Trumpcession?
As we listen to President Trump’s tariff “jibber jabber” (the classic line from the hit show Boston Legal), we bear witness to a masterful example of speaking much and saying little! Think of the noise as an unscripted comedy that is all about improvisation and less about a coherent message. Where rationalizing a dumb idea is grounded in political catchphrases like “tariff is the most beautiful word in the dictionary.” Or leaning on the late astronomer Carl Sagan’s catchphrase ‘billions and billions’ to describe this ‘very big’ untapped revenue source.
This is Trump 2.0 with no guardrails. Congressional and Senate leaders have promised loyalty to President Trump, which means they have given a machine gun to a chimpanzee and seem content to survey the impending carnage from the sidelines.
Whatever one thinks about President Trump, one thing is clear, his on-again-off-again tariff threats are trashing business confidence on both sides of the border. His doubling-down-art-of-the-deal strategy is increasing the odds of a Trump induced recession (dubbed Trumpcession). We cite recent reports from Goldman Sachs and J P Morgan Chase. Goldman has raised the probability of a US recession within the next eighteen months, from 15% to 20%. J P Morgan Chase have put the odds at 40%.
There is turmoil in the financial markets as the S&P 500 Index has given back all the gains including the Trump bump after November 5th, 2024, election results. Not surprisingly, volatility has spiked with the CBOE Volatility Index hovering between 25 and 30, the highest levels since August 2024, when the Japanese currency trade unraveled.
What makes Trump’s daily waffling so frustrating is the fact that no one fully understands the endgame. We understand that tariffs can play a role when dealing with unfair trade practices. But torching long-held partnerships supported by questionable justifications seems like a dumb idea. So it is that we return to the $64 trillion question; what is the justification for starting a global trade war?
The most common themes are to balance trade and spur US manufacturing. Specifically, as Trump suggested in his speech to the joint session of Congress, the mere threat of tariffs have spurred more U.S. manufacturing in the auto industry. According to Trump, “plants are opening up all over the place!” He is right about that as many companies are setting up facilities in the US to avoid tariffs.
To add his own version of an exclamation point, he made direct threats to manufacturers by declaring “if you don’t make your product in America, under the Trump administration, you will pay a tariff and, in some cases, a rather large one.”
As noted, Trump has so far engaged in a Texas two-step by granting one-month exemptions for imposing new tariffs on imports from Mexico and Canada. Particularly worrisome are his attacks on the auto sector. In the words of Ford CEO Jim Farley, a north / south trade war would “blow a hole” in the US automobile industry. Truth be told, we doubt Trump will ever impose punitive tariffs on the auto sector because any attempt to build and re-tool factories in the US would cost billions of dollars and take years to accomplish.
Trump has also hyped the notion that tariffs will stop illegal immigration and human trafficking which he believes is a national security threat. Likely, the “national security threat” is how the administration intends to defend the trade-related executive orders against a tranche of lawsuits that are working their way up to the US Supreme Court.
The national security issue is premised on concerns that lumber, copper, steel and aluminum are critical resources used by the construction industry and the military. Trump believes that it is imperative to source these products internally given their vital importance to national security. There is some merit to that point of view.
Stopping the flow of Fentanyl was the original national security trigger point. However, this has been a tough sell to Americans who are beginning to question his hostility towards Canada. Over the past year, US customs agents seized 43 pounds of Fentanyl at the Canadian border (which may have overstated the actual number given that one of the seizures occurred in Washington State nowhere near the Canadian border), compared with 21,100 pounds at the Mexican border.
The imposition of additional tariffs on China is predicated on the view that the Chinese Communist Party provides a “safe haven” for criminal organizations to “launder the revenues from the production, shipment, and sale of illicit synthetic opioids.”
We suspect the Chinese assault has more to do with US efforts to get companies to reshore manufacturing facilities back to the US. However, since labor costs were the key determinant that caused manufacturers to offshore in the first place, we suspect that most US companies would gravitate to India, South Korea and Vietnam which have much lower tariff friction.
There is also a train of thought espoused by Trump’s Secretary of Commerce Howard Lutnick, that tariffs generate an external revenue source that could ultimately replace income taxes which the Trump administration sees as an internal revenue source. Not sure how one rationalizes that when US companies pay the tariffs.
Taking that position to another level, the Trump Administration believes that tariffs are a massive piggy bank that could help balance the federal budget. Considering the US government is carrying an annual trillion dollar plus budget deficit it is hard to see how US $453 billion in tariffs will plug that hole.
