Defense Wins Championships – or at Least the First Quarter

April 1, 2025

By Mark Oelschlager, CFA

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On November 30, 2024, Ohio State concluded its regular season on the gridiron by losing to Michigan.  For Buckeye fans this defeat was particularly disappointing because the team had been heavily favored to win and because it extended the recent run of Wolverine success in the best rivalry in sports.  The loss kept OSU out of the Big Ten championship game but not the newly expanded college football playoff.  Many wondered how the team would respond to such a crushing defeat; would they stay together and maintain their focus, or would they splinter?  It turned out to be the former, as the Buckeyes, led by a stout defense and the play of all-world freshman wide receiver Jeremiah Smith, cruised to a national championship, with wins over perennial powers Tennessee, Oregon, Texas and Notre Dame.  Head coach Ryan Day, who had endured calls for his ouster after the loss to Michigan, had now quieted the critics.  Worth noting is that were it not for the expansion of the playoff from four to twelve teams this past season, Day would not have had the opportunity to redeem himself in the postseason, and he may not have kept his job.  Sometimes luck plays a large role in life.

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Portfolio managers that didn’t fully embrace the AI trade withstood their share of criticism over the past year or two, as many AI-linked stocks reached great heights.  The flip side to this was that some of the boring areas such as healthcare and consumer staples were largely ignored.  Like Ohio State’s, their fortunes reversed in the first quarter, as investors flocked to safety amid the economic uncertainty brought on by a trade war.

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The S&P 500 actually rose to start the year, peaking on February 19, which happens to be the five-year anniversary of its pre-Covid peak.  It then declined 10%, before recovering a bit in the final weeks of March to finish with a return of -4% for the quarter.  The Nasdaq Composite fell 14% from peak to trough and 10% for the three months.  The “Magnificent 7” fell 16%.  It’s important to keep this market correction in perspective.  The S&P 500 is roughly where it was about six months ago and has returned 51% since the end of 2022.

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In our fourth quarter commentary we talked about the difficulty in predicting corrections, and how so few were expecting one in 2025.  In fact, around the turn of the year we had multiple people comment to us that 2025 looked like it was going to be a good year for the market.  Our response was that we have no idea how the market is going to fare from one year to the next.  We may have a sense of where the risk-reward equation stands for stocks and for certain types of stocks at a given point in time, and we may have an opinion about how stocks will do over many years, but we are the first to admit that we can’t forecast short-term market swings.  Our focus is always on the long-term value proposition of stocks versus the alternatives.  If someone offers an opinion on the near-term prospects for stocks, you would be best served by politely thanking them and walking away.

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The Tariff Man Cometh
The correction, and rotation in the market from cyclicals to defensives, was likely brought on by the realization that President Trump’s affinity for tariffs is genuine and may cause damage to the economy.  His threat of tariffs had been shrugged off in the months after his election, which was understandable to an extent given that his first term as president turned out more benign in that regard than feared.  But since entering office Trump has shown that he is serious, implementing various tariffs on foreign imports.  Perhaps even more damaging, the Administration has waffled on some tariff proposals, which has created an environment of extreme uncertainty for businesses and consumers, who don’t know what to plan for.  During the quarter, the US Economic Policy Uncertainty Index hit its second highest level in the last 40 years, exceeded only by the pandemic.  Uncertainty leads to paralysis, which isn’t good for an economy.

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25% tariffs on all imported automobiles and auto parts are set to go into effect on April 2.  Almost half of the cars purchased in the US are imports.  Thus, these cars would immediately become 25% more expensive; in fact, they may have risen in price already, in anticipation of the tariffs.  Second, 60% of the cars assembled in the US are imported before they are assembled here and many of the parts used in their manufacture are imported.  These would be taxed.  Again, this burden would fall on consumers.  The global supply chain for automobiles is complex, with products moving back and forth across borders multiple times.  While the goal may be to assist domestic producers, any such benefit is swamped by all the unintended effects of the policy.  Interestingly, on the day the Administration announced the coming tariffs, the stocks of the domestic auto companies declined significantly.  Thank you for your, um, help, Mr. President.

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Mr. Trump also announced 25% tariffs on all steel and aluminum imports, which didn’t earn him any Buckeye-leaf helmet stickers.  These tariffs are designed to boost domestic manufacturers, but they increase input costs for US industries that use steel in their production process.  A few examples include construction, autos, machinery, aviation, and oil and gas.  These increased costs will eventually pass through to consumers.

