Lyn Alden's next newsletter is out.

https://www.lynalden.com/september-2024-newsletter/

I have re-posted an article from Morningstar below.

I have been mulling the impact of a Trump presidency on asset classes and whether I should be making some significant changes, so this was a timely read.

It’s good to get some big picture reassurance that living with uncertainty and being near fully invested is still probably the right thing to do. I have been guilty of trying to be too clever in the past, so will try not to repeat my error!

Is the world order set to change?

It would be logical to expect retaliation from trading partners, such as the EU and China, if the US imposes big import tariffs.

Mathew Hodge, CFA

21 June 2024

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Mentioned: Deterra Royalties Ltd Ordinary Shares (DRR), ASX Ltd (ASX), AUB Group Ltd (AUB), Carsales.com Ltd (CAR), Clinuvel Pharmaceuticals Ltd (CUV), Virgin Money UK PLC Shs Chess Depository Interests Repr 1 Shs (VUK), Helia Group Ltd (HLI), Integral Diagnostics Ltd (IDX), QBE Insurance Group Ltd (QBE), Super Retail Group Ltd (SUL), Seven West Media Ltd (SWM), Tabcorp Holdings Ltd (TAH)

I don’t like writing about politics, but where changes material to investors may be coming down the track, I feel an obligation to flag them. I have no strong opinion what will happen one way or another and think forecasting big macroeconomic and political events is difficult at best.

The US presidential election on the horizon looks more consequential than most. It feels like there are more chips up for grabs, and more uncertain scenarios on the table than normal. If Trump’s rhetoric is to be believed, a massive rewriting of global trade is on the cards. The exact motivation is difficult to divine, but at its core there is a large group of dissatisfied voters who feel left behind by a world of globalisation, centralisation, financialisation, downsizing, wealth inequality and technology. Trump looks set to mine that rich seam of dissatisfaction in America in the November election. The markets appear sanguine about the prospects of significant changes to global trade and economics and do not appear to be pricing in material changes.

Trump’s policy is big and fluid. A recent idea appears to be to dramatically cut taxes and offset that lost government revenue with tariffs on imports. Given the scale of taxation in the US, USD 2.2 trillion from personal income taxes in 2023, and USD 420 billion for corporate income tax, tariffs would need to be massive to offset any substantial income or corporate tax cuts. US imports in 2023 totalled USD 3.8 trillion. This would have substantial implications for inflation with 1) more money is left in consumer pockets to be spent, particularly high-income earners, 2) higher prices for imported goods, 3) higher prices for domestic goods given higher priced imported inputs and, 4) a substantial reduction in purchasing power for low-income households. The bottom 40% of households pay no income tax and would be subject to higher-priced goods without greater take home pay.

A few things need to happen for something along these lines to pass; 1) Trump’s election, 2) a firming up of the policy—which may involve significant horse trading, and 3) sufficient support to pass his agenda. But if something along these lines were to happen, the future could look very different.

A taste of what may come for companies

Tariffs will likely benefit manufacturers and producers in the US who face substantial competition from imports. Automakers from the US immediately spring to mind. Other industries that have fallen by the wayside in the US would also likely get a boost, such as solar panel and computer chip manufacturing. Cutting taxes would disproportionately favour the wealthy, given they pay the most income tax, so home grown luxuries produced in the US could get a massive boost from both increased demand and reduced competition. Tesla could benefit if cheap competing cars from China suddenly become expensive. Premium US based alcohol brands could also do nicely.

Companies that have offshored a lot of the capital-intensive production functions of their business, such as Apple (NAS:AAPL), would face the prospect of reshoring or friendshoring. That would be a headwind for costs, but with more money in the hands of consumers, it could provide an opportunity to raise prices or make a more concerted effort to premiumise its product range. Pricing power is important if heading into a world of higher costs and inflation.

The economy and market are too big to consider all the potential impacts, but the above gives a taste of what we might expect for some US companies if substantial tariffs eventuate.

What about trade?

Internationally, it would be logical to expect retaliation from trading partners, such as the EU and China, if the US imposes big import tariffs. Expect slower trade and a new big inflationary driver. If goods no longer come from the cheapest locations globally, and trade distorted, the price of imported goods will go up. This will be especially true in the US from the tariffs themselves, but it’s also expected elsewhere as a knock-on effect of less trade efficiency.

