Q4 2024 Quarterly Letter

 

“Kaninchen und Ente”

October 1892 issue of Fliegende Blätter

On behalf of all of us at Avenue we hope you had a wonderful holiday season, and we want to wish you a Happy New Year and a healthy and prosperous 2025.

To begin this quarter’s letter, we start with the famous image of the Kaninchen und Ente from a magazine in Munich in the year 1892. This image is one of the earliest known examples of something called an ambiguous image, which is a visual image that creates two distinct forms. An image like this creates the phenomenon of multistable perception, where the human brain can visualize multiple stable perceptions from the same image.

As an exercise, when you look at the image do you see a Duck, or a Rabbit? How about both?


Applying multistable perception is important for investors because we must be able to see things from different perspectives to properly analyze the world we are investing in.


An optical illusion such as Kaninchen und Ente serves as a good metaphor for how to interpret recent political events we have experienced, as well as the current state of the economy and financial markets.


The political landscape has shifted significantly over the past few months with the election victory of Donald Trump in November 2024 and now the resignation of Justin Trudeau as prime minister in January of this year. Both political events will have a significant impact on shaping how 2025 unfolds.

With regards to the outcome of the U.S. election one can consider two different perspectives. The first perspective is the results highlight that despite all the events of the past eight years it appears Donald Trump is more popular with the U.S. electorate. In 2016 he earned just under 63 million votes while in this past election he surpassed 77 million votes, meaning he has gained 14 million additional votes since 2016.

 

 

He won additional support relative to 2020 in 90% of the counties throughout the country.

The New York Times published this data on the graphic to the left.1

The red arrows are in counties which saw the incoming President win a larger share than in 2020.

Donald Trump was closer to winning in New York, New Jersey, and Illinois, all solid ‘blue’ states, than Kamala Harris was in Texas or Florida.

His victory included winning the electoral college and the popular vote along with all the important swing states, in addition to a majority in Congress and the U.S. Senate. The expectation was for a close election, meanwhile the results proved to be an electoral landslide.

This initial perspective can be thought of as the image of the Duck – and it tells us that Donald Trump has grown in popularity since 2016.

The image of the Rabbit tells a different story. The large-scale fiscal spending in the aftermath of COVID provided significant financial support for a large segment of Americans. These benefits ranged from student loan forbearance to daycare subsidies and additional funds for food stamp programs. Not to mention $800 billion of Economic Impact Payment cheques that were sent to Americans in March 2020, December 2020, and March 2021.

Some of these payments contributed to higher inflation, but the fact is these support programs were very popular with the electorate. Many of these support programs expired in late 2023, meaning that millions of Americans were no longer receiving the same benefits.2

In 2024 all that remained were the higher prices and inflation which were politically unpopular. The loss of essential benefits, such as those mentioned above, created conditions that would make it tough for any incumbent president to win again when a large segment of the voting population benefitted from this financial support.

The image to the left from the Financial Times provides a picture of the electorate when you divide the population based on class lines.
The results are clear: voters who were significantly harmed by inflation supported Trump by a margin of 7-to-1. Trump also won a majority of voters who experienced moderate hardship from inflation.

Americans who faced little to no hardship from inflation supported Democrats by an 8-to-1 margin. Some could argue that this above graphic sums up the election.

Although macro economists like to talk about how the economy is strong in aggregate, there are millions of Americans who are not experiencing a strong economy and who are disproportionately harmed by inflation.

Many American citizens have not benefitted from the increasing financialization of the U.S. economy because they don’t own financial assets.

The labour share of GDP remains stuck near the lowest level since World War II, as shown above, and has been around the same level since 2008.

The perspective of the Rabbit tells us the election results highlight not that Donald Trump is more popular, but that inflation is very unpopular. And when a politician gets blamed for inflation, like Joe Biden and Kamala Harris did, it becomes very hard to win again.

These are just two different perspectives of the same image. Of course, one could interpret the election results in other ways as well. The important summation is that regardless of what one thinks about the election result, it is a fair observation to say that the results show Donald Trump is more popular with the American public. Of course, this means that in Donald Trump’s mind he is more popular than ever, and for now he is interpreting the election results to have given him a broad mandate from the American people to implement his policies.

 

Trade War Redux

The central focus of the new Administration’s economic policy is expected to centre on the United States’ economic relationship with China.

The structural trade and financial imbalances that have accrued over the previous few decades have created a very precarious situation for the global economy. As we discussed in our Q2 2024 letter, China has been engaging in predatory trade practices with the West ever since it was allowed to enter the World Trade Organization in 2002.

The United Sates plays a central role in the global economy as the supplier of the global reserve currency and as the largest consumer economy. This means that most global trade is conducted in U.S. dollars, which creates added demand for U.S. dollars and U.S. financial assets.

The global economy can be summarized into the below graphic between the four biggest economies.

