Investors have been highly concerned about the impact of President-elect Trump’s victory on companies/sectors levered to international trade broadly as well as specifically with regard to China and Mexico, which have been chief targets of Trump’s campaign rhetoric in Rust Belt states. Today’s note lays out how and why we believe that, once in office, the Trump administration will not resort to the more punitive measures threatened on the campaign trail but will still find ways to placate his blue collar voting base. However, there is one particular goal that Trump and the House Republicans have in common: a potential sweeping new import tax that could hit retailers regardless of where they source product. WTO concerns and industry lobbying could ultimately water down the proposed “border adjustment,” and corporate tax rate reductions and a multi-year transition period will likely lessen the sting somewhat. Nevertheless, investors should expect to start hearing a lot more buzz about this proposal in the coming weeks and months.
- We do not believe Trump will ultimately withdraw the US from NAFTA or impose punitive tariffs on goods from Mexico or China as a matter of policy. We do believe his administration will step up prosecution of trade enforcement cases and use other means of leverage (including CFIUS), reserving the right to retaliate if negotiations fall through.
- We do not believe Trump’s proposal to tax US companies that shift production and jobs overseas will be approved by Congress; however, a “border tax adjustment” that would raise the cost of imports is getting a serious look from the House GOP. Legislation to make it easier to impose penalties for currency manipulation also is likely to gain momentum in 2017.
- We are encouraged by signs that Trump may be assembling a “team of rivals” for certain top White House and Cabinet picks, including some internationalist, pro-trade voices.
TRUMP THE ECONOMIC POPULIST Donald J. Trump cajoled, pleaded for and won votes in states such as OH as well as MI and PA, both of which Trump appears likely to turn “red” for the first time since 1988 (MI had not officially been called as of this writing) in part by campaigning on a platform of tough trade enforcement measures and the return of lost manufacturing jobs. Therefore, we believe a prudent discussion of Trump’s agenda and the art of the possible begins with his stated priorities for the first 100 days, which provide the President-elect an opportunity to deliver quickly on his promises or risk losing popularity and the political capital Trump believes he’s earned. Despite these promises, none of Trump’s first 100-day trade priorities will likely lead to the imposition of punitive measures such as a 45% blanket tariff on Chinese imports, for instance, once touted by Trump during the campaign.
Executive actions (which do not require Congressional approval)
“First, I will announce my intention to renegotiate NAFTA or withdraw from the deal under Article 2205.”
Here Trump is referring to the provision of the NAFTA text that provides for the ability of any party to the agreement to exit the agreement after submitting six months’ notice to the other parties. Despite Congressional passage of legislation implementing the NAFTA deal in 1993, US law also provides for the ability of any president to withdraw from any trade pact after submitting six months’ notice (see Sec. 125 of the Trade Act of 1974). But note withdrawal from NAFTA is not the preferred option in the construction of Trump’s phrasing; renegotiation of the deal is preferred. In addition, Trump’s “7 Point Plan” for trade as issued during the campaign contained the following phrasing for this item (#4 on that list): “Tell NAFTA partners that we intend to immediately renegotiate the terms of that agreement to get a better deal for our workers. If they don’t agree to a renegotiation, we will submit notice that the U.S. intends to withdraw from the deal.” We know now that Canada and Mexico both do intend to enter into renegotiation talks with the US, so immediate withdrawal is likely off the table. According to a leaked transition memo obtained by CNN, on Day 1 Trump would also task the Department of Commerce and International Trade Commission to “begin a study on what the ramifications of withdrawing from the treaty would be” and what if any legislative initiatives are required. By “Day 200,” if no progress is made on the renegotiation, Trump would be “considering” formal withdrawal, but also begin to pursue bilateral trade deals with Canada and Mexico.
