Tipping the scale - will the weight of tariffs affect collateral values?

Article

What are the possible implications of recent tariff announcements and how can lenders prepare for this climate of uncertainty? A team of executives from Gordon Brothers answers these questions.

Date November 2018

Originally featured in The Secured Lender
 
Summer 2018 saw the continuation of tariff threats among major world trading partners affecting nearly all major industries. Following the Trump administration’s announcement of tariffs on imports from Canada, Mexico, Turkey, the European Union, and China, many of these countries announced countermeasures, escalating the situation and threatening a trade war. Affected goods range from imported steel and aluminum, fruit, handbags, and beauty products, to exported lumber, pork, cheese, fruit, corn, and grain, as well as whiskey, motorcycles, technology components, and lawnmowers. While the picture has evolved since then and, as of this writing, a general climate of uncertainty has given rise to mixed reactions among asset-based lenders.
 
Of respondents to a joint TSL and Gordon Brothers survey, 41 percent are concerned about recently announced or enacted tariffs, while 47 percent are neutral. (See infographic on page 28.) The balance, 12 percent, feels positively about the impact of tariffs. After all, the intention of the administration’s tariffs is to stimulate domestic industry, and some sectors are benefitting. At the same time, others are poised for stress depending on the degree and duration of changes and customer response to increased pricing.
 
For better or worse, change brings potentially increased risk and lenders are adapting. The majority of respondents (63 percent) have adjusted their portfolio monitoring based on their level of concern. Specific sectors where clients have altered monitoring include metals (55 percent) and agricultural commodities (31 percent) where tariffs are already in place. Additional sectors lenders felt warranted monitoring include automotive (41 percent) and retail (35 percent), while technology (18 percent) ranked lower.
 
As part of their efforts to mitigate risk, lenders reported increasing their "diligence regarding potential direct and indirect impact[s] on borrowers;" "relying on third-party appraisal firm[s] to help monitor go-forward changes;" "avoiding cross-border activities with Chinese companies;" and limiting certain asset categories and sectors from their portfolios.
 
HIGH-LEVEL IMPACTS TO ASSET VALUES
Macro-economically, some sectors will benefit, like domestic metals manufacturing, and others suffer, like U.S. soy farming. In the short term, some inventory values may increase, though the gain will be short-lived. Long term, tariffs may make certain business or product lines uneconomical, and they will certainly have an inflationary impact across a large number of industries
 
To the extent investment occurs to support positively affected industries, machinery and equipment values may increase. However, it is unlikely that significant investment will occur until a new paradigm of tariffs and trade agreements is in place and stability returns to the market. In sectors where investment is not occurring, machinery and equipment values will decline.
 
The impact on retail and consumer finished goods inventory will depend on consumers’ willingness to withstand price increases. To the extent that increased costs cannot be passed on to consumers, asset values will suffer.
 
Below we detail broader trends by asset class and the sector-specific impacts to help lenders understand how to focus their monitoring activity.
 
KEEPING IT IN PERSPECTIVE – GEOGRAPHICALLY AND HISTORICALLY
The early action in U.S.-imposed steel and aluminum tariffs has affected North American trade more so than Chinese trade to date. The Chinese retaliatory rates on soybeans, seafood products, and other products have had significant impacts, but compared to a full-on trade war like that of the early 1930s, current tariffs are still very low. Nevertheless, Great Depression era history shows that unabated tariff escalation can have a detrimental impact on economic growth.
 
At its peak in 1932, the average U.S. import tariff rate was just under 20 percent. Current rates are comparatively low at 1.5 percent for the year-to-date period ended July 2018. In examining China only, year-to-date duties are 2.8 percent relative to 2.7 percent for the same period in 2017.
 
As U.S. steel and aluminum trade volume with Mexico and Canada is high, the impact of tariffs has been material with a $332 million increase in Canadian duties in 2018 and a $145 million increase in Mexican duties. Again, duties still remain historically very low at aggregate rates for imported goods of around 0.2 percent for each country. But this could change; in fact, governments have announced that it will.
 
