Reading the Tea Leaves (Ep. 4) – The Impact of Tariffs

Chris Zand: Hello, and thank you for joining us today for another edition of Reading the Tea Leaves, where we connect with senior portfolio managers at the firm and gain insights on the latest quarter's earnings and an update on the markets. Joining me for today's edition are Co-Chief Investment Officers for the Core Equity Strategy, Nael Fakhry and Greg Hermanski. As everyone knows, the trade war has created considerable economic uncertainty and volatile investment markets in recent months. Nael, I'd like to start with you. Can you tell us how the consumer is holding up given everything that's been going on this year?

Nael Fakhry: Yeah, I think the consumer's actually holding up pretty well. Unemployment is 4.2%. It's been stable there for a while, and if the consumer's employed, they're going to spend their income. In terms of the broader Consumer sector, I'd say consumer packaged goods businesses are under more pressure, probably because retailers, particularly the large retailers, are substituting their own store brand products where they can to save the consumer money, and meanwhile, they're also squeezing those branded consumer businesses to reduce costs for the shopper and the end consumer. In terms of the retailers, those who have scale are definitely most advantaged. They're able to front load inventory, they did so before the tariffs. They're able to squeeze costs out of their supply chain. I just mentioned what they're doing with the consumer packaged goods businesses, and overall we'd say that the retailers that have scale, those that are saving consumers money and those that are selling non-discretionary products are best positioned.

Chris Zand: Thanks, Nael. Very helpful. Greg, can you talk about what you're seeing on the industrial side?

Greg Hermanski: Sure, Chris. Most of the high quality industrial companies that we follow, they appear to be managing well through this period of increased tariffs. Like Nael had mentioned, most of the companies that we follow, they're larger, have scale and great management teams, and they've been able to limit the impact of the tariffs so far. And what we're seeing is that these industrial companies are using three primary strategies to blunt the impact. The first one is optimizing the manufacturing to localize their production or move it into other low-cost areas. The second thing that they've been doing is putting in place broad-based cost-cutting measures to increase the efficiency of the organization overall. And then finally, where they need to, they've been placing surcharges on their products. Interesting, as we look longer term, it seems like there may be some opportunities for these industrial companies to benefit from onshoring and nearshoring of manufacturing from sectors like pharmaceuticals and semiconductors.

Chris Zand: Thanks, Greg. How about on the technology side?

Greg Hermanski: Yeah, it's been interesting on the technology side, it seems to be two different stories from software companies, cloud companies, hyperscaler companies. They're seeing very little impact because they're not really impacted by tariffs. And then on the semiconductor and hardware side, it's been a mixed bag. When Trump repealed some of the tariffs, it made things a lot easier, but we are watching to make sure that there's not new tariffs that come on that could negatively impact those two areas.

Chris Zand: Thanks, Greg. Very interesting. Clearly the economy has been through a lot so far this year. We've started the year with gains, experienced a massive selloff, and now the markets have recovered for the most part. We haven't seen much in the way of trade deals yet, but there still remains a lot of things in flux as well with the current economy. How does all that fit into how we're managing client portfolios, Nael?

Nael Fakhry: Well, we'd say it's kind of normal course. That's what happens in markets just generally. So we'd give a few pieces of advice. First of all, keep things in perspective. Just recall there was a pandemic that no one expected a few years ago. We had a banking crisis within the last couple of years. Of course, we had a huge financial crisis years back, an industrial recession, tech bubble before that. And that's just kind of how things happen. And the reality is that markets and companies adapt and that's likely to happen in this scenario. Secondly, it's worth keeping in mind that we've been building the portfolio around this quality growth framework, and that means we own companies that we would argue have very durable competitive advantages that protect them against competition. These are businesses that generate significant and growing free cash flow.

They're well capitalized and they should actually come out on the other side stronger in many cases because they can grow in most environments and are well positioned to take advantage of the volatility and instability that we're seeing. Lastly, we've constructed the portfolios in what we think is a very productive fashion. They are primarily comprised of businesses we consider defensive and compounders, and we do obviously have businesses we consider more offensive, but they're a smaller portion of the portfolio, and we've also been carrying a little bit of extra cash to protect portfolios. So I would say the most important thing is to maintain a long-term perspective and realize that over time things will resolve, and I think we're well positioned to come out stronger from all of this.

Chris Zand: Great. Well, thank you very much for joining us today for this session of Reading the Tea Leaves. If you have any questions, feel free to reach out at any time. Thank you.