The ‘fairness’ argument that underpins reciprocal tariffs has merit. Reciprocity could be used to eliminate discriminatory practices. Although even this Trumpian approach has limits. One can hardly argue that GST or Value Added Taxes are discriminatory.
In one of his appearances when on the campaign trail, Trump raised the issue that tariffs could help solve rising childcare costs. That was in response to a question about how he would tackle childcare so more women could enter the workforce. The answer: hike taxes on imports! Mind you that issue was never raised again probably because Trump is not particularly interested in childcare or having more women in the workforce.
The wealth effect was another talking point as Trump believes that revenue from tariffs will make the country wealthy. In his speech to Congress, Trump said: “Tariffs are about making America rich again and making America great again.” Not sure how one connects the dots between layering additional taxes on US businesses to wealth creation.
Finally, as happens so often in American politics, he gave a shout out to the religious right. During his address before Congress, Trump personalized the tariff argument by spotlighting an Alabama steelworker who attended the speech. “Stories like Jeff’s remind us that tariffs are not just about protecting American jobs,” Trump said. “They’re about protecting the soul of our country.”
A Tariff Investment Thesis
The Administration’s positioning around tariffs seems impenetrable. Without guardrails the only way to break this tariff wall is when the damage from the chimpanzee holding the machine gun becomes unbearable.
The first step is to generate pain in ways that Trump understands. The market sell-off driven by recession fears or worse, stagflation, is an excellent starting point.
The second step is when tariff threats are personalized by higher prices at the gas pump and the grocery store. Penetrating the tariff wall will begin with cracks in the MAGA base. Until then, we are stuck in Trump’s version of Alice in Wonderland.
Formulating an investment thesis comes down to assigning probabilities to Trump’s tariff end game which is like trying to solve a series of riddles orchestrated by the Mad-Hatter.
What we know is that Canada is in Trump’s crosshairs. While it is not clear why, we can assign probabilities to rationalize his way of thinking. To that end, we weigh the following possibilities in order of importance:
1. It could be frustration about the 2017 USMCA negotiations when Chrystia Freeland would not budge on Canada’s supply management system.
Negotiations for a new USMCA are slated to begin in 2026 if Canada and Mexica agree. The tariff threats may be Trump’s way of getting the parties to begin negotiations earlier. Any restart of negotiations will certainly focus on Canada’s supply management system which the US believes is an unfair trade policy.
Given the challenges during the original pact, Trump may want to ensure that he has enough time to structure a new agreement before his term ends. Reopening talks early will provide a buffer so that he can announce a new “better” deal that would be concluded before the US mid-term elections. We suspect that Trump may win some supply management concessions from Canada, which would lower domestic costs for dairy and food products.
The Digital Services Tax (DST) will likely be part of the negotiations as Trump believes they harm US tech giants. Canada may be willing to defer a DST until a global standardized model is put in place.
2. He might believe that under maximum economic pressure, Canada will acquiesce and become America’s 51st State.
While we do not believe that Canada will ever allow a foreign country to gain control of its’ sovereignty, there may be a strategy that could benefit both sides. The US is the world’s leading manufacturer and Canada has an abundance of raw materials that are an integral part of the manufacturing infrastructure. Setting up a system that allows for the free flow of goods could position North America as a powerful trading block that would ensure dominance over China into the foreseeable future. Something that Premier Doug Ford has been advocating.
This would look something like the European Union trading block which would create a state-like structure protecting Canadian sovereignty while solving border issues. The concern is that we could end up with a single currency hindering our independence.
3. He may simply have a personality conflict with Canada’s leadership in which case, Mark Carney’s assent to the Prime Minister role could allow for a reset.
We assign the lowest probability to this position but cannot discount the fact that Trump may have delusional tendencies. We will know soon enough if this becomes the most likely outcome when Trump has a face to face with Mark Carney. It will also weigh on Canadians choice for the next Prime Minister.
If we operate from the position that the first two bullets are the primary issues, then we may be able to avoid a recession. If the third possibility rises to the top, then a recession on both sides of the border is all but certain.
In a recession, we will get lower interest rates and massive infrastructure spending. Notably projects would include an east-west pipeline that would spark a movement to open new trade routes with other partnerships. Canada will survive this disruption, but it will take time.
At present we are focusing on the most logical outcomes but recognize that logic is not high on the US administration’s decision tree.
To finish on a positive or negative note (depending on your point of view), we are reminded of the Chinese proverb “may we live in interesting times!”
