What’s Next?

 “ELECTIONS HAVE CONSEQUENCES”, and this one is certainly more consequential than most. The new administration has promised nothing short of a revolution. Whether or not they can deliver is yet to be seen, but at least we can look at their proposals, and try to determine their likely effect on the economy, financial markets and our portfolios so if there is a revolution, we’ll know what to do.

THE BIG FOUR election promises were enacting tariffs, limiting immigration, cutting taxes, and deregulation alongside a dose of government efficiency. Any one of these would take heavy lifting to accomplish. If they can be enacted at anywhere near their proposed levels it would be an astounding accomplishment with profound implications. How profound, and whether it leads to a better or worse outcome, will depend upon the scope and timing of their implementation. Let’s go over them one by one.

TARIFFS
We know that tariffs are inflationary. It is just a fact, at least in the short run. Maybe the avocado growers in the US can grow them as cheaply as Mexico but until then, the price of a Chipotle bowl goes up because Chipotle (the importer) pays the tax. No big deal in isolation but add in the price of everything else we import, and you have significantly higher prices for a broad range of goods. The best estimates are that 10% across the board tariffs would result in an extra 2-3% inflation. That would be a big deal.

The implications of tariffs are easily understood on importers, but there is almost sure to be a tit for tat that effects exporters as well. Most of our technology hardware is imported, but we export a lot of software so Microsoft, Adobe and Google could be in the crosshairs of overseas buyers. In addition to technology, we export a lot of wheat, soybeans and lumber that are available elsewhere in the world. How much pain farmers are willing to bear before they turn on their elected representative is anyone’s guess, but we suspect it will act as a brake on extremely high tariffs.

Some in the administration say that tariffs are just a threat and will only be imposed on nations that fail to negotiate a fair-trade deal. Conceivably deals could be struck before we know the full inflationary impact of tariffs, or how much inflation the administration can stomach, but deals are hard to predict.

As a result, we’d be committing financial malpractice if we didn’t have some exposure to investments that historically do well with high inflation and have a plan to increase those holdings if inflation reemerges as a longer-term problem.

Commodities are the obvious inflationary hedge, but between a glut of global oil and a commodity cycle that continues to be dominated by the Chinese government, it’s hard to over index to this asset class. Bonds look attractive as interest rates go up, but that yield is fool’s gold after factoring in the loss in value if rates go up. Cash is safe, but inflation means that you have to part with more cash to buy the same thing. In other words, your cash lost value. The one thing cash does provide is an opportunity to buy assets if there were a major blow up, so a little extra cash is ok.

Stocks on the other hand are shares of businesses that are raising prices and increasing their income as inflation ravages people’s savings. As we saw just a few years ago, good companies will cope with inflation, and some will prosper as their hard assets increase in value and they take advantage of the weaker players to consolidate their market positions. It may seem counter intuitive, but despite the pain inflation inflicts on the economy, stocks are the best hedge against inflation, so we will remain largely invested.

IMMIGRATION
The effect of immigration on the economy is debatable but there are a few things we know. No one denies that immigration holds down wages and is therefore deflationary which logically means that curtailing immigration is inflationary. On the other hand, we can debate whether the cost of services provided to immigrants are a drain on government’s resources. Either way, in the short run, if you take a couple million people out of the labor pool there will be some wage inflation.

Wage inflation is what the Federal Reserve fears most because it isn’t transitory like energy prices or housing costs. Depending on how aggressive the Trump administration goes with deportation, it’s possible the Fed will be on hold next year instead of cutting rates as the market anticipates. The obvious conclusion is to avoid investments that are dependent on much lower interest rates next year.

TAXES
Whether or not some campaign promises like lower corporate tax rates or the elimination of taxes on tips and overtime become law, taxes will probably move marginally lower over the coming year. The great debate will be whether tariffs will offset tax cuts and whether the growth in the overall economy will increase government revenue even with lower rates.