What would NAFTA renegotiation entail? The leaked transition document notes issues such as currency manipulation (Trump has accused Mexico of devaluing the peso); “lumber” (the US and Canada have had a longrunning dispute over Canadian softwood lumber exports); country-of-origin labeling for US meat products (the WTO recently struck down the US requirements, which Canada and Mexico opposed); and “environmental and safety standards.” The latter could include a discussion of Trump’s contention in his “7 Point Plan” that renegotiation should “end sweatshops in Mexico that undercut US workers.” Renegotiating the text of the agreement would require a vote in Congress, which presumably would pass if Trump put his full weight behind it, backed by GOP leaders. Certain issues can also be worked out by “side agreements” among the countries, such as the “North American Agreement on Environmental Cooperation” and “Commitment to Labor Cooperation” President Clinton negotiated in the context of NAFTA, but which were unenforceable and not subject to formal ratification by the three parties.
What happens if Trump exits NAFTA? While ostensibly Trump would begin negotiations on bilateral deals (such as the US-Canada Free Trade Agreement superceded by NAFTA) to mitigate the negative impacts of NAFTA withdrawal, it is technically possible for Trump to impose higher tariffs on imports from either country as a consequence of having no agreement in place. Sec. 125 of the ’74 Trade Act allows the President to “proclaim increased duties or other import restrictions” upon withdrawal from an agreement (reiterated in Sec. 201 of the NAFTA implementing legislation). WTO rules require nondiscrimination against member countries (“Most Favored Nation” treatment under Article I of the General Agreement on Tariffs and Trade), so Trump technically is bound to apply the MFN rate to Mexican and Canadian imports.However Trump could theoretically choose to flout the WTO and impose the highest tariffs allowed by US law (again see Sec. 125 of the ’74 Act: no more than 50% above the base rate applied to a list of 19 thenCommunist countries and regions, or 20% ad valorem above the rate existing on Jan. 1, 1975, whichever is higher). So for example the US MFN tariff rate on auto imports is 2.5%, but Trump could technically increase that to 23% based on the existing rate under the pre-WTO tariff schedule in place in 1975, though such a move would undoubtedly lead to retaliation against US exports. Also, tariff increases won’t occur immediately; under the ’74 Act there is a one-year grace period before tariff increases would take effect, unless the President submits notice to Congress in writing, within 60 days of withdrawal, that tariffs should increase sooner (Congress can’t block this from happening, but a public hearing would be required unless the President waives that requirement for national security reasons).
Height’s take: Trump won’t pull the US out of NAFTA; his apparent recognition of the negative consequences and willingness to negotiate separate deals with both Canada and Mexico (our #1 and #2 export markets, respectively) seems to preclude a dramatic exit. Face-saving tweaks will likely be made that give all three countries’ leaders something to take home, with little disruption of the status quo.
“Second, I will announce our withdrawal from the Trans-Pacific Partnership.”
No surprise here; Trump railed against the TPP on the campaign trail and was never expected to push for its adoption on Capitol Hill. The failure to move ahead on TPP represents opportunity cost (failure to gain concessions in key Asian markets such as Japan, Malaysia and Vietnam), this outcome should not be unexpected and businesses won’t face punitive measures as a result.
“Third, I will direct the Secretary of the Treasury to label China a currency manipulator.”
By itself, there is no immediate impact of this step other than to anger the Chinese, who in fact have been attempting to stop the RMB (yuan) from depreciating –for example by selling $570 billion in foreign currency assets during the year ending August 2016, according to Treasury’s semiannual report on foreign exchange policies issued last month. “Overall, the balance of evidence suggests that the RMB is likely to continue to trend stronger over the medium to long term,” the report states. The Obama Treasury has never labeled China a currency manipulator to avoid triggering a diplomatic row (and because the yuan has at times appreciated in response to threats from US policymakers). But US manufacturing interests and labor unions have long pressed for concrete action to counter what they claim has been a historical pattern of Chinese currency devaluation, making it cheaper to buy Chinese goods and more expensive to sell into China, and here is an easy win for Trump to deliver.
