Human behaviour

If you ever get close to a human
And human behaviour
Be ready, be ready to get confused
There's definitely, definitely, definitely no logic
To human behaviour
But yet so, yet so irresistible
- Björk

Logic did not play a great part in the global events of the past month. Whether financial market reactions to those events was any more logical is debatable. Attempting to unwind the myriad of interdependencies emanating from a multi-decade globalisation process in a week or two was probably never going to go swimmingly. It didn’t. The initial premise seems to involve the US somehow being ‘ripped off’. The logic behind this premise is not immediately visible. The US runs a significant trade deficit with the rest of the world, partly because it consumes a lot more than it produces (the polar opposite of China), and partly because the world needs to balance (if other countries want to depress currencies or artificially support certain sectors, someone needs to do the opposite). Even ignoring the fanciful idea that trade balances for most countries should somehow be near zero in a globalised world or the problems in reshoring production when wages are vastly higher than in production centric economies, as a revenue measure it totally ignores the massive differences in profitability of different import and export types. The US tends to export extremely high margin products and services (e.g. Microsoft (NASDAQ: MSFT), Google (NASDAQ: GOOGL), Visa (NASDAQ: V), Mastercard (NASDAQ: MA), Nvidia (NASDAQ: NVDA), Apple (NASDAQ: AAPL)) and import very low margin products from China. These high margins, plus an expectation from investors they will continue to grow faster than the rest of the world, explain much of the premium multiples US equities command versus the rest of the world and the total dominance of global market capitalisation. When it comes to the ‘ripped off’ bit, it seems the rest of the world would probably have better arguments, particularly given the lack of local tax paid on profits. Additionally, the nature of western production means almost nothing is comprised of purely domestically produced components. It is entirely unrealistic to bring 100% of production of most end products back to a single country. As the chart below illustrates, Chinese imports to the US are comprised significantly of intermediate products, supporting production rather than consumption. The longer term economic impact of US actions on the rest of world obviously remains uncertain. Regardless of whether tariffs are almost entirely rolled back, the impact of increasing global tension and the US taking a more adversarial approach to international relations seems likely to be longer lasting.

Trade deficits aside, the budget deficits afflicting the US and most of the western world are probably the real issue when it comes to sustainability. While DOGE suffered from the same lack of realism as tariffs when it comes to correcting decades of accumulated bureaucracy and inefficiency in weeks, it is tougher to argue with the logic. Wasteful government spending is strangling economies everywhere, yet plans to spend less and collect more in taxes are absent, meaning government debt is spiralling everywhere. Asking foreigners to fund ever increasing government largesse will always be more palatable than asking your own citizens, unfortunately, most of the foreigners are in the same boat. As Australians were dragged to the voting booth to choose between two parties competing on unfunded handouts, bipartisan housing policies which fundamentally ignore the demand side of the housing affordability crisis and don’t touch the issues of an overly complex and poorly structured tax system, it is tough to throw stones. We are on the same path and the road sign doesn’t read ‘sustainable’.

Equity markets have reacted fairly simplistically. US equity market returns for 2025 to date tell the story. Purely domestic equals good, cross border equals bad. Amazingly, even as bonds reflect concerns over some of the aforementioned deficit dynamics and the wisdom of having so much of the world’s investment capital centred in the US, overall equity market performance since ‘liberation day’ has remained solid. The domestic equity market has risen as domestic defensives, banks and gold compensate for losses elsewhere. Falling share prices have been concentrated in mining and energy. 

We are struggling with the logic behind these moves, but human behaviour (even if it is in the form of computer coded portfolio rules) sets share prices. 

As always, economists are preoccupied by increased odds of US recession as measured by their beloved ‘GDP’. Recession fears mean sell cyclicals and buy defensives. The focus on China as the primary target of US acrimony and the expectation of declining US demand as tariffs flow through to higher US prices and then back into lower Chinese production may not be illogical should significant and sustained tariffs actually eventuate, however, the US is a far less important cog in the global commodity demand wheel than in products in which it pays a disproportionately higher price than the rest of the world (e.g. pharmaceuticals). The nature of commodities means the US pays largely the same price as other consumers globally (adjusted for on-costs such as shipping) and is most certainly not being ‘ripped off’. While commodity prices will always oscillate through time, particularly as ever more financial capital enters constrained physical markets, we continue to see low cost mining assets as durable and attractively priced businesses relative to the assorted avenues into which investors are seeking to run and hide at present. As has become ever more the case in recent years, starting valuations appear meaningless, it is only the direction of the next move which matters. We live in the era of the increment.

When it comes to avenues for seeking safety, gold has been front and centre of recent times, heading in exactly the opposite direction to most other commodities. In typical financial market fashion, when tariff threats and tensions most need the financial plumbing to assist in keeping the economy flowing, investors are most inclined to do the reverse. Buying gold, after all, is the financial equivalent of hiding your money under the bed. There is no yield and speculative capital gain or loss is the only source of return. March quarter World Gold Council data indicates jewellery demand for the quarter fell some 20% from a year ago, while central bank purchases fell a similar amount. Good old ETF demand exploded as investors chased all-time high prices, both in absolute price terms and relative to most other benchmarks (e.g. barrels of oil, other commodity prices). As a commodity in which there is no fundamental basis for formulating a long-run price, we have always struggled. It’s price is purely driven by human behaviour and that behaviour is unpredictable. Nevertheless, our theory that other commodities should provide similar inflation protection if investors are worried about the debauchment of fiat money has proven entirely incorrect in the short-term and the winners write the history. Analyst enthusiasm for gold stocks is growing with share prices and they are applauding the cash generation of gold stocks (a function of extremely high gold prices and denominated in exactly the fiat money they are seeking to avoid by buying gold).

