Washington Macro Commentaries

Ahead of the Curve ™

Ripple: Retaliatory Tariff Impacts Across Sectors

Jul 13 2018

Report by Cowen Research, Karl Ackerman, CFA, Vivien Azer, Helane Becker, Andrew M. Charles, CFA, , Oliver Chen, CFA,  Jason Gabelman. Joseph Giordano, CFA, Joshua Jennings, M.D.,  John Kernan, CFA, Gautam  Khanna, Charles Neivert, Jeffrey Osborne,  Matthew D. Ramsay, Charles Robertson II, CFA, Krish Sankar, Doug Schenkel, Jason H. Seidl, Paul Silverstein, Cai von Rumohr, CFABrian, Nicholas Velez, Chris Krueger, Robam Schweizer and Jaret Seiberg


With the magnitude of multi-billion dollar tariffs and retaliatory measures mounting by the day, herein 22 Cowen analysts from the Washington Research Group and Equity Research collaborate to offer views on the policy pathways and sector/stock specific implications.

Washington Research Group

Washington Strategy (Krueger – Cowen Washington Research Group)
June 1 was a watershed moment in U.S. trade policy and the Trump trade narrative. The imposition of a 25% steel tariff and 10% aluminum tariff on imports from Canada, Mexico, and the EU because they are deemed a threat to national security signified such a Brave New World. There are now tariffs on over $150B in goods from the start of the year (U.S. tariffs and retaliatory tariffs). And those numbers could start to get out of control should the 20% tariff on autos and auto parts hit on August 1 and the next tranche of China tariffs under Section 301 hit as early as August 31. Canada, Mexico, the EU, China, Turkey, and India have all levied retaliatory tariffs against the U.S. this year. Trump’s views on trade are hiding in plain sight: punitive, reciprocal, and visceral. The good news in the tariff narrative is that the 232 and 301 processes are relatively well-telegraphed and follow a fairly rigid time frame with public hearings and hard catalysts. The bad news is that all of the deadlines are actually being met – and there are multiple deadlines throughout the summer and fall.

Financial Services (Seiberg – Cowen Washington Research Group)
When it comes to banks and housing, the ever-escalating tariffs are not a direct threat. What matters is the broader impact on the economy and interest rates. To us, this macro threat to financials and housing gets more serious the longer the trade war extends.

Aerospace & Defense (Schweizer – Cowen Washington Research Group)
We have been positive for years about the strong global demand and increasing spending for U.S. military hardware in Europe, the Middle East and Asia. The Trump Administration’s hardline trade and tariff policies has raised the possibility, in our view, that NATO allies could defer some hardware programs in retaliation or look internally for their own defense solutions when a suitable substitute exists. A longer term worry is that European governments could look to create competitive solutions to U.S. systems by starting their own development programs to counter act “America First” with “Fortress Europe.” Our larger concern is that European governments may politically be unwilling or unable to buy U.S. systems when European substitutes exist (and Brexit also throws an interesting wrinkle in U.K.-Europe defense industrial cooperation).

Consumer Goods

Beverages, Tobacco & Cannabis (Azer) – BFB
With over 30% of sales in tariff geographies, BFB is the most exposed to tariff risk in our coverage. While the company has been taking pricing as an offset, this will prove to widen price gaps relative to competition, while the trademark Jack Daniel’s brand also runs the risks of product boycotts. Aluminum exposure for TAP, KO, PEP, DPS and MNST is also a consideration. Longer term we will be watching for the potential impact to the lower-income U.S. consumers, where a bulk of our coverage is exposed.

Restaurants (Charles) – MCD, QSR, YUM
We note restaurants are largely insulated from the direct impact of tariffs as major food needs outside of coffee and avocados are largely produced in the U.S. Herein, we look more closely at the second derivative of the impact of tariffs on the restaurant industry. Our greatest concern is if tariffs weigh on consumer spending, given a +0.9 correlation between restaurant industry sales growth and growth in disposable income. This is echoed when viewing restaurant sales as a percent of disposable income, which have been remarkably consistent at ~5% for the last 60 years. Another variable is the timing and magnitude of potential erosion in chicken/cattle prices given protein prices play an integral role in dictating the level of industry value activity. We note depressed grain prices and a potential decline in the level of protein exports present potential downward pressure on chicken/cattle prices.

