Over the last few weeks, if you have watched the news or browsed the web, chances are you’ve heard about tariffs, a global wave of populism or trade negotiations turning sour. The experts can hardly make their predictions on how tariffs will affect one country or another before the situation changes again.
Winners And Losers
When it comes to trade, there are always winners and losers, and given the interdependence of the global economy, it’s nearly impossible to ensure the U.S. comes out on top. That’s because implementing tariffs meant to benefit native businesses will have both intended and unintended consequences.
We do however have two certainties at this point. We know that the process is far from over and there are key steps we can take to mitigate the damage connected to the process for investors.
The U.S. tariff announcements have been targeted to benefit steel, aluminum, dairy, timber and other industries. The winners here appear to be miners on the Iron Range of Minnesota, timber workers in the Pacific Northwest and dairy farmers across the U.S. Whether they will remain as winners in the long run remains uncertain. However, the retaliatory responses by other nations have specified a wide-range of industries, infamously including Kentucky bourbon, Levi’s Jeans and Harley Davidson motorcycles. What has become increasingly clear to us is that the tentacles of the trade negotiations can reach any company in any industry. And the apparent beneficiaries today, may not be winners once all of the dust settles.
The effect for those outside of the industries directly caught in the crossfire may be material too. Aside from costing us more at the grocery store and on our next home or car purchase, it creates an issue for all investors. That’s because the back and forth tariff exchange could lead to an all-out trade war, which would only increase uncertainty and leave companies feeling less willing to make investments.
Perfect Storm
Let me illustrate by going back to Harley Davidson for a moment. Unfortunately, Harley Davidson has become a poster child for the negative consequences of a trade conflict. Tariffs imposed by the U.S. on foreign steel and aluminum are expected to increase costs for the manufacturer. At the same time, thanks to retaliatory tariffs on imported motorcycles, the cost of buying a Harley Davidson rose significantly in Europe, the second largest market for Harley. Because of this, the company has announced that it will be closing plants in the U.S and moving jobs overseas in order to manage costs. This is just one, if not the most notable, example of American companies being stuck in the middle of this new era of international trade instability. Thus, company risk is a primary concern all investors need to be on guard against.
We see a lot of investors that take undue comfort in owning a company they know well or one that has a great brand and is beloved by the masses. In studying brands, there may be no greater stamp of approval for a brand than to be literally tattooed on its’ patrons, as is the case with Harley Davidson. However, as we found out even the greatest brands can find themselves in the crosswinds of issues due to market, industry or political dynamics.
Diversification, Again
While we believe diversification is one of the most overused words in finance, the importance of a truly diversified approach may be greater than ever today. Many people believe that by owning 60% stocks and 40% bonds in your portfolio, you are adequately diversified. The reality is that the underlying portfolio holdings can matter a great deal. As we saw in the financial recession of 2008 and 2009, too many investors had financial stocks dominating their equity portfolio and bonds connected to the financial industry, too. For the truly unfortunate that held Lehman Brothers stock and bonds, and thus considered themselves diversified, they learned that the primary risk wasn’t the stock or the bond exposure, it was the now defunct business of Lehman Brothers.
The financial recession was also a sobering reminder that as defaults soar for bonds (when bond payments are extended, reduced or missed), recovery rates in defaulted bonds usually fall too. According to Moody’s, if measured on a value-weighted basis, the average senior unsecured bond recovery rate for a defaulted bond fell from the 56.9% average in 2007 to just 26.2% in 2008. In other words, investors were receiving 26 cents on the dollar for the average defaulted bond. Now imagine if you will that the equity in your favorite company gets virtually wiped out and the bonds only pay off at 26% of par. That 60/40 holder is left with about 10.5 cents for every dollar of exposure.
Because company risk is the largest risk in most portfolios, and a mistake we constantly come across in evaluating those by do-it-yourself investors or even many of our peers, I want to illuminate it in greater in detail. Most investors remember the example I brought up earlier with Lehman Brothers, but the list of companies that imploded during the same period was much longer and contained household names, such as AIG, Bear Stearns, General Motors, Washington Mutual, etc. You might chalk this up to an extraordinary time in the U.S. financial markets, however, we have witnessed a similar hollowing out of several different industries in recent times, including technology, media, and telecommunications from 2000 to 2002. We’ve seen it happen to energy multiple times and even in the “safe” utility sector in 2001 and 2002, and we are witnessing it in real time within the retail sector today.
These examples are precisely why portfolios must be diversified based on four underlying risk factors: company risk, interest rate risk, inflation risk and investment manager skill risk. If you’re only thinking about your portfolio’s diversification from a stock/bond, industry or country perspective, I would encourage you to take advantage of today’s good times and rethink your approach to portfolio risk management.
