By Jon Bathgate, CFA
Technology Research Analyst Jon Bathgate discusses why markets reacted negatively to this latest round of tariffs, but why the secular tailwinds propelling tech stocks remain intact.
While last week may have begun with all eyes on the Federal Reserve, it ended with the market having to absorb an escalation in the trade war between the U.S. and China. This most recent salvo comes in the form of a list covering just about all other Chinese exports not already included in previous rounds of tariffs. The list is heavy on technology products, including the electronic gadgets upon which consumers have become so dependent in recent years.
Given the reaction of global stocks, the market does not welcome this escalation. Ideally, we would prefer a trading regime based on the free flow of goods, services, capital and ideas. Indeed, many within the tech industry appreciate the Trump administration’s efforts to tackle issues like intellectual property (IP) protections and greater market access. But tariffs are a blunt instrument, and one that we believe may have unforeseen consequences.
Companies often state that they can manage through just about any backdrop; they just need clarity. We believe that premise applies here. In our conversations with management teams, it is clear that the uncertainty around the size of tariffs, the products covered, whether they’ll continue into perpetuity – or ultimately be reversed – has impeded these companies’ abilities to make long-term decisions.
A Double-Edged Sword
Global supply chains, especially within the technology sector, have become incredibly integrated. A significant amount of the subcomponents within the phones, televisions and other devices assembled in China originate in other countries, including the U.S. With high-end smartphones, for example, although the final assembly of many of these devices takes place in China, much of the value-added work occurs in other markets, with the cost of China-based operations accounting for very little of the overall device. Given this industry structure, any demand destruction caused by higher-priced Chinese-made products will likely pressure U.S. suppliers, including the semiconductor industry. China is an important buyer of U.S.-made chips, and any softness in that market would likely push out the recovery that the semiconductor industry had hoped would materialize during the second half of this year.
Picking One’s Poison
Companies that market directly to the consumer, in our view, will be most directly impacted by these new tariffs. In order to navigate the upheaval in their cost structure, tech companies will likely face a choice between two paths, neither of which is pleasant: They can absorb the higher costs of their products, thus taking a hit to margins, or they can attempt to pass along higher prices to consumers. The challenge with the latter is that it may put market forces to work, and not in a manner favorable to these companies. Consumers may be unable or unwilling to accept price increases and, thus, alter their behavior. That scenario is all the more likely when viable alternatives exist, such as lower-priced phones and televisions from an earlier generation. Furthermore, the final assembly of several televisions and computers occurs in other low-cost countries such as Mexico, Malaysia or Vietnam, meaning they are not impacted by the new tariffs. In this case, consumers could unconsciously opt for the Mexico-assembled product, to the detriment of the company whose supply chain goes through China.
Unwelcome but Manageable
We believe that consumers and countries have largely benefited from integrated global supply chains. While our preference would be a world with a less encumbered flow of goods – and improved IP protections – we suspect that the distrust built up between the U.S. and China over recent months is here to stay.
Still, despite the presence of an unwanted cost, the trade war, in our view, does not dampen, especially over the long term, our enthusiasm for the chip companies and device makers that continue to empower a digital-native and mobile-first society. We believe this trend will only gather steam as the Internet of Things, artificial intelligence and 5G networks are deployed.
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