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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation report for 02/18/2025. I'm Phil Adler. The initial Trump tariffs did have an impact on financial markets, but the takeaway might not be what many investors expect. Confluence Chief Market Strategist Patrick Fearon Hernandez joins us today to discuss how we might fold what we've learned so far about the Trump tariffs into our investment strategies. First of all, Patrick, at the time we're recording this, the scope of these tariffs may seem relatively mild.
Phil Adler:After all, the administration did postpone tariffs on Mexico and Canada while keeping 10% tariffs on imports from China. But that's far below the 60% threat made during the presidential campaign. Now regarding future tariff policy, what might we reasonably anticipate?
Patrick Fearon-Hernandez:Well, hi, Phil. Thanks for having me on the program. To answer your question, I think you're being way too complacent. After all, the tariffs on China are an additional 10% on top of the big tariffs that still remain from Trump's first term, most of which were maintained by president Biden. And the Canadian and Mexican tariffs of 25% were merely paused.
Patrick Fearon-Hernandez:They could well be reinstated or even increased in early March. And finally, we still expect to see more tariffs being imposed on the European Union and probably on a range of other economies as well, not to mention the tariffs that were just placed on steel and aluminum products. So in other words, it's still early days and all signs suggest that additional tariffs are probably coming.
Phil Adler:Well, many of us assume, I think, that tariffs will boost inflation. But you say not so fast, that tariffs could even reduce inflation. How?
Patrick Fearon-Hernandez:Yes. As I mentioned in the report, there certainly are instances where import tariffs can boost prices, say by curtailing supplies of a given good or when an importer has enough market power to pass the cost onto its domestic customers. But tariffs can also, paradoxically, reduce demand and thereby lower price inflation. For example, if the disruption from tariffs is so great that companies pull back on their investing, the drop in activity could theoretically slow economic activity enough to reduce price pressures, at least in the short term. In sum, tariffs are complicated, and we think it's still too early to know whether Trump's tariffs will be inflationary or deflationary.
Phil Adler:So much of the impact depends on how tariffs are portioned out?
Patrick Fearon-Hernandez:Exactly. That's a key point. Tariffs can have different impacts depending on the product they're applied to.
Phil Adler:Well, if it's too soon to tell how the Trump tariffs will eventually impact prices, what lessons can we learn from the way markets have responded to the early stages of these tariffs?
Patrick Fearon-Hernandez:Well, we're struck by the way that the tariffs and other early actions of the new administration have seemed to spur safe haven buying in US Treasury obligations and gold. Treasuries have been bid up, driving down yields while gold prices have climbed to record highs. That tells us that even if the policy's impact on inflation is still up in the air, investors seem concerned about the risk of inflation and the potential for economic disruptions. As I mentioned before, we think additional tariffs and other aggressive policies are still to come, so we think investors will continue to respond to the potential for volatility and uncertainty.
Phil Adler:Well, if we can count on further volatility and uncertainty, does it make sense to increase our investments right now?
Patrick Fearon-Hernandez:Recent quarterly adjustment to Confluence's asset allocation strategies, we lengthened our average bond durations and maintained gold exposure across our various portfolios. For the near term, at least, we think that's a useful strategy.
Phil Adler:Patrick, how high could gold prices go, and what's a reasonable short term floor for the long term bond yield?
Patrick Fearon-Hernandez:Well, with our expectations of continued safe haven buying, those are excellent questions. Since gold prices have recently reached new highs, we're in the area where the next big round number becomes the expected resistance area. As of right now, that would be 3,000 or even $3,100 per ounce. And given that central banks continue to buy gold aggressively, prices for the yellow metal could ultimately go even higher. For the benchmark ten year treasury note, it looks like the next major resistance area would be about 4.17%.
Patrick Fearon-Hernandez:And by the way, that would be roughly consistent with our forecast in our 2025 economic and financial market outlook.
Phil Adler:Patrick, if the yield on the long bond continues a downward slope, how would this impact inflation?
Patrick Fearon-Hernandez:At the margin, lower interest rates would encourage more investment in corporate or residential fixed assets. So that would help put a floor under any economic downturn because of the tariffs and their uncertainty in the near term. However, it likely would not be enough to avoid potential economic disruptions entirely. Of course, any increase in investment and new industrial capacity could help reduce inflation over the longer term.
Phil Adler:So at the risk of hammering at this issue, is it reasonable to assume that a new round of tariff announcements could fuel uncertainty, drive investments in bonds, and reduce inflation by pushing the yield lower?
Patrick Fearon-Hernandez:Yes. Although the reduction in inflationary pressure would be more likely over the longer term, not necessarily in the short term.
Phil Adler:Patrick, do you think that the markets could pretty quickly have only muted responses to tariff announcements if the administration fails to follow through?
Patrick Fearon-Hernandez:Well, that's something we're thinking about quite a lot. Given the administration's willingness to quickly backtrack and pause the tariffs as we saw with Canada and Mexico, it's entirely possible that the market will start to ignore them. All the same, tariffs have the potential to affect the economy over the long term, so we still think they're important. They'll likely have some impact on the market in the coming years.
Phil Adler:As you mentioned, Confluence increased its allocation to long term bonds in three of its asset allocation models in the current quarter. And one reason why is that they now offer a real return above inflation. I wanted to ask, what role did the attention Confluence Investment Management pays to geopolitics play in this allocation decision?
Patrick Fearon-Hernandez:Our big picture focus on geopolitics and domestic policy actually had a big role in that. We pay a lot of attention to the world's big megatrends and how actual policy initiatives are likely to play out in the financial markets. Our outlook for global fracturing, for supply chain disruptions, and higher tariffs are a big reason why we expected longer term bonds to outperform. In some, this is a great example of how our big picture top down analysis can help identify good investment opportunities.
Phil Adler:Thank you, Patrick. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.