Trade War! Trade War! Man the Barricades!

Now that the United States is headed into a trade war with China, Canada, Europe, Japan — everyone, really — compliance officers might want to consider the implications of the tariff tussles that lurk ahead.

Not so much for the new policies and procedures you might need to implement, although those are legitimate questions. Rather, consider the macroeconomic risk that we’ll lurch into recession or stagflation — tempting CFOs to look at your line-item as they try to cut costs. That scenario may be more plausible than you realize.

Start with where the Trump Administration wants to impose tariffs: foremost, on aluminum, steel, and lumber. Those are materials that companies purchase to manufacture goods. So as President Trump raises taxes on them, a company’s cost of goods sold is going to increase. (Either you’re going to buy imported materials, and their taxes will be higher; or you’ll buy domestic materials, and those suppliers will raise prices to a hair’s breadth of the higher imported prices.)

So I wondered: how much are the cost of goods sold rising for Corporate America? And are those costs exceeding companies’ increases in revenue?

To answer those questions I analyzed the data from nearly 1,700 publicly traded companies, all with at least $250 million in annual revenue and from any industrial sector except financial services. (The cash flows in financial services make that sector a special case, so I excluded it.) I looked at growth in revenue; cost of goods sold; and sales, general & administrative, comparing first quarter 2018 to first quarter 2017. (All data sourced from Calcbench, my cool friends in financial data analysis.) 

The bottom line: Corporate America has less breathing room here than it might like, and a trade war will only make the income statement that much more of a tight squeeze. Compliance officers may want to consider how their own company’s financial picture compares to the whole, and then game out the possible consequences for your budget, program, and career.

The Data Picture

We can tell the tale in two charts. First is total revenue and cost of goods sold for all 1,688 companies, and how much each line-item grew in first quarter 2018 compared to the year-earlier period.

As you can see, revenue grew 9.94 percent — but the cost of goods sold rose by 10.76 percent in the same period. So as a whole, Corporate America was spending more money on the raw materials it needs to generate sales. That is not good.

The other crucial line-item for operations is sales, general & administrative (SG&A) costs. Those are overhead costs, where companies report items such as salaries, commissions, rent, office supplies, postage, marketing — and, yes, the compliance program. Your salary and program budget live there.

The good news is that SG&A costs are rising less than revenue. See below.

It’s worth noting, however, that SG&A costs have been rising faster than the rate of inflation for quite some time. Just this week, the Labor Department reported inflation at 2.8 percent in May, the fastest pace we’ve seen in six years. That’s on top of inflation at 2.5 percent in April.

Take these two charts together, and we see a Corporate America keeping its operational nose above water, but not much more than that. Remember, a company’s share price is a function of expected future profits. And the equation to calculate operating profit looks (roughly) like the chart at right.

So if we experience a spike in either costs of goods sold or SG&A costs — like, I dunno, imposition of tariffs, or salary inflation because of a tight labor market, or rising oil prices — then operating profit must fall; it’s math. Then share price starts to suffer. Then investors start to grumble. If left unattended, they start to scream bloody murder.

Trade War: Duck and Cover

To be clear, there are many company-specific exceptions to the sketch I painted above. For example, a jump in your cost of goods sold could be explained by one-time items like an expansion into new product lines or a temporary spike in some volatile raw material. SG&A might spike because you’re betting on a big marketing campaign, or just acquired new operations and haven’t finished consolidating (read: firing) your workforce yet.

But that’s my point in this post. Taken altogether, the evidence shows a plausible scenario where the Trump Administration piles a trade war onto an economy already struggling with surging costs, and tips us into recession. So compliance officers may want to compare their own company’s financial position, to gauge whether you’re part of the exception or the rule.

For example, the spread between revenue and cost of goods sold was -0.82 percent for my entire sample. But break that group into quintiles, and the spread grows wider for larger companies. (Again: the more negative the spread, the more costs are rising faster than revenues.)

The smallest companies in the first quintile deserve even more sympathy: their cost of goods sold fell (yay), but revenues in first quarter 2018 fell even faster (yuck), while SG&A costs were rising (ugh).

Under the worst circumstances, companies have no pleasant options. They could try to pass along costs by raising prices to customers, and perhaps your company has the clout to do that. If all companies raise prices, however, that stokes inflation, which prompts the Fed to raise interest rates. Which results in recession. Meanwhile, trade wars also cut into your overseas sales (because Canada and Europe will slap taxes on them), so finding growth becomes that much more difficult.

Or the company could try cutting SG&A costs. That could mean layoffs, hiring freezes, passcodes for the photocopier, canceled IT upgrades, or other buzzkills of modern corporate life.

Or the company might try merging with others to weather tough times that might arise. That could be tempting for firms with large piles of cash, thanks to the tax cut Republicans enacted last year. (For many companies, lots of the rosy profit growth they reported earlier this year came from the tax cut — not from lean operations and robust sales. What happens next year, when that one-time shot in the financial arm is gone? You tell me.)

My imported used car.

The Trump Administration knows all of this, of course. That’s why the president and his chief trade adviser, Peter Navarro, turned up the shrill-o-meter to 11 last week when Canada and Europe had the nerve to call President Trump’s bluff. Trump might like to babble about tariffs and trade wars on Twitter, but here in the real world, his strategy could backfire like the imported used cars Trump now wants to call a threat to national security.

I’ve driven an imported used car for 15 years. Trust me, you want to watch where you’re standing if a backfire happens.

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