They’re Baaack

By Peter Tchir of Academy Securities

They’re Baaack…

While not as catchy or creepy as “They’re Heeere” (remember when TVs were tubes and had “snow”?), Poltergeist II tried to expand on the franchise. Unfortunately for markets, tariffs with China are back.

It is always dangerous to argue that “this time is different” but I think it is very different.

This Time is Different (not in a good way)

Leading up to Liberation Day, there were tariffs implemented against certain products, certain countries, etc. Then we had the Liberation Day tariffs and markets ensued a deep sell-off until the tariffs imposed via executive order were dramatically reduced.

Since Liberation Day we’ve had some trade deals (in principle) and have been in a “steady” state of tariffs somewhere between 10% and 20% on most things. We have argued (and continue to argue) that the tariff impacts are only starting to be felt in the economy and will weave their way into markets in the coming quarters as their costs are finally felt.

Tariffs have “only” been about $200 billion more than usual so far, a big number for you and me, but still a small number relative to the U.S. economy.

But that all potentially changed this week.

The “steady” state is no longer so “steady.”

We specifically say “this week” as opposed to Friday, as the potential issue emerged earlier in the week – reports that China would restrict shipments of not just processed rare earths/critical minerals, but also some products that incorporate them.

The President responded on Friday by imposing 100% tariffs (starting November 1st) and restricting sales of critical software (I have to admit there is some confusion around that). Chips are likely to face restrictions as well.
Notice the timeline and how different it is than prior escalations in the trade war.

This was NOT a relatively unilateral act by the admin. China provoked this.

We will explore why China may have done this (it is a natural extension, to a large degree, of our previous work, and quite possibly a dangerous extension), but markets “bucketing” this tariff with others may be missing the critical point – how we came to adding this 100% tariff is very different than how we got to other tariff escalations.

If You are Planning on Eating a TACO, You May Go Hungry

It is easy to understand why the “buy the dippers” all chattered about TACO (Trump Always Chickens Out). We think that is the wrong analysis.

• TACO was never quite right, because the admin “pivoted” out of policies that weren’t working as well as they expected or were more unpopular than they envisioned. Not quite the same as “chickening” out, but a crucial difference, if we are right about this time being different.

• The President largely initiated the escalations and it was very easy to argue that they were “negotiating” ploys for “maximum leverage.” I still think we could have achieved the state we have been in without the “Art of the Deal” and would be better off, but today is not the time or place to rehash that argument on the American Brand. That timeline played out on virtually every element of tariffs, until now. This does not, at least to me, seem like an escalation by the admin, but far more like a response to a legitimate threat from China.

More on our “response function” in a bit, but “spoiler” alert – it will be heavy on ProSec™.

What is China Up To?

Since China initiated this round of escalation, let’s think about what China may or may not be thinking. Yes, we get to play the “red team” as an exercise here.

• It is possible that China didn’t think this through. That they were taking steps that they viewed as mere formalities that we misinterpreted. Or it is conceivable that China might be trying to play the “maximum leverage” game and this was just their first foray into “instigation” in the recent tariff wars. Those are all possibilities. It is also possible that the NY Jets call me up to kick for them this weekend (I went with the Jets because it would be impossible to believe any team other than the Jets would do it). But it isn’t very likely.

The reality is that this is far more likely to be a calculated step by China. That there is intent in this escalation.

• China controls the processing/refining of rare earths and critical minerals. The West ceded the entire industry to China as it was energy intensive and very “dirty” at least in the “green” world point of view. So, while rare earths and critical minerals are abundant (there are markets that you can buy them on), they are “just” commodities. The processing and refining is more difficult and this is a huge advantage for China (it has driven the “extensions” that the admin has put in place with China on tariffs).

• China likely sees the intensity with which the U.S. is starting to address the problem. We have been all over ProSec™ as an investment strategy as this admin takes Production for Security very seriously. We have seen several investments made into the space to help jumpstart domestic capacity. We fully expect that to continue and grow over time if the admin is able to create some form of Sovereign Wealth Fund as opposed to the more ad hoc deals that have been done so far. The admin is also finally doing things on the deregulation side (again, we would have started with production for security and deregulation rather than a global tariff war, but that is water under the bridge now). Does China see a future where the U.S. isn’t dependent on their processed rare earths and critical minerals? If the answer is “yes” then they “know” their biggest bargaining chip will get smaller over time. That is a reason to escalate now for true (not hyperbole) maximum leverage.

