He Said, Xi Said and We Said

Once again, the world’s fragile geopolitical situation has again taken center stage with the tragic and despicable use of chemical weapons by the Assad regime in Syria, ongoing nuclear provocations by North Korea and deadly terrorist attacks in Stockholm and Egypt. In a sharp reversal from his opposition to Syrian intervention during his campaign, President Trump ordered an attack on a strategic target in Syria in response to Assad’s use of Sarin gas on civilians including children. President Trump approved the strike on the evening that he hosted China’s President Xi for the initial meeting between the world’s two most powerful leaders. With a single move, President Trump sent a message to Assad, North Korea, President Xi and the rest of the world that the United States will act forcefully and unilaterally, if necessary. This statement was particularly important considering the role that China will likely need to play in helping restrain North Korea’s nuclear ambitions. Given the Chinese government’s long-standing anti-interventionist position, the prompt U.S. response caught many off-guard and was further evidence of the unconventional approach by the new Administration.

Importantly, for investors concerned about the geopolitical situation and its impact on the markets, current economic conditions suggest a positive backdrop heading into the second half of the year and into 2018. Notwithstanding soft patches in the economy that are likely on the horizon, we remain positive on equities even with a possible pullback in the coming months. We are also encouraged by the economic improvements in Europe and Asia as well as the market’s ability to shrug off negative news. While the meeting between President Trump and President Xi did not yield any major announcements, it should be viewed as a positive first step in the relationship between the two leaders as President Trump was respectful of the Chinese leader and avoided the anti-China rhetoric that was so much a part of his campaign. China’s Communist Party has a big leadership conference in the fall and President Xi needed to show his strength to his country and the rest of the world. According to Cabinet officials, one development coming out of the meeting was the agreement to work towards a 100-day plan to review the trade relationship with China and to better cooperate in addressing North Korea’s nuclear program as it had reached an urgent stage. In addition, both sides agreed to subsequent meetings to discuss economic cooperation and security issues including cyber threats. For those trying to make sense of the long-term relationship between the U.S. and China, the Chinese Foreign Ministry website provided some insight as it reported a statement from President Xi’s discussions with President Trump as follows: “We have a thousand reasons to get China-US relations right, and not one reason to spoil the China-US relationship.”

Deregulation: The Bridge to Other Pro-Growth Initiatives

“Business Roundtable is not proposing that all regulations on this list be repealed, although some are so deficient they cannot easily be fixed. Others can be improved, however, by providing additional compliance flexibility, which will help to reduce unnecessary costs and compliance burdens. While addressing existing regulations that are unduly burdensome is vitally important to help jump-start American business investment and job creation, Business Roundtable believes that fundamental regulatory process reforms are key to ensuring long-term success.”

– Business Roundtable February 22, 2017 letter to Gary Cohn, Director of National Economic Council

In the United States, one of the most critical elements driving the positive sentiment among business leaders is the emphasis by the new Administration on reducing or eliminating inappropriate and excessive regulations. At ARS, we believe that it is essential for our government to better thread the needle when it comes to regulating business by balancing the risk of overreach with failing to ensure the proper safeguards on the system. The Business Roundtable, an association of chief executive officers of leading U.S. companies working to promote sound public policy and a thriving U.S. economy, has suggested that “a smarter approach toward regulation is needed to strengthen economic growth and job creation.” Businesses large and small have cited deregulation as perhaps the most important pro-growth initiative to drive increases in spending and hiring. President Trump has already taken several steps including placing a freeze on new regulations, lifting restrictions on the energy industry and asking government agencies to prepare a list of unnecessary regulations currently on the books. According to President Trump’s legislative affairs director, Marc Short, the previous administration authored more than 600 major regulations with an estimated cost to the economy of about $740 billion. To reduce regulation, this Administration has also asked Congress to employ a little-used piece of legislation called the Congressional Review Act (CRA) to undo 11 pieces of regulation with two additional regulations under consideration. Government agencies can also choose to selectively enforce regulations, and their willingness to do so might provide an additional boost to the economy. At a time that Congress appears to be struggling to repeal and replace the Affordable Care Act and reduce or reform taxes, deregulation is a tool that can be a bridge to push the economy forward until those pro-growth initiatives can be passed.

