Q1 2025
Kinsman Oak Investor Letter Q1 2025
April 29, 2025
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MARKET COMMENTARY
Financial markets began this year with an audible bang. The first few months experienced volatile swings with the S&P 500 collapsing -22% from peak-to-trough before recovering more than half of the move. The trade war is officially in full swing. Nobody knows how this will ultimately unfold. Market participants, business executives, and world leaders are reacting as best they can to constantly changing policy measures. Anything we write could be rendered outdated and utterly useless by the time we hit the publish button. Our discussion will be broken into two sections: Before and after Liberation Day (April 2nd).
Prior to Liberation Day
Economists became increasingly concerned about economic growth starting in early February. The Atlanta Fed revised their GDPNow Real GDP estimate for Q1 2025 from +3.9% on February 3rd to -1.4% on April 1st adjusted for gold imports/exports (-3.7% unadjusted). At the time of writing, the adjusted estimate is slightly worse (-1.5% adjusted) but at least it hasn’t deteriorated much further over the course of this month (Appendix A). While the magnitude is significant, these downward revisions are even worse given they occurred prior to Liberation Day and took place in less than three months.
Price action for individual stocks was negatively skewed during earnings season. Based on our extensive watchlist (including a few of our long positions) experienced brief gains after reporting strong results that surpassed investor expectations. But these gains were merely transitory and reversed course over the next few days or weeks. Companies that fell short of expectations or lowered guidance were mercilessly punished.
Other areas of concern were AI capex deceleration and reduced fiscal spending once DOGE started to streamline government operations. As we perused our extensive watch list, which was littered with stocks crushed anywhere from 25-35%+ from their respective peaks, we found ourselves wondering how the broader market wasn’t down more than it was. Unveiling the strongest tariffs in our lifetime was simply the final nail in the coffin.
After Liberation Day
Investors were initially unsure how Liberation Day would play out, but positioning appeared cautiously optimistic. The stock market rallied for three straight days heading into the event before quickly unwinding after hours when President Trump unveiled the reciprocal tariffs chart (Appendix B). Simply put, the numbers were huge, and the sheer magnitude caught the market by surprise. The announced tariffs, when/if enacted, would be the largest tariff increase in almost one hundred years and maybe one of biggest single tax increases in recent memory.
Stocks sold off in an unorderly fashion. Panic ensued and the stock market experienced GFC levels of volatility as the VIX increased by +179% in the next three trading days. Market participants tried to quickly digest what the immediate impact of these tariffs might look like. At minimum, economists expected a deteriorating economic growth outlook combined with a higher likelihood of recession. Knock-on consequences for individual companies are more nuanced and will be discussed below.
It wasn’t just the stock market that was reeling in the aftermath. The U.S. dollar declined, yields went vertical, and gold was hit new all-time highs seemingly every day. In fact, the U.S. 10-Year was +60 basis points in five trading days. We can’t emphasize enough that the rollout took everyone by surprise. The White House spent months giving the public the impression there would be reciprocal tariffs, and the formula used to calculate the imposed rate would be precise and designed to ensure fairness. In reality, Liberation Day tariff rates were based solely on trade imbalance. They were not reciprocal nor were not targeted for national security purposes either.
Therein lies the biggest problem. Investors are downright confused about what the administration wants to ultimately accomplish here. And, thus, how can we be expected to reasonably predict what happens next? Will the threat of tariffs be used as negotiating leverage with respect to other geopolitical issues? Are they intended to reshore manufacturing or generate additional tax revenue? Something else entirely?
The White House eventually chose to delay reciprocal tariffs for 90 days but only after enough carnage was done to financial markets. While delays are beneficial in a vacuum, this decision creates numerous other unintended consequences such as prolonged uncertainty overhang, demand pull-forward, and sustained decision paralysis. In our view, the longer it takes to fully resolve these policy question marks, the more detrimental the economic impact.
TARIFF DISCUSSION
Our thoughts on policy matters are inconsequential. As much as we would like to discuss investing from a bottom-up standpoint, the market is not overly focused on business fundamentals right now. With the VIX trading north of 50 it’s a shoot-now-ask-questions-later type of environment. Equity correlation has surged to multi-year highs and stocks are moving based on the most recent tariff headlines. An overly simplistic analysis is as follows: more tariffs are bad and less tariffs are good.
According to Abraham Maslow, it is tempting if the only tool you have is a hammer, to treat everything as if it were a nail. President Trump re-entered the White House with a sense of urgency and an aggressive agenda but pretty much every policy decision he tried to implement was relentlessly obstructed by his opposition. One of the only reliable tools at his disposal are tariffs, and he is wielding that tool wildly. Any dust-up with global leaders is met with the threat of tariffs. This is partly why we assumed the threat of reciprocal tariffs would similarly be used a negotiating tactic for other unrelated geopolitical concerns or to address national security concerns (and because the implementation of such steep tariffs is borderline economic malpractice).
