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Volatile Times

Unprecedented changes coming from the world’s largest economy driven by a President who can be described in the politest way as unorthodox and more realistically as grafting the world and, in particular, Americans on his quest for “Me the People”. Markets, economies, businesses and employees (i.e. Citizens) are trapped in a world being upended by acrobatics more amazing than Cirque de Soleil with dangerous, stunning and unbelievable moves with a fair share of backflips. Like all good circuses, no one knows what’s next, so we stay glued to the seat as spectators, oblivious to the real world outside and not willing to put a hand in the pocket, get down to work or invest in the future. The only certain thing is that the current instability will pass.

UNCERTAINTY makes everything harder

However, uncertainty creates opportunities that we see are beginning to surface. Here are some of my personal thoughts (not advice), which I am watching and interested in as the world changes. To quote one of the most famous Russians (topical at this point in time) – Vladimir Lenin — ‘There are decades where nothing happens, and there are weeks where decades happen.’ It feels like the latter. To steal another quote, this time from Howard Marks, “I don’t reach my conclusions with confidence or act without trepidation. There’s absolutely no place for certainty in the world of investing, and that’s particularly true at turning points and during upheavals. I’m never sure my answers are right, but if I can reason out what’s most logical, I feel I have to move in that direction.”

Let’s try and be reasonable.

Inflation seems likely to RISE not fall, which will impact interest rates and the liquidity interest rates provide or take away. Deglobalisation and rejigging the economic pipes can only increase the cost of goods and services (regardless of whether tariffs materialise or are just a deal-making headline). 

A change we have seen globally is the politicisation of central bankers, unduly influenced by politicians who didn’t understand the GFC or the inflationary impact of expansionary fiscal policies. Those Central Bankers now understand that the short-term emergency measures they implemented, which lasted 15 years, have created asset bubbles, income inequality, and inflation. However, it took COVID and a fiscal splurge to match the monetary one to force the issue.

Inflation can be disastrous for society, and it is more likely central bankers will risk a fall in GDP and a tick-up in low unemployment rates to avoid inflation. This is one reason I believe interest rates, generally at historically normal levels, have more risk to the upside than downside and are perhaps being signalled by Jerome Powell and, to a lesser extent, Michelle Bullock. Those wishing for a return to 2-3% mortgage rates are likely to be disappointed.

So if inflation gets managed well as it appears to be, hats off to the Central Bankers for recognising inflation, resulting in rates higher for longer and bond markets signalling a need for fiscal responsibility from politicians, who have been stealing from tomorrow to give to voters today, we are likely to see liquidity drained out of the system.

 In this process, one would expect to see asset allocation shifts and some decent returns.

Let’s try and be logical.

• Value may return vs Growth – Earnings today may be more important than forecasted TAM (Total Addressable Market) and revenue growth tomorrow. Ensuring that earnings exist, dividends are paid, gearing is suitable, and growth is in earnings, not the size of a potential market, almost sounds boring these days, but it shouldn’t.
• Credit spreads may/should widen from historic low levels. If liquidity is drying up, each dollar loaned needs more to attract it to being lent, and lower quality or higher risk funding needs to be rewarded.
• Cash may return to being an asset that can provide income and opportunity (see last point) – The chart below shows the growth in Buffett’s cash pile, which suggests that he is excited by the possibilities and income it currently provides.

• AUD should rise – Australia, while struggling with productivity issues and possibly from having it too easy for too long, represents a strong investment destination for global investors. Our country is blessed with deep capital pools thanks to compulsory superannuation, a strong fiscal position (except maybe Victoria), a growing population, a large natural resource pool, the rule of law and enviable places to live. Improvements could be made by having a strong government cut red tape, developing the industry, and encouraging foreign investment. These changes could see the A$ back at parity with the US$ it was 10-15 years ago.

• Private Equity has been commoditised, being followed by Private Credit, on the back of abundant liquidity – it has been the poster child for asset bubbles – it is getting tougher with asset exits difficult and abundant dollars in PE funds at the ready, reluctant to chase businesses with optimistic PowerPoint presentations. The Red Flag is Private Equity buying and then selling to Private Equity – what extra value can one extract that the other can’t? Pass the Parcel minus the fees.