Banking remains one of the most regulated sectors and appropriately so. Some experts have blamed the 2008 financial crisis on the repeal of the Glass-Stegall Act which was originally designed to protect the system through the separation of investment and commercial banking. Gary Cohn, the former President of Goldman Sachs and a key member of the Trump Administration, has recently suggested that Glass-Stegall be reconsidered. The main regulation put in place to address many of the issues believed to have contributed to the financial crisis was the introduction of Dodd-Frank legislation which includes the Volker Rule. While well-intended, Dodd-Frank was complex, costly and burdensome both on the banks as well as on their regulators. This has been a complaint of bankers for years including in the recent annual shareholder letter by Jamie Dimon, CEO of JPMorgan Chase. The point was further driven home by outgoing Federal Reserve Governor Tarullo who served as the primary regulator for the major banks. In his final speech, Governor Tarullo said, “Several years of experience have convinced me that there is merit in the contention of many firms that, as it has been drafted and implemented, the Volcker rule is too complicated. Achieving compliance under the current approach would consume too many supervisory, as well as bank, resources relative to the implementation and oversight of other prudential standards.” It is estimated that only two-thirds of the Dodd-Frank regulations have been implemented. Designing the regulatory framework that allows the system to function properly and provide the necessary protections for consumers is critical.

Gradualism is Required for an Extended Business Cycle

The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run… This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”

– Federal Open Market Committee statement released March 15, 2017

In response to the 2008 financial crisis, the Federal Reserve under Chair Ben Bernanke announced in March 2009 that it would introduce the most unconventional and highly accommodative monetary policy initiative in history to stave off deflation and stimulate the U.S. economy. Since that time, market participants have been eagerly awaiting a return to normalcy.   This year on March 15th, the Federal Open Market Committee (FOMC) took another step toward normalization by raising the federal funds rate for the third time in three years by 0.25%, while suggesting further increases of 0.50% by the end of the year.   Based on the Committee’s projections below, real interest rates should remain at or below 1% for several years which means that even though interest rates will rise in coming quarters, the Federal Reserve’s monetary policy will remain supportive of the economy. The FOMC recently announced that it will consider starting to reduce its $4.5 trillion balance sheet later this year which would be a form of monetary tightening. The stock and bond markets initially sold off on that news in what has become a typical short-term overreaction to a Fed statement. It is notable that while the balance sheet has expanded from around $900 billion in 2008 to its current level, a significant portion of the money created remains parked in the Fed in the form excess reserves and it has not been lent out. As it is not circulating in the economy, a measured reduction in the Federal Reserve balance sheet should not create economic headwinds.

The Federal Reserve is emphasizing a balanced approach to stimulating the economy without overdoing it. It is critical to the Committee that its plan to hike rates and reduce its balance sheet does not create an economic slowdown and force it to backtrack. During the Presidential campaign, the Federal Reserve was criticized by President Trump, but the Fed is doing its part to support the Administration’s pro-growth initiatives with its measured approach to raising rates. The Fed’s current path will aid the much-needed spending required for the United States to maintain and update the nation’s infrastructure by keeping borrowing costs relatively low.

The Federal Reserve is highlighting its gradual approach to normalization because it sees an improving economy but also one with ongoing challenges. Unemployment has improved considerably in recent years, wages are slowly rising, housing is improving and consumer net worth has reached new highs. While monetary policy has helped arrest the deflationary effects of the financial crisis, there are secular forces which will continue to suppress inflation and which should work to keep interest rates below normal levels for longer than many market participants may be anticipating. These secular forces are technological advances, globalization, aging demographics in much of the developed world and excessive debt levels. Each of these presents a distinct challenge for monetary and fiscal policy makers who are struggling to put the United States economy on a sustainable growth trajectory. Because these are longer-term challenges, investors tend to acknowledge them but then promptly revert their focus back to shorter-term issues such as the policy agenda of the Trump administration or the upcoming elections in Europe. Investors with a longer-term focus should bear in mind that secular forces are helping to create a positive environment for equity investments as they will extend the business cycle.

