"Elections have consequences."

This axiom has never rung truer on Wall Street than it has in recent months. Indeed, we can't remember a time in our careers when Washington, D.C., had more of an impact on the stock market. Since inauguration day on January 20, an unrelenting barrage of policy proposals, executive orders, and other actions by the “Trump 2.0” administration has led to extreme volatility on a daily, and even hourly, basis. These initial actions have thus far overshadowed the administration’s pro-business and consumer actions yet to come in the form of significant deregulation, tax cuts, and what should be a more favorable environment for mergers & acquisitions.

While the year started on a relatively positive note, with the S&P 500 hitting a record in February, the market's mood soured as the new administration's initial actions raised concerns over a slowing economy and rekindled inflation. For example, Elon Musk's Department of Government Efficiency (DOGE) got off to a fast start with a federal workforce reduction program, proposing to cut: 50% of the IRS workforce, or up to 45,000 jobs; 80,000 employees from the Department of Veterans Affairs; 50% of the Department of Education; 65% of the environmental protection Agency's budget… and more. According to Challenger, Gray & Christmas, Inc. (whose “Challenger data” is often used by economists), job cuts through March 31 reached almost 500,000, the highest quarterly rate since 2009, with the government contributing over 279,000 to the total. While these DOGE cuts caused some consternation over the potential for decreased government spending and the overall jobs picture, more concerning were the potential ramifications from a trade war which quickly heated up during the quarter.

The metaphorical first shots were fired in late January, when the President announced 25% tariffs on Canada and Mexico. This was followed by additional tariffs on Chinese imports above pre-existing levels, as well as a Presidential Memorandum ordering a review of “non-reciprocal trade practices.” Threats of reciprocal actions by three of our largest trading partners, in addition to what additional actions against other countries might come from the ongoing review, added to investor nervousness surrounding the burgeoning trade war. Fears of rekindled inflation as a byproduct of a trade war, as well as the potential for a global economic slowdown, also fueled the selloff. Ominously, the much-feared term "stagflation" was increasingly used in print and television media as the quarter progressed.

These fears only got worse following quarter’s end, when on April 2, which the President dubbed "Liberation Day," the administration announced a 10% global tariff on all imports, with higher rates for 57 specific countries. With the announcement being more draconian than expected, the S&P 500 fell more than 10% in the three days following, and volatility has continued as the tariff "goal posts" continue to be moved on a day-to-day basis (modifications, carve-outs, additional tariffs, and delays have made the situation extremely fluid). As of this writing, President Trump has postponed many of the tariffs for a 90-day negotiation period while maintaining a 145% tariff rate on China, the world’s second largest economy.

Whether these tariff announcements will ultimately be used as a negotiation tactic by the administration or made permanent, we don't purport to know (likely a combination of both). What we are more certain of, however, from our conversations with company management teams and what we are hearing on quarterly earnings calls, is that uncertainty is already having negative ramifications for the economy. It is understandably very difficult for companies to enter into major contracts and make long-term plans in this environment. Hard to estimate is also the impact from “bad will” being created with our trading partners. For example, reports and data suggest Canadians are canceling trips to the States as well as boycotting U.S. products in the wake of the tariffs and amid President Trump’s continued suggestion Canada should become a U.S. state.

All of this, including the stock market's recent plunge, has greatly reduced consumer confidence, which saw the March reading fall to its second lowest level on record. Warning signs can also be seen in high-yield spreads which, prior to the tariff announcements, were trading near record lows but have spiked since.

High Yield Spreads Have Spiked From Near-Historic Lows

While we are fond of the maxim, "Now is always the most difficult time to invest," it would be dishonest to not acknowledge that recent months have felt especially difficult. However, we at Prospector have navigated difficult waters many times before. Given the recent turbulence, now seems an appropriate time to reiterate our modus operandi during times of market distress.