• The risk with semiconductors (and software). To the extent there has been a “balancing” act in the trade negotiations with China, it has been U.S. dominance in this area. The consensus seems to be that China wants our chips so badly that they will do what it takes to maximize their access. But we have “felt” that this was not the correct take, and think China’s recent moves support our view that China is comfortable (or even wants) to cut themselves off from U.S. chips. They want to continue to develop their chip industry. They believe they can be successful (just look at the success of Huawei and BYD to understand why China might be confident in their own ability). We’ve seen some announcements from Chinese companies about some progress that has been made (and assume there is progress here and there that is not public).

  • By refusing to buy our chips (or not being allowed to buy our chips, if you prefer) they deny revenue to our companies which would be nice to have (not necessary, but nice).

  • To the extent that necessity is the mother of invention (and I believe there is a lot of truth to that), they set up the “necessity” for their companies to be successful. So, it might work (just like it should work for us on ProSec™ which is the flipside of this whole battle).

  • China is spending a lot on AI and has more engineers than we do (not necessarily as good, or as creative, but there is a strength in numbers), so we shouldn’t assume that China has concluded that the U.S. will continue to dominate the space.

So, China’s bargaining chip is declining in value and they think they can actually benefit from restricted access to chips.
That would support an argument that China has analyzed the situation and is prepared for a full-on trade war.

This also fits well (from China’s perspective) with the steps they have been taking to transition from Made In China to Made By China (where they don’t want to make goods for us to sell, they want to make their own brands to sell).

There were signs of this already. China has handled Trump 2.0 very differently on trade. During 1.0, every time we said tariff, they said, negotiate. Now they just accepted some, or quietly matched the President’s tariffs. China had 4 years to prepare for this and 4 years to better understand how the President negotiates.

My working assumption is this is a very calculated escalation by China and they are prepared to dig in.

Seriously, we are being asked to believe that we wouldn’t retaliate aggressively? I find it hard to believe that anyone who has watched the admin really thinks we won’t respond aggressively to something that has to be perceived as an assault on our economy.

From a Post-War World to a Pre-War World

General (ret.) Spider Marks discussed this concept recently. He also went through the thought process in more detail during some meetings in Milwaukee this week.

Basically, the argument is that the post-war world we lived in since the end of World War II (with a big bump from the fall of the Soviet Union) is changing. That the mentality of a post-war world (basking in the glow of peace) may have to shift to the mentality of a pre-war world.

In the pre-war world, all of our decisions (and investments) have to be looked at through the lens of how it helps us prepare for war (or create the deterrence necessary to avoid war).

• ProSec™ will not just be a shortform word that we at Academy use, but a national movement.
• The natural response from almost any administration, but almost certainly from this administration, will be to double or triple down on their efforts to make things we need for security. We continue to argue that every country should think, to some degree, about behaving like this.

The element that could be most interesting is that in a pre-war world, people are more willing to make sacrifices for the greater good.

Some could argue that we have lived a “pampered” life where the battles, except for the horrific events of 9/11, happened elsewhere. That Putin’s invasion of Ukraine was an aberration, rather than a shifting norm.

That mindset could be changing.

Germany, for example, ahead of the first winter after the Ukraine war, put serious restrictions on anything from heating to lawn mowing to preserve precious energy supplies. The Germans abided by those rules and made it through that winter better than they would have had they gone about “business as usual.”

We’ve argued before (and we will argue again) that we had the luxury to create a lot of regulations and we need to revisit those regulations to see if they still make sense.

How many people would agree to fight a battle with one hand tied behind their back (even an economic battle)? Yet that is to some extent what we have been doing.

Bottom Line

This week may turn out to be more pivotal to markets and the economy than people currently think. This may be the week that really turns the tide in how we think about our economy and our need to manufacture, process, and refine things.

If I’m wrong, then back to business as usual.

If I’m right:

• Accelerate efforts to become self-sufficient on energy, electricity, components, chips, pharma/biotech, etc. Maybe not quite a “war-time” economy, but something more akin to that.

• The President really started to frame this as China against “a more collective us.” He framed this as the U.S. response to China’s actions, but (basically) called on others to take action against China.

• China is going to try to rapidly grow their businesses and shape their global relationships in direct opposition to the U.S.

• China stocks should not be owned offshore at this point, as many of the actions around Chinese ADRs and their VIE structure could get called into question.

Maybe I’m overreacting, but I think China’s response is calculated and it is “game on” for us versus them in global trade and production.

I want to own anything and everything that benefits from ProSec™ while being cautious on some of the companies most exposed to China.

Maybe it will be TACO Tuesday, but I think it is far more likely to be Lithium Thursday (I’m pretty sure eating Lithium is not good for your health – but making and refining it is).

For the first time, I think we might be ready for a period where Main Street is more important than Wall Street (or whatever street it is where we extract and make things).

We didn’t touch on the Fed today or growing concerns about the private credit market, as we did not want to dilute today’s message, but we will address those topics early in the week too.