Technology Leadership Continues

In recent quarters, we have written about technological advances and how they are changing the way we live. These advances are being driven by research and development spending.   The Wall Street Journal recently reported that the top three companies in cloud computing – Amazon, Alphabet’s Google and Microsoft – collectively spent $31.5 billion in 2016 for an increase of 22% over 2015.   Adding in Apple, AT&T, Verizon and other technology and telecom companies and the amount of spending rises significantly. As the capital requirements to maintain leadership continue to rise, the big are getting bigger. And that is even before data requirements grow with the introduction of 5G and continuous growth of the Internet of Things (IoT). In the February 28, 2017 Outlook, we wrote about the increase in download speeds that 5G will have on information available to be accessed and its required data storage. One area where the impact of technological advances will be seen is in autonomous cars. According to Intel, the average autonomous car will soon create 4,000 gigabytes of data per day based on just one hour of driving. The new cars will have hundreds of on-vehicle sensors to record data with cameras, sonar, GPS and radar being big drivers of data creation. Intel’s CEO Brian Krzanich, in a speech to the auto industry, estimated that “one million autonomous cars will generate 3 billion people’s worth of data.” This does not even begin to address the additional information that will be generated by devices designed for residences. Government spending on technology also continues to grow rapidly, and one area of significant spending will continue to be by the military’s growing need to improve cyber defense. These are just a few examples as to why we believe that we are in a unique, multi-year cycle for technology.

Investment Implications

Investors should expect to see continued volatility in the markets. Our ongoing portfolio strategy focuses on three things – high-quality growth, high-quality dividends and opportunistic investments. Our emphasis remains on selecting companies benefitting from positive trends in cloud computing and mobility, rising defense spending, changes in the financial and healthcare industries, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India.   We especially favor leading technology companies with strong growth characteristics that are driving changes in cloud computing, big data, autonomous vehicles, the internet of things, artificial intelligence and augmented reality. ARS has spent substantial time researching the beneficiaries of greater infrastructure spending and will look to increase our investments in this area as our conviction grows that Washington is taking steps to make the investments our nation requires. We continue to target companies that are gaining market share, maintaining or improving profit margins, increasing free cash flow, restructuring to gain more efficiency, increasing pricing power and/or growing dividends.

Companies that are able to more aggressively invest in the future growth of their businesses should be more highly rewarded as there is a growing view that many corporations have been able to only financially engineer their performance improvements in recent years.

At the same time, global developments will impact investor sentiment and short-term behavior. The United Kingdom has begun the process of negotiating its exit from the EU, and several European nations, particularly in France, Italy and Germany, have major elections this year. North Korea and Russia remain aggressors and the focus of geopolitical discussions between the U.S., China and other leading nations. It is easy to be distracted by the headline news. Importantly for investors, the Outlook is that the Fed will remain accommodative, the business cycle is likely to be extended and the backdrop for equities should remain positive.

Rather than focus on the short-term market moves, investors should focus on targeted investment opportunities in the many areas we have emphasized over the past year. With the U.S. economy and consumer confidence improving, the outlook for small capitalization stocks has also improved and yet these companies have not participated in the strong returns so far this year. Small cap companies represent an area of undervaluation that may present some interesting opportunities for investors. When and if corporate and personal tax cuts are enacted, overseas cash is repatriated, and infrastructure spending occurs, U.S. companies and consumers will be major beneficiaries. The combination of these forces should increase after-tax earnings for companies whether it should occur in 2017 or 2018. Irrespective of the specifics and timing of these policies, the direction of change is positive for the economic outlook and therefore for equities.

Kicking the Can Down the Broken Road

As we wrote in our last Outlook, the rapid pace of change is leaving many feeling unsettled, but also angry and frustrated with the government institutions they feel have failed them. This anti-establishment sentiment helped propel President Trump into office. Since the election, politics have become the focus for many investors as President Trump is now experiencing the difference between being the anti-establishment candidate and being the President who is trying to work with both Republicans and Democrats to make good on campaign promises. The President is finding out how hard it is to affect change inside the Beltway. To be sure the election of President Trump has raised expectations for a pro-growth agenda highlighted by deregulation, tax reform, fairer trade practices, infrastructure and defense spending. Those expectations have been built into stock market valuations to some extent. The market has been quite strong since the election as the three major U.S. stock indices have hit new highs. However the market itself had been improving since last June, and the positive momentum should continue as first quarter revenue growth is expected to be strong with earnings estimated to be up 10%. This has less to do with the new Administration and more to do with an economy that has continued to expand as employment growth continues to be accompanied by low inflation and slightly higher interest rates. The conclusion is that additional delays of key elements of the Trump agenda could result in a market pullback and investors should use the market dips as an opportunity to buy.

