4th Qtr 2024 West of the Hudson™

Dear Clients:

We have opined over the years that investors shouldn’t let their partisan leanings affect investment decisions. However, we were admittedly, if quietly, rooting for gridlock to win because political congestion is generally bullish for U.S. equities. Regardless of which party sits in the White House, stocks historically responded well to “split” governments because a lack of agreement is seen to provide more, not less, certainty. Gridlock on Capitol Hill is a structural means to protect the nation from socio-political extremism and, accordingly, provides a degree of clarity about consequential policy changes. Indeed, the framers of the Constitution created a system of checks and balances largely designed to create disagreement. Many of the Founding Fathers were lawyers: 25 of the 56 signers of the Declaration of Independence were lawyers (including its authors), as were 35 of the 55 delegates who attended the Constitutional Convention of 1787 ⁽¹⁾ . All those lawyers created a constitutional system that was purposefully designed not to work (usually). This was for the good of the citizenry to protect us from our own very human tendencies.

The administration of President Trump 1.0 (2017) began with his party holding majorities in both the House of Representatives and the Senate. But as is often the case, they overpromised, undelivered and lost control of the House in the mid-terms (2019). His second coming (2.0) begins again with a clean sweep and an agenda that includes a mix of bullish and bearish policies that reflect his distinct blending of pro-market and populist urges. Despite extraordinary societal division and voluble threats to geopolitical norms and negotiated treaties, investors have thus far chosen to accentuate the up-front positives of the electoral results (tax cuts, deregulation) and set aside the real threat to growth embedded in the threats of tariffs, deportations, and their collective inflationary impact on consumption (bond markets have been more circumspect with rising yields in part reflecting risks of higher inflation and larger fiscal deficits) ⁽²⁾.

As we reduce the tax base further while federal spending surges upwards, the national deficit highlights a rare blemish in the Constitution: the articles do not provide a framework to limit politicians from perpetually adding to the national debt. Politicians recognize that spending our collective treasury on their local constituencies is a winning strategy, while raising taxes is sure way to be shown the exit. The debt pile is someone else’s future issue to manage.

Term 1.0 cut the corporate tax rate from 35% to 21%., and 2.0 is projected to include a further reduction as well as further permanent tax breaks ⁽³⁾. This tax policy is good for stocks but only on the front-end as benefits are diluted by aggressive trade policies enabled by a determined and united government. Inflation remains high and the gap between haves and the have-nots is growing. Whatmore, the election result will have broad implications beyond domestic policy and directly impact non-U.S. investment outcomes (of which we and virtually all of our readers are exposed). The overriding foreign policy concern is Chinese competition and tensions in the South China Sea, through which one-third of global trade transits ⁽⁴⁾.

For investors, the arrival of a new administration delivers the challenge of figuring out which campaign promises will end up as policy, and which will end up on the cutting room floor. Today, the added challenge is wading through the plethora of statements that, on the surface, are contradictory and replete with ambiguities and inconsistencies. Will he look to cut taxes, or reduce the fiscal deficit? Will he seek to deport millions of workers, halt immigration, and implement broad tariffs, or reduce inflation? Positioning for any particular outcome is speculative. Nobody knows how markets will react once the president-elect takes the steering wheel on January 20. The three pillars of the 2.0 agenda are import tariffs, tax cuts, and immigration. This is where our focus resides as we review the environment supporting future returns. Election uncertainty has given way to the chaotic uncertainty that a majority of voters welcome. This is where we are now as the Earth completes another turn, and it is here that we jump off for this, our fourth and final letter West of the Hudson^TM in 2024.

• Tariff Man

We will speak in brief detail about each of these schemes, but for now we settle our gaze on the most easy-to-grasp issue: taxing imported goods. When a company buys widgets from abroad and they arrive at a U.S. port of entry, customs agents levy the prevailing import tariff on the part. The failure to pay results in the products seizure. Who pays this tax? The company importing the widgets — everywhere and always. While an importer does not have to raise the price when it resells its product to consumers — it could decide to eat the import costs — there are NO instances that we are aware of where this has ever occurred. The freedom to adjust prices is a foundational principle of the capitalist system on which American economics is built.