• Momentum cuts both ways – Markets have increasingly become driven by Momentum. The rise of passive over active (which increases the importance of indexing), machine learning, data scraping, trend following, meme following or sophisticated quant trading has created Momentum in a time of liquidity that feeds on itself. The liquidity hose created the desired Momentum during a crisis over 15 years ago and during Covid in 2020, with the short-term market “voting machine” dominating the style and direction of what has become long-term. Is it time now that the momentum reverses and it is time to step onto the market “weighing machine” scales? As quoted above, you cannot be certain, but I feel I must move in that direction. Momentum, like love, “cuts both ways” sorry Gloria

Gloria Estefan – Cuts Both Ways (iTunes Originals Version)

• Volatility will be higher going forward – deglobalisation, higher rates, and headline reactions should see volatility settle higher than the QE (Quantitative Easing) and ZIRP (Zero Interest Rate Policy) average of 2010-2022. 

VIX measure since inception

In high-volatility environments, low-volatility returns increase in value. 

Lower drawdowns, increased income, smoother returns – this is attractive in a time of heightened volatility. Don’t exit the market (see below), but look to limit drawdowns, have protection and stay nimble (have liquidity, transparency and ability to invest).

This brings the classic debate to the fore: Time in the market vs timing the market? Which seems now to be universally agreed to have been won by the former.   

Below illustrates the cost and reward of being bad enough/good enough to “time the market” – I believe and agree that trying to time the market ends poorly over the long term….BUT….hear me out…

An old trading boss of mine at Lehman Brothers told me, “You can never beat VWAP (Volume Weighted Average Price)”, which, over the long term, I now agree with, but what was not said is that you don’t have to always be participating in the market or always buying the market. Buying on large drawdowns and selling on large market rips WHEN they happen can help, and this is where the Buy-Write strategy can effectively be put to use and where staying in the market and increasing investment on down days (staying nimble) and receiving income on up days, by selling away upside, can enhance your return and enhance your income generated.   Note in the chart below that timing CAN be important if one is planning retirement, and somewhere on the right section of the chart below occurs to you – the importance of diversification and avoiding drawdowns.

Furthermore, below are almost 100 years of returns on the S&P500. These are all logarithmic scaled charts, so they might not look wildly different, but if you look at the numbers, you can see that they really are. As discussed above, timing is not a viable long-term strategy, but having lower drawdowns accompanied by regular income/cash to buy on down days and generating income on up days by selling away upside can add to performance. My biggest takeaway from the chart and table below is missing the Worst and the Best days on the index result in a better return of being always invested.    In some ways, this can reflect the return profile of an actively managed buy-write portfolio and can further be enhanced in Australia by utilising the franking on offer for taxpayers.

And here is the table of the chart above

Let’s wrap this up

So change is certain, and it feels like the magnitude of change now and going forward will be larger than it has been for some time – embrace the change that provides opportunities.  

It is also a time to ascertain how returns are generated. In a time of volatility, that is, when asset prices fall (rarely does one panic when valuations jump aggressively), suddenly, there is a focus on risk-adjusted returns, not just the return – Why are risk-adjusted returns not ALWAYS the primary focus?

Have protection and stay nimble!

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Fundies say ASX still too expensive despite correction

Investors are snapping up technology stocks like WiseTech and others in energy and healthcare, but remain cautious on expensive bank shares such as CBA.

Over the past few years, the press has been full of articles about tariffs and trade policy and seen politicians from Trump to Albanese trumpet the desire to relocate entire industries driven by tariff walls or massive taxpayer subsidies. Our elected leaders inevitably paint some utopia, with factories as far as the eye can see in a nation that is self-sufficient in the production of most goods. However, we have seen little analysis of the economic rationality of producing sneakers or jeans in the USA (replicating existing plants in South East Asia) or building a solar panel industry from scratch in Australia. This would see high-cost domestic production try to compete in a saturated market currently dominated by low-cost photovoltaic panels, generally made by experienced Chinese manufacturers who own the intellectual property.

Every country, even the USA, has a finite amount of resources that can be allocated to the production of goods and services, and it is not rational for a nation to produce goods where it has no competitive advantage. Indeed, the Australian car manufacturing industry enjoyed $7 billion of direct government subsidies from 2001 to 2017 in addition to tariffs on imported cars that were as high at 60% in the 1980s. Arguably, taxpayer funds could have generated greater utility being directed to hospitals or agriculture research, than propping up the production of cars that increasingly fewer Australians wanted to drive.

