Tariff Impact

The two primary concerns economists and investors have regarding higher tariffs centre on their potential impact on economic growth and inflation. Tariffs function as taxes on importers and, according to economic theory, can create the challenging scenario of "stagflation" – declining economic growth combined with rising consumer prices. When tariff rates increase, importers and businesses face two main options: absorb the additional costs (reducing profitability) or pass them through to consumers as higher prices (or employ some combination of both strategies). By the end of July, the average US effective tariff rate reached 18.2%, the highest level since 1934. While widespread economic impact was anticipated, the effects on US growth and inflation have been surprisingly muted to date.

There are signs of US economic deceleration, with employment gradually softening, though not dramatically. Although wholesale prices have risen, consumer price inflation has not increased significantly. Two explanations may account for this: businesses front-loaded imports earlier in the year ahead of tariff implementation and may still be working through excess inventory before raising prices. Alternatively, businesses and importers may be absorbing costs temporarily, hoping for future policy reversals given the frequent tariff changes.

US Fiscal Concerns

Growing concerns about US government debt levels and fiscal deficits have intensified following passage of the Trump administration's "One Big Beautiful Bill Act." This legislation extends previously introduced tax cuts and will deepen US fiscal deficits while adding several trillion dollars to government debt over the coming years.

Historically, US government bonds have been considered the ultimate "risk-free" asset, with investors typically purchasing US dollars and bonds during economic uncertainty. However, this pattern reversed during the peak tariff announcements in early April, with the USD continuing to decline since then. Rising government debt will likely lead to higher interest rates and slower US economic growth, negatively affecting corporate earnings and performance. While US equity markets have been the world's strongest performers over the past decade, many investors are now diversifying their allocations toward European and emerging market equities.

New Zealand Economic Update

After early-year indications of economic improvement, New Zealand's economy has stagnated over the past quarter. The "survive until 2025 and then thrive" expectation appears increasingly optimistic as we progress through the second half of the year. Although official figures show inflation returning to target ranges, essential costs, including food and local rates, continue to pressure consumer spending. Unemployment has reached 5.2% and is expected to rise further.

The Reserve Bank delivered an expected 0.25% reduction in the Official Cash Rate at their meeting on 20th August but provided a more pessimistic outlook for the economy in the short-term. After peaking at 5.5% over a year ago, the OCR now sits at 3.0%. Most economists project it will be reduced to approximately 2.50% before stabilising. This trajectory suggests mortgage and term deposit rates may fall another 0.50%, with 12-month deposit rates settling around 3.5%. In the medium-term, the future path will be determined by the usual drivers, including economic growth and inflation.

Investment Strategy

Our investment management approach remains fundamentally "long-term strategic," focusing on evidence-based portfolios that look through short-term market fluctuations. However, when clear trends emerge that can be addressed, we implement "tactical tilts" in collaboration with our group and investment consultants to target improved returns and reduce volatility and downside risk. Currently, we are employing three main tactical positions:

•  Defensive Asset Allocation: Compared to long-term targets, we maintain a modest underweight to growth assets (equities) and a slight overweight to fixed interest across all risk profiles. This positioning reflects high valuations in some markets, particularly the US, and is designed to reduce volatility during potential market corrections.

• US Equity Underweight: Within international equities, we maintain an underweight position in US stocks. After an exceptional run, US markets are trading at elevated valuations compared to historical averages. While we don't view this as a major bubble, maintaining lower exposure to expensive markets is prudent. European, Asian, and Australasian markets offer more attractive valuations by comparison. To provide context: while US markets represent approximately 65% of global market capitalisation, our international equity allocation is approximately 45%, with the remainder allocated to emerging markets (primarily Asia) and Europe.

• Enhanced Currency Hedging: We have increased hedging levels against the US dollar. The NZD currently trades around US 60 cents. Given US debt levels and the tariff environment, the consensus expectation is for NZD strengthening toward approximately 65 cents over time. Should this occur, even assets with flat USD performance would decline roughly 8% when converted to NZD. While currency movements are notoriously difficult to predict, we are utilising funds that employ various methods to hedge these currency exposures.

We continue monitoring market and economic developments closely and will recommend portfolio adjustments when we believe they are warranted.

Interesting Article:

“The Calculus of Value” by Howard Marks

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