It didn't take long for us to realize that President Trump and his advisors were serious about change. The level of tariffs announced this week surprised even the most pessimistic. We have been speaking with many clients over the past week and the common thread has been disbelief. Although we haven’t lived through this situation before, in my career there have been a number of instances where we have had to navigate things that we never have had to before – 9/11, the 2008 Financial Crisis, and COVID. What makes this situation different is that the world was told this was going to happen, we just didn't believe that one administration would do as much as they have at the speed that they have. I apologize in advance for the length of this commentary, but there's a lot to cover.  Let's dig into (1) Tariffs (2) The US Federal Reserve (3) Markets, and our game plan. 

The basic purpose of a tariff is to either protect a domestic industry, generate government revenue, or economically influence another country. President Trump has acknowledged and admired President McKinley (the 25th President of the US) and like McKinley, Trump believes that tariffs will boost the economy and protect American jobs. As such, the US administration has placed a blanket 10% tariff on all goods entering the US and much harsher tariffs on other countries (also referred to as the bad offenders).

Rather than looking at tariffs on a case-by-case situation, this administration wanted to make changes quickly so they chose a simple formula: trade deficit with a country divided by overall trade with that country, divided by two. For example, let’s look at China. The US buys more goods from China than it sells; there is a goods deficit of $295B. The total goods it buys from China is $440B.

Therefore: 295/440 = 67% ….67%/2= 34% tariff on Chinese goods.

I'm hopeful that these tariffs will prove to be more of a negotiating tactic going forward, however, I'm convinced that tariffs in general are here to stay. Tariffs will clearly raise prices in the US, but the administration believes that the tax cuts they propose will offset higher costs. Tariffs will bring back some manufacturing to the US, but the question is whether those factories hire as many people as President Trump hopes, or will they use more automation and robotics. 

The FED has a dual mandate – to maintain stable prices (inflation) and to secure full employment. In the past crises I referenced above (9/11, 2008 financial crisis, and COVID,) the FED played a critical role in recovery by quickly and aggressively lowering interest rates. In those events, the demand for goods was dropping and the risk of layoffs was severe. It was an easy decision for the FED to reduce rates and their aggressive approach stabilized markets. This time it's different; the FED is stuck. The risk of a recession in the US is increasing which can lead to higher unemployment, however the tariff war will increase prices in the US. Even though the FED was expected to drop rates, most recently Chairman Powell stated that "the US central bank won't rush to react to Trump administration tariffs or financial market turmoil and will wait to gain more clarity on those policies before lowering interest rates." Unlike past events where they have acted aggressively, this turmoil is self-imposed. If they act too quickly and the administration reverses course on tariffs, they will have overreacted. 

The speed and steepness of the decline in the markets since the announcement on April 2nd is remarkable. The S&P 500 declined by 10% in just two days.

Stock prices are influenced by two financial factors, company earnings and what investors are willing to pay for future earnings as a multiple. Historically, the S&P 500 trades at 17x future earnings. On April 1, before the announcement, the market was trading at 21x earnings. After the 10% decline, the market is now at 19x. Simple math tells us that another 10% decline is not out of the question to bring it to historical average. That also assumes that company earnings are not going to decline which is hard to predict with the tariff proposal.

In addition to financial factors, the other factor to consider is emotion. Investors overpay for earnings when they are optimistic and underpay when they are pessimistic. In January, most investors were overly optimistic and with the events this past week, the pendulum may swing too far the other way.

Until we have clarity on tariffs, the trajectory of markets is still lower, albeit there may be some short-term bounces. Using history as a guide, 20% declines in stock markets have been very good entry points for long term investors. 

Going into this year, we were defensively positioned. Portfolios have more bonds and cash than historical allocations, our equity selection also avoided any industries that could be permanently impaired by tariffs (forestry, manufacturing, auto parts) and we are geographically diversified. With the market decline and further drops expected, we will:

1. Upgrade holdings - On Friday, there was indiscriminate selling of all companies, regardless of their exposure to tariffs. This is not the time to add more risk, but to make sure we own the best companies for this environment. Market declines offer a chance to upgrade the holdings. We will be selling some securities and switching to others that have a better recovery and prospects. Although we may be selling a company that is down, we are simultaneously putting the proceeds into another company that is also down.

2. Transition from bonds to dividend companies - We bought bonds at a time when yields where high. Recession fears have brought interest rates down and bond prices have gone up. Bonds have done their job. We will slowly start selling bonds and buying dividend companies where the yield is substantially higher than the rate on bonds.

3. Add to secular growth stocks – We will patiently add to long term secular growth themes, namely European defense companies, cybersecurity, energy transition that includes improving the electrical grid, and software companies that benefit from the deployment of artificial intelligence.

4. Look beyond North America - We want an emphasis on investing outside of North America. Actions by the US have seemed to awaken other countries into taking action of their own. For the past 15 years, the US has attracted both financial and intellectual capital from around the world however, that trend might be reversing. 

On a personal note, my soon to be 85 year old Mom had knee replacement surgery on April 1.  On the drive to the hospital, I was trying to lighten the mood and told her it was a good thing she was having the surgery before the tariffs kick in – otherwise her knee would cost more! When we were approaching the hospital, I commented on how calm she was and asked how she felt. She said she wasn’t worried however, upon arrival, her blood pressure was 180/90! I looked at her and said, “I thought you weren't worried about the surgery?”. She said, "I'm not. It's your tariff talk that's stressing me out." Based on the outcome of both, she was right to worry about the tariffs.

Senior Portfolio Manager, Senior Investment Advisor

T: 604-482-8336

ashit.dattani@td.com