Under the Omnibus Trade and Competitiveness Act of 1988, if Treasury finds that manipulation is happening in countries that have “material global current account surpluses” and “significant bilateral trade surpluses,” the Secretary “shall take action to initiate negotiations with such foreign countries on an expedited basis, in the International Monetary Fund or bilaterally, for the purpose of ensuring that such countries regularly and promptly adjust the rate of exchange between their currencies and the United States dollar to permit effective balance of payments adjustments and to eliminate the unfair advantage.” If such negotiations fail, however, then Trump could have a pretext to use other existing authorities, such as Sec. 301 tariffs in retaliation for acts that are “unreasonable or discriminatory and burdens or restricts United States commerce.” Trump likes to tout Reagan’s 100% tariffs on Japanese semiconductors using 301 in 1987; the US also imposed 100% tariffs on 34 European agricultural products in 1999 that were in place for 10 years before being lifted. Imposing 301 remedies without prior WTO approval would be considered a violation of global trade rules, but Trump of course could choose to flout the organization and risk retaliation.
Also on “Day 1,” according to CNN, Trump would direct the Committee on Foreign Investment in the United States (CFIUS) to review food security issues associated with takeovers of US companies (though we do not believe this will impact the pending Syngenta (SYT) – ChemChina deal, expected to close in 1Q2017, and which has already received CFIUS approval with USDA signoff) while examining reciprocal opportunities for US companies to purchase foreign companies.CFIUS is emerging as a potential leverage point with China that we believe Trump will want to employ, rather than for instance heeding the latest recommendation of the US-China Economic and Security Review Commission to amend the statute to simply exclude Chinese state-owned enterprises from ownership of US businesses.
Height’s take: Trump wants to use the threat of tariffs and blockage of Chinese M&A activity as negotiating tools to get China to the table on improving market access for US companies and investors. We don’t think he has any intention of actually starting a trade war with China, which is the third-largest US export market and a source of low-cost, ubiquitous imports for US consumers ranging from smartphones and laptops to furniture and toys. The US and China have continually engaged in minor trade skirmishes over the last decade that have never blown up into a full-fledged conflagration, and we believe that will remain the case under Trump.
“Fourth, I will direct the Secretary of Commerce and U.S. Trade Representative to identify all foreign trading abuses that unfairly impact American workers and direct them to use every tool under American and international law to end those abuses immediately.”
Another step that on its own would have no direct, immediate impact; in fact, Commerce and USTR are very likely to pull off the shelf the latest National Trade Estimate report, issued every year by USTR, which goes through grievances against countries ranging from Algeria to Vietnam (and devotes 15 pages solely to China). This report, whenever it is completed, could be used to justify actions using the various trade authorities previously mentioned or other little-used provisions, such as Sec. 122 “balance of payments” authority to impose additional tariffs of up to 15% and/or numerical quotas on certain imports for a period of no more than 150 days to deal with “large and serious” trade deficits.
Legislative actions (Congressional approval required)
No legislated tariffs, but border adjustment mechanism in tax reform could be costly. In addition, Trump’s 100- day “Contract” states he will push to pass something called the “End the Offshoring Act,” which is yet-to-be introduced legislation that “establishes tariffs to discourage companies from laying off their workers in order to relocate in other countries and ship their products back to the U.S. tax-free.” The proposal is aimed at Ford (F), Carrier (UTX) and others who have moved plants to Mexico in recent years. We think it highly unlikely GOP leaders will opt to pass such legislation, though we would note there is interest in tax reform plans to entice US businesses to operate domestically: a 20% corporate tax rate coupled with a border adjustment mechanism that taxes sales only to US consumers rather than foreign customers. This would be similar to Value-Added Taxes (VAT) imposed by most other developed countries that exempt exports but not imports, which currently disadvantages the US because we do not have a VAT that would provide a level playing field. We would also note Trump’s 7 Point Plan that references ending “Mexico’s one-side backdoor tariff through the VAT” – thus the common ground between Trump and the GOP leadership appears to be on some type of border adjustment mechanism.
