Hugh Larratt-Smith
Managing Director

No one wins a trade war. Hugh Larratt-Smith examines the current take-no-prisoners tariff battle between China and the U.S. and analyzes the impact on asset-based lenders.

It is no secret that the American Civil War was decades in the making. While slavery is the most commonly-cited cause, the Tariff of 1828 triggered the Nullification Crisis which pitted the South against the North. Designed to protect industry in the Northern U.S., it was labeled the Tariff of Abominations by its Southern detractors because of the searing impact on the South’s economy.

The tariff’s major goal was to protect northern industries by heavily taxing goods from Europe, which was flooding the market with low-cost products. In addition, since the North’s agrarian industry could not compete against the South’s, northern political leaders sought more aggressive protectionist measures against the southern states despite the economic stress this exerted on the South.

The tariff harmed the South in two ways. Cotton and tobacco shipped from the South to northern states was taxed at 45%. Additionally, the slowdown in exports of British goods to the U.S. made it difficult for the Brits to pay for southern cotton — the region’s greatest source of income.

The Tariff Wars of 2019

Today, two economic superpowers are sparring over trade. Once seen as the world’s low-cost factory, China is now being held responsible for the hollowing out of the American hourly workforce. Industrial cities like Milwaukee, Toledo and Cleveland are now shadows of their former selves with one or two major companies instead of dozens. Company towns in the Carolinas, which were once the proud source of America’s rug, textile and furniture industries, are now ghost towns with low-paying service jobs and drug epidemics. American politicians point fingers at one another for allowing the Chinese into the World Trade Organization in 2001, whose officials looked the other way while the Chinese were dumping everything from steel to baby food. Many people thought China was close to breaking the WTO rules.

Ask any Chinese entrepreneur, and they will say that they did nothing wrong, just played by the rules. Ask American retailers, who will say that the American consumer has benefitted from men’s socks for a dollar and three-dollar stereo headphones.

Tariffs are blunt economic policy instruments which can turn into currency wars. Before the Bretton Woods Agreement, which fixed currencies after World War II, governments deployed currency depreciation strategies to counter tariffs. The recent depreciation of China’s currency sent shock waves through the international markets as critics said, “See, we told you that China was manipulating its currency.” Yet some of the Asian currencies are pegged to the Chinese currency, so they can’t be accused of engaging in a currency war — it’s just smart business.

Just like shooting wars, the trouble with trade wars is once they start, you never know how they’re going to end. The enemy gets a vote, and sometimes events escalate in ugly fashion. When the trade war started escalating in the spring of 2019, people assumed things would be settling down by Labor Day, not intensifying. The problem for U.S. borrowers is the trade war is constantly taking new turns. Not monthly. Not weekly. Daily.

If trade uncertainty spills over into the broader economy, the Federal Reserve’s ability to counteract the damage may be limited. Part of the problem is the Fed has no real sense of how it should proceed. So far this year, employment and consumer spending have continued to do well even as business confidence has eroded, making it unclear how much easing the economy actually needs. First, there is the simple matter that with rates already low, the Fed only has so many rate cuts to give. But there may also be limits to what monetary policy can do to offset trade troubles. The Fed’s safety net might be flimsier than Wall Street believes. On the fiscal side of things, there is only so much government spending can do, like subsidizing farmers.

The trade war has led to calls to reduce interest rates. But according to remarks from Fed Chairman Jerome Powell at the annual central bankers’ conclave in Jackson Hole, WY, “While monetary policy is a powerful tool that works to support consumer spending, business investment and public confidence, it cannot provide a settled rulebook for international trade.” The Trump administration has dismissed the risk of a recession, but the continued mauling of Powell suggests less confidence about the U.S. economy. Perhaps Beijing has taken note and believes its leverage in trade negotiations is increasing?

Economists say China is having a harder time retaliating in proportion to the U.S.’s moves, since it imports fewer products from the country. But for those Chinese-made products which can’t be readily substituted, the Chinese tariffs increase the water level for all companies which are importing U.S. consumer goods, forcing U.S. retailers to accept higher prices.

The Chinese government is also subsidizing some companies which are adversely affected by tariffs. This is particularly true with “favorite son” companies.

Taking Stock

What is the impact of the trade war so far? The stock and bond markets have careened wildly up and down according to the latest headline or tweet.

On Main Street, supply chains are facing uncertainty. In particular, U.S. businesses that rely on integrated supply chains — whether the chain is linked to Canada, Mexico or Asia — are starting to tap the brakes. For example, inventories may increase as manufacturers redefine what safety stock levels are. Stockpiling of key inputs like rare earth minerals used in automotive manufacturing may become common.