To be clear, we remain positive on the opportunities for well-selected equity investments in the areas we have highlighted in recent quarters. The outlook for corporate profits remains positive while interest rates and inflation rates have been rising only modestly and proportionally to the current rate of growth. The yield differentials between non-U.S. government bonds and treasuries may also serve to limit any disproportional rise in U.S. interest rates which would otherwise be a negative for economic expansion and for equities. Furthermore, the Federal Reserve’s measured approach to increasing interest rates, expected delays in implementing pro-growth initiatives in the U.S. and improving economic numbers out of Europe and Asia are working to keep the U.S. dollar in check. Many investors have been on the sidelines and missed out on the strong move in the markets and appear to be hoping for a pullback to get their money to work. These same investors may end up disappointed and forced to buy in at higher prices.

In this Outlook our focus continues to be on the crisis facing the United States with respect to our nation’s crumbling infrastructure. The problem is so severe in our view that the necessary spending can no longer be postponed.

Aside from the economic costs of American jobs and lost sales for U.S. companies, we are putting people’s lives at risk. For more than a decade we have written about the findings of the American Society of Civil Engineers (ASCE) as it has issued reports every few years projecting the spending required to maintain our infrastructure in a state of good repair. In the past this report has fallen on deaf ears in Washington D.C. as the federal government has failed to make the commitments to secure our future and invest meaningfully in shoring up our infrastructure. We are encouraged that Transportation Secretary Elaine Chao recently announced that the White House is targeting late May to introduce a $1 trillion infrastructure plan to be spent over 10 years.

A Positive First Step – FirstNet/AT&T Announcement

Today is a landmark day for public safety across the Nation and shows the incredible progress we can make through public-private partnerships. FirstNet is a critical infrastructure project that will give our first responders the communication tools they need to keep America safe and secure. This public-private partnership will also spur innovation and create over ten thousand new jobs in this cutting-edge sector.”

U.S. Commerce Secretary Wilbur Ross, 3/31/17

An encouraging sign of Washington’s resolve to address our future infrastructure needs came with the recently announced contract between FirstNet, an independent arm of the U.S. Commerce Department, and AT&T to build and manage the first broadband network dedicated to America’s police, firefighters and emergency medical services (EMS). Today our nation’s first responders use the same networks as consumers and businesses which has been a severe problem in times of crisis when communication networks have been overloaded. As highlighted in the press release, “In addition to creating a nationwide seamless, IP-based, high-speed mobile communications network that will give first responders priority access, the network will help:

  • Improve rescue and recovery operations to help keep first responders out of harm’s way
  • Better connect first responders to the critical information they need in an emergency
  • Further the development of public safety focused IoT and Smart City solutions such as providing near real-time information on traffic conditions to determine the fastest route to an emergency
  • Enable advanced capabilities, like wearable sensors and cameras for police and firefighters, and camera-equipped drones and robots that can deliver near real-time images of events, such as fires, floods or crimes”

As 5G technologies develop over the next few years, AT&T and FirstNet will work together to provide significant increases in the speed which data and video travel across the FirstNet network. AT&T will work with several leading technology, data, communications and defense companies, including General Dynamics, to make this project a reality. Under the terms of the deal, AT&T will receive $6.5 billion in funding as well as important spectrum for data and wireless transmission. In turn, AT&T will spend $40 billion over 25 years on the project. It is also significant that this project will create 10,000 jobs over the next two years. FirstNet’s funding was raised from previous spectrum auctions, and is a reminder that the government has assets which may be used to help finance future projects. This represents a possible public-private partnership model for future infrastructure investment in air-traffic control, roads, bridges and other infrastructure needs.

2017 Infrastructure Report Card Update

Our nation is at a crossroads. Deteriorating infrastructure is impeding our ability to compete in the thriving global economy, and improvements are necessary to ensure our country is built for the future… Even though the U.S. Congress and some states have recently made efforts to invest in more infrastructure, these efforts do not come close to the $2 trillion in needs. The good news is that closing America’s infrastructure gap is possible if Congress, states, infrastructure owners, and voters commit to increasing our investment. To raise the overall infrastructure grade and maintain our global competitiveness, Congress and the states must invest an additional $206 billion each year.”

