The heated rhetoric in recent months around global trade in general, and the North American Free Trade Agreement (NAFTA) in particular, continues unabated.
President Trump, in his first State of the Union Address vowed to “work to fix bad trade deals and negotiate new ones,” and while he did not mention NAFTA by name, he has previously described it as “the worst deal ever signed.”
U.S. Commerce Secretary Wilbur Ross then doubled down on NAFTA, saying it is “definitely a possibility” the United States will exit the deal and that current talks to renegotiate NAFTA “will be either 100 percent or zero percent” acceptable to the United States.1
In light of all the tough talk around global trade, we felt it important to weigh-in on this topic, which is of great significance to – and may have potentially negative implications for – investors.
In our view, the freer people are to trade with whomever they choose (regardless of national borders), the better off those people will be.
Protectionists often make an argument that goes something like this: “XYZ industry is subject to unfair competition from abroad. Therefore we must erect trade barriers to protect this domestic industry and its employees.” Sounds reasonable, right?
Unfortunately this view buys into one of the most common fallacies in economics. It is the fallacy, first articulated by French economist Frederic Bastiat, of “That Which Is Seen, and That Which Is Not Seen.”2
What Seems Obvious May Not Be
In this case, the outcome that is seen is that the domestic producer is “protected” and jobs are “saved” by erecting trade barriers.
According to Bastiat, however, a good economist will look past that which is seen and dig into the unseen effects of such a policy. In terms of trade, we need to examine the situation not only through the eyes of the producer, but also the consumer. Let’s take a closer look using a hypothetical example.
Imagine there is one producer of toaster ovens in Colorado – Rocky Mountain Toasters (RMT). Over the years, RMT has been very successful manufacturing and selling toaster ovens in Colorado. However, in recent years, a few “foreign” companies have been able to produce, ship, and sell toaster ovens in Colorado that are of higher quality and at a lower price than what RMT offers.
Not surprisingly, consumers flock to the “foreign” toaster ovens. But RMT management, rather than trying to improve their own manufacturing processes and the quality of the toaster ovens they produce to become more competitive, instead petitions the government to “protect” this vital Colorado industry. The government agrees to protect RMT, and imposes a hefty import tariff on “foreign” toaster ovens.
At first glance, it may seem obvious who the winners are here. RMT management and its employees cheer the government for taking action to keep jobs in Colorado. Politicians call attention to their support for the tariffs while campaigning to drum up votes. Everybody wins, right? Wrong.
When we look past what is seen to what is unseen, a different picture emerges. Colorado consumers are the losers in this scenario. Every Coloradan in the market for a toaster oven now must pay a higher price for the higher-quality product than they would have absent the tariffs. Consumers are left with a few choices, none of them ideal:
- Pay an artificially inflated price for that “foreign-made” toaster oven of superior quality,
- Buy an inferior product made by RMT, or
- Do not make the purchase at all.
With the first option, there will be less money in consumers’ pockets for other items they also might have wanted to buy. With the second option, they are forced to spend money on a product that might not be their first choice or exactly what they want. With the final option, they have no toaster oven. Either way, consumers and the economy are both worse off.
Consider this: How would the analysis of protectionism in favor of RMT change if we substituted “Texas” for “foreign”? The point is it makes no difference if the “foreign” firm is located in China, Mexico, Canada, South Korea, Germany or any other country or U.S. state. The imposition of trade restrictions amounts to a coerced transfer of wealth from consumers to producers. In a free society no producer has a moral claim on consumers’ dollars. That is our view.
Free Trade Implications for Our Investment Approach
The higher costs associated with trade barriers have wide ranging economic implications, almost all of them negative. This “lost” economic output is NOT compatible with a strong equity market.
As it relates to the current debate over NAFTA, one of the many industries that could be negatively impacted is transportation. For example, rail operator Kansas City Southern (KSU) provides transportation services throughout the southern United States and into Mexico. Almost half of the company’s revenues are generated by its Mexican business. If tariffs are increased on Mexican-made goods KSU usually transports by rail into the United States, the company’s revenues would likely be negatively impacted by the reduced U.S. demand for those goods, leading to lower demand for the company’s rail services
In addition, the increased cost of those goods, many of which are inputs into U.S. companies’ outputs, would decrease profitability for those U.S. companies or result in higher prices paid by customers.
Our investment approach on the Value and Income team is to identify unanticipated improvements in a company’s return on invested capital (ROIC). Because of the potential negative effect trade barriers could have on company margins, those improvements in ROIC will be harder to come by and may work to the detriment of value investors.
As of 12/31/17, Oppenheimer Value Fund’s holdings were 0.61% in Kansas City Southern.
As of 12/31/17, Oppenheimer Mid Cap Value Fund’s holdings were 1.26% in Kansas City Southern.
OppenheimerFunds is not undertaking to provide impartial investment advice or to provide advice in a fiduciary capacity.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value. The mention of specific companies and countries does not constitute a recommendation by any particular fund or by OppenheimerFunds, Inc.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Value investing involves the risk that undervalued securities may not appreciate as anticipated. Small and mid-sized company stock is typically more volatile than that of larger company stock. It may take a substantial period of time to realize a gain on an investment in a small-sized or mid-sized company, if any gain is realized at all. Diversification does not guarantee profit or protect against loss.
These views represent the opinions of the portfolio managers at OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.