Michael Haddad, president of Capital Finance for Sterling Bank in Dallas captures the impact of the trade war in one sentence: “The great squeeze is on.” He adds, “Some of our levered ABL multi-national manufacturing borrowers with both U.S. and China operations are beginning to be hurt badly. They feel ‘in the middle’ and have actually began to write letters to the current administration asking ‘what is the endgame?’ and ‘how much hurt do you expect us to take?’ We are making active accommodations to these long-standing customers to see them through this period.”

Kate Lepak, Asset Based Lending business director, People’s United Business Capital in Hartford, CT, notes, “As ABL borrowers look for ways to soften the impacts of the trade war, particularly with China, ABL lenders are providing support through loan structures that accommodate increased inventory levels, allowing businesses to make purchases in advance of tariffs taking effect. Although increased interest expense and a rise in shipping rates due to lines being stressed by short-term demand have added cost for borrowers, Chinese factories are lowering their prices so that their goods continue to be cost-effective for U.S. manufacturers and distributors. ABL loan structures are well-suited to allow borrowers to manage the flow of goods as strategies evolve, to stay ahead of the volatility caused by dramatically shifting global trade policy.

“Absolute inventory borrowing is also up and comprising a larger portion of an ABL borrowers outstanding — and it isn’t to fund growth,” she adds.

“Many people are focused on imports,” says George Psomas, managing director of BHC Funds in New York. “However, the tariffs only affect the wholesale price — not retail —and will largely be offset by China’s currency devaluation. The real damage is to our exporters, particularly in agriculture and food. Most of them are high volume, low margin operators who invariably find themselves using some form of asset-based financing. “

“We have found there exists a sentiment that since a company doesn’t really have a strong reliance on imports that the tariffs won’t hurt them,” Haddad points out. “They, of course, are wrong as price increases aren’t getting passed on completely or fast enough and are compressing profit margins, leading to some of the highest ABL utilization rates in many years in Q1 at 46.3%, up 2.8% from Y/18.”

The Big Squeeze

Today, supply chains are tightly woven linkages between suppliers and manufacturers. Cities like Easton, PA have become critical hubs in supply chains, with masses of trucks moving down I-78 on a 24/7 basis. The trade war is introducing elements of uncertainty which are straining supply chains.

Loss of trust in supply chains is causing some parts to be repatriated back to U.S., while non-critical parts are still being manufactured in China. The issue for many U.S. companies is that the skilled workers who are needed to manufacture their products have left town. And even if the workers can be found, they can’t be hired back, because the required equipment was sold 10 years ago to some company in China. For example, much of the equipment of Rome Cable — once a proud, $400 million utility cable company in Upstate New York — was sold to the Chinese in 2002, who loaded the equipment onto ships, never to be seen in America again.

Major car companies will be hit particularly hard by the increase in tariffs, particularly Tesla, Ford, BME and Mercedes-Benz. These companies build a significant number of vehicles in the U.S. for export to China — mostly premium models — and a higher tariff could force them to raise prices and lose sales. China is the second-largest export market for U.S.-made automobiles, accounting for $6.2 billion of exports last year, according to statistics published by the U.S. International Trade Administration. For automotive parts, China was the third- largest market, with 2018 exports worth $3.6 billion. In all, auto makers exported roughly 230,100 U.S.-built cars to China last year, according to forecasting firm LMC Automotive.

Ripple Effects

The trade war is causing many sectors to slow down. Steel supply centers throughout the industrial belts in Ohio and Pennsylvania are seeing a slowdown. Throughout 2017 and most of 2018, U.S. freight shipment volume was booming, which was a very strong sign that overall economic activity was rising. But when economic activity begins to decline, freight shipment volume often goes negative, and that is precisely what is happening right now. In fact, U.S. freight shipment volume has now declined on a year-over-year basis for eight months in a row.

“Class A truck orders are down 22% year over year. As a result, the pricing and structure on transport equipment finance loans is extremely competitive,” notes Vince Belcastro, managing director/group head, Corporate Equipment Finance, Santander Bank in New York. “While no one can lay this slowdown directly at the feet of the trade war, you only have to look at volume in the Port of Long Beach to see the impact.”

Transportation companies — notably the railroads — are experiencing slowdowns, particularly in coal, which has dropped 50% in price in the past year from $120/ton to $60/ton. Originated carloads of coal at Class I railroads has declined almost 50%. Railroads will be especially exposed if the trade war sharply cuts into U.S. economic growth. During the last recession between July 2008 and June 2009, CSX’s stock declined more that 50%.

U.S. oil exports to China have already fallen this year amid the trade tensions. Chinese imports of U.S. crude averaged 230,000 barrels a day, or 11% of U.S. crude exports, last year. Through May of this year, crude exports to China have slowed and are running at about 110,000 barrels a day, or 4% of U.S. crude exports.