The ASCE’s recent assessment of our infrastructure yielded a D+ which is the same grade as in 2013. For the period of 2016-2025, the total U.S. infrastructure needs are estimated to be $4.59 trillion with $2.53 trillion funded and a shortfall of $2.06 trillion. As highlighted in the chart that follows, the United States can no longer postpone the required investment as the cost to improve our infrastructure has grown from $1.3 trillion in 2001 to an estimated $4.6 trillion today. In a 2016 study, the ASCE determined that failing to close the investment gap has serious economic consequences for the U.S. with an estimated $3.9 trillion in losses to U.S. GDP, $7 trillion in lost business sales, and 2.5 million in lost American jobs by 2025. The ASCE has called for the United States to increase infrastructure investment from the current level of about 2.5% of GDP to 3.5% by 2025.

The ASCE further estimates that if the infrastructure gaps are not addressed, the U.S. economy is expected to lose $18 trillion in Gross Domestic Product (GDP) over the 25-year period of 2016 to 2040 with each household losing nearly $4,400 in disposable income. To provide some context, Americans spend approximately 6.9 billion hours a year delayed in traffic. In 2014, these delays costs the economy an estimated $160 billion in wasted time and fuel.

Airport congestion is a growing problem as well, and it is expected that 24 of the top 30 major airports may soon experience “Thanksgiving-peak traffic volume” at least one day every week. The average age of the 94,580 dams in the United States is 56 years. While 4 out of 10 bridges are over 50 years old, 9.1% of the 614,387 were deemed structurally deficient in 2016. Our drinking water is delivered via one million miles of pipes, many of which were laid in the early to mid-20th century with an expected lifespan of 75-100 years. There are an estimated 240,000 water main breaks each year wasting over two trillion gallons of treated drinking water.

While the United States is the global leader driving technological advances, it has underinvested in the infrastructure to support the growing needs to support these advances. According to The State of the Internet report from Akamai Technologies, the United States ranked 16th in average connection speed of 17.2 Mbps in Q4 2016 among nations. Megabits per second (Mbps) are a unit of measurement for bandwidth and throughput on a network. The result was well above the global average of 7.0 Mbps, but considerably behind top-ranked South Korea with speeds of 26.1 Mbps.

The neglect of our infrastructure spending requirements has been a source of frustration for our team as we have shared the ASCE report with readers for nearly a decade. Politicians have been sitting and watching the costs escalate and the risks of further tragedy increase. President Trump has made infrastructure spending one of his key priorities, it remains to be seen whether Congress will act and if so whether they will respond with the appropriate commitment of dollars. However, we are excited by the possibility of further public-private partnerships along the lines of FirstNet/AT&T as these types of arrangements leverage the strengths of our government agencies and businesses to attack specific problems. Since it is politically a challenge for Congress to find a way to finance the cost, a portion of the burden will likely fall on state and local governments to fund these projects. Given the fact that many states are already struggling, it will possibly mean consumers will bear some of the burden in the form of higher state and local taxes or consumption taxes.

Investment Implications

Given the combination of political, economic and social forces at work in the U.S. and global economies, it is easy for investors to be unsure of their investment strategies at this time. We would emphasize that there are important beneficiaries of the Outlook that we have described in recent quarters, and see opportunities for well-selected equity investments in technology, defense, health care, infrastructure, and high-quality dividend payers. It is notable that small capitalization stocks have not participated in the strength of the equity markets so far this year creating interesting valuation prospects for investors. ARS has spent substantial time researching the beneficiaries of greater infrastructure spending and will look to increase our investments in this area as our conviction grows that Washington is taking steps to make the investments our nation requires. The outlook for corporate profits remains positive, while interest rates and inflation rates have been rising modestly and proportionally to the current rate of growth. As a direct result of the improvement in U.S. economic conditions and its outlook for a continuation in the coming quarters, the Federal Reserve is now able to take a measured approach to increasing rates and possibly begin to reduce its balance sheet later this year. The Federal Reserve’s positive outlook is further supported by improving economic numbers out of Europe and the Emerging Markets.

Our next Outlook will discuss the ability of the Administration to continue to use deregulation as a bridge to buy time to negotiate other pro-growth initiatives. We will also address the short term and secular forces arguing against much high interest rates and inflationary pressures. In addition we plan to share our thoughts on the important meeting between President Trump and China’s Premier Xi. Please call us with any questions or comments.

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