THE CANADIAN RESPONSE TO TARIFFS
Provincial trade is governed by the Canadian Free Trade Agreement (CFTA). The 2017 agreement signed by federal, provincial and territorial governments, aimed to eliminate and reduce trade barriers within Canada. The problem is that it also granted governments flexibility to establish exceptions and as happens so often with inter-governmental agreements, the CFTA is full of exceptions.
Considering the burgeoning north-south trade war, the Committee on Internal Trade (CIT) has taken steps to dramatically reduce trade friction within CFTA. The number of current exceptions (note the Federal government removed 17 federal restrictions in June 2024) have been reduced from 39 to 19, although most of these pertain to procurement.
Aside from procurement, the CIT is removing restrictions on industries subject to federal regulation. For example, Ottawa will remove an exception that stipulates Canada Post has the “sole and exclusive privilege of collecting, transmitting and delivering letters.”
We expect policy makers to spotlight regulatory and administrative differences that stifle the movement of goods and workers within the country. For some time, the business community has been lobbying for governments to recognize each other’s regulatory standards by default.
With a new Prime Minister and a federal election looming, provincial premiers have taken a larger role in responding to the threat of US tariffs and proposing ways to strengthen the Canadian economy. Ontario Premier Doug Ford and Alberta Premier Danielle Smith have played leading roles in this outreach program.
The Bank of Canada has been cheerleading these efforts to improve productivity and strengthen the economy. According to Tiff Macklem the only way to offset potential economic damage from US tariffs is to make structural changes in the economy with trade barriers being the centerpiece of that agenda.
According to a 2019 report published by the International Monetary Fund, Canada’s real gross domestic product per capita would be 4% higher if all barriers, excluding ones related to the country’s geography, were removed.
Clearly, there would be improvements if we scuttle trade barriers, but the IMF report may have been overly optimistic. A more recent report by the Canadian Centre for Policy Alternatives agreed that there would be benefits but questioned the degree to which barriers hinder domestic economic activity.
Their report, authored by senior economist Marc Lee, raised concerns about standardizing regulations across provinces. According to Lee, “attempts to remove so-called interprovincial trade barriers is mostly a push for ‘mutual recognition’ of regulations – a process by which all provinces could be forced to accept the least stringent regulations for safety, environmental protection and consumer protection. Not a given!
The bottom line is that various levels of government are at least talking. The hope and expectation is that these discussions will lead to some outcomes that will benefit Canada well beyond the current north-south hostilities
EVALUATING THE FUTURE OF ARTIFICIAL INTELLIGENCE
The future of Artificial Intelligence (AI) has been drawn into a debate about its advantages and limitations. It has become a proverbial tug of war with the right advocating the benefits and economic inducements against the left pullers promoting a reality check around unintended life-changing outcomes.
Will we enjoy the benefits in a world where home appliances assume the role of a sous-chef managing time and temperature settings, recommending side dishes, wine and dessert pairings, so that your Sunday dinner is exactly the way you like it? Or will we suffer the consequences when human interactions are replaced by machines that can manage mundane repetitive tasks more efficiently? How we view these transformative changes will come down to how we balance the limitations on future employment opportunities versus the benefits of productivity improvements.
What we know with certainty is that AI has become a momentum driven investment theme supported by the fear-of-missing-out (FOMO) crowd. Tech centric investors believe that AI will infiltrate and transform our daily routines in ways that have not been seen since the introduction of the Internet. It is, according to Bill Gates, the most important technological advance in history. In the not-too-distant future, AI will be as indispensable as today’s mobile phone.
The economic value of AI will hinge on how it disrupts specific industries. Think about this in terms of say, the legal profession. AI can decipher contracts as well as, or according to some, more efficiently and certainly more cost-effectively, than a human.
The same can be said about assembly lines where there is a clear advantage in using machines to execute repetitive tasks. We already see that playing out in the auto industry where robotics has replaced much of the workforce that used to run the assembly line.
Whatever the outcome, the capital required to fund AI infrastructure has no historical precedence. The question is not about AI’s potential to revolutionize industries and redefine (either positively or negatively) the way we live. It is about whether this massive spending will lead to once-in-a-lifetime investment opportunities or burden hyper-scalers with excessive debt and no offsetting bump in profitability.
While there is no way to know about long-term outcomes, we can examine the use case over time, to weigh the investment merits associated with AI’s long-term benefits and pitfalls.
Growth Prospects: No one questions the fact that the AI market has been experiencing exponential growth that is expected to continue into the foreseeable future. Putting some meat on this skeleton, the total market for AI in 2020 was US $62.35 million and was projected to grow at a compound annual growth rate (CAGR) of 40.2% from 2021 to 2028.