Non-partisan economists concur that import tariffs are bad and, as I learned from Professor Breimer in his History of Economics class (1985), “the data set underlying this factoid is rich and deep”. Consumers are better off when goods flow across borders as freely as possible. Adam Smith related this in The Wealth of Nations (1776) and David Ricardo refined the work into his thesis of comparative advantage in On the Principles of Political Economy and Taxation (1817), which states that nations which specialize in areas with a clear edge produce the highest marginal return. Thus, the seeds of modern globalization were planted.

But, having endured the supply disruptions of Covid, it is clear that in a world where all companies produce in the most profitable locations are at risk of the kind of fragilities which we have examined in prior communiqué. Remarkably — despite a demonstrably split government — the Biden administration was able to pass two massive federal programs to fill some of the largest manufacturing holes. It began with the $1.2 trillion Infrastructure Investment and Jobs Act (2021) with provisions to invest in highways, rail, broadband, water, and upgrades to the electric grid. Next came the need to address America’s largest hole: the world’s largest economy manufactures just ~12% of the world’s semiconductor chips — and 0% of the most advanced, small node variety ⁽⁵⁾. Thus, was born the $75 billion CHIPS and Science Act (2022) to jumpstart American competitiveness and reduce foreign dependence.

Whether these capital commitments are successful or not remains to be seen, but are meant to stimulate, encourage, and support the future. They stand in stark contrast to the enthusiasm building behind the proposed tariff platform, which is not needs-based nor builds on the just-in-case supply chain redundancy that the above Acts provide. Tariffs are a consumption tax, not an investment, and reduce consumer choice. Our once-mighty auto industry offers ample anecdotes. China produces electric vehicles that global consumers want and can afford to buy. The U.S. does not and cannot. Blocking imported EVs in U.S. markets does not address our manufacturing shortcomings. It buys Rust Belt and oil-adjacent votes but fails to address the rapid decline in American industrial prowess. Nonetheless, to the self-styled “Tariff Man”, import duties are magical — an instrument that solves myriad socio-economic problems and, as important, acts as a tactical “win” against adversaries and partners alike ⁽⁶⁾. The President-elect boasts that import tariffs are “awesome” and, based on the election outcome, you would think a majority of people agree (where we source our news is entirely responsible for this deception, BTW) ⁽⁷⁾.

It is hard to imagine that the initial tariff salvo will be completely unrestrained. In the first trade war, 1.0 was careful to avoid putting tariffs on highly visible consumer goods (and he will probably be even more careful on this score now, given the political cost his predecessor paid for inflation!). But whatever the goals are, evidence is mounting that the opening gambits will be aggressive and will not be limited to China.

Changes are not implemented in a vacuum and pulling these levers creates a complex chain of cause and effect. It is an open question how other countries will respond, but one should consider that escalating rounds of tit-for-tat tariffs that typically follow. China for one has plenty of ways to push back: its major point of leverage is less on what it buys from the U.S. than on what it sells. And here we highlight a topic we raised many quarters ago — the spectrum of rare earth minerals crucial for industrial (especially military) production: gallium, germanium, antimony and graphite, all of which China’s control of global refined production is in excess of 90% ⁽⁸⁾. Post-election, China has gotten ahead of the negotiating curve and announced a halt to these minerals exportation. We cannot and will not predict the complex interplay of economic and diplomatic interests, but this is a significant warning shot over growth’s bow.

If Term 1.0 taught us nothing else, the incoming president relishes chaos, pitting members of his cabinet against each other or making sudden policy U-turns that catch even his closest advisers unawares. All politicians make promises during campaigns that cannot be kept, so pushing for a blanket tariff of 10% on all imports and a 100% tariff on cars made outside the U.S. seems feasible only if he is willing to abandon other priorities like inflation and U.S. production. Tariffs raise production costs and are passed on — especially in sectors without domestic alternatives. Those with sizable international exposure (technology, agriculture and manufacturing) will be especially challenged ⁽⁹⁾.

