Stocks rose yesterday after reports that Washington was softening its stance against Chinese telecom giant Huawei after realizing that a total ban on use of Huawei products would cripple wireless service over parts of the U.S. and would create immediate supply chain issues for other companies. It granted a 90-day cooling off period to allow companies to adjust and to see if a compromise solution could be reached.
In part, this is another element in the trade conflict between the U.S. and China. The U.S. alleges that Huawei is captive to the Chinese government, and therefore the company’s equipment could be used for spying purposes. Huawei and the Chinese government, of course, deny such allegations, but if the U.S. chooses to ban or restrict the use of such equipment either in the U.S. or within products made and sold by U.S. companies, the damage will be done. Huawei is huge. It buys billions of dollars of chips and other high tech gear from U.S. companies. China, today, doesn’t have comparable alternative sources. China also, should it choose, could retaliate in other ways. That thought has scared investors away from semiconductor and related companies over the past few weeks. China, for instance, could conceivably retaliate against Apple#. But most Apple phones are assembled in China by tens of thousands of Chinese employees. In times like these, markets seem to take on a life of their own dreaming up worst case scenarios. Weaker hands trade on these notions sending share prices reeling. Then, when even a spark of good news appears, the same shares rebound almost as violently as they fell.
As we have noted in recent comments, the real 30,000 foot view is that China and the U.S. are going to be prime competitors for years to come. President Trump has taken it upon himself to become more combative, defending U.S. rights and trying to level the playing field by eliminating theft of intellectual property and forced technology transfers. We can argue tactics but most in the business world appreciate his goals.
Changing Chinese habits, however, isn’t going to be easy. Dealing with a single strongman leader like President Xi, doesn’t make it easier. Intellectually, the Chinese know they cheat and steal. They know that is wrong, at least by the rules of developed nations. That doesn’t mean, however, it is willing to stop or even slow down. It won’t until it realizes that continuing to cheat carries a cost that exceeds the benefits of cheating. That is where tariffs and restrictions on companies like Huawei come into play. In addition, American companies that have been using China as a low-cost manufacturing location are quickly moving to adjust supply chains away from China. The makers of generic goods with little technological input, like tee shirts, can move fairly quickly. Apple, on the other hand, has established a huge Chinese infrastructure and will require years to reconfigure its supply chain. It may end up doing so outside of China but using the same Chinese manufacturers. For instance, Foxconn, which does the majority of its assembly work, is looking to open a new plant in India. While that location may focus on the Indian market, it could be used to offload some production headed for the United States.
Ultimately, China will have to play by the same set of rules as everyone else. But it won’t opt to do so until its own patent and intellectual property portfolio is worth protecting, perhaps by the middle of the next decade, unless forced to do so by steps we are taking. The risk for us is that tariffs are taxes, partly or mostly borne by U.S. companies and consumers. Consumer products so far have been excluded from direct tariffs with some notable exceptions like furniture and appliances. To date, retailers and intermediaries have absorbed a good part of the first round of 10% tariffs but the next 15% will be tough to swallow without some price increases. Opinion polls so far show that Americans are negative on the trade war; they just see it as an added cost to themselves. We are still almost 18 months away from the U.S. elections and Mr. Trump has months to maneuver. But months aren’t forever, and the Chinese may choose to play a waiting game.
Obviously, there are a wide range of outcomes, and it would be foolish for me to put odds on political events. Uncertainty lowers prices. If both sides kiss and make up, these low prices will prove to be a bargain. But if there is to be further escalation, i.e. more tariffs, and both sides become entrenched, the damage to equities overall could be worse. Some predict that the cost of 25% tariffs on all things Chinese could approach a full percentage point of growth. It would also crimp capital spending plans. That doesn’t mean recession, but stocks don’t like economic deceleration. All this suggests a bumpy month or two at least until outcomes come into clearer focus. Perhaps the G-20 meeting at the end of June will become a focus.
Of course, the Federal Reserve is watching as well. It is doubtful, however, that it will make any changes in interest rates until there is an actual major change in economic data. Markets are forecasting at least one rate cut later this year. But that isn’t going to happen without some evidence of sustained deceleration. The quarter-to-quarter movements won’t sway the Fed until there is a multi-quarter trend.
I want to switch gears a minute and talk about one of the most controversial companies around, Tesla. I will start by saying that Tower Bridge Advisors has never made a decision to buy or sell Tesla shares. With that said, I have great admiration for their vehicles and have never met an unhappy Tesla owner, although I am sure there must be a few out there.
Tesla is a unique company, a true disruptor. As I noted, people love their cars. Early owners, those willing to pay upwards of $100K for the privilege of owning something truly iconic, were enthralled. When you saw a Tesla on the road, heads turned. But Tesla wasn’t built to satisfy a niche market; it was built to revolutionize the automobile business. That is what a disruptor does. A battery pack could replace a great majority of what rests under the hood of a traditional auto. No engine block. No radiator. No spark plugs or pistons. Vastly fewer moving parts and hoses that could break. Forgetting for the moment the logistics of charging and recharging the battery, or battery range, the real issue for this disruptive company was its ability to drive down the cost to be competitive or, better yet, cheaper to build than a Camry or a Jeep. Could the battery pack be made less expensively than the internal combustion engine and all its related necessary components?
Tesla’s founder and Chairman, Elon Musk, a master engineer and showman, has never doubted that it would succeed. But although it took many thousands of $1,000 deposits when it first introduced its Model 3 at a price as low as $30,000, the company has not gotten to that crossover point yet where its electric vehicles are cheaper to make than the dinosaurs out there today. Simply said, the push to drive down the cost of the battery pack with better technology and higher volume hasn’t crossed the threshold yet. Some are beginning to speculate it might never happen, at least on Tesla’s watch. The company hasn’t helped itself by financing its growth to date with debt as opposed to cheap equity.
Someday soon, the electric car will cross that threshold. Sometimes, the pioneer gets across the finish line first. But Xerox didn’t invent the copier. Does anyone still have a Bowmar calculator or a Radio Shack laptop? There are a lot of high-end auto companies about to introduce electric vehicles. Many won’t be as good as a Tesla. But the real victory lap won’t be taken until the price of the battery pack falls significantly. When that happens, electric cars will quickly take over leadership in the marketplace just as digital cameras quickly replaced film or laptops replaced desktops. It’s not just about being better; it’s about being better and cheaper. We clearly aren’t there yet. I’m rooting for Tesla but not willing to place any bets either way. What I do know is that Tesla doesn’t have infinite time to fight the battle and, if it is a war worth fighting, there will be lots of other competitors down the road. There are many investors who will argue all day about Elon Musk’s managerial faux pas or how operations could be made more efficient. But it all comes down to the cost of the battery pack. When that gets cheap enough, electrics will win. All the other issues will fall into place. If I knew when, I could be a very smart investor.
Today, Novak Djokovic is 32. is Naomi Campbell turns 49.
James M. Meyer, CFA 610-260-2220