At this juncture, we are having a difficult time wrapping our minds around what the administration is even trying to accomplish. President Trump seems to be talking out of both sides of his mouth. Tariffs are being used to negotiate favourable trade deals but simultaneously they are also intended to be a lasting source of additional tax revenue. Which is it? We fail to understand how both can be true at the same time. Tariffs are also designed to reduce reliance on China for critical goods, but pretty much all critical goods received tariff exemptions.
The contradictory nature of his comments creates confusion amongst investors and business leaders who cannot possibly begin to understand his vision with the mixed messaging. From the outside looking in, it appears the White House may be winging it, which results in a loss of confidence and reduced risk appetite – and panic selling.
President Trump has expressed his interest in bringing manufacturing back to the United States. We view this as an uphill battle. The challenge is convincing businesses to upend their finely tuned global supply chain networks, relocate expensive facilities to a higher cost region (labour costs, regulatory burden, etc.), spend years recruiting and training a specialized workforce from scratch, build brand new factories and fund complex infrastructure projects with useful lives of 25+ years.
Meanwhile, these tariffs can be suddenly reversed with the stroke of a pen. Either on a whim by President Trump himself or by the following administration. In places like California, it might take 25 years to get necessary permits before construction can even begin. Financially, it probably makes more sense to keep the factories offshore and bite the bullet. Pay the tariff and try to pass as much of it onto the end customer as possible.
Keep in mind, many businesses already relocated manufacturing out of China and into places like Vietnam in response to tariffs implemented during the first Trump administration. Now, Vietnam was hit with 46% tariffs too. Imagine spending all that time and money reorganizing your supply chain only to get hit with fresh tariffs just a few years later anyway. Suggesting companies should do that all over again is a big ask. And if the goal is to encourage domestic relocation, then at minimum, there needs to be a commensurate deregulation wave.
Tariffs are a regressive consumption tax on citizens. There is no way around it. National security concerns may justify the additional cost but make no mistake, there is price, and it’s disproportionately paid for by the lower and middle class. Allowing adversaries to control critical industries is a non-starter for the survival of a nation and it makes sense to sacrifice efficiency for security but otherwise tariffs are not worth it, in our view.
In theory, tariffs are mainly confined to a financial problem. Prices to change, markets adapt, and consumer behaviour adjusts accordingly. But in the real world there is a lot more involved. Business owners will need to run their business as usual and also become experts on international trade law at the same time. They will need clarity on the legal thresholds between what goods are considered manufactured versus assembled and how to interpret the correct country of origin. Even worse, the snip-snap nature of tariffs on-tariffs off makes strategic planning practically challenging at best. Disruption is expensive and the longer it drags on, the worse the damage will be.
WHAT THIS MEANS FOR MARKETS
Worst case scenario, markets experience a one-two punch. Uncertainty overhang will weigh on valuations and tariffs will weigh on earnings. Reduced earnings combined with lower multiples suggests much lower stock prices. Will the delayed reciprocal tariffs get rolled out in 90 days? Lingering uncertainty for three months could have a meaningful impact on economic activity and various unintended consequences which we will explore later.
In our view, the market is pricing in an elevated chance of imminent recession. The S&P 500 has held up relatively well, all things considered, but the Russell 2000 and homebuilders are reflecting a far more ominous economic outcome. Headwinds include reciprocal tariffs (and question marks surrounding their permanence), fading consumer and corporate confidence, negative wealth effects from the recent sell-off, surging mortgage rates, etc. It’s virtually impossible to handicap the odds and severity of any potential recession.
Tariff-induced inflation remains another known unknown. Sticky inflation with slower GDP growth would be disastrous for equity valuations. We wonder if rising prices from tariffs would be met with a partially offsetting decline in velocity, resulting in less than expected inflation. Either way, the Fed likely remains on the sidelines until there is more clarity with respect to the inflation outlook.
As we have written about previously, the American economy is experiencing unprecedented bifurcation. We highlighted the differences between Dollar General (DG) and Ferrari (RACE) to demonstrate how those at the top and bottom are living in two disparate realities. Financial wealth is highly concentrated in the hands of the few, and that wealth has never been so dependent on the stock market, which is interesting given its recent decline. Should the sell-off continue, we could see the tail wagging the dog where the stock market drives the economy.