Our Stock Market Distress Playbook

Throughout the 28-year history of Prospector Partners, we have experienced a number of significant equity market sell offs. These include the burst of the internet bubble in 2000, the Great Financial Crisis of 2008, and the COVID-19 related swoon. During these periods of distress, we return to a few key strategic portfolio management actions:

• First, we upgrade the quality of the balance sheets for portfolio investments. As you are aware, we are chronically “allergic” to leverage and debt in our positions. That said, there is always room for improvement when the music stops, and a market crisis erupts. Generally, this re-underwriting process leads us to hold larger balance sheets with more staying power.
• Second, in long/short portfolios, we typically trim the gross and net exposure to reduce overall risk during the heightened uncertainty.
• We reduce cyclicality in portfolios at the margin. Again, you likely are aware that we chronically are underweight cyclical sectors of the market such as materials, technology, and consumer discretionary. This time is no different.
• Finally, we actively and aggressively manage our tax position. We are loathe to deliver a taxable gain at the same time as a total return loss to our customers. Recall that Prospector’s partners and employees hold significant investments in our various products. As such, we pay close attention to maximizing after-tax returns for our clients.

Trade War - Investment Implications

As mentioned above, investing during turbulent times is extremely difficult. Active portfolio management during times such as these is crucial. Not only because passive indices like the S&P 500 continue to be heavily weighted towards high-valued, mega-cap technology and communication services companies, which derive a considerable portion of their revenues from overseas and thus are at risk to the trade war, but also because volatility creates opportunities. We consistently strive to take advantage of the opportunities created by this volatility.

Source: JP Morgan Asset Management

Much uncertainty remains as to the ultimate impact of the trade war, and we have not made wholesale changes to portfolios. We view many companies within the technology and communication services sectors as still having lofty valuations and exposed to the global trade war. We continue to have a favorable view of the insurance sector given that these companies have relatively low exposure to tariffs, benefit from higher interest rates and, in the case of property-casualty insurers, can take advantage of inflation via higher premiums. Within banks, we have become even more conscious of loan portfolio strength given the potential for an economic slowdown, and we are striving to upgrade the quality of bank holdings from an already solid positioning. We also continue to look for opportunities to upgrade in other areas. Whether swapping one investment in a sector with a similar company possessing a stronger balance sheet or finding opportunities to increase exposure to long-term favorable secular trends (like healthier-for-you ingredients in a GLP-1 world), rest assured we are working harder than ever to maximize risk-adjusted returns and, of course, always looking to mitigate downside risk.

Outlook

Much has changed in a few short months. The new administration entered the White House with the goal of an “economic renaissance” marked by a revival in American manufacturing, tax cuts, and deregulation. The early focus on U.S. trade deficits and the aggressive use of tariffs as a tool have outweighed the promise of stimulus and deregulation to come, as the long-term ramifications which will reverberate from the rapidly growing trade war are unknown. In the short-term, the impact has included sharp moves in world currencies, equity, and fixed income markets. The risk of a potential systemic shock is heightened in this environment. The Federal Reserve is likely to refrain from acting until there is more clarity over trade disputes and the potentially stimulative tax bill to come but stands ready to provide liquidity and other support should the need arise.

We expect continued housing market pressures as a result of higher interest rates and affordability concerns. However, the shortage of housing after over a decade of underinvestment following the Great Financial Crisis should prevent a disastrous decline in home prices. Lower-income consumers have been most impacted by the recent inflationary environment, but consumer balance sheets remain generally healthy for most Americans, and consumer credit quality remains strong at the moment. The short-term inflationary impacts from tariffs will likely be detrimental.

What we see argues for a more inflationary and higher interest rate environment than seen in the past 10 years, and risks for a recession are heightened in this uncertain environment. As always, with our bias towards quality, we strive to mitigate any downside, while also participating in the upside. Ultimately, we are optimistic the new administration in Washington will lead to less regulation and a more favorable merger & acquisition environment.

We continue to find opportunities to invest in quality businesses with solid balance sheets and cash flows, whose share prices have detached from our assessment of the fundamentals.