The United States runs a trade deficit with all its major trading partners. That is their role as the supplier of the global reserve currency.
Starting at the bottom of the above graphic, the United States is the largest consumer of produced goods, and they pay for these items in U.S. dollars. The trade surplus countries on the right accrue a trade surplus, and these U.S. dollars then get recycled back into U.S. financial assets.

The global economy is currently structured in a way that creates extreme trade imbalances on one side of the image, with extreme opposite financial imbalances on the other side of the image. The U.S. manufacturing sector has been substantially harmed by the role of the U.S. dollar as the global reserve currency. The U.S. manufacturing sector has become uncompetitive relative to China, Japan and Germany who have pursued export-driven growth models.

 

Meanwhile, U.S. financial markets have benefitted substantially from the resulting capital flows back into the U.S. which contributed to substantial asset bubbles over the past 30 years.

Since China entered the World Trade Organization in 2002, they have pursued aggressive mercantilist trade practices which centre on the Chinese Communist Party’s management of their foreign exchange rate, essentially not allowing it to rise.

This has led to a heavily subsidized export sector, which has created substantial overcapacity in manufactured goods. At the same time, this weaker currency hurts the Chinese consumer as it lowers their purchasing power with the rest of the world.

China produces too much and consumes too little, while it sells its excess goods to the rest of the world at cheap prices. China produces 31% of the worlds manufactured goods while it only accounts for 13% of global consumption.3 Subsidizing their export sector has been a deliberate policy choice by the Chinese Communist Party and the current global trading system has been welcomed by the United States political class with a form of benign neglect up until the 2016 election.

This structural imbalance is the key reason for increased wealth disparity in the West, along with the decay of our manufacturing industrial base. Citizens in the West who own financial assets or real estate have benefitted substantially over the past few decades. The working class have suffered as their wages have stagnated because of foreign competition and mercantilist trade policies from China and other trade surplus nations.

In recent years China has doubled down on their export-led growth model to a point where they now have a 2% goods surplus relative to the rest of the world. The chart on the above right highlights the excess capacity China has built up in the automotive sector over the past five years.

A recent article from Foreign Affairs titled “China’s Real Economic Crisis” highlights the scope of the overcapacity issue:
“In many crucial economic sectors China is producing far more output than it, or other foreign markets, can absorb. Despite denials from Beijing, Chinese industrial policy has for decades led to recurring cycles of overcapacity. Factories in government-designed priority sectors of the economy routinely sell products below cost to satisfy local and national political goals. In China’s domestic market, overcapacity issues have provoked a brutal price war in some industries that is hampering profits and devouring capital. According to government statistics, 27 percent of Chinese automobile manufacturers were unprofitable in 2024.” 4

China’s economic model has hit the wall as the rest of the world becomes unwilling to absorb these trade imbalances. China is now mired in the early stages of a debt deflation which will require substantial fiscal and monetary support to prevent a further deterioration in their economy. This means that China will need to weaken its currency even further, which will exacerbate the current trade situation.

From all appearances the incoming Trump Administration is going to handle the Chinese trade situation with an increasing degree of seriousness. It has been reported in recent days that after his inauguration the incoming President is considering declaring a national economic emergency under the International Economic Emergency Powers Act. This would give the President broad unilateral authority to manage imports and to declare across-the-board tariffs.

 

Tariff Man 2.0 – Echoes of William McKinley

The United States has a long rich history of using tariffs as a means of conducting international economic policy. The intellectual foundation for these policies harkens back to 1791 and Alexander Hamilton’s “Report on the Subject of Manufacturers”, which he presented to the Congress. In this report Hamilton argued for a robust industrial policy which used tariffs to protect the domestic manufacturing sector.

 

One hundred years later we arrive at the presidency of William McKinley. McKinley was the first self-proclaimed “tariff man” and in the 1896 election he advocated for high tariffs and protectionism policies which he claimed would restore economic prosperity to America after The Panic of 1893.


These were popular sentiments at the time just like they are today.
At the time, the United States was a burgeoning economic power but still had a smaller role in the global economy relative to the British Empire and other countries in Europe. And so, tariffs could play a more strategic role in supporting domestic industries.

 

Prior to World War I and the implementation of income taxes, tariff revenue was one of the largest components of Federal government revenue comprising between 40 and 50% in the period between the Civil War and World War I as shown in the graph to the left.
Between the founding of the United States and the Civil War, tariffs were the principal form of revenue received by the Government each year.

Since the end of World War II tariffs have had a marginal role in government revenue collection comprising between 1% and 2% of annual revenue.

On January 3rd the incoming President tweeted:

Like William Mckinley, Donald Trump has claimed that tariffs will make America rich as they collect “billions and billions” of new tariff revenue. The problem is that this is not William McKinley’s economy anymore.
The current globalized economy and interconnected trade relationships means that other countries can have a retaliatory impact on different parts of the U.S. economy.