These figures only show the change in duties paid to the U.S. and do not measure the increase in duties paid abroad by U.S. exporters. These tariffs also don’t reflect the impact of trade diverted and shifts in pricing that has affected trade flows. For example, soybean tariffs implemented by China in June shifted Chinese buyers to the Brazilian market. This shift depressed U.S. soybean prices, but did not result in a significant increase in duties paid on soybeans in China.
 
A MIXED BLESSING FOR MANUFACTURERS
New tariffs could spur investment domestically to offset the lack of imported supply, as seen with U.S. solar panel manufacturing, where about $1 billion in new spending plans were announced. To meet this new demand, companies will have to increase production. Braidy Industries, for example, recently broke ground on a $1.3 billion aluminum rolling mill in Ashland, Kentucky. In Illinois, U.S. Steel Corporation has reopened one of its shuttered steel manufacturing facilities. Equipment asset reinvestment can be achieved in a number of ways including reactivating idle equipment, upgrading existing equipment with new technology, or making capital expenditures in new machinery. However, many producers are hesitant to make the investment due to concerns that these conditions will not prevail long-term.
 
On the other hand, new tariffs are hitting some industries, like agriculture, twice as hard. According to the U.S. Farm Bureau, the farm economy is suffering under reduced commodity prices and income, at the same time that it’s facing rising interest levels, increased debt and lower loan performance. Fixed asset and equipment costs are also rising. Retaliatory tariffs on agricultural exports, such as pork and soybeans, are exacerbating headwinds for many farmers. Further in the supply chain, increased metals costs, for example, are increasing canned food and beverage production costs. The long-term impact is still to be seen, in large part based on the end consumer response.
 
ABILITY TO PUSH ON COST INCREASES WILL MAKE OR BREAK MANY
With the prospect of increasing costs of goods, wholesalers and retailers’ success will largely be determined by consumers’ tolerance of price increases. For many borrowers, tariffs will be a non-issue, especially if they are able to push cost increases through the supply chain, or constrain cost increases by shifting purchasing away from affected countries. For example, one heavy equipment wholesaler now facing increased costs for Chinese-cast parts is transitioning to South Korean suppliers. However, moving capacity or switching suppliers takes time and wholesalers may not reap the benefits immediately. To the extent increased costs can be pushed to customers, increased tariffs may not immediately impact NOLVs; however, it may eventually have an effect on wholesalers’ sales volume as tariffs take hold and/or expand across additional categories.
 
From an inventory perspective, input cost increases will buoy the value of some firms’ inventories in the short term. Once that product is sold, however, and is removed from inventory, that one-time gain will disappear. Thereafter the same volume of parts will require additional capital to procure and the price of finished goods must increase to maintain gross margins. Price increases may ultimately temper demand or compress margins to the extent that prices require discounting to sell through. Wholesalers and retailers are still assessing how tariffs will affect pricing to their end customers. Presently, affected products include imported Chinese and Canadian raw materials and finished goods including cotton, leather, clothing, and handbags.
 
SECTOR-SPECIFIC IMPACTS
Metals
Domestic steel prices have increased and producers will see higher values as margins rise. In the short term, some companies holding commodity steel are seeing an increase in raw material values as the market price rises relative to booked cost. Conversely, the entire supply chain is impacted by increased costs. Many manufacturers are reporting compressed margins and/or price increases to end users. Raw material costs move quickly, with the impact on finished goods and downstream markets moving more slowly.
 
Producers expect that rising costs will lead to increased prices for all canned products, food, and beverages. The ultimate impact on gross margins and how much of that can be passed along will be a major monitoring point. Additionally, the increased cost of new equipment will have an inflationary effect on used equipment prices. As tariffs increase prices on imported steel, consumers may be reluctant to buy new and instead buy used.
 
