(Bloomberg Opinion) -- Investors have quickly transitioned from gaming out whether China and the U.S. can reach a tariff-free deal, or at least one that doesn’t ramp up cross-boarder levies further, to accepting that tariffs are a given for now and pursuing strategies to make their portfolios as trade-war proof as possible. Strategist Ed Yardeni wrote on Friday morning that, at least in the past, “geopolitical crises often created buying opportunities for stock investors.” And my colleague John Authers writes that at least one strategist believes he has found the ideal tariff trade: German stocks and industrials.
Finding someplace to hide does seem smart. The market has dropped for five days straight, and companies whose stocks make up the S&P 500 Index have already lost nearly $650 billion in market value collectively coming into Friday morning. The environment that has pushed the U.S. stock market to new highs – one of historically high profit margins, low inflation and expanding sources of revenue – is one that seems inextricably tied to globalism. So the rhetoric from both sides suggesting things could get worse before they get better should freak out investors.
As trade tensions have accelerated and backed off during the past year and a half, there have been a handful of suggestions on areas of the market that could do better than others if a full-blown trade war breaks out. How trade-proof have they turned out to be? Now is a good time to walk through some of the most-cited strategies and see how they’ve fared.
SMALL-CAP STOCKS: No company is safe from an economic downturn. But if a recession is brought on by tariffs, that should hit exporters most. That’s why some strategists have recommended moving into small-cap stocks; the thinking is, because smaller companies get less of their sales from overseas, they won’t get hit as hard. That logic, though, hasn’t worked out so well. In the past year, the Russell 2000 Index, a small-cap benchmark, has lost nearly 1%, even including dividends. The S&P 500, on the other hand, is up 7.5%. Economic studies have shown that much of the cost of the tariffs, unlike what President Donald Trump says, has been born by consumers. Those higher prices can reduce demand for all goods, not just ones sold to foreigners. What’s more, even companies that sell their goods in the U.S. – like, say, home builders – tend to need raw materials, so they can get hit by tariffs even if their sales are in the U.S. Small caps also tend to have less-diversified businesses. Perhaps even more important, much of the global growth over the past decade, and the expected growth over the next, is coming from outside the U.S., so a U.S.-focused small cap company could be the worst place to invest in any downturn or recession.
UTILITIES: It would be harder to come up with a more trade-insulated sector than utilities. All of the customers are in the U.S., the plants can’t be moved out of the U.S. and electricity is an economic staple. And yet, utilities haven’t been all that protective for investors, either. The utilities stocks in the S&P 500 have lost 2.3 percent since Trump’s first tweets last weekend on new tariffs, on par with the rest of the market. The problem is probably where utilities are trading. The average price-to-earnings ratio is 18.4. That’s considerably higher than that of the broader market. What’s more, JPMorgan Chase & Co. CEO Jamie Dimon warned earlier this week that he thinks interest rates are too low. Higher rates are kryptonite for utilities. Plus, while everyone needs to turn on the lights, industrial companies suck up a lot of the power that utilities produce. And if manufacturers are hard hit by the tariffs, as most people assume, then that will hit utilities as well.
S&P 500: One of the big reasons investors are so worried about a trade war is because it’s so hard to avoid. But here’s the good news: The best bet might be to just stick with the S&P 500. The scenarios that many are predicting seem worst-case. Bank of America Corp. strategists on Friday morning said a full-fledged trade war could send stocks into a bear market, but that doesn’t seem realistic. The U.S.-China trade isn’t that big. We import roughly $540 billion in goods from China, or less than 3 percent of our overall economy. The most dire predictions are that a full trade war with China would cut around 1% from GDP growth, or roughly $200 billion. Apply that to the forward market earnings multiple of around 16.5, and you get a loss in market value of $3.3 trillion, which would send the S&P 500 down by 15%, roughly – nothing to sneeze at. But that’s if all of the costs are born by the large companies in the index, and that’s assuming that tariffs will be put on and remain on for a long, long time. That’s not likely. Certainly, the next president would be likely to rethink Trump’s trade policies. And if the market were to drop that much, Trump would likely rethink them as well.
There is a case to be made that market multiples in general are too high, given that the economy is slowing, profit margins may have peaked and trade wars will only make this worse. But those same forces that could drive down stock values are the same ones that should keep interest rates low; that could provide a cushion of sorts for the equity market. Trade wars are very hard to trade. Perhaps the best answer for investors is likely to stay put.
To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Stephen Gandel is a Bloomberg Opinion columnist covering banking and equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.
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