In our opinion, it is difficult to drastically reduce net exposure given the reason behind the sharp decline is largely self-inflicted and can be reversed without notice. Investors find themselves trying to predict future policy decisions from one of the least predictable people on the planet. That does not strike us as a recipe for success. Instead, we prefer to gauge sentiment which anecdotally feels downright terrible. For instance, TD Ameritrade recently send out a circuit breaker warning to clients. That is not something you see at market tops. However, we also question whether positioning is equally as pessimistic. While investors are mentally braced for the worst, they may be positioned aggressively since nobody wants to miss the next +8% day.
KNOCK-ON CONSEQUENCES & HOW COMPANIES WILL RESPOND
Various knock-on consequences will inevitably follow the implementation of tariffs. In our opinion, the biggest problem is not the financial aspect but the vast uncertainty surrounding the policy itself. Slapping a 10% base level tariff is one thing. While it may be painful, businesses can adapt accordingly and move on. But how should businesses react when a tariff is implemented, reversed, applied again with exemptions, increased, and then delayed for 90 days pending negotiations happening behind closed doors? Below includes some of the fallout.
Scrapping Forward Guidance
Management teams have already rescinded and/or declined to issue forward guidance which will only compound the uncertainty issues for investors.Reduced Production & Inflation
The cure for high prices is high prices. However, it’s possible this truism is no longer a given. An overwhelming amount of uncertainty means less things are produced. Reduced production could cause supply shocks and inflation due to shortages. Creating new supply is not easy. Capital, regulatory requirements, raw materials, distribution, time, etc.Margin Compression
Companies will have levers to pull to mitigate tariff impact on their bottom line, but the end result will be some degree of margin compression. The magnitude remains to be seen but the inability to pass along price increases to end customers or reduce operating costs to offset lower gross margins might be fatal. It is worth noting margin expansion, which was the driving force behind remarkable corporate profitability (and valuations) since the financial crisis, may be on the cusp of working in reverse.Demand Pull Forward & Inventory Stuffing
Imagine trying to buy lumber to build a house. Do you purchase raw materials and pay the tariffs? What happens if your competition waits and then the tariffs are removed by next week? On the flip side, if tariffs are delayed for 90 days, do you purchase as much as humanly possible and front-run the tariffs should negotiations fail? Customers will purchase products early to avoid high prices in the future. This could create an air pocket where economic data looks good today but hits a trap door later this year.Cancellation of Major Capex Plans
Input costs for expansion projects suddenly doubled if material was sourced from China. At least one company we follow closely halted a major and highly anticipated capex initiative given extreme cost uncertainty. Further, sustained higher prices will impair ROIC on capital spending and so the prudent move would be to slam the brakes until clarity returns. This kind of paralysis will progressively extend from growth capex to maintenance capex as companies stretch useful lifecycles beyond their limit since replacing new equipment costs twice as much.Supply Chain Restructuring
We briefly discussed this earlier, but companies moved production to other countries to avoid tariffs and then got hit with tariffs anyways. Hurts margins, very messy and time consuming for management.
The sticker price on tariffs barely scratches the surface of the long-term structural economic impact. Anticipating potential knock-on consequences is far more challenging and crucial. Heighted risk-off behaviour, lower economic growth and margin compression is a lethal combination for an expensive stock market with little margin of safety. The factors discussed above would dramatically compound the problems in short order. Once this process is underway, recession is almost inevitable.
LOOKING AHEAD
We are flying blind through unchartered territory. Unprecedented government policy with limited visibility beyond 90 days presents unique challenges for investors. We continue to assume the tariffs will eventually be walked back, reversed or at least negotiated for better terms but our conviction is increasingly challenged with every passing day that a deal has not yet been struck. Keep in mind, trade deals are not drafted and inked overnight either.
While the current environment is challenging to navigate, investors will be presented with some tremendous opportunities over the coming months, even if they are few in numbers and time horizons need to be stretched to take advantage of them. Stocks have sold off indiscriminately and correlations have surged. Our focus remains on searching for needles in haystacks. We want to own businesses with attractive long-term prospects even if the outlook for the next few quarters remains foggy. If our theses are correct, we expect these stocks will disproportionately bounce over the next few years.
President Trump is adamant the United States will no longer be the consumption powerhouse for the rest of the world. Encouraging more balanced international trade relative to the lopsidedness we see today will require profound growing pains. Fiscal largess will be required if foreign countries plan on producing less and consuming more, which suggests higher inflation and possibly much higher gold prices. As we continue to scour our investment universe for potential beneficiaries of these newfound policy goals, we will also prioritize flexibility as major policy swings may become the norm throughout this administration.
Sincerely,
APPENDIX
Appendix A – Federal Reserve Bank of Atlanta – GDPNow – April 29, 2025
Appendix B – The White House – April 2, 2025