While investors tend to use the direction of U.S. equity markets as a proxy for the economy’s outlook, the transitory potency of tax cuts and the ransacking of regulatory guardrails belies the less transitory issues of tariffs (and other tent pole policies discussed below). This is a problem for U.S. businesses and where our interest as investors overlap. Details matter. Using tariffs as an indiscriminate blunt instrument does not have a favorable track record (see solar panels, high-speed rail, 5G, foundational legacy chip manufacturing). But presidents have broad flexibility to impose taxes on imported goods and doesn’t require Congressional permission (the House and Senate surrendered that authority decades ago). We have time to evolve to this theme, but a policy of this sort is not beneficial to U.S. businesses or consumers.

• Immigration

The outlook for migrants — especially the undocumented — is the most controversial policy, and arguably the riskiest for a platform meant to support a robust, market-friendly, growth agenda. Economic projections indicate that a hard line on migrant workers — documented or not — will increase consumer inflation quickly and is a policy clearly at odds with the lower inflation mantra ⁽¹⁰⁾. The industries most reliant on undocumented workers include construction (14% of the workforce), agriculture (13%), hospitality (7%), transportation (6%), manufacturing (5%), retail trade (4%), and mining/oil (4%) ⁽¹¹⁾. Of these industries, housing and farming are most at risk of deportations with immigrant (not all undocumented) workers totaling a staggering 85% of their respective workforce ⁽¹²⁾. And you think eggs or home ownership are unaffordable now!

There are over thirty-four million immigrants in the U.S. workforce of which an estimated eleven million are undocumented workers across various industries ⁽¹³⁾. Migrants make up ~19% of the active labor force with a labor force participation rate of 67% — 5% higher than the native-born participation rate (62%) ⁽¹⁴⁾. If the policy is executed as advertised, the estimate of industries at risk could see the removal of one in eight workers from the housing and farming industries. In the hospitality sector, about one in fourteen workers could face deportation due to their (or a family members) status ⁽¹⁵⁾. It’s not a Red vs Blue state problem as just three states — California, Florida, Texas — host ~47% of total undocumented workers ⁽¹⁶⁾.

Most immigrants typically enter the blue-color workforce so fewer migrants points to slower labor supply growth in critical base consumer areas. This is especially true when combined with a declining U.S. birth rate. Economists predict that a full frontal assault on immigration will weigh on economic growth, and morph quickly from a short-to-long-term obstacle ⁽¹⁷⁾. According to the National Foundation For American Policy, immigration has accounted for 88% of the growth in the labor force since 2019 and, by 2052, it will be the only source of labor force growth ⁽¹⁸⁾. While productivity growth is everywhere and always an important factor, economic growth depends on labor force growth.

In its examination of projected manufacturing growth (propelled in part by current government incentives), Deloitte estimated that U.S. factories will need to employ a net new 4 million new workers by 2033 ⁽¹⁹⁾. However, the consultant went on to warn that half of these posts could remain unfilled if deportations are fully realized. This is an important outlook as shortages of skilled workers are already a problem. As we recently wrote about, trouble sourcing talent is one reason chipmaker TSMC cited for delays in opening the two chip fabs it is building in Arizona ⁽²⁰⁾. Since then, numerous high value-adding, next generation plants have made similar announcements. This is causing a ripple effect down the supply chain, with suppliers also postponing or reducing their investments in new facilities ⁽²¹⁾. Importing trained semiconductor workers is a necessity — they are not “taking our jobs” but filling the wide void in American manufacturing.

Here’s the kicker: the reduced inflow of base labor points to slower demand growth among immigrants for goods and services. Federal Reserve data shows that in 2022, undocumented immigrant households contributed their fare share to the economy via paying $467 billion in federal taxes, $29 billion in state/local taxes, $23 billion in Social Security contributions, and $6 billion in Medicare contributions! ⁽²²⁾. U.S. demographics are missing millions of people in the prime age range (20-40) even as our economy demands millions of unskilled/semi-skilled workers. With the supply of skilled workers already limited, the risk is that wages are pushed higher, with additional input costs (electricity, water, industrial metals) set to weigh on corporate margins ⁽²³⁾.

Stepping back from this minutiae is a larger fact that protectionists decline to acknowledge: America is no longer competitive in many industries including textiles, coal, steel, automobiles, and semiconductor fabrication. One could argue that perhaps we shouldn’t try to be, but dislodging the essential foreign workforce certainly hinders rather than helps, and risks gutting large, job-heavy industries, causing import prices to rise and lowering the average Americans purchasing power.