In this week’s piece, we are going to look at some of the greatest economists of all time and apply their thoughts as to why tariffs are a bad idea and why the USA should not produce sneakers nor Australian four-door hatchbacks.

Adam Smith’s (Father of Economics) Absolute Advantage and Specialisation:

Adam Smith was an 18th-century Scottish economist and philosopher who developed the economic theory of absolute advantage and specialisation amongst economies. An economy is said to have absolute advantages when it can produce goods at the lowest cost. The economy with the lowest cost of production could then export to other countries, bringing down the price in the importing country. This benefits everyone as the exporter makes money from exporting goods, and the importer lowers the cost of products in their economy. The original example used by the father of economics was England, which specialised in producing cloth in the mills of Manchester and Portugal, which specialised in wine. This is an example that reflects political tensions in 1776 with England’s traditional wine source, France.

Specialisation refers to a business or economy focusing on one or a few products in order to become more efficient and cheaper to produce those products. An example would be China setting up thousands of steel smelters across its nation, making it much cheaper to produce steel in China than in Australia. This specialisation caused BHP to stop smelting steel in Australia and just ship the iron ore to China, as it was much cheaper and more value-accruing in the long run for the company.

David Ricardo’s comparative advantage:

David Ricardo was a British Economist who was inspired by Adam Smith’s theory and developed his own theory that focused more on comparative advantages across economies. Here, he expanded on Adam Smith’s theories to account for a situation where a country had an absolute advantage in producing two goods, such as Portugal producing wine and cloth with fewer resources than England. Comparative advantage accounts for opportunity cost, something missed by Trump and Albanese in that this is the cost of foregoing another opportunity to create a particular good. For example, America could become the cheapest producer of steel or Australia in solar panels, but that would see capital (or more accurately, taxpayer subsidies) moved into lower productive industries rather than highly accretive industries such as technology and data centres or agriculture and mining in Australia.

How does this apply to bringing manufacturing back to the United States?

The main point of the two economic theories above is that specialisation and comparative advantage only work if there is free trade between economies. As seen in the graph below, introducing tariffs into an economy will increase the price of goods and services within the economy. This is partly offset by an increase in tax revenue but also creates dead weight loss (the yellow shaded area), which is economic loss due to market inefficiencies. Whilst this looks small in the graph, once applied across a whole economy, it will see a major slowdown in growth across the economy as well as increasing inflation from market inefficiencies.

By bringing manufacturing back to the United States, President Trump is encouraging the American workforce to move towards lower-paying and producing industries. Whilst they can have an absolute advantage in many of these manufacturing industries, they are forgoing the opportunity to invest in much more advanced areas that contribute more to the economy.

As for specialisation, the nations that Trump is trying to bring manufacturing back from (Vietnam, Cambodia, China) have specialised in these manufacturing procedures for years, with the best infrastructure in place to the point that they are the lowest-cost producers in the world.

Moving this manufacturing back to America will increase the unit cost of the products for consumers, as infrastructure and capital will need to be invested, adding to inflation. Tariffs are used to make these higher-cost American-made products more competitive in the marketplace by increasing the costs of international products entering the USA.

Our Take:

The past month has seen many market commentators dust off their old economics textbooks to research what tariffs are, and politicians simplistically assume that free trade is a zero-sum game that transfers wealth from one country to another. Ultimately, the biggest victim of Trump’s erratic trade policies will be his own constituency, which will raise inflation with far less tariff revenue raised than expected and fewer factories on-shored. Nike is as unlikely to start building new sneaker plants in Oregon, even in light of 125% tariffs, as American workers are to line up to man the glue guns.

While the past month has been unpleasant in terms of share price volatility, the Atlas Portfolio is populated with companies that will see minimal impact from Trump’s tariffs, with earnings and dividends for the six months ending June 2025 similar to what we expected during the February results season. The companies we own with operations in the USA sell goods and services to US consumers that rely on minimal imported products, with the rest of the Portfolio comprises companies such as banks, toll roads and insurers that service the domestic Australian market.

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What the market got wrong and where the opportunities lie now

Aussie equities manager Hugh Dive from Atlas Funds Management joins the podcast to discuss: Which companies delivered during reporting season, and which didn’t The results the market has clearly misread Why Telstra is back to its old tricks The sector that remains overvalued, and Where he is sifting through the underperformers for opportunity.