We could envision a scenario where lower protein prices lead to an intensified round of quick service discounting, while consumer purchasing power is hampered. This backdrop would be beneficial for national quick service concepts such as MCD, Burger King and Taco Bell; and less so for regional concepts like SONC and JACK, as well as fast casual hamburger concept HABT, who do not have the scale or marketing budget to compete as aggressively on value promotions.

Specialty Retail, Broadlines, Department Stores & Luxury Goods (Chen) – WMT, COST
Within the retail space, we anticipate the changing dynamics of tariffs on U.S. imports and exports can have three primary impacts: (1) higher input costs for retailers on items such as cotton and agricultural products from increased level of tariffs, (2) potential for adverse impact on the health of the consumer, and (3) reduced tariffs on jewelry in China potentially benefiting luxury companies (gold and silver jewelry from 20% to 8% and platinum/precious or semi-precious gemstone jewelry from 35% to 10%). We believe, within our coverage universe, stocks including WMT and COST could be most defensible against potential headwinds from tariffs given their scale and sales mix skewed towards consumer staples. We note that softline retailers, such as AEO, JILL, and GPS, could see the most potential risk from higher cotton costs – as much as -30bps to -200bps impact on gross margin and -3% to -22% change on full-year EPS. Conversely, we think TIF and LVMH can be the beneficiaries from reduced tariffs on gold and silver jewelry and platinum/gemstone jewelry as this may increase local consumption in China. We note, however, increased domestic luxury consumption may lead to a decrease in comps in other parts of the world if the Chinese shop less when traveling abroad; we expect tourism-related spending in areas such as Europe and New York City to be potentially adversely affected.

Retail and Consumer Brands (Kernan) – HBI, TJX, ROST, BURL
Recent escalation of tariffs comes simultaneously with first half 2018’s acceleration in overall traffic and improvement in industry inventory levels; coincidentally, the sector FY1 P/E multiple has expanded from 23x in November 2017 to 27x in July 2018. Potentially higher costs for consumers and the accompanying uncertainty in policy could suppress multiples, which are not cheap relative to historical standards. The United States imported $27B of apparel goods in 2017 from China, which is down 11.5% from its peak of $30.5B in 2015 and represents (34% of total imports), we estimate that footwear imports from China are roughly the same share. NKE for instance only has 27% of its factory base in China. While most of apparel and footwear related goods were excluded from the recent tariff announcement on 7/11/18, there continues to remain a threat that the situation could escalate further beyond the incremental $200B in announced tariffs, along with Chinese disruption of the retail supply chain within China and or boycotting of American brands. In the event of greater escalation in tariffs and or higher costs faced by consumers – Off-price pricing umbrella could expand, inventory uncertainty could lead to buying opportunities, and stretched consumers may trade down. BURL, ROST, TJX would likely be sector outperformers. Another defensively positioned stock (albeit Market Perform rated), HBI strategically removed itself from China so it faces no supply chain risk from China. The opportunity for China to reform its consistent copying and counterfeiting of American brands such as Nike and others could actually be helpful in the long term. Our trips to China in the past have unearthed blatant cheating and copying of US based intellectual property and brand logos. We suspect there is some skepticism and uncertainty among investors regarding the implementation and negative long-term effects of these measures – the XRT retail index is down only -1% since the announcement of the plan to enact incremental tariffs on 6/15 and declined only 0.7% following the $200B escalation on 7/11.


Basic Materials

Agricultural Chemicals (Neivert) – CF, MOS, NTR
The impact of tariffs and any subsequent retaliation may have little effect on the fertilizer industry itself. Thus, we believe that fertilizer shares may represent a defensive investment posture in a trade war environment. However, farmers are among the most affected by the tariffs. Before any tariffs were put in place, US growers of soybeans and corn experienced a loss of over $30 BB as prices of the two products plummeted The impact is not only being felt on a near-term basis, but creates strong detrimental long-term effects as well. The tariffs open up U.S. growers to additional competition, market share losses and reductions in land values.

