Portfolio Management Newsletter #45

Clients and Friends of Mader Shannon,

Over the past eight years, our portfolio management team distributed newsletters quarterly. We recapped three months of market action and provided perspective on the coming months. That ambitious scope drove page counts to levels that may have exceeded some folks' willingness to read, and that's a shame.

So, we've decided to begin providing thematically focused notes more frequently. This adjustment will lead to more timely coverage of market-moving themes and help make our thoughts more accessible.

In this note, we'll address the unavoidable topic of the day – tariffs. Hopefully, the daily noise on the subject hasn't already driven you mad, though if it has, you're in good company. Kidding aside, we understand that policy uncertainty and market upsets can be anxiety-inducing.

Luckily, our active approach affords us flexibility, so we're not stuck simply owning 'the market.' Commodities, fixed income, and cash have offered opportunities to buffer market volatility. As of writing, all our risk-managed strategies are still positive year-to-date.

As always, please let us know if you have any questions or want to schedule a review to discuss our strategy and the implications for your financial plan.

-Kyle

Mr. Trump's Wild Ride

The parsing of President Trump's words is (again) a booming industry as analysts/strategists/traders hyperactively integrate every policy and whim into market prices. And boy, he has a lot to say. 

If you went 'all in' on the S&P 500 the day after the election, you'd be down -5% through mid-morning on 3/13/25. The average stock has produced an even more frustrating result, spending much of that time in negative territory. Interestingly, the sharp selloff in the S&P 500 has only closed the gap between the two measures of stock market performance. Gold, on the other hand, has notched several new all-time highs. 

A market-friendly Treasury Secretary nomination (Bessent) and encouraging readings on inflation initially supported stocks. Then, on the final day of January, markets were jolted awake by the news of 25% tariffs on Canada and Mexico. Amid that sharp intraday selloff, news broke that constructive talks were held between the three countries' leaders, and the tariffs would be postponed until March – whew! 

Markets are discounting mechanisms. They're always considering the probabilistic odds of a given outcome. And when it comes to trade policy, the market has seen plenty of big threats, including quick retreats/declarations of victory. It's quite literally how the first Trump administration brokered the USMCA (new NAFTA). So, everything is going just as planned, right? Nope. 

The end of February approached, and the President matter-of-factly indicated that the tariffs would go on, as planned, on March 1. 

A great scene from My Cousin Vinny comes to mind  – Vinny (Joe Pesci) is excoriated by the judge for his informal attire and is instructed to dress appropriately for court the next day. Vinny didn't listen and again showed up in his leather jacket. The judge got angry. Vinny, completely surprised, utters the classic line – "You were serious about that." 

Markets have officially discovered that Mr. Trump is serious about implementing the bluster-filled trade policies he campaigned on. 

I'm usually opposed to overlay charts, as they oversimplify relationships and are easily manipulated. That said, the S&P 500 in 2025 resembles the 2018/19 Trade War 1.0 too closely to ignore.

Warning: it's a scary chart. Please remember a) It’s a coincident chart, and the two lines are not actually related. b) Our active risk management strategies are uniquely suited for turbulent times.

Also, the final leg lower in December of 2018 was arguably the result of an ill-timed rate hike and out-of-touch policy commentary from the Federal Reserve. Comparing periods of market history is complicated. 

So, new tariffs are officially in effect on China, Canada, and Mexico. All three have responded with varying degrees of retaliation. And markets have thrown a fit. I think it's safe to call this Trump Trade War 2.0. 

Let's review the policy and the economic impact. We'll try to find some good news along the way. 

In Trump Trade War 1.0, the principal adversary was China, and tariffs were staged on a relatively narrow set of goods. In Trade War 2.0, the principal adversary appears to be the entire world, and the scope seems to be nearly everything we import. 

During Trade War 1.0, the effective tariff rate on all imported goods went from roughly 0% to not quite 3%. So far in 2.0, tariffs have increased effective annual tariff rates to an eye-watering 12%. And that's before what is likely to be a substantial tranche of 'reciprocal tariffs' slated for implementation on April 2.

The chart below tracks the average tariff rate over the past 134 years. It approximates the total annual impact of different proposed rates on targeted countries. Remember – these rates assume a given policy remains for an entire year without carveouts/exemptions.