Based on a 2005 proposal from President George W. Bush’s tax reform advisory panel, House Republicans could achieve their objective by denying US businesses a deduction for the costs of producing the imported good while crediting them for the costs of goods sold abroad. The Tax Foundation, a DC think tank, estimated the border adjustment would raise import taxes by $1.1 trillion over a decade, though the plan is designed to net out evenly for US companies through the reduced business tax rates coupled with full first-year expensing of capital investments. Retailers that rely primarily on imports still stand to be hit hard by the plan, however, and it’s unclear if it will pass muster with the WTO. Details are still being fleshed out, and they could yet change before official introduction of the GOP tax reform plan. We also expect a big fight from retailers such as Nike (NKE), with 46% of sales in the US in their most recent fiscal year; Walmart (WMT), with 62% of revenue in the US; and manufacturers with a foreign sourcing base such as Apple (AAPL) – with 38% of sales in the US in the most recent quarter.
Back to currency manipulation. The leaked memo reported by CNN claims that Trump would submit legislation to Congress to address currency manipulation. It is unclear what such a bill would look like, but one template could be legislation backed in previous Congresses by bipartisan senators including incoming Democratic Leader Chuck Schumer (D-NY) and Jeff Sessions (R-AL) – considered a top candidate for Secretary of Defense under Trump. The Currency Exchange Rate Oversight Reform Act of 2013 would, among other provisions, require the Department of Commerce to investigate currency devaluation as a countervail-able export subsidy and ultimately take measures such as prohibitions on export financing for projects in that country.
Final observations. An assessment of Trump’s economic plan by his advisers Wilbur Ross and Peter Navarro (both potential candidates for jobs in the new administration; Ross has been floated for Commerce Secretary, for example) is indeed littered with references to the negative impacts of “bad trade deals” such as NAFTA, allowing China’s accession to the WTO, etc. However, the tone of their policy prescriptions is actually somewhat surprising. Among their key recommendations for luring investment back to the US rather than moving overseas is not punitive tariffs but rather reducing the US corporate tax rate and moving to a territorial tax system that exempts overseas earnings as well as bringing back stored-up “trapped” cash through a reduced repatriation rate (10%). Ross and Navarro then launch into the VAT issue that penalizes US exporters (noting in particular Mexico’s moves to increase VAT to 16% from 10% preNAFTA), pushing for changes to the tax code seemingly akin to what the House GOP is proposing. They also want to get the WTO to reconsider its disparate treatment of export taxes that disadvantage the US (border adjustments for direct income taxes are prohibited, but consumption-based indirect taxes are not), including by threatening to pull the US out of the global trade body (which Trump could achieve by submitting the aforementioned six months’ notice).
Throughout the remainder of the paper’s discussion of trade, the authors talk about retaliatory measures as a response to alleged “cheating” such as currency manipulation, dumping of low-cost steel and aluminum, etc. “Tariffs will be used not as an end game but rather as a negotiating tool to encourage our trading partners to cease cheating. If, however, the cheating does not stop, Trump will impose appropriate defensive tariffs to level the playing field,” they write. With the exception of pressing the currency manipulation issue, what Ross and Navarro describe is little more than an outgrowth of existing Obama-era trade enforcement policies, including perhaps a stepped-up focus on anti-dumping / countervailing duty (AD/CVD) investigations. The authors also call for renegotiation of every US free trade deal, not just NAFTA and the WTO, though this is unfeasible in our view even if simply from a timing and manpower perspective. In sum, the paper states: “Trump’s goal is not to reduce overall trade flows but rather increase them. Through tough, smart negotiations, he will improve our trade deals, increase our exports, and displace some goods we now currently import with products made in America.”
Overall, we believe the paper presents the Trumpian view on trade as hopeful for continued mutually beneficial engagement with trading partners rather than as a protectionist screed in favor of a trade war (though there are plenty of sticks to complement the carrots). Time will tell but some positive early signs are that Trump is looking at a diverse group of potential Cabinet picks, including those with an internationalist bent. Mitt Romney and Sen. Bob Corker (RTN) are names floated for Secretary of State, for instance, while outgoing Rep. Charles Boustany (R-LA) has been mentioned for USTR. Such candidates balance out the more protectionist voices such as Ross and other possible Cabinet picks such as former Nucor (NUE) CEO Dan DiMicco for USTR.
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