Capital Goods/Industrials

Industrials (Giordano) – AQUA, GVA, MWA, ROP
The industrial sector, specifically multinationals, face obvious tariff implications. Within our coverage, we look at potential impacts from auto specific tariffs and escalating China trade war rhetoric. We looked at exposed names in the context of 4 groups, from least impacted to most impacted: 1) US based companies that produce and sell predominantly in the US (AQUA, GVA, MWA, ROP); 2) Foreign domiciled companies that produce and sell locally (PNR, ST, TEL); 3) US based companies that produce and sell locally (AME, APH, FTV, PH); 4) US based companies that produce in one region and sell to another, at least in part (CFX, CGNX, WTS, XYL). There is a lot of nuance that needs to be considered – such as where raw materials are sourced and the availability to flex suppliers, where is the “value add” being done, how “brand obvious” is the product being sold, etc. When making our analysis, we take for given that establishment of tariffs will likely negatively impact demand and ultimately impact volumes (autos being a good example). Our work is done on a relative basis within that context.

Sustainable Energy & Industrial/Transport Technology (Osborne) – APTV, VC, DLPH
President Donald Trump’s threat of a tariff on vehicles not assembled in the U.S. catches European and Asia produced vehicles in the crosshairs, though appears aimed at slowing the growth in automobile production in Mexico and ultimately stimulating domestic production longer term. According to media reports, the tariffs could reduce U.S. consumer choice by as much as a quarter, increase costs of the average vehicle by over $5,000, reduce jobs domestically, and impact future R&D programs. We take no view on the outcome of any investigation by the Department of Commerce, the likelihood of policy implementation of U.S. tariffs, or reactionary tariffs by the European Union and China. In this report we look at the potential impact on auto suppliers if exposed to the proposed 25% import tariff. We note there is a great deal of uncertainty at this point and initial hearings are scheduled for later this month on July 19 and 20. We believe investors are prepared for downward estimate revisions at many companies but are embracing their high conviction long ideas for companies most exposed to some of the key megatrends ongoing in the sector. Trade wars typically aren’t permanent and based on our conversations some investors are using this volatility in recent weeks to build positions in either attractively valued secular shift plays such as BorgWarner and Delphi, or more expensive but strategic “platform” plays such as Visteon and Aptiv, which remain our top two ideas in the Transportation Technology sector.

Aerospace & Defense (von Rumohr & Khanna)
The key direct threat of a trade war is Chinese retaliation against Boeing, the #1 U.S. exporter, for whom 20-25% of commercial deliveries (mostly 737’s and some 777’s) are to China. But since Airbus’ A320 has a 9+ year lead time, switching would be impractical, and China’s robust traffic growth (+12.7% YTD) suggests they need the planes. Bizjets are an early-stage market in China, and China already imposes a 20% tax on their importation. Thus, Chinese buyers of bizjets, which mostly are large, long range planes, tend to register them in Hong Kong to bypass the tariff. However, the threat of a potential global economic slowdown from a trade war(s) is a larger concern that would impact airline passenger and freight traffic, ultimately restraining demand for aircraft. Tariff tensions also could import military exports as discussed by Cowen’s WRG analyst Roman Schweizer.


Airlines, Air Freight, Aircraft and Container Leasing (Becker) – ALK, LUV, SKYW
Travel and tourism is an export and the US has a surplus, which totaled $85 billion in 2016. In 2017, 3.0MM visitors came to the US from China. This is are the fifth largest group of inbound travelers, behind Canada, Mexico, the UK, and Japan, and ahead of Germany. The major concern for US airlines is that Chinese government officials will discourage their citizens from visiting the US, and encourage travelers to go elsewhere. The three largest US airlines, American, Delta and United don’t have a major presence in China, but American and Delta have equity positions in two Chinese airlines. Investors who are concerned about international travel to and from the US should focus investment on Alaska Air Group and Southwest Airlines.

Airfreight & Surface Transportation: Rail and Air Freight & Logistics (Seidl) – CNI, CP, KSU
Companies that transport goods could be greatly affected by the recently proposed and enacted tariffs. Regarding tariffs with Canada, the Canadian rails, Canadian National (CN) and Canadian Pacific (CP), would seemingly be most affected. Kansas City Southern (KSU) and Union Pacific (UP) would be most affected by tariffs with Mexico. UP has access to every Mexican rail border interchange which they use to handle 70% of the total Mexican cross border market. KSU has 47% of its revenues coming from their Mexican operations and 30% is cross border. Lastly, freight forwarder Expeditors International (EXPD) has international and Asia exposure. That being said, we see no reason for investors to panic. In addition to having some geographic diversity, the rails’ businesses are diverse, and we don’t foresee the tariffs having a significant effect on any of these companies.


