Trade Tensions Move to the Fore

Equity markets finished the second quarter on a down note as financial markets became jittery about the prospect of escalating trade tensions. While there hasn’t been a sustained plunge, concerns about tariffs and their impact on the economy have contributed to increased volatility in 2018 relative to last year. Clearly, investors are increasingly focused on equity market risks.

Nevertheless, despite trade concerns and the market retreat in the latter part of June, U.S. equity markets delivered solid second quarter performance on the prospect of continuing economic growth and strong earnings prospects. The S&P 500 Index erased the negative returns of the first quarter and increased a robust 3.43%. Smaller companies again outpaced larger companies as the Russell 2000 Index was up more than double the S&P 500 Index, returning 7.75%. Small cap companies have benefited from the perception that they are more sheltered from trade tensions given the predominance of U.S. revenues.

Non-U.S. developed market stocks, as represented by the MSCI EAFE Index, significantly underperformed U.S. stocks. Concerns related to the trade war impact, a strong U.S. dollar and the risk of an end of synchronized global economic growth led to a negative return of -1.24% for the Index.

In this quarter’s commentary, we’ll take a closer look at escalating trade tensions and the implications for markets and sustainable investing.

A Brief Recap of Escalating Trade Tensions

What exactly has happened? The opening move occurred in late 2017, when the U.S. International Trade Commission filed the first industry petitions alleging injury from unfair imports since 2001. Here are actions that followed:

  • Solar panels and washing machines: In January of 2018, the Administration announced tariffs on imports of solar panels and washing machines from China, and China swiftly announced its own investigations of unfair imports of sorghum from the U.S., followed in April by the imposition of tariffs on U.S. sorghum (which it subsequently withdrew after a trade negotiation).
  • Steel and aluminum: In February of 2018, the Administration announced that its own investigation into steel and aluminum imports found that these imports threaten U.S. national security, and in March the President announced that tariffs would be imposed on all trading partners of certain types of steel and aluminum. After some exemptions, the tariffs went into effect in late-March. Within days, China announced retaliatory tariffs, and late in June, Canada and the European Union (EU) announced their own retaliatory tariffs.
  • Unfair trade practices for technology and intellectual property: In mid-June, after the results of a broader investigation of unfair trading in China, and after various rounds of announcements and threats of duties, the U.S. imposed additional tariffs on nearly $50 billion worth of Chinese products, and China responded on the same day by announcing tariffs on $45 billion worth of U.S. exports to China.
  • Automobiles: In May of this year, the Administration launched another inquiry into whether imported automobiles and parts pose a national security threat.
  • Made in China: In early July, the Trump Administration announced a new list of tariffs on imports from China totaling $200 billion. The tariffs do not take effect immediately, but could be implemented after a two-month review process.

Assessing Market and Company Risks

Escalating trade tensions have market- and company-level implications, and accordingly, investors need to factor these implications into investment decisions.

At the market level, we are examining how a potential trade war is intertwined with other risks on our radar, including any impetus for a slowdown in economic growth and the potential for rising interest rates.

We remain vigilant in the identification of any risks that point to a slow-down in economic growth that equity markets have not yet priced in. Higher tariffs are an additional risk to consider. They have the potential to offset the impact of fiscal stimulus from the tax cuts and create uncertainty for management teams to commit to capital spending, both of which can lead to slower economic growth.

The risk of rising interest rates now needs to also factor in the impact of tariffs along with evolving Federal Reserve policy to raise rates to combat an increase in inflation. Tariffs will raise the prices of imports contributing to a one-time increase in inflation, but if a trade war escalates and the Federal Reserve becomes concerned about economic growth, we believe it could slow any planned tightening. In the event of a severe, destabilizing escalation in trade tensions, U.S. Treasuries would benefit from a flight-to-quality and interest rates could fall, in our opinion.

At the company level, the impact of tariffs needs to be integrated into fundamental analysis to assess the range of possible impacts on earnings.