Agriculture
Approximately 20 percent of U.S. agriculture revenue comes from exports. The U.S. Agriculture Department has forecasted approximately $11 billion of losses due to new tariffs. For example, National Milk Producer Federation economists are forecasting tariffs to cost farmers $1.10/cwt in the second half of 2018. To date we have seen decreasing commodity prices in agricultural products including dairy, soybeans, corn, wine, and others.
 
In response to tariffs on soybeans, fruit, and other items, the U.S. government is planning a $12 billion bailout for farmers, but there could still be a long-term impact of lost markets and customers. With fewer international buyers, the U.S. meat industry is seeing an oversupply of protein and decreasing prices as a result. Tyson Foods recently cut its profit forecast, citing lower U.S. meat prices due to duties on pork and beef exports. New equipment prices are also rising as a result of steel tariffs.
 
Energy and Chemicals
Steel tariffs have increased the cost of pipe, fittings, and equipment for oil and gas producers. As the majority of drill pipe is imported and it takes time to change producers, margins are compressing and energy costs are rising.
 
The American Chemical Council warned that impacts from tariffs on over 1,600 Chinese chemicals and plastics would increase prices for U.S. chemical firms and the end users of their products. To the extent that the increased cost of goods cannot be passed along to the end user, manufacturers’ gross margins will compress, negatively affecting appraised values.
 
Construction
Most machinery contains steel or aluminum elements. Tariffs on these metals will increase the cost of virtually all new machinery and equipment. Caterpillar stated that tariffs on imported metal would raise its production cost $100 to $200 million during the second half of 2018. Those increases may be pushed to customers, and Caterpillar has largely succeeded in doing so. Many heavy equipment manufacturers are anticipating lower margins and earnings in 2019.
 
Lumber costs have increased to an alltime high as a result of the 2017 U.S. tariff on Canadian lumber. Over the past year, lumber pricing increased in certain markets due to opportunistic domestic mills "matching" imported Canadian lumber pricing. Subsequently, the cost to produce homes has increased in some markets.
 
Automotive
The auto industry has been particularly affected due to the large number of inputs subject to tariffs, ranging from tires and brake pads to engines and batteries, and steel and aluminum. Ford and GM lowered profit forecasts for 2018, with Ford estimating the cost to its business at $1.6 billion. BMW announced a combined response of raising prices and absorbing some costs. Harley Davidson plans to absorb the cost of European tariffs.
 
Aerospace
Aerospace has not yet felt the impact of imposed tariffs, but rising metals and fuel prices will create headwinds for the industry. Boeing delivers 80 percent of its aircraft outside the U.S., putting it at elevated risk. Additionally, increased input costs are driving up the cost of other transportation categories, specifically shipping and logistics.
 
Retail
Retailers face the perpetual challenge of assessing how much additional cost can be passed on to consumers, in addition to constraining their own costs of goods. Firms that are best positioned to do this include vertically integrated firms and those that have large buying power and relationships that enable effective supplier negotiations.
To the extent that retailers can pass along these costs, and their gross margin and average discount rates remain consistent, NOLVs should also remain consistent. Lenders should continue to monitor these metrics in addition to comparable and new sales to ensure that customer goodwill remains stable. For those companies that depend heavily on products sourced from Chinese manufacturers, consumer price tolerance remains to be critically tested before customers seek alternatives or abstain.
 
WHERE DO WE GO FROM HERE?
The long-term impact to some manufacturers could include major disruptions such as switching suppliers or moving production overseas. Compressed margins and lower sales could lead many companies into distress. Alternatively, some segments may thrive as production moves onshore. Across all five continents on which we operate, we have observed varying impacts and are actively assessing the effects on all sides. Changing dynamics are affecting our disposition strategies and these considerations are reflected in our valuations, even as they change week-to-week.
As noted, asset-based lenders are altering their portfolio monitoring or are using increased appraisal discipline to minimize downside risk. This is an important step in mitigating risk associated with the geopolitical change and uncertainty. Values across the supply chain are fluctuating quickly based on changing market prices, input costs, and buying patterns. Continued variation in these patterns is likely. Under these quickly shifting conditions, knowledge is power.