Happy New Year! As we reflect on 2024, we entered the year with modest expectations amid a complex and uncertain environment. The stock market, however, demonstrated resilience, delivering strong results. Artificial Intelligence (AI) was a key focus for investors and stock index returns were skewed by outsized returns on a handful of megacap tech stocks. Staying true to our investing philosophy, we didn't chase the hottest ones. However, several companies in our portfolios are in the thick of the race to develop AI applications and all are beginning to find ways to use AI in their operations. Our goal is long-term compounding, and we made good progress in 2024.
Looking ahead, 2025 could be a very interesting year. The world was already a complicated place before the election, but the prospect of President Trump 2.0 raises the level of uncertainty. Fans and critics—few are neutral—have hopes and fears, but for now, we can only guess what changes are in store. Clues from his previous term, campaign promises, proposed cabinet appointments, early advisors, and pre-inaugural actions offer some insights. Conventional wisdom suggests a pro-business, anti-regulation administration, and initial investor reaction to the election has been positive. However, the president's plans depend in part on navigating a divided Congress, a somewhat inconsistent judiciary and a notoriously inflexible bureaucracy.
In a country divided by politics, culture wars and a widening wealth gap, there is more at stake today than returns on stocks. We are hopeful that sensible, moderate leaders will emerge to guide both sides toward a workable middle. In the meantime, as investors, we cannot simply sit out periods of uncertainty and volatility. Instead, we remain focused on companies with the financial strength, flexibility and competitive position to withstand, and even take advantage of, any wobbles in the economy. We also take comfort in the belief that things are almost never as good, or as bad, as one fears.
The Two Most Important Things
In this commentary, we'll address some of the concerns that investors and advisors have shared with us. While we make few predictions, we'll share our working assumptions. But first, before diving into the murky unknown, we want to remind readers of two very important things.
1. We invest in businesses, not ticker symbols.
Our investment results depend on how well those businesses perform over many years. The business environment in which they operate is affected by interest rates, regulation, trade wars, etc., but owning the right businesses is more important than predicting the next economic data point.
2. When stocks go down, we get to buy more at lower prices.
This should improve our long-term results. Money that must be available on a short deadline shouldn't be invested in stocks, but long-term investors shouldn't fear volatility.
The Market's Worry List
- Interest Rates and the Fed. Longer-term rates (e.g.,10-year Treasury bonds) are very important to stock investors because they compete directly with stocks. The Fed Funds rate is the price of overnight inter-bank loans. While the financial media often fixates on changes in this rate, it has little impact on a company's long-term business value.
- National Debt and Budget Deficits. Investors began wringing their hands over the state of the nation's balance sheet long before I bought my first stock 63 years ago, so it's hard to imagine 2025 being the year that the national debt becomes a serious problem. However, the money we “print” to cover our deficit spending must be raised by selling new Treasury securities. Campaign promises about tax cuts, tariff revenues, and deep spending cuts from the nascent 'Department of Government Efficiency' should be taken with a large grain of salt. The Treasury can create an infinite quantity of bonds (subject to Congressional approval) but higher interest rates may be needed to entice investors to buy those bonds. This would raise rates for all borrowers and would be negative for stocks.
- Global Trade and Tariffs. “Tariffs” may be a beautiful word to some, but a tariff is a tax on imported goods. It raises the price of the import and provides a pricing umbrella for domestic alternatives. By definition, this is inflationary, putting upward pressure on interest rates. Depending on how they are implemented, tariffs may also add intangible costs to our relationships with trading partners and political allies.
- Immigration. The U.S. is a nation of immigrants but has experienced intermittent waves of anti-immigrant sentiment. The populations of most developed counties are aging and all face demographic crises of varying severity. Ironically, immigration offers a solution to our demographic problem. It is telling that despite vocal opposition to immigration, some local governments have declined to enforce their own anti-immigrant legislation because they need the workers. It would seem that with some creative reframing of the issue, immigration reform could be an area of common ground, but no solution seems imminent. Mass deportations seem unlikely, but a significant reduction in the American labor force would create inflationary pressures on wages and probably raise the odds of recession.
- Relationship with China. Anti-Chinese rhetoric plays well in the U.S. today but both nations need each other. We are major trading partners with conflicting ideas about fair terms of trade. Strategic questions regarding cutting edge computer chips, rare earths and even TikTok add political complications. Then, there is the future of Taiwan. We don't own any Chinese stocks, but most of our companies have at least some exposure to China. We do our best to understand the risks and opportunities for our companies that do business in China. It's a fascinating subject, but complicated.
- Shooting Wars. The war in Ukraine is entering its third year, with potential shifts in U.S. policy under the new administration. Israel faces a multi-front war involving Hamas, Hezbollah, Lebanon, Yemen and Syria, and thus by extension, Iran. It's impossible to know whether this widely expanded conflict will just multiply the chaos and suffering or clear the way for a wider agreement that could bring some stability to the area. Additionally, wars in Sudan, Ethiopia, and other parts of Africa, which receive less media attention in the West, have impacts that extend beyond their borders. Although dislocations in commodities markets (e.g., Ukrainian grain, Russian gas) are disruptive and expensive and can affect the entire operating and supply chain, we wouldn't expect any material impacts to our portfolios.
- Domestic Politics and Policymaking. Many of the trial balloons from the new administration seem farfetched, e.g., abolishing the FDIC and withdrawing approval of polio vaccine. But the country is deeply divided on many fronts. The inability to compromise, and the pursuit of winning for its own sake, will likely continue to limit Congress' effectiveness and keep the level of societal angst high. We should probably expect more drama around fiscal budgets and the debt ceiling.
Outlook and Game Plan
We enter 2025 with a “mixed bag” of investment considerations. The economy is doing well, and the earnings outlook is good. Inflation has been ticking down toward the Fed's 2% target. Meanwhile, 10-year Treasury yields remain at manageable levels in the mid-4% range.
On the other hand, stock valuations are on the high side by historical standards. Stock prices will track with earnings growth as long as price-to-earnings (P/E) multiples remain constant, but if inflation and interest rates surprise to the upside, we should expect some multiple compression.
We should expect some market worries to materialize. With luck, they may turn out to be more “sound and fury” than lasting disruption. But if some of the promised or threatened changes do upset the markets, we believe we own the right collection of businesses to not just withstand economic trouble but to take advantage of it.