If goods and capital move less easily around the world, we will see greater divergence in how economies perform. This would be a break from the long-term trend of convergence for economic growth. It would be reasonable to expect slower growth in aggregate, given increased trade friction, and more variable growth between different economies.

First order thinking suggests shipping companies will fare poorly in this world if traded volumes decline globally. But it may not be so. As the pandemic taught us, global supply chains are fragile, interconnected and surprisingly complex.

If trade is less efficient, and more goods come from more distant friends, rather than the cheapest country, goods may travel further for longer on ships. Betting on the outcome for shippers is not one I’d want to make and is not one as investors we need to make, as they’re typically very capital intensive and competitive businesses at any rate.

What if import prices stoke US inflation?

If inflation in the US is rampant, rates there would likely need to go up and potentially significantly. This would also likely impact interest rates and the cost of capital globally. US stock markets account for nearly 50% of the world’s market cap and are about four times larger than in the EU and China. The US bond market is similarly sized to its equity market at just over USD 50 trillion. So, what happens to US capital markets reverberates around the world.

More expensive capital is likely if inflation is higher, particularly if more cheap capital stays at home in a more isolationist world. Foreign buyers own about 30% of all outstanding US treasuries. Japan and China, for example, have supplied plenty of cheap capital to the world and are the largest holders of US treasuries. All else equal, this would increase the cost of capital and weigh on asset prices.

If rates are meaningfully higher, this would mark a sea change, as Howard Marks of Oaktree capital has called it, in the cost of money. Interest rates have generally been low since the global financial crisis. Those highly levered businesses that have benefited from lots of cheap debt would face much greater challenges. And the reverse is true. Those with net cash, or who have substantial free float, are better placed to withstand higher interest rates and take advantage of investment opportunities if markets dislocate.

Highly levered private equity, or PE firms, would face a stiff headwind with interest rates like gravity for the economy and asset prices. For the past 15 years or so, geared up PE firms have generally benefited from falling or low interest rates. More leverage when the after-tax cost of debt is 5% or less usually just boosts returns. If asset returns fall with a weaker economy, and debt costs rise, equity returns can start looking unattractive fast. We’ve not seen a big shake out in private equity in recent memory, and transparency is much less. Expect some surprise changes in asset values if rates rise materially. And who knows what would happen in the world of the ethereal tokens known as crypto.

Alternatively, if the US were to attempt to keep rates low despite inflation, we’d likely see a devaluation of the US dollar and an increase in the competitiveness of US exports—barring aggressive tariff retaliation. A policy to devalue the currency could result in some foreign sales of US bonds and perhaps some equities too. Bond sales would again impact the cost of debt and capital globally. So, it’s doubtful if rates can stay low for long amidst high inflation.

What to do?

To draw a boundary around the above, I hate laundry lists of risks. They often sound clever and likely to happen. But frequently, seemingly prescient hypotheses end up on the massive scrap heap of bad economic predications. I expect much of the above will too.

What to do when faced with uncertainty? Well, the reality is we never had certainty, so it’s a false ideal to start. We must get comfortable with what we don’t know and be humble about what might happen, rather than fixate on certain economic scenarios.

• Be agnostic to macroeconomic factors in your portfolio where possible. Inflation—have some stocks that will do well, some not so well, some unperturbed. Same for interest rates.
• Hold a large and diversified portfolio of good quality stocks with moderate leverage to take advantage of specific opportunities should they present.
• Don’t try to time the market, stay invested. This is key to building and preserving wealth long-term. Many managed funds correctly ascertained early on that the COVID pandemic would crush markets, and liquidated equities to cash. But few reinvested at the bottom, a painful lesson.
• Position yourself to act counter cyclically. Use of margin debt is an anathema to clear thinking. So too a portfolio full of highly levered or speculative stocks.
• Avoid the blow ups.
• Be ready for opportunities should they present. Draw up your watch list in advance. Refer to some of my recent overviews for some ideas on how to do this and what to look for. Important too to draw up the list of what to sell and under what conditions. Unless you have cash sitting around, which is generally a drag on long-term performance, new investments will require sale of existing holdings.
• Think in scenarios and get comfortable with uncertainty.
• Safe investment options exist but these bring very low or no return. Judicious risk taking is required to preserve and build wealth

Think everyone has been highlighting that small caps have underperformed - not sure what the catalyst is for them to outperform though. Interesting history to see how they did in the tech boom of the late 90s.

Australia is top of the table again. If only it were the medals table at the Olympics.

May not be a huge factor in ASX small cap investing, but all info is good info.