JT’s Insights

Tariffs lead to higher prices

By support@jt.capital / March 8, 2018

Last week President Trump announced his response to Secretary Ross’ proposals for new tariffs on steel and aluminum, of 25% and 10% respectively, that are to be levied on all imports with no countries exempted. By choosing across the board tariffs that are even more draconian than those recommended by Secretary Ross, the President has likely created a two-tier metal market, US versus the rest of the world, and politically created friction with key US allies . Of the three options that Secretary Ross laid out, we and the market had expected the Trump would have chosen steep tariffs targeted at China, Russia and other non-US allies of 53% on steel and 23% on aluminum, but exempting US allies to only quotas.

The reason these policies are likely to create a two-tier metal market is that not all metal is created equally. US allies produce many of the value-added steels that current US capacity cannot fully replace without substantial increase in investment, and given the high level of policy and demand uncertainty going forward we don’t see the economic justification for such investment. As a result, the US will end up simply paying the tariffs on the higher quality imported metal from US allies even if the amount was at or under the quota . Had the tariffs only been targeted at non-US allies that represent 47% of US steel imports and 21% of US aluminum imports, global markets could have adjusted. In the end, targeted tariffs would have mostly created a redistribution of trade flows with only a modest and temporary rise in US metal prices until US production adjusted appropriately to offset the targeted imports.

Although the administration has hinted at niche market exemptions, it has reiterated that no country will be exempt, which will create real economic and political dislocations. In steel, while overall capacity utilization stood at 76.5% in February, most of the spare capacity is in long products (often used in construction) rather than flat products (often used in manufacturing). Thus, the introduction of tariffs would likely result in a smaller trade deficit in long products (net imports of tubes, pipes and bars currently add up to 11 million tonnes) while leaving the balance in other product categories largely unchanged unless US steel producers invest in the upgrade, conversion and/or expansion of current electric arc furnace capacity that produces higher quality steel.

Moreover, higher domestic production requires higher volumes of steel raw materials. The US is a net exporter of steel scrap, but mini-mills may also require other inputs such as hot briquetted iron (HBI) that would either have to be imported or else produced domestically, requiring further investment. On balance, we believe that investment in US steel capacity resulting from the tariff is likely to focus on projects with short amortization periods. As a result, the US may not be able to fully close the current mismatch in product types, leaving room for continued imports, which at the margin will likely create a two-tiered steel market globally.

We see similar dynamics in the aluminum markets. While the primary aluminum sector has contracted severely over the past five years with the US currently producing only 1.2% of aluminum worldwide, the US is actually the second largest producer of semi-manufactured aluminum products after China. Besides this “upstream vs. downstream” division, there is also a significant amount of heterogeneity within the downstream sector. For example, survey data show that capacity utilization rate is 99% for aluminum plate manufacturers but only 41% for tube and pipe producers . Trade data also show that US is a net importer of aluminum plates, wire and sheets but actually a net exporter of aluminum tubes and pipes. Given such dramatic differences, a blanket tariff will likely generate much more significant price pressure for some products than for others. All of these suggest that exemptions for certain niche steel and aluminum products may be needed to avoid outsized price jumps. Yet, producers and exporters often find ways around these duties because they are specific to certain products from certain countries. As a result, allowing exemptions could dampen price increases in the US and make US producers less willing to expand production.

Economically, a two-tier market is ultimately damaging to US downstream industries that consume these metals, as it creates an uneven playing field for US industries that face higher metal prices. While some downstream industries may be intensive users of steel or aluminum, if they are able to add a lot of value to these materials then we expect that they should also be able to absorb higher input costs from steel and/or aluminum without disrupting production or having to hike output prices significantly. In contrast, if an industry is both an intensive user of these metals and has very thin margins, output volumes and prices are likely to have to readjust rapidly. In order to assess these potential impacts, we use a calculation based on “direct requirements” from US industry Input-Output tables. This analysis points to three downstream industries as being potential vulnerable: motor vehicle and trailer parts (steel and aluminum), can manufacturing (aluminum), and to a lesser extent soft drink manufacturing (aluminum). While some structural, architectural and spring steel manufacturers also screen as vulnerable, some of their outputs are likely to be close enough to the raw metal to also be covered by the new tariffs, partially insulating these sectors (albeit at the cost of requiring more adjustment further downstream).

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