  • A thorough understanding of industry and market dynamics can provide insights into the ability of companies to pass on higher tariffs-related costs to customers or whether the tariffs will pressure profit margins.
  • Supply chain analysis helps to better assess the impact of higher input costs resulting from tariffs.
  • Analysis of the sources of revenue from end users of a company’s products is essential to understanding the risks that tariffs may have on future earnings potential. For example, while small caps as an asset class may be less exposed to the impact of a trade war, a thorough understanding of a small cap company’s products and where it may sit in the supply chain of a larger cap company with exposure to foreign revenues is essential to understanding the risks that any tariffs may have to earnings.

Implications for ESG Integration

One consequence of tariffs is the increased probability of layoffs, particularly in manufacturing. Not much has happened yet because the tariffs are in reality only a few months old. But the portents are ominous; the Peterson Institute indicates that imposing tariffs of 25% on automobiles and parts could cost nearly 200,000 jobs.

How companies treat their workers, throughout the value chain, is a key component of sustainability analysis, and one that some people interpret as “no layoffs.” In fact, though, a no-layoff policy is something that companies may not be able to sustain.

What really speaks to a company’s commitment to sustainability is not whether it lays workers off, but how.

“A company that values its workers will provide assistance to those displaced, give them plenty of notice, and do what it can to help them regain employment.”

It is also important to workers, customers and other stakeholders that when the company is in distress, everyone shares it — including executives.

Larger Concerns for Sustainable Investors

But a larger consequence of any trade war, and one that we are even more concerned about, is the potential loss of the international comity we have enjoyed for years, and that enabled the world to develop institutions like the World Trade Organization, the United Nations, the Organisation for Economic Co-operation and Development (OECD), and other groups that work internationally to create conditions of fairness and transparency.

One of the most concerning losses of the new era of suspicion and retaliation could be the United Nations Framework Convention on Climate Change (UNFCCC), the group that every year meets to agree to new strategies to combat greenhouse gas emissions and promote adaptation to a warming world. Other efforts to address poverty and environmental quality could also suffer in a world where international cooperation is undermined by “me-first” policies.

As investors, we have very little power to directly address the problem of waning cooperation among countries. What we can do, and keep doing, is invest in companies that undertake programs to reduce emissions, like the 137 that have already committed to go 100% renewable. Making a more sustainable world isn’t easy if governments are at loggerheads, but it is neither useful nor necessary to despair: we can keep working to reduce climate change, promote gender equality, and make workplaces all over the world safe and fair through the companies we invest in. And we will continue to do so.

Index Definitions

The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net”, which includes dividend reinvestments after deduction of foreign withholding tax.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
One cannot invest directly in an index.


Steve Falci, CFA®

Chief Investment Officer, Executive Vice President

Steve Falci is Chief Investment Officer at Impax Asset Management LLC and Executive Vice President of Pax World Funds. Steve oversees the investment management of Pax World Funds, the development of fund strategy and the collaboration between investment analysis and environmental, social and governance-based research to enhance the firm’s sustainable investing strategy.

Steve has 30 years of experience in investment management. Prior to joining the firm, he served as Head of Strategy Development, Sustainable Investment at Kleinwort Benson Investors, where his duties included strategic direction, product development and identifying new market opportunities in the sustainable investment business. Steve previously served as Chief Investment Officer, Equities at Calvert Group and was a Principal and Senior Portfolio Manager at Mellon Equity Associates.

Steve serves on the board of directors of the US Forum for Sustainable and Responsible Investment (US SIF). He also serves on the Investment Committee for Mercy Investment Services. Steve has a Bachelor of Science in Economics and a Master of Business Administration from the Stern School of Business at New York University and a Master of Arts from Pittsburgh Theological Seminary. Steve is a CFA® charter holder.

CFA® is a trademark owned by the CFA Institute.

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