year(s). You will likely read a lot of breathless headlines and analyses saying one thing or another. Ultimately, there is a very real chance that we’ll see a simple shift in where the federal government collects tax revenue with no major earth-shaking stock market impact.