Come January 20, the next administration will own the same economic problems they talked about in the campaign. They will blame their predecessors of course, but like tariffs, these big challenges — including the need for and cost of labor — won’t magically disappear. Economic policy debates have been relegated to an afterthought as politicians promote personality and cultural issues. Taken alongside the president-elect’s tendency for hyperbole and the scattershot execution of his first term, it is tempting for investors to discount the astonishingly bold economic outlook on offer for his second term. This would be an error. He is in control of his party, has shaken loose from the old guard’s supervision, and enjoys a large congressional constituency who enthusiastically buy into his brand of Republicanism. When it comes to the unknowable’s surrounding immigration, as investors, it is best to stay clear of the more at-risk industries and their tributaries and remain focused on the areas he cannot — or has no incentive — to control.

Above all else — beyond the inflationary impact of tariffs and the impact of tax cuts on the deficit, there is one sure-fired way to ensure a higher cost of living up and down the consumption chain: a greatly shrunken workforce in critical economic areas including home construction and food production/preparation.

• Inflation

The overarching premise of an extraordinary tariff regime (buy American) is at odds with the ability for most U.S. businesses to turn a profit, which includes affordable domestic labor and the ability to sell at affordable levels. It is where the limits of pricing power available between merchant and consumer meet. The lack of available labor only adds to the cost chaos. Lest we forget, America’s largest and most valuable companies are mostly international so there is no benefit to any of this (other than lower corporate taxes, which will likely be used to buy back shares!). Chinese trade into the U.S. is increasingly made up of goods actually manufactured (or controlled) by U.S. businesses like Apple, Nike, and Tesla ⁽²⁴⁾. Such companies may have wanted to move trade away from China but have found it logistically difficult. And at the lower value, higher volume end — the companies that own significant, dedicated shelf space at the “big box” retailers — the math to profitability no longer works.

Indeed, when Walmart warns of impending price-hikes it is newsworthy! The company’s CFO told analysts that “there will be cases where prices will go up” though he noted the company would “work with its suppliers to try and bring prices down” (CFO-speak for suppliers eating as much of the inflation price-through as they could get away with) ⁽²⁵⁾. Producers across a wide range of items — clothing, footwear, auto parts — say they will pass along the cost of the tariffs to the customers: “We’re just going to deal with it and raise the prices. It’s going to be very, very difficult to keep products affordable for Americans” (Columbia Sportswear) ⁽²⁶⁾; “If we get tariffs, we will pass those tariff costs back to the consumer — we’ll raise prices ahead of what we know tariffs will be” (AutoZone) ⁽²⁷⁾; “We will have to do some surgical price actions to offset any new tariffs” (Stanley Black & Decker) ⁽²⁸⁾.

The prospect of higher inflation is now the elephant in the room and the president-elect is soon to own it. Inflation in any given country is political-kryptonite — especially for voters who live paycheck to paycheck and so suffer most from inflation’s stinging bite (and overwhelmingly voted for him — as we said, news sources matter!). Rounding up undocumented workers and restricting immigration puts upward pressure on the price of labor and shrinks the labor pool. Tariffs and other protectionist policies likewise do not create more demand but reduce choice. Any one of these policies are inflationary by themselves. Together, these make for a potent inflationary brew. One has to wonder if a president-elect worried about inflation may have to choose between his priorities. ⁽²⁹⁾.

The two main economic aspirations — non-inflationary growth and nativism — are fundamentally incompatible ⁽³⁰⁾. If forced to recognize the contradiction between isolationism and growth, we as investors hope he will prioritize growth and price stability. These were, after all, the issues that most voters identified with and the ones most likely to determine his popularity, which is a high priority. If he follows this logic, one can hope that he suppresses his instincts and turns his tariff and deportation threats into rhetorical devices or bargaining tools, not serious economic policies.