Integrated Oil, Refining and LNG (Gabelman) – VLO, XOM, HFC
China has threatened a 25% tariff on U.S. crude oil as part of the second portion of its initial $50B tariff program. Should these be implemented, the main impact would be a widening of international crude (i.e. Brent) to domestic crude (i.e. WTI and U.S. Gulf Coast) as the U.S. now exports a significant portion of crude to China which would need to be redirected in a less efficient trade. We would expect both Brent price inflation and WTI price deflation. For refiners, VLO would benefit the most out of the large cap group while DK and HFC would benefit most in the SMID cap group. XOM could be the largest beneficiary within the Integrated Oil Companies given its earnings sensitivity to crude prices and material overweight position in US refining relative to oil production. Natural gas is included in the tariff list though specified in gas form, implying limited impact to U.S. lng as China seeks to preserve supply of the strategically important commodity.

Oil & Gas Exploration and Production (Robertson) – APC, OXY, PXD|
The implementation of Chinese tariffs could cause a widening in the Brent-WTI spread that would impact E&P margins differently based on international production exposure. We estimate that the cash flows of APA and MUR maintain the highest sensitivity to Brent prices while HES offers the most leverage to domestic, WTI realizations. We see the need for crude and natural gas exports to maintain an upward trend to support E&P production growth as producers will likely need to find alternate buyers. We favor COP and OXY as defensive names for investors fearing a global recession from tariffs as well as APC and WLL for investors who believe tariffs will not be a material headwind to crude prices. Mexican demand remains a cornerstone of the demand growth outlook for natural gas, but we do not expect this trade relationship to be impacted in the near term.


Medical Devices (Jennings) – ABT, JNJ, MDT
The fallout from the ongoing tariff proposals should be modest for our eight large-cap multinational medical device companies under coverage. We attribute the limited impact in part to AdvaMed, a Washington, D.C.-based group that lobbies on behalf of the industry. Our checks suggest that AdvaMed is not overly concerned with the North America tariff proposals – these do not address medical devices – and instead continues to focus its lobbying efforts on China. The group has made some headway with the China tariffs, having gotten more than 20 medical device products removed from the tariff list so far. The devices and device categories that remain subject to China tariffs in a meaningful way mostly involve capital equipment used for medical imaging, a product type that falls outside of our current research coverage universe.

Life Science Tools & Diagnostics (Schenkel)
The majority of large cap companies within our coverage universe have a relatively high proportion of sales within China (many have >10%, some >20%), and an even higher proportion of revenue growth with China growing double digits for the past several years. While there may be inherent risk associated with this exposure given the current environment, we note a few factors that make us feel comfortable with the outlook for continued growth: (1) the vast majority of products sold in China by these companies are manufactured in China, and very little of what is sold in the US is manufactured in China; (2) practically all relevant companies within our coverage expressed confidence in the ability to quickly alter supply chain and manufacturing locale if the conflict were to escalate – given an already diverse international manufacturing presence for most, including many locations outside the US/China (Singapore, EU, etc.), there is flexibility; and (3) the products sold by Tools companies are difficult to substitute with local or other non-US competition, and are in areas of high strategic focus for China (5-year plan, biopharma industry development, food/environmental safety, etc.). We believe the Life Science Tools industry is well positioned. Herein we describe company specific commentary for A, BDX, BRKR, DHR, FLDM, HOLX, ILMN, OXFD, PKI, PODD, QGEN, TMO, and WAT.


Technology, Media & Telecom

Semiconductors – Memory & Connectivity (Ackerman) – MU
Semis remain at the heart of the US and China trade war, as China’s aspirations to acquire global intellectual property (IP) and expand indigenous semiconductor production from 10% today to 70% by 2025 has been met with heavy resistance from CFIUS. A $160B treasure trove of China state-backed investment funds is now squarely focused on building the country’s IP in the memory market given China must import all of its ~$40B in memory chip demand, and we track ~$90B of capex investment across 6 indigenous memory fabs. Most recently, the preliminary injunction ruling against MU by an intermediate court in China to cease selling 26 DRAM and NAND SKUs, issued 7/3/18, appears inextricably linked to the US and China trade war. The near-term disruption appears factored into the stock, though we wouldn’t be surprised to see AugQ revs/EPS toward the bottom-end of the company’s $8.0-$8.4B/$3.23-$3.37 ranges. Longer term, we cannot ignore competitive risks are mounting in the memory market, though we remain skeptical that XMC, Jinhua and Innotron will be able to materially disrupt memory supply/demand dynamics for the next 5 years given XMC’s poor yields on 32L 3D NAND today and the broader group’s unproven commercialization of DRAM technology.

