A possible lull in the Sino-US conflict
While growth in international trade volumes plunged last year1, driven down in particular by the Chinese economic slowdown and protectionist US rhetoric, the markets are now keeping a nervous eye on initial signs of a take-off in China and headway on Sino-US tariff negotiations.
On both fronts, a lull appears to have been forming in recent weeks in the rebound in PMI and retail sales figures in China, and in recent high-level Sino-US meetings. However, some caution is in order, as 2019-2020 growth targets for Chinese GDP are barely over 6%, and as there appear to be some ulterior motives in tariff negotiations between the two superpowers. Even so, this lull, combined to the soothing language from central banks, has played a clear part in the market rally so far this year.
1 Falling from +5.0% in the first quarter of 2018 to 1.4% in the fourth quarter on a year-on-year basis.
Out of the frying pan, into the fire
For an investor in European equities, however, it would be premature to consider that most trade risks have been resolved, given US tariff temptations and Brexit uncertainties.
With an improvement now looming on the Sino-US front, the US may now shift its gaze to its bilateral deficits with the European Union (EU). Following Donald Trump’s scathing words regarding the BMW and Mercedes crowding Fifth Avenue and the raising of customs tariffs on European steel and aluminium, the Commission president, Jean-Claude Juncker, met with Trump last July and a truce was then concluded, pending further negotiations. Meanwhile, the US commerce secretary raised the bar in mid-February, presenting Trump with a report suggesting that imported cars “threatened national security”; this gave the president 90 days, i.e., until mid-May, to make a decision. And in early April, the US also raised again the issue of public subsidies to Airbus.
On the other side of the Atlantic, on 15 April the European Commission got a green light from the EU Council of Ministers to negotiate a new trade agreement with the US. The EU trade commissioner, Cecile Malmström, will be in charge of negotiations with the US trade representative, Robert Lighthizer. Talks will deal solely with manufacturing tariffs, to the exclusion of agriculture, services, access to public procurement and protection of investments.
Meanwhile, after three years of foot-dragging, a no-deal Brexit could automatically trigger customs duties as provided under WTO rules. The duties would vary from one product to the next and would amount, for example, to 10% in Automobiles & Components.
Both the UK and continental Europe would take a big hit, as the UK exports 631,000 vehicles annually to the 27 other EU countries (81.5% of UK output is exported, of which 51% to the EU), and the EU almost 1.8 million vehicles to the UK (12% of their total production and 32% of their exports). As the average price of a new vehicle in Europe, excluding VAT is about €25,000, WTO customs duties would raise their cost by 10%, or €2500. As cars have a high price elasticity of demand, this could result in a 10% decline in sales of the models involved2.
2 Some examples: Honda Civic, Toyota Corolla, Land Rover Evoque, Nissan Juke and Qashqai, Mini in the EU-27 and 90% of models sold in the UK.
Who would be hit the hardest?
In the event of a tariff war, who would be hit the hardest? On a macroeconomic level, various national and international bodies have already provided some useful indications.
According to the European Commission, for example, although the bilateral trade relationship, strictly speaking, is structurally in the EU’s favour, a broader view, including services, investments and repatriated profits, shows far greater balance, with a slight surplus in the US’s favour in both 2017 and the past decade (2007-2017)3. Meanwhile, the Bank of England has estimated that a global trade war – in which the entire world raised tariffs by about 10 percentage points – would subtract about 2.5% from global GDP growth over three years. Looking at Brexit alone, in a report last November, the UK government4 estimated that, in the event of a no-deal Brexit, UK GDP could decline by 8% in the long term (i.e., about 15 years) compared to its initial trajectory. According to various forecasters, the UK could hover around recession territory in 2020, rather than achieving the 1.4% currently forecast. Last but not least, in a recent article of the ECB Economic Bulletin on “the economic implications of rising protectionism, a euro area and global perspective”5 the authors estimated that “the impact so far were expected to remain contained, however, large negative effects could materialise if trade tensions were to escalate further”.
Our approach focused on equity markets is less academic and more practical. Our concern is, above all, to distinguish which countries, sectors or individual companies in Europe would be the most exposed if customs tariffs were to be raised. To do so, we listed the geographical exposure of various indices and sub-indices concerned. This filter is, of course, oversimplified. To make it complete, we would have to include not just sales but also purchases and production done abroad. Similarly, the net exposure thus calculated should be compared to the margins of each entity under consideration. The impact, for example, of a net duty of 2% of sales would depend on the entity’s margin. Be that as it may, this first filter does provide some useful indications and should simplify any complementary research.
We will look in particular at how exposed European equities are to the US. In two boxed insets, we will deal with Automobiles & Components, a sector that regularly makes headlines, and EU-27 exposure to the UK in the event of a no-deal Brexit.
3 Liberalization of tariffs on industrial goods between the United States of America and the European Union: An economic analysis http://trade.ec.europa.eu/doclib/docs/2019/february/tradoc_157704.pdf
The US accounts for 20% of the aggregate sales of MSCI Europe companies…
Chart 1 shows that sales to the US average 20% of MSCI Europe companies aggregate turnover. In the other direction, sales to Europe account for 14% of MSCI US aggregate turnover, of which 12% for the EU alone. In the event of a tariff war, the US would therefore be less exposed than Europe. But it would still be heavily exposed and would also lose out if the conflict were to fester.
