On April 2, the US government announced a new set of economic tariffs that have captured its size off the ground, and that its size has produced competing stories about economic impact.
This constant flow of uncertainty and narrative is of no use to investors. To better understand the potential impact, we used data showing how sensitive different sectors are to different economic outcomes to examine the scope of potential outcomes for key asset classes. This study is designed to ensure investors have a complete understanding of tariff exposure. Due to differences in modeling in this sector, we exclude real estate from this analysis.
Using three different methods, we feel that technology is the most sensitive sector, but utilities are the least sensitive. The estimated tariff sensitivity range found in our three ways shows the challenge of making confident predictions, allowing investors to interpret and use this data differently. Still, long-term investors will have a better understanding of the robustness of their portfolio when armed with this data.
Equity sector and shock to the economy
To determine the sensitivity of each sector to tariffs, we started by creating two macroeconomic shocks called demand and supply shocks.(1) Demand shocks only have a short-term impact on the output that disappears as prices and wages are adjusted and the economy returns to equilibrium. Conversely, production (supply) shocks can have a permanent effect on output. The basic sensitivity of each sector to these shocks was calculated and sectors were ranked by sensitivity. Among the US sector, technology is the most sensitive to both supply and demand shocks, while utilities and healthcare are the least sensitive.
Inventory returns were then decomposed into cash flow and valuation components, and the sensitivity of each US sector was calculated to impact on these variables.(2) We focused primarily on the former. Negative shocks to total cash flow represent a more serious risk for long-term investors, as they represent a permanent decline in wealth. In contrast, valuation risk is temporary as valuation declines in the short term balance the expected future returns.
When negative cash flow news arises, the most sensitive assets are consumer circulation and technology stocks, while the most sensitive assets are consumer defense, utilities, and healthcare.
Finally, we compared stock price behavior with the frequency of newspaper articles discussing trade policy uncertainty measured by trade policy uncertainty index.(3) For decades, the index has been fairly stable (previous spikes include the 1971 Nixon Shock and the 1975 Ford Shock). However, we have seen a significant increase in volatility over the past decade. The return of technology was most sensitive to this index’s movement, but the utility was least sensitive. For investors willing to take this risk, recent returns have increased.
Looking forward to tariffs and stock markets
The interaction of tariffs, macroeconomic shocks and stocks could continue to be central themes in the investment environment. While external factors such as trade policy uncertainty are difficult to predict, understanding how sensitive stock positions are to various shocks is crucial to maintaining a robust portfolio and maintaining it to financial goals. Given this uncertainty, it is equally important to ensure that the price paid for an asset includes a safety margin.
(1) Olivier Jean Blanchard and Danny Quah, “The Dynamic Effects of Total and Supply Disruptions,” American Economic Review 79, no. 4 (1989): 655–673.
(2) John Y. Campbell and Tuomo Vuorteenho, “Bad Beta, Good Beta,” American Economic Review 94, no. 5 (2004): 1249–1275.
(3) Caldara, Dario, Matteo Iacovillo, Patrick Molligo, Andrea Prestipino, and Andrea Raffo (2020), “The Economic Impact of Trade Policy,” Journal of Monetary Economics, 109, pp. 38-59. https://www.matteoiacoviello.com/tpu.htm
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