Semiconductors (Ramsay) – QCOM, INTC, NVDA, AVGO
In the medium term, we anticipate stock volatility within semis (nearly as simple as “one day China good, next day China bad”) as the vast majority of semiconductor suppliers have between 15-30% China end-market exposure including bellwethers Qualcomm, Intel, NVIDIA and Broadcom. However, despite the high exposure for nearly all of our coverage universe into China, we believe in digital and analog semiconductors Chinese buyers have essentially zero sources of competitive domestic supply – at least in the medium term – and a full non-compromised trade war between the U.S. and China would irreparably damage global competitiveness for several important Chinese tech giants (smartphone, wireless infrastructure and cloud vendors in particular) that rely often on single or dual-sourced critical semiconductor components from U.S. suppliers. Given our belief that China is still multiple years away from competitive n-node digital silicon manufacturing versus Intel, TSMC, Samsung and Global Foundries, we have little concern China has access to alternative supply for most components supplied by companies in our coverage universe. Hence, we view business risks (after a period of near-term volatility) as much less in our universe with memory and semiconductor capital equipment (discussed below) closer to the tip of the spear fundamentally. Near term, we view China’s near-perpetual delay in approving the Qualcomm/NXP merger as the largest broad true impact to our group.

Semiconductor Capital Equipment (Sankar) – LRCX, MKSI
With the current US administration’s rhetoric around trade tariffs and potential for retaliatory measures by China, we believe there could be a slight risk to WFE spending if bilateral actions were to be taken. While we do not expect any drastic outcome at this time, we note that SPE company revenues may be impacted depending on the final form that trade measures (if any) take. SPE revenues could be impacted in a number of ways including US preventing advanced equipment exports or China imposing tariffs on imported SPE tools from the US (we see both of these as unlikely), and decreased demand for SPE tools as a 2nd order impact from lower US demand for consumer electronics and other goods that contain semiconductors. Based on company data, the group average LTM sales exposure to China is 14% with AMAT having the highest exposure at 21% of sales followed by MKSI (19% Asia ex-Japan, Korea) and TER (18%). KLAC and LRCX are modestly above the group average at 17% and 15% of sales, respectively. We estimate China will represent 6% of 2018’s $105B in total capex or $6.6B, with rising penetration to 8% in 2019 ($7.8B), and 9% in 2020.

Telecom and Networking Equipment (Silverstein)
At present, the implemented and proposed tariffs—including those imposed by the U.S. and the subsequent retaliatory tariffs imposed by Canada, the European Union, China and Mexico—appear to be a non-issue for both networking equipment and optical component suppliers given the tariffs do not appear to apply to any networking or optical component products. However, these suppliers are at risk of being adversely affected by potential future tariffs. As a general proposition, these suppliers face a greater risk of being adversely impacted by potential future U.S.-imposed tariffs (as opposed to retaliatory tariffs) given their reliance on non-U.S. manufacturing facilities. Although few, if any, suppliers disclose their specific level of exposure to non-U.S. manufacturing, almost all suppliers manufacture a large share or all of their products either by way of third-party non-U.S. contract manufacturers (EMS, or electronics manufacturing services companies) or by way of in-house non-U.S. manufacturing facilities. Thus, the companies least at risk from any future U.S.-imposed tariffs or from any future retaliatory tariffs are those with either both strong non-U.S. exposure and non-U.S. manufacturing capabilities or those with both strong U.S. exposure and U.S. manufacturing capabilities. Conversely, the companies most at risk include those with strong U.S. exposure but that lack meaningful U.S. manufacturing capabilities and those with strong non-U.S. exposure but that lack meaningful non-U.S. manufacturing capabilities—although the latter case is not present within our coverage universe.