The markets will watch this very closely. If it appears that the government will be borrowing to fund tax cuts it will have to do so at much higher rates. In the short run, the market might give the new administration a pass, but eventually a lot of treasury supply must come to market and borrowing costs will go up.

DEREGULATION
Which brings us to the final promise, a focus on government efficiency and deregulation. Top lieutenants Elon Musk and Vivek Ramaswamy are tasked with running DOGE (The Department of Government Efficiency), ironically named after one of Musk’s favorite meme cryptocurrencies. Perhaps lower taxes and the resulting drop in tax revenue can be offset by cost cutting and greater ease of doing business.

Not surprisingly, most Americans are intrigued by the idea of less red tape and regulation. Much of the technology that runs the federal government is ancient, and it’s about time somebody looked at the way government contracts are negotiated. But it’s going to be very hard, and likely painful in the short run. Government spending accounts for nearly one-third of US GDP.

The hope is that any reduction in public spending will be offset by increased private sector activity driven by deregulation and resurgence of “animal spirits”, but even in the best-case scenario, this will take time. It’s also possible the elimination of thousands of federal jobs will fill some of the hole created by deportation, but it’s hard to imagine white-collar office workers doing hard manual labor.

WHAT TO DO
Things rarely go smoothly during revolutions. Volatility, a nice word for markets that whipsaw between euphoria and unbridled fear, is likely on the horizon. We have prospered in this kind of market before, in fact, we prefer it to a market that marches higher without regard to valuation. Our game plan is simple. The first thing we do is sell a little bit of the highest valued stocks when it seems they can do no wrong. We then buy some of the companies or sectors the market’s given up on. Lastly, we hold a little extra cash in case real bargains avail themselves.

Here’s what that looks like in action. Following the election, banks and large industrial stocks rallied on the prospect of deregulation. We own a lot of JPMorgan, the best bank in the world, but it sells for over 2.5x tangible book value (the net value of its loans and assets). It hasn’t sold for these prices since 2007. Now, a repeat of the great financial crisis is not in the cards, but if everything doesn’t go according to plan for the Trump administration, there’s nothing stopping it from selling closer to its average level of 1.7x over the past two decades. So, we sell a little, and we buy something that gives us a better opportunity for returns over the coming years.

Surprisingly, one of the biggest market adjustments wasn’t from Trump or Elon, but rather RFK Jr.’s nomination to the Department of Health & Human Services. Big pharma stocks, in fact the whole healthcare sector, got clobbered after his nomination. So did some of the “safe haven” consumer stable stocks. Opportunity!

While pharma and hospital stocks will likely face increased pressure to reduce prices and increase transparency over the coming years, we do not believe the Trump administration is going to blow up the entire bio-tech industry and we do not believe companies will stop creating innovative treatments for global health. Danaher, a large supplier of products into the bio-tech industry, is one of the best run companies is modern American history. Its stock is down 17% this quarter and has underperformed the market by nearly 30% this year. The same can be said for stocks in the cosmetics and beauty space, as well as the beverage sector. Innovation and safety went on sale.

At the same time, we find the rally in speculative assets that has accompanied the election results worrisome. Not because we aren’t happy to see our portfolios benefit from a nice rally. It’s the return of crypto mania, the surge in option trading volume, the concentration of the magnificent seven tech stocks and AI fever, the closing of risk spreads in the bond market and the explosion in risky private equity debt that has us thinking that all this euphoria might be overdone and end badly at some point. It’s just that we have no idea when that point will come, so in the meantime we’ll enjoy the ride and keep a healthy skepticism.

And finally, in the unlikely event that there is no volatility, interest rates fall, the economy grows at a record pace and there is worldwide peace and prosperity, we plan to do just fine owning good companies and getting a decent yield on bonds without taking unnecessary risks. We are optimistic about the United States and our growth potential, but we are also realistic and know that revolutions take time. Change creates volatility, and when expectations are already sky high, prudence is paramount.

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}