In illustrating the gap between tariff theory and reality and why we’d be surprised if some tariff levels are sustained, Alcoa is probably a useful example. Of the more than 70 million tonnes of aluminium consumed annually, the US represents a little over 4m. As the Alcoa chart below indicates, more than 80% of US consumption is imported. High cost refineries/smelters in the US have been closed through time (Alcoa closed Point Comfort in Texas in 2019) and sites are more likely to be re-purposed as data centres than restart given the low-cost power which is crucial for smelters can be far more lucratively used than in alumina refining and aluminium smelting and the US doesn’t have the good quality bauxite needed to make the stuff. Canada has low-cost hydro powered smelters which already supply most of US demand. China, despite being by far the biggest consumer (more than 40m tonnes) is not a low cost producer and occupies much of the high end of the alumina/aluminium cost curve. China successfully suppresses profits able to be earned by others, but they don’t make much profit themselves.

Tariff announcements caused the aluminium price to plummet (the good old recession arguments again), whilst the Midwest premium (the price paid by US buyers including tariffs) rose to reflect much of the tariff impact. Whilst there is still a net cost of tariffs to producers such as Alcoa as the Midwest premium doesn’t fully reflect tariff cost, the vast majority of tariff impact is simply to push up aluminium prices in the US. This will eventually flow through to prices of all goods using it. The only way any production could return to the US is if the US chooses to permanently force domestic customers to pay a higher price for a commodity in which the US is not cost competitive. As an investor, betting on permanent tariff protection as the justification for an investment in the billions in a location without low cost raw materials, construction costs or power seems unlikely to be a persuasive case. Logic suggests industry may be better supported by providing access to the commodity at the same prices the rest of the world pays and focus on making money turning it into Boeing planes and high value products. The $2bn fall in Alcoa’s market value during the month suggests panic was a more popular strategy than logic. The decline in market value for South32 was almost identical.

Where investors saw opportunity during April was the once in a lifetime opportunity to pick up some CBA at close to all-time high prices and a raft of defensive stocks and technology stocks with earnings yields at or below the bond yield, many vastly below. CBA (ASX: CBA), Wesfarmers (ASX: WES), Coles (ASX: COL), Telstra (ASX: TLS), Woolworths (ASX: WOW), Transurban (ASX: TCL), Goodman Group (ASX: GMG), NAB (ASX: NAB), ASX, The Lottery Corp (ASX: TLC), Stockland (ASX: SGP), Mirvac (ASX: MGR), Dexus, GPT (ASX: GPT), Vicinity Centres (ASX: VCX), Scentre Group (ASX: SCG), IAG (ASX: IAG) and Suncorp (ASX: SUN) all saw gains of more than 5%. Pro Medicus (ASX: PME), Life 360 (ASX: 360), Technology One (ASX: TNE), REA Group (ASX: REA), Car Group (ASX: CAR), Wisetech Global (ASX: WTC), Xero (ASX: XRO), Block (ASX: SQ2), Netwealth (ASX: NWL) and HUB24 (ASX: HUB) all bettered the 5% mark also. Seeing a theme here? Avoiding earnings risk at all costs continues to vastly overwhelm valuation risk. Numpties like me who perceive some risk in paying $24bn for the $200m of revenue generated by Pro Medicus (more than the value of Alcoa (ASX: AAI) and South32 (ASX: S32) put together) are receiving regular reminders of the stupidity of placing any emphasis on valuation. While CBA may be the poster child evidencing the diminishing importance of fundamental analysis in setting equity market pricing, the cohort of stocks suggesting business valuation is an antediluvian pastime is broad.

Market Outlook

As Björk’s 1993 lyrics suggest, we should we ready to be confused by human behaviour. We’d confess to not finding all of the current behaviour irresistible. Frustration would better capture our emotions in watching the CBA valuation climb past 25 times earnings and towards 4 times book value despite anaemic/non-existent growth and negligible bad debts. The bifurcation in valuations which pervades both sectors within the equity market and the ‘haves’ and have-nots’ when it comes to perceived growth has proven vastly more persistent than we could have imagined. Short periods of reversion have been followed rapid rebounds, renewing the confidence of momentum driven investors. On Björk’s “Be ready, be ready to get confused” bit, we’ve got that nailed.

Maintaining discipline isn’t easy. Regularly adjusting your long-term gold price to convince yourself that your gold stocks are still good value or amending the revenue multiple applied to a technology stock and comparing it to a bunch of others that have tripled as a purported valuation measure might create the illusion of discipline, yet the line between this and losing all discipline is fine. As global tensions rise and long years of seemingly unsustainable levels of government spending show signs of testing the patience of bond investors, it seem to us a dangerous time to shed discipline. Embracing sensible valuations and conservative financial leverage has been uncomfortable territory for much of the past decade. Human behaviour can change.

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