China imported $120 billion in U.S. goods last year. Some items on China’s tariff list, such as soybeans, beef and pork, already had tariffs imposed. Farmers have suffered especially hard from the retaliation to American trade measures. For U.S. farmers, every week the trade-war pain gets compounded. The latest escalation means even higher barriers into the Chinese market that not long ago was agriculture’s second-largest export destination.

Dan Karas, executive vice president of Triumph Bancorp in Dallas, notes, “Overall, the client impact has been immaterial with an exception in the agricultural portfolio, especially in terms of offshore, alternative competition. But the impact level is still manageable, and agricultural clients remain optimistic that federal assistance will arrive to help with the changes.”

Soon after the administration announced plans for fresh tariffs starting September 1, Beijing responded by announcing the freezing of purchases of U.S. agricultural products and letting its currency drop to its lowest level in a decade. A weaker yuan makes Chinese exports cheaper. With concerns mounting over the impact the escalating trade fight would have on businesses and consumers ahead of the holiday shopping season, the administration announced it was delaying some of its tariffs so that they would fall after the holiday shopping season.

“Cutting ties with China is not an option for some companies,” says Skip DiMassa, partner at Duane Morris in Philadelphia. “Many American companies have been sourcing product from China for decades. They can’t turn on a dime and find product elsewhere.” For instance, American Fire Glass, a California company which sells crushed glass used in fireplaces and fire pits, can’t source its raw materials which are physically not available on the continent of North America. China is the only source.

According to Psomas, “Compared to consumer products, imported raw materials like steel and aluminum are being more greatly impacted, which has affected a wide range of manufacturers, many of whom are financed with asset-based loan facilities. “

The impact of the trade war is starting to show up in economists’ global spreadsheets. Germany -– the locomotive pulling the European Union — is caught in the middle of the trade war. The IHS Markit index of factory activity in August dropped in the U.S., Japan, Germany and eurozone — the first manufacturing contraction in the U.S. since September 2009. A compound index of economic activity in the U.S. that includes services also fell to its lowest point since February 2016. The risk of a recession grows as trade uncertainty increases. Consumers have so far been shrugging off the market whiplash, but if job and wage growth slows amid falling business investment, consumers may pull back, too.

IHS Markit’s flash reading for the manufacturing purchasing managers index recorded 49.9 for August, which, like its index of factory activity, saw its first contraction since 2009. This is an indication a manufacturing recession could be imminent, seemingly plausible since a freight recession is already underway.

Over the summer, the IMF said a sharp deceleration of global trade driven by trade tensions slowed the global economy more than expected in the spring. The decline in U.S. factory activity is tied to three things: the trade dispute, softening demand for motor vehicles and weaker sales at Boeing. The factory malaise is leaking across the broader U.S. economy. IHS released a composite output index — reflecting production by manufacturing and service companies alike — which showed the record expansion losing momentum. It reflects a growing pessimism among purchasing managers, clearly associated with the trade dispute.

Further escalation of the trade war risks spillover into the service and household sectors which could signal a much larger risk of recession in 2020. “This is very much on the minds of CFOs,” says Belcastro. “They are tapping the brakes on CAPEX across many industries. The surge in CAPEX after the 2018 tax cut is more or less over.”

China is the world’s largest copper user, accounting for almost 50% of global demand. So, when copper prices slump, it’s also a proxy of the health of the Chinese economy. Copper dropped 3.34% in late August, its lowest point in 115 weeks amid new fears the U.S. economy is quickly slowing. In textbook commodity market fashion, the price slump has been associated with a J.P. Morgan Global Manufacturing PMI plunging to sub 50, a harbinger that a global manufacturing recession could be imminent or is already underway.

Recessions are like snowflakes — no two are alike. The questions on the agendas of many Monday morning portfolio review meetings are “What form will the next recession take? What will trigger the recession?” Some think that the sheer number and size of crazy deals in leveraged finance will trigger a credit crisis. Others think that multinational companies with global reach will cut jobs, capacity and CAPEX in the U.S., which will create a storm surge through the middle market cohort of companies. One common determination amongst economists is the Fed and Congress have few tools to fight the next recession. But the good news for ABL players is that recessions create strong loan demand.

The 19th Century Resolution of Tariffs

The economic havoc and political crisis echoed in the South for decades after the tariff was passed by Congress in 1828. In November 1832, South Carolina called for a convention to address the crisis. By a vote of 136 to 26, the Convention overwhelmingly declared that the tariffs were unconstitutional and unenforceable in South Carolina. In Washington, an open split on the issue occurred between President Andrew Jackson and Vice-President Calhoun. On July 14, 1832, Jackson signed into law the Tariff of 1832, which made some reductions in tariff rates established in 1828. Calhoun resigned on December 28 of the same year in protest of the legislation. While the Nullification Crisis would be resolved with a compromise known as the Tariff of 1833, tariff policy would continue to be a national political issue for decades to come as the economic interests of the South diverged more sharply from those of the North in the lead-up to the Civil War. •