This episode focuses on tariffs - how investors should think about them, how they should position their portfolios, and the types of companies that will continue to prosper.

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You can find the transcript for the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: All right, so big day today for us, Shani. We are doing three podcasts. We're recording three podcasts, which is exciting because you're away next week.

Jayamanne: I am. I'm away next week, and then we're both away in April. So we're trying to bank these up so you can have continuous Investing Compass podcasts.

LaMonica: There we go. And it's a big day for you because I got you a present.

Jayamanne: You did get me a present, yeah.

LaMonica: You said, last night you told me that you had a craving for a peanut butter sandwich.

Jayamanne: Yeah.

LaMonica: And I got you peanut butter, and then you said you wanted it on.

Jayamanne: Like really cheap white bread.

LaMonica: But then you said the white bread, which I thought was pretty cheap.

Jayamanne: You got me really bougie white bread. You got me Helga's white bread. Like I want a Wonder white, like a cold sandwich bread.

LaMonica: Well, there we go.

Jayamanne: But thank you.

LaMonica: So in between your cravings for peanut butter sandwiches, you might have noticed that there's a new president in the U.S.

Jayamanne: I have noticed, despite the lack of coverage on news outlets.

LaMonica: Yeah, exactly. I mean, who is this guy?

Jayamanne: Yeah, but since you mentioned him, you were supposed to tell us who you voted for.

LaMonica: I never said that I would say that. You, I got an email the other day, somebody wants you to say sponge.

Jayamanne: We're getting a lot of those emails.

LaMonica: I know. You just need to do it. I've never even heard you say sponge. You say that you say it in a strange way.

Jayamanne: You've heard it. You told me it was very strange.

LaMonica: Well, just look at that.

Jayamanne: You made fun of me.

LaMonica: I forgot it. All right. Well, so I'm not going to tell you who I supported in the election, but as you said, regardless of your political affiliation, obviously there has been a lot of reporting on the changes that Trump is putting into place. And so it seems like every day and, you know, multiple times a day, we are getting these announcements of new policy changes. And, you know, I'd say many of them are challenging sort of longstanding global policies. And so everyone either supporting or not supporting is kind of in an uproar about it.

Jayamanne: And at the very least, the Trump administration is seen as unpredictable. And if there's one thing that markets don't like, it is unpredictability.

LaMonica: Yeah.And it does make sense at the end of the day. And people always say that markets don't like or markets want things to be predictable, but, you know, investing involves trying to predict what's going to happen in the future. And we all know, I think intuitively, that the future is unpredictable, but the more certainty that at least investors perceive about the future, generally the more comfortable they are taking risks.

Jayamanne: And in the last three months, which is roughly when Trump got elected, the S&P 500 is down a bit more than 5% in U.S. dollar terms. The ASX 200 is down a little more than 4% and tech shares that have done so well for so long have fallen even more. The NASDAQ is down 7% over the past month.

LaMonica: Right. And that's all very short term. And we, of course, advocate taking a step back and obviously looking at the potential long-term implications of everything. And, you know, this does obviously, it's seemingly this very profound shift in U.S. policy, but we want to look at those long-term implications and not just sort of follow headline by headline, because that's really a lot of that is noise. So we're going to do the Mark and Shani view of the world today.

Jayamanne: When is the Investing Compass not the Mark and Shani view of the world?

LaMonica: I mean, I guess it is. So we will continue to do it, but we'll look at policy changes.

Jayamanne: All right. So we're recording this a few days after tariffs went into effect on imports into the U.S. from Canada, Mexico and China. And if everyone remembers these tariffs were supposed to go into effect earlier, but Trump provided a window for negotiation, but that window is clearly over. And of course, Canada, Mexico and China have retaliated. And this does not seem to be the end of tariffs as Trump has more targets.

LaMonica: Exactly. And, you know, I think the conventional wisdom that we always hear and that we're going to explore a little bit is that tariffs are inflationary. And that makes sense because tariffs, of course, increase the amount that goods cost for consumers and producers. And that seems to meet that definition of inflation. But it may not fully be the case because people can, of course, skip purchases, substitute different goods, cut back. There's all sorts of things that can happen.

Jayamanne: And that is what proponents of tariffs argue, because the substitute goods are often manufactured in the country they are purchased.

LaMonica: Yes. Ready for some history, Shani. So an example of this is the Smoot-Hawley Tariff. So that was enacted in 1930. Now, before I get into the tariff, do you know the movie that that was featured in Shani? And I know that the longstanding joke, which isn't a joke because it's true, is that you have not seen any movies, but I know you've seen this movie.

Jayamanne: No. If we had a Venn diagram of the movies you had watched and the movies I had watched, it would be Harry Potter 1 and Scent of a Woman. That's about it.

LaMonica: First of all, you made me watch Harry Potter. But this movie is in that Venn diagram. Ferris Bueller's Day Off.

Jayamanne: Oh, yes. Well, it's not in the movie.

LaMonica: It is in the movie. It's a scene in the movie. It is the teacher, Ben Stein.

