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How Will Tariff Uncertainty Affect Financial Markets?

Four implications based on historical data

Op-ed written by: Dongyoung Lee

Artwork by: Sébastien Thibault

The COVID-19 lockdown has created economic uncertainty in financial markets. With sudden border closures aimed at preventing the spread of the virus, financial market participants are left wondering about the impact these closures will have on companies’ bottom lines this year.

To make matters worse, U.S. President Donald Trump’s tariff war has further aggravated market uncertainty, making it more difficult to predict firm performance.

Against this backdrop, one question that investors are asking is whether they can trust financial analysts’ earnings projections for their investment decisions. On the one hand, financial analysts are professional earnings forecasters whose “livelihoods depend on the accuracy of their forecasts.” On the other hand, trade uncertainty might be severe enough to undermine the credibility and accuracy of analysts’ forecasts.

The pandemic’s impact on trade

The COVID-19 pandemic is having direct bearing on cross-border transactions. The United States, for example, imports roughly half of its personal protective equipment (PPE) products from China. According to the Peterson Institute for International Economics, Trump’s 2019 tariffs on Chinese medical supplies are purported to have hampered the U.S. fight against COVID-19. It was not until mid-March of 2020 that the Trump administration finally agreed to remove import tariffs from many PPE items.

North American oil firms have suffered from crashing oil prices amid an influx of foreign oilAnother example concerns international oil transactions. Due to travel restrictions and economic fallout from the pandemic, North American oil firms have suffered from crashing oil prices amid an influx of foreign oil from the Organization of Petroleum Exporting Countries (OPEC).

In response, political leaders in Canada and the United States threatened to increase tariffs on foreign OPEC oil as a tactic to protect their domestic energy industries. This move pressured OPEC and other oil-producing nations, in April 2020, to agree to an unprecedented production cut of nearly 10 million barrels a day, in hopes of boosting oil prices. Recently, OPEC and allied nations further agreed to extend this production cut through the end of July.

Quantifying costs

Even before the COVID-19 crisis, the Trump administration dismissed traditional open trade policies, leading to large increases in import tariff rates across many industry sectors.

According to a recent New York Times article, during the early part of 2019, despite a series of tariff-related headlines, financial analysts stood pat on both short- and long-term earnings forecasts. This was due to the practical difficulties of quantifying the costs of ever-changing trade conflicts and their economic implications for domestic firms’ earnings performance.

As financial analysts face trade uncertainty, they may not be able to generate informative reports. In turn, this implies that unsophisticated investors also face uncertainty since they cannot turn to financial analysts for valuation advice.

Can analysts still make a difference?

As an important group of financial intermediaries, analysts play a critical role in providing valuation information. Therefore, it is important for the investment community to know whether capital market participants can continue to rely on analysts’ earnings forecasts and other reports in the face of heightened trade uncertainty.

Given that regulators and policymakers seek to level the playing field for unsophisticated investors, they also need to be aware of the capital market consequences of the government’s actions on tariff barriers.

Prior research provides some evidence that import tariff changes have an economic impact on domestic firms, increasing leverage and decreasing both firm size and profits. In contrast, we have a limited understanding of how trade uncertainty affects financial analysts’ abilities to provide investors with accurate information on firm performance.

In our recent study, my coauthor, Jennifer (He) Wen (University of Missouri – St. Louis), and I investigate the impact of trade uncertainty on financial analysts’ forecasting behaviour.

Below are four major implications from our findings, based on historical U.S. import tariff data (1984−2005).

First, there is a significant drop in the number of analysts following domestic firms facing industry-level tariff shocks. This is in line with recent anecdotal evidence from the previously mentioned New York Times article; tariff uncertainty results in a loss of forecast revisions by financial analysts for tariff-affected domestic firms.

The implication is that a reduced number of reports from analysts will lead to greater investor uncertainty concerning financial marketsThe implication is that a reduced number of reports from analysts will lead to greater investor uncertainty concerning financial markets. Similarly, UBS analysts expect to see more earnings volatility for those firms exposed to tariff risk if trade uncertainty persists into the future, according to their 2018 report.

Second, we find no evidence of a change in overall analyst forecast errors following increased tariff uncertainty. This has a practical implication: investors may find it helpful to continue to rely on consensus earnings forecasts amid a turbulent market given that average forecast accuracy has not suffered, even after sizable changes in historical import tariff rates.

Third, by delving into analyst-specific characteristics—such as firm-level forecasting experience and prior-period forecast accuracy—we find that low-ability analysts stop providing earnings forecasts in response to tariff uncertainty, which contributes to an overall decrease in financial analyst coverage of domestic firms. In contrast, high-ability analysts continue to issue earnings forecasts because they can likely withstand greater tariff uncertainty, thereby helping to maintain the accuracy of consensus analyst forecasts. This, in turn, suggests that it is even more important for investors to identify high-ability analysts in this time of increased trade uncertainty.

Last, the negative impact of tariff-induced trade uncertainty on analyst coverage decisions is only conspicuous in the first year following large tariff reductions. In the second and third years, most analysts appear to have learned how to deal with such trade uncertainty and start to provide their valuation reports for domestic firms facing foreign competition due to reduced import tariff rates. This implies that investors are unlikely to suffer from decreased analyst coverage in the long run.

One caveat

Because the United States generally had open trade policies before the Trump administration, our data only involves sizable tariff reductions treated as quasi-natural shocks to cross-border transactions. In contrast, contemporary events generally concern increases in U.S. import tariff rates. Given that both increases and decreases in tariff rates escalate market uncertainty, historical import tariff data can potentially address the current situation involving the U.S. government’s stance against trade liberalization.

Under this assumption, we can anticipate that these four implications concerning the role of tariff uncertainty in financial markets will likely hold true in the post-Trump, post-pandemic period.

Dongyoung Lee
Assistant Professor, Accounting

Op-ed written by: Dongyoung Lee

Artwork by: Sébastien Thibault

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