• Final Thought

Tariffs are a classic tool of emerging economies and meant to raise revenue and protect the competitiveness of fledging domestic industries. Administration 2.0 means to use them to offset lower tax revenues in a scheme to prevent the federal deficit from widening. As is often the case, the team at GaveKal captured the spirit of the incoming president’s view of trade tariffs, describing them as “a multi-tooled Swiss army knife of policymaking…used to shrink the trade deficit, devalue the currency, reindustrialize the heartland, raise revenues, stem migration and stop Mexican drug trafficking” ⁽³¹⁾. It is unclear whether protectionism is the end goal, or if its true aim is to extract concessions from trade partners. Either way, U.S. tariffs seem set to both rise and multiply and U.S companies are spending time and resources to manage the chaos.

The larger issue is competitiveness, which the U.S. is clearly not in many large, jobs-creating industries. This fact is best illustrated by General Motors shocking $5.6 billion write-off of its China-based business, which has wiped out ~88% of its venture and effectively made its storied brands — Buick, Chevrolet, and Cadillac — next to worthless in China ⁽³²⁾. And that’s in China where every other car company has grown exponentially over the past five years. The U.S. is a far harder market to make things people want, so this bears watching for signs of progress. As it is, the incoming policy proposals do not suggest progressive movement in this area.

In physics, the “three-body problem” refers to the difficulty of forecasting the motion of three or more astronomical objects in orbit around each other. Although their motion is wholly deterministic, it is impossible to specify the initial conditions with enough precision to predict their future trajectories with any accuracy. The problem has lent its name to the title of a celebrated science fiction book (Liu Cixin, 2008) and is a timely metaphor of the difficulty reconciling what is a remarkable, fast-developing environment. We have a vague sense of how the economy will evolve but really, all bets are off and its best to remain focused on trends that are hard to slow down regardless of policy.

We were also reminded that the most level-headed reaction to the incoming presidents’ social media diatribes is to adapt Churchill’s immortal quip about Stalin’s policies following World War II: “It is a riddle wrapped in a mystery inside an enigma” ⁽³³⁾. In the months ahead, there will surely be many more enigmatic declarations forcing businesses to weave and bob to these potentially harmful policies rather than focus on productive growth but, considering his proud embrace of unpredictability as a core principle of government, policy oscillations are a given and we will adapt as necessary. And with that, from our families to yours, we wish you a peaceful, safe, and profitable start to the New Year 2025!

Yours truly,

Hirschel B. Abelson
Chairman, LCES

Adam S. Abelson
Chief Investment Officer, LCES

This information is intended for the recipient’s information only. It may not be reproduced or redistributed without the prior written consent of Fischer Stralem Advisors & HighTower Advisors LLC, an SEC-registered investment advisor. Securities offered through HighTower Securities, LLC, member FINRA/SIPC. This information is intended for the recipient’s information only. It may not be reproduced or redistributed without the prior written consent of Fischer Stralem Advisors. This commentary reflects our current views and opinions. These views are subject to change at any time based upon market or other conditions. Past performance is not indicative of future results. Sources 1. (U.S. National Archives), 2. (Evercore 12/31/24), 3. (Bloomberg 12/13/24), 4. (Geopolitical Futures 12/29/24), 5. (McKinsey & Co 9/23/24), 6. (Bloomberg 11/12/24), 7. (Bloomberg 12/07/24), 8. (Eurasia Group 12/23/24), 9. (Peterson Institute for International Economics 12/12/24), 10. (Economic Policy Institute 10/4/24), 11, 15, 16. (Visual Capitalist 11/23/24), 12. (American Immigration Council 10/4/24), 13. (Pew Research Center 7/23/24), 14. (Bureau of Labor Statistics 6/30/24), 17, 19. (Deloitte Consulting 4/24/24), 18. (National Foundation For American Policy 10/24/24), 20. (Reuters 6/24/24), 21. (New York Times 6/27/24), 22. (Federal Reserve 7/24/24), 23. (Gavekal 5/31/24), 24. (Council on Foreign Relations 12/7/24), 25. (Walmart IR 11/7/24), 26. (Columbia Sportswear 10/30/24), 27. (AutoZone IR 10/30/24), 28. (Stanley Black & Decker IR 10/10/24), 29. (Gavekal 11/21/24), 30, 33. (Gavekal 12/10/24), 31. (Gavekal 11/13/24), 32. (Bloomberg 12/5/24), 33. (Winston Churchill 10/1934)