Jayamanne: Yeah. He's teaching about it, but it's not. I thought you were talking like Big Short kind of situation.

LaMonica: No.

Jayamanne: I was like, I've not seen a movie about tariffs, but okay.

LaMonica: There we go. But in that case, whether they didn't talk about it much in the movie, but in that case, inflation actually significantly decreased after that tariff was enacted. Now, of course, that tariff is also credited with throwing the U.S. and the world into the Great Depression, but, pluses and minuses for that policy.

Jayamanne: But the other thing that the tariff caused was a significant decrease in international trade, and that's what we want to focus on. Because ultimately, we're in a very different era than we were in 1930.

LaMonica: Make your joke, Shani.

Jayamanne: I don't know the joke.

LaMonica: Okay. Well, we're going to go to the 1970s and yes, Shani, I was born in 1979. So technically, I experienced the 1970s, but...

Jayamanne: Groovy.

LaMonica: Groovy. I think that's the 60s, Shani. So basically, since then, really, the kind of dominant, I guess, economic theme has been globalization. So, of course, we're summarizing the last 50 years, but basically, we've had globalization. And globalization is this giant anti-inflationary or deflationary force where, of course, goods and services that people consume in Western countries were moved offshore and they were produced in low-wage countries.

Jayamanne: And this was a huge deflationary force in the world. It was one of the key factors in the fact that we went through a long period of low inflation from the early to mid-80s on. And that allowed us to have ultra-low interest rates for an extended period of time. Most people took advantage of cheap goods and low interest rates to buy a lot of stuff and go into a lot of debt.

LaMonica: Now, the first shock to this long-standing globalization trend was the pandemic. So, all of a sudden, it just didn't seem so smart to import everything from other countries when borders were closed and supply chains were broken. And so, this, of course, is one of the contributors to that inflationary spike that we went through a couple years ago.

Jayamanne: The question is, if tariffs are the second body blow to globalization? And if it is, are the implications going to be the end of this inflationary tailwind we've had for so long?

LaMonica: Yeah. So, I think that's a good way of putting it, Shani. So, the market obviously tends to fixate on the short term. And I think right now, everyone's focused on the next rate cut. Right? So, we just had a rate cut in Australia. Everyone's wondering if there'll be another one, how many there'll potentially be this year. In the U.S., rates were cut earlier and more significantly, but now there's a bit of a pause and people are wondering if the Fed's going to start cutting rates again. But really, the question, I think, for long-term investors, that we should be asking ourselves, is will inflation and interest rates be higher in the next 20 years than the last 20 years? And I think my bet would be yes.

Jayamanne: And of course, if interest rates are higher, the advice would be to really focus on your debt levels. But to be completely fair, we would always recommend that you focus on your debt levels. So, even if this prediction is wrong, you would still be in better shape than otherwise. The other question is, what are the other potential implications of higher interest rates over the next 20 years than the last 20 years?

LaMonica: And one thing I think we should be clear about is, I guess, if you look back over the last 20 years, but particularly recently, what was happening was not normal. So, interest rates were shockingly low.

Jayamanne: And don't shoot the messenger. But if you think that rates are going back to the levels we saw during COVID, that's very unlikely.

William Ton: Hi, I'm Will, producer of Investing Compass and here are this week's must reads on Morningstar.com.au. Industry super funds have turned to private assets to invest the retirement savings of millions of Australians. In this week's Unconventional Wisdom column, Mark explores whether they live up to the hype. The 3 million super cap was originally seen as a tax for the wealthy. With no adjustment for inflation, with time, it will impact more and more Australians. Shani's Future Focus column looks at whether investors should stop contributing to their super and the ways in which they can approach the problem.

Warren Buffett often cites Phil Fisher as one of his biggest investing influencers. In this week's Bookworm, Joseph explores one of Fisher's essential criteria for long-term holding. As Joseph shows, this X factor can be the difference between owning a company that fizzles out after initial success and one that continues to thrive for many years. Australia's obsession with home ownership is constantly increasing as first home buyers rush to get into the market. Last week, Sim explores whether you should save for a deposit or invest in shares. It appears that amongst the shares versus housing debate, there emerges a third wildcard, that is rentvesting. These articles are more and now available in the show notes and now it's back to Mark and Shani.

LaMonica: We do want to talk about some of the other impacts from higher interest rates other than just costly or debt. So we can start with valuations. So valuations of growth assets like shares. So what we've seen and we'll go through several examples, but really we've gotten this free lunch as investors that valuation levels have continued to increase and increase. So let's go through those examples. So since 2009, the S&P 500, so the 500 largest shares in the U.S., the price to earnings ratio has gone up 44%. And that of course is one driver of share returns. So the others are dividend growth and earnings growth.

Jayamanne: So an example might help. So if we look at CBA, in 2015, CBA earned $5.61 a share. In the last 12 months, CBA has earned $5.88 a share. So earnings have increased 4.8% since 2015.

LaMonica: Which really isn't very good.