The global Artificial Intelligence market is expected to reach USD $35,870 million by 2025 from its direct revenue sources, growing at a CAGR of 57.2% from 2017 to 2025, whereas it is expected to garner around USD 58,975 million by 2025 from its enabled revenue arenas, according to a new report by Grand View Research, Inc.
While we do not dispute the historical growth pattern, it does not address the question of who will benefit. The surge in the value of the magnificent seven stocks plus the outsized gains in a trio of AI startups (notably; OpenAI, Anthropic and Inflection AI) was predicated on the position that these businesses with their access to top-of-the-line AI chips controlled by an army of engineers would dominate the field.
That may no longer be the prevailing view. When China’s DeepSeek demonstrated a chatbot that was presumably developed for considerably less money using inferior chips on the back of Meta’s open-source software, it unsettled the status quo. No longer did the US have the impenetrable black box.
The implications for investors are profound. If DeepSeek can offer low-cost solutions using first generation AI chips, then the mega-cap tech community may find that their deep pockets are not enough to guarantee any long-term advantage in the AI space. The fallout in the broader market could be profound given the outsized weight of the magnificent seven plus Nvidia within the S&P 500 index. Any slowdown in the mega-cap momentum trade could have an outsized impact on the US stock market.
The Use Case: To accept the position that AI will be transformative, one must ask what is the “Killer App” that solves existential problems.
Think about the current batch of AI products that include, but are not limited to, ChatGPT, Microsoft Co-pilot, alternative search engines and Musk’s Xai. These are useful products, but none are vital.
Hyper-scalers are spending trillions of dollars to develop by all accounts, critical AI applications that longer-term, will presumably provide pivotal bumps to their bottom lines. That may be true for must-have applications, not so much for nice to have remedies. Is it possible that hyper-scalers have put the cart before the horse by attempting to solve a trillion-dollar problem that may not exist?
Applications like ChatGPT do not impart original thought. It is, after all, software developed on the back of machine-based learning. AI models work best by using brute force to solve problems. Running multiple outcomes to see which one works best.
Those promoting AI point to its ability to disrupt and improve health care. AI-driven algorithms can analyze vast amounts of medical data to identify patterns and predict outcomes. For example, AI can examine MRI scans and spot abnormalities that sometimes escape the healthcare professional. The challenge comes down to the appropriate treatment option.
If the AI system was built within the pharmaceutical industry, it will likely recommend drug-related treatments. If the system was constructed by naturopaths, the treatments would likely be slanted towards diet and holistic interventions.
Brute-force applications have made inroads into finance as well. AI-powered algorithms can analyze market data, identify trends, and make real-time trading decisions. This has led to the rise of algorithmic trading, which has the potential to outperform traditional human-led trading strategies. What it does do is add to market volatility.
Within the banking industry, AI can detect fraudulent transactions, assess credit risk, and automate customer service. The adoption of AI in finance will continue to expand leading to greater efficiency… maybe!
Skeptics argue that for the foreseeable future, AI models will not develop human-like intelligence. Some believe that AI, like any other information technology, will become more complicated and less intuitive. The robots will get in each other’s way just like we do, and during this initial phase, humans may be overestimating the benefits.
When it comes to benefits, one must ask where investors are placing their bets. The current focus is on companies that develop apps (Open AI, Xai, Meta Platforms and Broadcom) and companies that manufacture AI chips (Nvidia, AMD, etc.). How that plays out in the future will depend on how widely AI is used.
Cost is also a significant impediment. In its current configuration, ChatGTP 3.0 budgets $20 to respond to a single prompt. Daron Acemoglu, an economist at MIT, estimates that less than 25% of AI-automated tasks will be cost effective within the next 10 years.
That latter point raises questions about the macro-economic impact. How significantly will AI impact economic growth. The idealists believe that AI has the potential to increase productivity which will have an outsized impact on economic growth. Maybe… maybe not! Historically, it is difficult to find any link between labor productivity and technological innovation.
Productivity growth surged after the Second World War into the 1970s. By the latter half of the 1970s and during the 1980s, productivity stalled, despite the advent of personal computers and office software. Productivity growth picked up for a decade between 1995 and 2005, which was propelled by the Internet and to some extent, by falling interest rates. Since 2005, productivity has softened.
Analyzing historical patterns is a lot like playing Monday morning quarterback. There are many ways to explain the variability in productivity, but you cannot escape the fact that there is no direct link between breakthrough technology and long-term accelerated productivity.