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Commerce Secretary Howard Lutnick acknowledges that tariffs will cause foreign products to become more expensive here but contends that American products will get cheaper.  This doesn’t jibe with economic theory or history.  As noted, tariffs raise input costs for American manufacturers, which cause companies to raise prices.  In the case of tariffs on finished goods, why would an American producer lower their prices just because their competition is weakened?  In 2018 the US placed tariffs on imported washing machines.  Naturally, prices on these machines rose.  But interestingly, prices also rose significantly on the machines made in the US.  The tariffs created a pricing umbrella that US companies were happy to take advantage of.  Prices also rose on dryers, despite not carrying tariffs.  According to The Wall Street Journal, a study concluded that the washing machine tariffs created 1,800 jobs in the US, but the cost increases cost US consumers $1.5 billion – equivalent to $815,000 for each new job.  The tariffs generated $82 million in revenue for the US Government, which is a rounding error.

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We haven’t even mentioned the effect of retaliatory tariffs by other nations.  As the US implements new tariffs, many of the affected countries institute their own tariffs on US goods.  China’s retaliatory tariffs caused their demand for US cotton to fall by 80% in the first two months of the year.  Their purchases of our large-engined cars dropped by 70%, and their imports of US oil and liquified natural gas declined more than 40%.  Of course, this reduced demand from overseas means lower sales for US businesses, which means they need fewer workers – the very workers the tariffs are designed to help!   Those US workers are then faced with declining employment prospects amid higher prices.  Not exactly what we are looking for.  As a wise man once said, nobody wins a trade war.
 

In conjunction with his auto tariffs, Trump warned US automakers not to raise prices on cars.  This is reminiscent of the methods of authoritarian regimes, where they tell businesses what they can charge.  It doesn’t lead to positive economic outcomes.  We always chuckle when politicians try to bend the laws of economics in an attempt to offset the damage created by their very own policies.

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Protectionists point to the large and growing deficit in the trade of goods with other countries as justification for the imposition of tariffs.  They might have a case if this deficit had led to chronically high unemployment, or if it had eroded our standard of living or compromised our national security.  But it has done none of these.  It is true that many of the old US manufacturing jobs have moved overseas, but what has been the net effect of this?  Has unemployment skyrocketed?  It has not.  In fact, it has been incredibly low, and that is because we have a dynamic economy that is constantly creating new professions in new industries as new discoveries are made.  There is also a problem with how the trade deficit is calculated.  When an iPhone is made overseas and purchased in the US, it counts as an import.  While some of the added value of that product came from its foreign manufacture, the real value is in the intellectual property, which was created by American engineers at an American firm.  Apple has created an enormous amount of wealth for many US employees and US shareholders while providing an affordable life-changing product to roughly half the citizens of this country.  Is this a bad thing?  The archaic trade statistics say it is.  And the iPhone is just one example of many.

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The Trump Administration is trying to reverse an 80-year trend that has seen manufacturing as a percentage of total nonfarm employment in the US fall by 75% since 1946.  Similarly, the Smoot-Hawley tariffs of 1930 were aimed at stemming the decline in agriculture employment that had started around 1900.  However, like the decline in manufacturing, the disappearance of agriculture jobs was a result of a slew of economic factors and a reflection of a re-allocation of resources to a better use.  The prescription not only didn’t reverse the downward trend in that industry but caused US exports in general to shrink by about 2/3 due to retaliatory duties.  In addition, it exacerbated the Great Depression.  We don’t expect Trump’s tariffs to reverse the 80-year trend, though they may play well politically with some swing voters.

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It is possible that this is all just posturing and that the President doesn’t intend to implement many of these tariffs or keep them in place for long.  It could all be part of a big negotiation to use the power he knows this country possesses to extract as much as possible from other nations.  We find that unlikely for a number of reasons but acknowledge it’s within the realm of possibility.  It’s also conceivable that he recognizes the damage his policies are creating in the economy and the stock market and reverses course.  But we think tariffs are here to stay, in one form or another.

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A note on performance.  After a period in which we lagged the mega-cap driven S&P 500 in 2023 and 2024, the return of our Towpath Focus Fund sat about 15 percentage points (roughly 97% to 82%) behind the S&P 500, as measured from the fund’s inception through the end of 2024.  One would think that closing this 15 percentage-point gap would require 15 percentage points of outperformance, but it did not.  Our fund outperformed the index by only nine percentage points in the quarter, but that was enough to not just catch but overtake the S&P 500, as measured from inception.  You can find the figures in the table below.

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We find this interesting for several reasons beyond the geeky math.  First, it illustrates how quickly things can change in one quarter.  Second, it demonstrates the damage that drawdowns (negative returns) can have on long-term performance.  Third, it validates our investment discipline.  Fourth, it shows why we always say our goal is to outperform over a long period of time (rather than the short term).  We didn’t know when the market would shift, but we were positioned well for when it did.  Fifth, the fund’s returns are net of fees, meaning the cost you pay to own the fund has already been taken out when you see these returns.  With annual expenses of about 1%, our fund essentially starts 1% behind the index every January 1.  This is one reason so few managers beat the S&P 500.

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Mark Oelschlager, CFA  

Oelschlager Investments ​​