I hope you all had a nice Father's Day weekend. I've tried to write this note a few times hoping to discuss the impact of the US trade policy decisions. However, before I have a chance to finish the article, the policies change and my article is no longer pertinent. Instead, I will discuss the broader implication of the US losing exceptionalism status, pending US tax changes, and how I'm thinking about allocating portfolios in this environment.

US Exceptionalism - The combination of low interest rates, modest inflation, and a vibrant economy (bolstered by the most powerful technology companies) made the USA the envy of the world and a magnet for both financial and intellectual capital. It also drove up the value of the US dollar against a set of global currencies known as the US dollar index. In July 2011 the index was $86.34 and by January of this year it hit a high of $108.95. Global investors investing in the US were rewarded by a strong economy and stock market, and by an appreciating currency. Success begets even more success, and this attracted even more capital into the US. Much of this capital found its way into the US stock and bond markets.

When the Trump administration took office, we saw this situation start to change. The policies on tariffs and immigration have certainly had an impact on the US dollar index which is currently at $98.18. The US stock market has underperformed global markets year to date and 10-year rates in the US are higher than most developed markets. I suspect global investors are contributing to the change we are seeing as they repatriate capital by selling US assets along with the US dollar.
It's hard to make long term conclusions about the US economy and markets on relatively short amount the past. There was a period where the only country that was exhibiting growth was the US, now there is competition. Japan seems to be emerging out of its deflationary spiral and Germany is finally willing to deficit spend on infrastructure and defense. Trump policies may be the catalyst for non-US outperformance.

Potential change in US tax policy for foreigners - Canada and the US have a tax treaty that applies to a number of investments. With stocks and bonds, the US currently withholds 15% of dividend income that is generated by US companies. When you file your Canadian tax return, you get a foreign tax credit for the taxes withheld. There is also a provision that exempts US dividend income earned in RRSPs or RRIFs from withholding tax. In addition, for those who have real property in the US such as a vacation home, there is a 15% withholding on the gross sale value.
Some of these tax arrangements may be changing to retaliate against countries that the US feels have implemented an unfair tax. Proposed IRS code 899 "Enforcement of Remedies Against Unfair Foreign Taxes" is included in Trump's new "Big Beautiful Bill" which has made its way through the House of Representatives and is now with the Senate. IRS Code 899 outlines and defines a number of categories of "unfair foreign taxes" including a number that will impact Canada. For example:

- in 2024 we enacted a Digital Service Tax, a 3% tax on revenue on the sale and use of Canadian data. This Digital Service Tax could put us in the cross hairs of code 899 and if we are found to be in violation, an additional tax of 5% a year could be imposed starting January 2026. This will increase by 5% every year.

- the sale of real property may be impacted similarly.

It's unclear how RRSPs and RRIFs would be treated, or whether our current arrangement of exempting capital gains on US shares from withholding tax would remain under new rules.

Although it is uncertain whether the Senate will make amendments to the proposed bill, it is certain that in its current form the proposed changes would negatively impact Canadian residents. This may be yet another reason why investors may opt to diversify away from the US markets.

Portfolio Positioning - In this environment it's important to diversify between stocks and bonds but also consider diversifying based on different potential economic outcomes.

Equities - global diversification is more important than it has been in the recent past. The US market is no longer the only place to invest. Japanese and European equities offer compelling valuation and potential for currency appreciation compared to US equities. Japanese and European Equities are trade at a discount to US equities that trade at over 22x earnings. Specifically, Cybersecurity, Defense Spending, Energy Transition and AI infrastructure seem to have long term tail winds.

Fixed Income - The level of deficit spending by all governments is concerning. Combined with inflation that seems to be stickier, long duration bonds are concerning. Investors may demand a higher risk premium driving up long term yields in the coming years. It's best to stay with short-dated government bonds and look at opportunities in higher yielding corporate bonds.

Commodities - Very few clients that I come across own commodities in their portfolio despite the fact that commodities are required for defense companies, electrification and AI infrastructure. According to Rio Tinto (one of the world's largest miners) the lack of investment in developing mines companies combined with the increased demand may create an environment where we may not be able to produce the minerals we will need. Generally, when there is more demand than supply, prices tend to be well supported. *

Infrastructure Assets - Many infrastructure assets have annual inflation clauses priced in and are long duration assets. The values will be less correlated with economic activity and provide a good cash flow stream. This would be better option than owning long duration bonds.

Last summer we had to put down our amazing Labradoodle, Millie. She joined our family when our son Samir was in grade 1 and was with us until he finished his undergrad last year. We adored her and she became such an integral part of our family that her absence left a hole in our home. So, we decided to do it again! A few weeks ago, we welcomed 9-week-old Lenny the Goldendoodle into our family. A friend of mine asked how it's going and I had to be honest with him - it's like when we had kids. With our son, we thought we were amazing parents because he was a good sleeper, loved food, and was a very easy baby. Then we had our daughter Maya, and she taught us very quickly that we weren't as good as thought! Lenny definitely is not Millie he is a furry ball full of energy who has already captured our hearts (and most of our energy!). It's unclear whether we are training him, or he is training us, I suspect it's the latter.

*Reference: https://www.reuters.com/sustainability/climate-energy/global-mining-investment-too-low-support-energy-transition-rio-tinto-chairman-2024-04-15/

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