A case in point was China’s retaliation in 2018 and 2019 against U.S. farmers.

Although the United States collected over $60 billion in tariff revenue from China, almost all of this was redirected to support farmers who were hurt by China’s retaliation against soybeans, corn, and wheat exports from the U.S. as shown in the chart to the left.6

So yes, the United States raised tens of billions of dollars in tariff revenue, but all of this was used to support farmers who were financially harmed by China’s retaliatory tariffs in 2018 and 2019.7

The United States has the most leverage in this situation given they have the largest consumer economy, supply the global reserve currency, and give the world open access to buy their financial assets. But they also have a lot to lose as certain segments of their economy could be targeted in retaliation, and any repatriation of foreign capital would push interest rates higher and harm financial asset prices, which have never been more expensive relative to GDP.
The long-term impact of foreign trade and industrial policies on the health of American manufacturing have reached what feels like a critical tipping point. This is just the open recognition of the trade and financial imbalances that have built up over the past few decades. There is a growing bi-partisan consensus between Democrats and Republicans that this needs to change.

We will have to watch how the situation evolves over the coming months but the chance of collateral damage is very high in the global economy and financial markets.

Who says they don’t ‘ring a bell’ at the Top?

The initial reaction from financial markets to Donald Trump winning the election was for the markets to increase on the expectations that Trump would usher in a pro-business policy stance that would be good for stocks just like in 2016.

One month later Donald Trump rang the Opening Bell at the New York Stock Exchange, which creates an ominous image, given the euphoria surrounding U.S. equities and their historic overvaluation.

To return to the Kaninchen und Ente image from the first page, one requires multistable perception when making a current assessment of the stock market. For some investors their view is that this is the greatest stock market of all time, while for some other investors this is the biggest financial bubble of all time. Both perspectives have valid arguments. More on Avenue’s particular investment approach below.

There has been a collective mass euphoria building over the past few years as it relates to investor sentiment about the U.S. stock market.

It’s hard to blame investors for this shift in sentiment when they are bombarded with news headlines of rising stock prices and reports like this one from Barron’s in October:

 

November 2024 witnessed the largest net inflow into U.S. equities ever recorded, as shown below (left) from the Financial Times. Meanwhile institutional investors are the most overweight US equities in the last 25 years (below right), as per Bank of America.

 

There is further evidence of euphoria from individual investors whose confidence in the stock market reached the highest level on record in November 2024 based on monthly surveys from the Conference Board as shown in the chart to the left.


For investors who are excited at the prospect of strong future returns from the S&P 500, you are not alone. This euphoria about the U.S. stock market is shared by a record amount of investors, and positioning and investment flows data suggests that investors are “all in”.

 

 

 

 

 

Perhaps this euphoria is well founded, and stocks will continue to post record gains in the years to come.

The challenge to that perspective is that not only are market participants exhibiting euphoric behaviour, and expectations for future returns are high, but market valuations are at the highest level on record.

This means that investors in the stock market are paying the highest price relative to economic output, as recorded in history.
The U.S. stock market capitalization to GDP now stands at over 200%, meanwhile the CAPE earnings ratio is near a record high of 38 times earnings. In an economy as highly financialized as ours is, any decline in this valuation level could create negative feedback to consumer spending in the real economy.

If we zoom out and look at total corporate profits relative to GDP, then we also see profits at a record share of the economy, as per the chart to the left.


The argument that the new administration is going to usher in a golden age of economic prosperity is naïve because the U.S. economy has been in a golden age of corporate prosperity for the last decade.

 

Given this backdrop, what should investors do?

 

 

 

 

 

Avenue’s Investment Strategy

At Avenue, we are focused on quality investing. Quality investing means we focus on owning businesses who have a set of common characteristics that allow our companies to be consistently profitable.

We look for businesses that earn good returns on capital and tangible assets, have minimal ongoing capital needs, and either reinvest profits back into their business at good rates of return, or return profits to us through dividends.

We believe that any business is worth the cash flows it generates over its lifetime, which is why we focus on these criteria. Doing so gives each of our individual investments the highest probability of earning consistent profits long into the future.

Although the turn of the New Year brings considerable uncertainty given everything we have discussed above, we are confident with the investments we own, and we continue to be active in looking for new investments that meet our criteria.

As of today, we have considerable embedded gains within the portfolio, and it is our expectation that portfolio turnover will be low going forward.

Bryden Teich, CFA®

Bryden Teich, CFA®

Chief Investment Officer, Portfolio Manager Bryden is a CFA® charterholder and a member of Avenue’s investment committee, managing both equity and bond portfolios. He leads investment research, client relationships in Ontario, and oversees trading and operations. Before joining Avenue in 2013, he worked in Debt Capital Markets at TD Securities.

1024 576 Bryden Teich, CFA®