A jolt of such magnitude (again, if sustained for an entire year or more) will be economically disruptive. Proponents would argue that's the whole point – disruption is the cost to close the trade deficit and bring more manufacturing/production into the USA. Administration officials, including Trump, have framed this as a transition phase in which 'short-term pain will produce long-term gain.'

Trade taxes are paid by a blend of the exporting entity, intermediaries (producers, logistics, retailers, etc.), and the end consumer. The textbook risk of a moderate trade war is stagflation, where consumer price inflation accelerates, corporate profit margins contract and economic growth stagnates. That puts central banks in a tough spot – do they cut rates to soften the economic slowdown or raise rates to stabilize prices? A great question that we'll address in another newsletter.

Trade War 2.0 is not off to a moderate start, but let's pretend that the opening maneuvers from the Trump Admin are akin to an 'escalate to de-escalate' strategy whereby trading partners quickly come to the negotiating table, and the extreme tariffs are short-lived. Let's review the starting position for business profitability and inflation.

Some good news for investors! Corporations in the United States are the most profitable they've ever been. The pandemic and the flourishing of services and technology firms have pushed profit margins to 13%. In aggregate, companies are in good shape and could theoretically absorb some portion of trade taxes.

Nobody knows if they will, as they'll also be weighing the risk of a demand shock if the trade war harms consumers' willingness and ability to spend. Note how rapidly margins contract in periods of recession (grey shading).

More good news! Over the past two years, consumer inflation has returned to a pre-pandemic annual pace (red line). Unfortunately, the public nature of trade negotiations and the meteoric rise in the price of high-frequency purchases like eggs and insurance have driven consumers' inflation expectations higher (blue line).

The uptick is concerning, but consumers' ability to forecast inflation is far from prescient (see the 2010s). Sentiment data is also subject to politics – the 'other party' will always cause inflation. Also, depending on where you get your news, you're likely hearing politically reinforcing opinions such as "tariffs don't cause inflation" and "tariffs are inflation." So, which is it? Here are a few ways that tariffs might not be inflationary.

• ECON 101 – inflation is 'a broad-based rise in prices.' A tariff is what economists call a step change, which only impacts the price of a good once. For example – if a $100 widget suddenly is tariffed at 10%, it'd cost $110, up 10%. Easy enough. Well, one year later, two years later, and three years later, that widget would theoretically still cost $110 because the 10% tariff only impacted the original price. I can feel eyes glazing over, so let's say it this way: a tariff will cause a price to rise, but that price increase doesn't technically fit the definition of inflation.

• Wishful thinking – the exporter or foreign manufacturer will pay the entire tariff, or currencies will adjust to offset the tariff fully. Economists are generally skeptical of this idea. Interestingly, Wal-Mart is actively lobbying Chinese suppliers to absorb tariffs; we'll see how it goes.

• Crazy like a fox – unthinkably hefty tariffs on all trading partners will spur a global rethink on trade restrictions. Once international tariffs and trade barriers are eliminated, everybody will enjoy an era of greater competition and low/falling inflation. Thus, the long-term payoff more than compensates for the pain on the front end. Under this scenario, I suppose some manufacturing returns to the United States, but that's a topic for another newsletter.

Also, tariffs aren't inflationary because they are revenue for the government. They raise prices and siphon money from the private sector, like a sales tax. In a genuine inflation shock, some businesses might get by with margin expansion, but generally, everybody has a tough time, and confidence in the currency suffers. The immediate risk from rapidly raising tariffs isn't inflation; it is a demand shock.

Our final exhibit outlines tariff levying authorities and how they were applied in Trade War 1.0. Before the passage of the Reciprocal Tariff Act in 1934, trade policy was the domain of Congress. Since then, much of that authority has been relinquished to the executive branch. In those nearly 100 years, trade restrictions only ever eased. So, a ramp-up in tensions like we've seen from the opening months of the Trump Administration has never been tested against the litany of trade legislation. And while it seems exceedingly unlikely that Congress would assert any authority in the matter, if a cycle of retaliation gets out of control, that could change. In that eventuality, the courts would also probably be involved.

Unfortunately, by the time this note finds you, the particulars of the ongoing trade war will have certainly changed. It's an absurdly fluid topic, but we're keeping the details straight. I sincerely hope this review helped put some of the messier details into perspective. Please let us know if you'd like to continue the tariff conversation or have questions about other topics or themes.