Where to now for investors?
A big backdown on tariffs earlier this month saw markets roaring back to be higher than before the tariff announcement. Probably just as importantly, the new fiscal package is far more stimulatory than advertised. It is working its way through the political system.
DOGE cuts are far more about appearances than substance. Arguably, they are merely a fig leaf for fiscal conservatives to spare their blushes as the debt continues to grow.
In the US, issues around governance, the limits of presidential power, and corruption are long-term concerns. But we expect stock markets to ignore those issues.
A broad range of possible outcomes
In the short term, there are (largely) two schools of thought.
One says that the mayhem around the implementation of cuts has already caused significant issues for supply chains, inflation, and employment. Add to that the shutdown of capex plans due to uncertainty, and economic conditions will worsen. Eventually, corporate profitability will take a reasonable-sized hit, and then stock markets will re-price. Looming over all of it, high (and rising) interest rates will keep the consumer and corporates in a shell, and the Fed will be hamstrung by higher inflation.
The other school says that the US economy was already strong, and while Trump’s mayhem will damage it, the blow will not be fatal. More importantly, the worst has passed, and corporate spirits will recover as Trump rolls back or reduces tariffs. The fiscal plans are effectively for more tax cuts, more spending and bigger deficits. Corporate profitability may suffer in the very short term. In the mid-term, it is underwritten by government largesse, tax cuts and a significant drop in regulations. In terms of markets, they will look past any short-term weakness with an eye to the now market-friendly Trump. 1st quarter numbers were inflated due to a bring forward of spending to beat the tariffs. 2nd quarter will be weak, but the market will look beyond that. 3rd quarter will include companies rushing to order more in case higher tariffs return, which may excite markets once more. Smaller companies will be less able to afford the cashflow issues around tariffs (you must pay the tariff before you sell the goods). They will also be less able to navigate or reorient changing supply chains. So, while overall profits in a sector might be similar or weak, large companies may well be picking up market share.
So, in that environment, how do we think about stock selection?
First, the focus needs to be on improving the quality of the stocks in the portfolio. A broad grouping that investors use is to split companies into three categories:
- Quality stocks that earn a high return on capital invested, have low debt and higher margins.
- Value stocks which are cheap, but typically have lower margins and earn lower returns.
- Growth stocks which are the companies that are not cheap, but are not high quality. The conclusion being these stocks must be priced for growth.
These stocks perform well at different times in the cycle. Overall, you want to:
- buy quality stocks when they are (relatively) cheap and then hold them throughout the cycle.
- buy growth stocks when markets are rising; sell them when falling.
- buy value stocks when inflation is rising and companies have pricing power; sell them when they don’t.
Given the environment, quality stocks seem like the way to go. But there is also microeconomics to consider. Stocks with production or costs in the wrong countries will suffer regardless of their classification.
So, in that environment, how do we think about asset allocation?
Asset allocation is harder. We have less exposure to the US than usual.
Long-term Australian government bonds trade more based on international rates than Australian rates, so we are limiting our exposures. As inflationary policy regimes emerge in Japan and the US, yields in both countries face risks to the upside.
Shorter-term Australian bonds look attractive despite smaller potential returns. Given the international risks and dovish RBA, we are sticking closer to the short end of Australian bonds.
We have a reasonable amount of spare cash which we will look to use to buy stocks when markets take a tumble. We are expecting company earnings to get hit, economic growth to slow markedly. Then we expect the calvary to arrive with stimulus, interest rate cuts and tax cuts. Too late to save the economy from a sharp slowdown / mild recession, but early enough to avoid a deep recession.
Asset allocation
We are underweight shares overall, significantly underweight Australian shares. We are overweight bonds, and with lots of foreign cash:
Performance Detail
Core International Performance
April was notable for its volatility with wild swings as the Bulls and Bears fought for the Market. Pleasingly, our portfolio proved more resilient over the month, eeking out a small gain, owing to our recent European stock concentration and Japanese exposures.
Core Australia Performance
Australian equities proved less volatile than their international counterparts and the ASX had a nice recovery at month end, with defensive stocks the best performers.