Jayamanne: No. Then we can look at the price to earnings ratio. In 2015, CBA traded at 15.85. Currently it is trading for 27.05. So that's an increase of 70%.

LaMonica: Yeah. And so we can see how this has impacted the share price. So the share price is up roughly 75%. So it's 75% higher than the beginning of 2015. So returns from dividends, that's just the share price. Returns from dividends, of course, would be added to that. But if we include those, you had an annual return of roughly 8.15% per year over the last 10 years.

Jayamanne: And we could use a lot of different examples here. We just picked the largest share in Australia. But if we turn our attention to Apple in the U.S., we can see a similar pattern. In 2015, Apple traded for 11 times earnings. And currently, Apple is trading for 37 times earnings.

LaMonica: Yeah. So that's an increase of 236% from a valuation perspective. It's 236% more expensive, which I think is pretty crazy. Now, there was more earnings growth at Apple than CBA. So earnings grew from $2.31 to $6.30. Which is an increase of 172%. Over that time period, the shares are up 705%. And they have a modest dividend, but the overall return, including the dividend, was 22.5% a year over the last decade.

Jayamanne: So the lesson is that in some cases, returns are driven by increases in valuations. So valuation levels are held in check or even go down. It is not going to be a great outcome unless a company is able to grow earnings and dividends over time.

LaMonica: And this kind of falls in that same category as the debt advice that we gave, right? Earnings growth, paying the right price for share, all very important. So the fundamentals matter. And I think that's a theme, hopefully you'll hear frequently during this podcast.

Jayamanne: And we have focused a lot on the U.S. And the U.S., of course, has an outsized influence on the world. But we do need to turn our attention to another large and influential country that influences Australia, and that is China. Do you want to give me that with an accent?

LaMonica: What kind of accent?

Jayamanne: I mean, this is about Trump, isn't it?

LaMonica: I'm supposed to do a Trump accent?

Jayamanne: Yeah.

LaMonica: I will not be doing that. I will not be doing that.

Jayamanne: For a second, I thought you were going to do it.

LaMonica: I know, but then I would be fired, probably. So you can probably guess the country that China exports the most goods to. That is the U.S. And there has been a lot of talk and focus on building out the consumer economy in China. And basically just hasn't worked.

Jayamanne: China's household spending is less than 40% of annual economic output, so 20 percentage points below the global average. The government has been trying to fix this issue since 2004, and there are a lot of reasons for this. The property market is in shambles. The population is aging, and consumers save too much money because they're worried about the future.

LaMonica: And China, and the reason, of course, we're focusing on China, is because that's really important for Australia, because Australia exports a lot of commodities, shouldn't be news to everybody, but exports a lot of commodities to China, so the Chinese economy matters. So the question is, of course, what's going to be happening in the Chinese economy? And there have been worries about this for a while. This is not really a Trump thing, but if we go back to 2021, iron ore, so obviously an example of a big commodity that's exported to China, was $214 U.S. for a ton. It was $125 a year ago, and now it's around $100, and our analyst, Jon Mills, thinks it will reach $72 the price of iron ore by 2029.

Jayamanne: And that obviously has implications on our economy and the miners who dominate the local share market. We just touched on iron ore, but overall, 60% of BHP and Rio's sales are to China. Almost all of Fortescue's sales go to China.

LaMonica: So obviously the worry here is that Trump's tariffs will hurt the Chinese economy, and that in turn will, of course, impact the Australian economy. So China obviously just isn't going to accept these tariffs and not do anything around it, so they did just have another round or announced another round of stimulus. They've been doing this a lot as the economy has been slowing, but we think, the Morningstar house view is that there are just too many structural headwinds, including the things that we mentioned, the declining population, their slowing urbanization, there are declining returns on infrastructure spending. So we think there's just too many headwinds for the Chinese economy to keep growing like it has in the past.

Jayamanne: So the question, of course, is what we do as investors, and honestly, our answer is nothing. We've tried to portray how complicated all of this is, how the interplay between all of these factors that ultimately stem from an unpredictable man with an unpredictable policy direction have all these consequences.

LaMonica: And the issue is that if you were trying to arrange your portfolio based on all of these potential outcomes and you're making changes every time Trump decides to change his mind, you're -- number one just going to drive yourself crazy, I think, but you're most likely going to significantly hurt your returns.

Jayamanne: And the guidance we've given so far seems simple. Focus on reducing debt, invest in companies that can grow earnings and consider the different sources of returns doesn't sound like rocket science, but it is our behavior and that is the biggest drive of returns.

LaMonica: And it's times like this when there is all this uncertainty and the volatility that we talked about when you get a lot of opinions on what to do. And that makes it more likely that you're going to make a mistake as an investor. So take a breath, buckle in and just remember to focus on long term goals and try if it's even possible to ignore all this day to day noise and news. I'll use that term loosely out of the White House.

So thank you very much for listening. I should cut back and spend less money on "cheap white bread" that I buy, Shani. So that's going to be my resolution for the rest of the year. But thank you for listening. My email address is in the show notes if you have any questions or comments.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)