Conclusion
In a recent interview on CNN, Bill Gates said that AI is a transformative technology that will eclipse the personal computer and the Internet. He qualified his enthusiasm with an interesting timeline. Gates believes that over the next five to ten years we will be exposed to AI’s benefits. After that, we will begin to experience the challenges.
It may be that the optimism around AI is fully justified. Maybe it will change the world in a positive way. Maybe the AI euphoria that has pushed the stock market to record highs will continue to generate above-market returns for the foreseeable future.
But in our view, a successful investment thesis comes down to identifying the right opportunities and more importantly, staying ahead of the curve.
A PRIMER ON STRUCTURED PRODUCTS
Remember when the world of finance was a peaceful place with clear lines separating institutional and individual investors. Individual investors diversified portfolios by allocating weights to the three major asset classes: cash, bonds and stocks. Institutional investors accessed additional levels of diversification including passive and active equity strategies, geographic dispersion, private equity, real estate, commodities and hedge funds. How times have changed!
Today, through financial engineering, individual investors can access products that, while sometimes complex, put them on an equal footing with their institutional brethren. One notable innovation is an investment class broadly referred to as structured products.
Structured products are pre-packaged investments that normally include assets linked to bonds plus one or more derivatives. They are generally tied to an index or basket of securities and are designed to facilitate highly customized risk-return objectives. This is accomplished by taking a traditional security such as a conventional investment-grade bond and combining that with derivative securities on one or more underlying assets. This fixed income + derivative structure tempers the potential payoff but protects the principal investment.
The Return Matrix
Structured products normally pay out at maturity. The fixed income component provides the return of principal, and the derivative piece generates the payoff. This means that structured products are closely related to options pricing models, either by direct exposure to over-the-counter options or byproducts such as swaps, forwards and futures that have embedded features including leveraged upside participation and / or downside buffers.
A Basic Structured Note
Typically, large financial institutions issue Structured Notes with a notional face value of $1,000. Basic Notes consist of two components; a zero-coupon bond and a call option on an underlying equity instrument such as common stock or an ETF that mimics a popular index like the S&P 500. The maturity can range between three and five years.
Although the pricing mechanisms that drive these values are complex, the underlying principle is simple. On the issue date, you pay the face amount of $1,000. Your principal is either fully protected or set up to minimize downside risk.
In the principal-protected note, you will get your $1,000 back at maturity no matter what happens to the underlying asset. This is accomplished via the zero-coupon bond accreting from its original issue discount to face value.
For the performance component, the underlying asset is priced as a European call option and will have intrinsic value (the difference between the strike price of the call option and the current value of the underlying asset) at maturity if its value on that date is higher than its value when issued. If applicable, you earn that return on a one-for-one basis. If not, the option expires worthless, and you will get back your initial investment.
The key driver for Structured Products is the principal protection. The trade-off is that you must be willing to forfeit some of the underlying asset’s upside potential.
Customization
Over time, the basic Structured Note has morphed into more complex iterations with greater customization. Some versions provide exposure to more than one underlying asset. For example, a note might derive its performance from a basket of un-correlated assets such as the S&P 500 index, the MSCI Pacific Ex-Japan Index, and the Dow-AIG Commodity Futures Index.
Another twist is the so-called lookback feature where the value of the underlying asset is based not on its final value at expiration, but on an average of values taken over the note’s term. This may be monthly or quarterly. This structure can lower volatility by smoothing returns over time.
Liquidity Issues
One common risk associated with structured products is a relative lack of liquidity that comes with the highly customized nature of the investment. Moreover, the full extent of returns from complex performance features is often not realized until maturity. For this reason, structured products tend to be more of a buy-and-hold investment rather than a means of getting in and out of a position with speed and efficiency.
A significant innovation to improve liquidity in certain types of structured products comes in the form of exchange-traded notes (ETNs), a product originally introduced by Barclays Bank in 2006.
These are structured to resemble ETFs, which are fungible instruments traded like a common stock on a securities exchange. However, ETNs are different from ETFs because they consist of a debt instrument with cash flows derived from the performance of an underlying asset. ETNs also provide an alternative to harder-to-access exposures such as commodity futures or implied volatility.
Summary
The complexity of derivative securities has long kept them out of meaningful representation in traditional retail and many institutional investment portfolios. Structured products can bring many derivative benefits to investors who otherwise would not have access to them.
As a complement to traditional investment vehicles, structured products have a useful role to play in modern portfolio management. But their use case is magnified when employed by professional money managers.
Richard N Croft
Chief Investment Officer