However, Europe’s US exposure varies widely from one country to another, from Portugal’s 2% to Switzerland almost 30%. There is less dispersion in the MSCI Europe’s Big Four – Germany, France, UK, and Switzerland – which together account for 73% of Europe’s market cap. Their US exposure ranges from 16% to 30% and averages 22% (weighted by their MSCI Europe weights).
As Switzerland is not in the EU, and as the UK is a special case (due, among other things, to Brexit and its status as a close ally of the US) among the Big Four, Germany and its famous premium cars, looks most heavily exposed.
…. and close to 40% in some sectors!
However, a more detailed look at the MSCI Europe (see chart 2), shows that, with 20% of its sales in the US, the European auto sector is merely average. Despite what you may have heard, it is far from being the most heavily exposed in the US. While it would take a hit from higher customs tariffs – the US is the key market for German automakers, after China6 -- other sectors are also at risk.
We are thinking in particular of Pharmaceuticals and Healthcare Equipment, 37% and 36% of whose sales, respectively, go to the US. What’s more, with elections coming up, we are certain to see the ritual campaigning over drug prices and healthcare in general. As these sectors are in normal times regarded as defensive, they may doubly disappoint if the US and Europe also engage in a tariff war.
Four other industrial sectors are also more prominent than Automobiles & Components – Food, Beverages & Tobacco; Tech Hardware, Capital Goods and Household & Personal Products, with their US sales ranging from 22% to 25% of their total.
In chart 2, we isolated services. Although some of them7 are heavily exposed to the US, they come under a different approach as they would appear to be at little risk of customs tariffs, though, in an aggressive trade war, they could be affected by many non-tariff barriers, such as standards, certifications, legal protectionism, and extraterritoriality of US law.
6 The US is the second-largest market after China, but ahead of Germany for BMW and Mercedes, and the third after China and Germany
Healthcare and Capital Goods companies are generally the most exposed
Beyond the European sector average, it is also worth going one notch further on a national level. Once again, German Automobiles & Components (18%) are no more exposed than Food in Switzerland (30%); Pharmaceuticals in France (32%), the UK (35%) and Switzerland (41%); and medical equipment in Germany (46%). These sector scores are led by national champions such as Nestlé, Novartis, and Sanofi, which makes us wonder about which individual companies are the most heavily exposed.
For example, the two tables below list the MSCI Europe’s 30 manufacturing companies with the heaviest US exposure in relative terms (as a percentage of total sales) and in absolute terms (in millions of euros of sales).
In this first Top 30, the percentage of sales to the US ranges from 32% to 84% and averages 47%, vs. 20% for the MSCI Europe. These are large caps but not necessarily giants. Their median size, in fact is €13bn in sales, of which €6bn in the US. By sector, Healthcare (12 out of 30) and Capital Goods (12) have the lion’s share, far ahead of Food, Beverages & Tobacco (2) and other sectors. Of the latter, there is only one auto sector group, Fiat, which, as a result of its 2014 takeover of Chrysler, now makes 56% of its sales in the US. With the exception of some Fiat 500 models (38K in 2017) and a handful of Ferraris (2518 in 2017), 98% of Fiat’s US sales are Chryslers. So, the group has very little tariff exposure.
Because of their sheer size, most European champions do have heavy footprints in the US, but their relative exposure is actually rather ordinary
The second table ranks companies on the basis of their US sales in millions of euros. Thirteen of them, which are highlighted in red, are also in the previous rankings, such as Fiat-Chrysler and Roche.
However, in this second Top 30, the profile of new entrants (Daimler, VW, Nestlé, etc.) is quite different – their median size is four times greater (€51bn in total sales, vs. €13bn), but their relative exposure is far lower (22% vs. 47%) and is closer to the MSCI Europe as a whole (20%). Given their sheer size, it is no surprise to find most European giants on this list, such as BMW, Continental, Daimler, Michelin and VW in Automobiles & Components, as well as Airbus, BASF, LVMH, L’Oréal, Nestlé, Siemens and Unilever.
By sector, this second Top 30 if far more diversified given that, in addition to Capital Goods (8) and Healthcare (7), it also includes Automobiles & Components (6), Food, Beverages & Tobacco (3), Materials (3), Household & Personal Products (2) and Luxury Goods (1).
To sum up
Given the extent of reciprocal links between the US and the EU, both would be losers in a trade conflict. Although on a pure trade basis Europe is most heavily exposed, when services, investments and repatriation of profits are factored in, the relationship is almost perfectly in balance and perhaps even to the US’s advantage. Even so, given that goods are more easily taxed than services, Europe would be the first to bear the brunt of increased tariffs. While European Automobiles & Components already appear to have been convicted by a jury of tweets, this is not the sector with the heaviest US exposure and, moreover, has many counter-arguments in its defence. However, other sectors – including healthcare, capital goods, and food, beverages & tobacco – which are less subject to media hype but also have large US footprints, are worth greater attention and a more in-depth review.