Weighing the Prospects of Trump’s Policies against Political and Economic Realities

Weighing the Prospects of Trump’s Policies against Political and Economic Realities

In our Outlook (October 13th) published before the Presidential election, we described a world at an inflection point.  Monetary policy, which had succeeded in stabilizing economies and markets after the financial crisis, appeared to be reaching its limits. We wrote that “without proper fiscal policy, investors should expect more of the same low growth, low interest rates and low inflation … we have experienced for some time.”  The election result in the U.S. is being interpreted as a call for change, and some of the initiatives being proposed echo the policies that we have called for in this Outlook for years.  These include investing in U.S. infrastructure, making corporate tax policy globally competitive, repatriating cash held overseas by U.S. corporations and reducing the regulatory burden on businesses.  Importantly for investors, there is a renewed sense of confidence and optimism developing from U.S. businesses and consumers as the long-awaited fiscal policy initiatives appear to be on the way to complement the accommodative monetary policy stance of the Federal Reserve.  The outlook for corporate earnings (higher), inflation rates (slightly higher) and interest rates (trending higher, but continuing to be well below historical norms) remains supportive of equity investments.

The current optimism for future policy changes should be balanced against the market conditions present today.  Whenever rapid changes occur in the markets as we have seen in the post-election period, it often gives us pause as the global economy needs time to adjust.  We cannot help but notice that markets are already giving significant credit for legislation that could take many months to pass, and possibly then only after considerable debate and compromise.  Furthermore, the confirmation process for Cabinet positions may be contentious and drawn out.  Even as new laws are passed, they often require several months for their benefits to flow through the economy.  While we are awaiting those benefits, what economic impact will rising interest rates, and oil and gas prices have in the meantime?  And what impact will a sharply rising dollar have on developing economies whose depreciating currencies make it more difficult for them to service their dollar-denominated debts? We also wonder whether investors are postponing making security sales until January in anticipation of lower tax rates in the New Year?

These are some of the questions we are asking as we witness a growing chorus of optimists, many of whom were so cautious just six weeks ago.

In balancing the opportunities presented by the transition from an economy supported primarily by monetary policy to one which also has added fiscal policy initiatives, investors should consider an investment strategy with three elements – owning quality growth companies, owning quality companies with strong balance sheets and reasonable dividend growth prospects, and owning opportunistic investments with specific catalysts.  An added challenge for market participants, many of whom were over-allocated to fixed income, will involve the timing of getting back into the equity market given the uncertainty as to the timing of policy implementation and anticipated market volatility in 2017.  Near-term uncertainties aside, equity investors with a longer-term view should continue to be rewarded in the coming years as the recovery continues.

The Handoff of Monetary Policy to Fiscal Policy Likely to Begin in 2017

“The projections in this Economic Outlook offer the prospect that fiscal initiatives could catalyse private economic activity and push the global economy to the modestly higher growth rate of around 3.5% by 2018. Durable exit from the low-growth trap depends on policy choices beyond those of the monetary authorities – that is, of fiscal and structural, including trade policies – as well as on concerted and effective implementation.”

     “Escaping the Low-Growth Trap”, OECD, Economic Outlook No. 100, 10/28/16

The challenges in the world cannot be erased by one election as economic headwinds such as excessive indebtedness, aging demographics, underfunded pensions, excess capacity and declining productivity (not to mention environmental) are structural in nature and will take years to address.  Of more immediate concern is the adjustment process the global economy must undergo due to the rapid strengthening of the U.S. dollar and nearly 1% rise in Treasury bond yields.  The suddenness of these moves is driving capital outflows from China, Europe and developing nations into the United States.  As many European and developing nations have already been experiencing anemic growth, the challenges posed by a stronger U.S. dollar and rising interest rates come at an inopportune time.  China’s currency reserves have declined by over $1 trillion in recent years and are approaching the $3 trillion level.  Recently the Euro has reached a multi-year low, Italy is dealing with the need to form another new government and to strengthen a weak banking system, the region is struggling with immigration issues, and austerity programs have fueled anger and anti-establishment sentiment in many nations.

We continue to believe that the global economy could be at an important inflection point in which fiscal policy initiatives, encouraged by the OECD and other leading institutions, begin to be implemented and become supportive of monetary policy. In recent months the economic data out of Europe has improved, and its sustainability may accelerate the introduction of more pro-growth initiatives. As the chart highlights, there are several important elections coming up in 2017 and 2018, and the pressure is growing for Europe to replace its austerity orientation with pro-growth fiscal policy initiatives.   The European Central Bank (ECB) President Mario Draghi has repeatedly called upon governments to implement fiscal policy to support the ECB’s highly aggressive monetary policy initiatives.  Until these countries adopt more pro-growth policies, the U.S. will remain a magnet for capital flows and among the strongest economies in the world.

Reasons for Cautious Optimism

For several years, we have discussed the United States being the standout economy among developed nations.  While the post-financial crisis recovery has been muted, the U.S. has continued to be a global leader due to its adaptability, innovation and resilience.  Prior to the November election, the U.S. economy was slowly but steadily improving.  The Federal Reserverecently announced that based on the improvements in economic data and its projections for 2017, the FOMC anticipates three rate hikes next year.  Per the Council of Economic Advisors November 2016 Economic Indicators report, U.S. corporate pre-tax earnings were projected to exceed $2.26 trillion with an increase of $78.3 billion for 2016 alone.  After-tax earnings for U.S. companies were estimated to be $1.69 trillion with an increase of $57 billion. Personal income rose at an annual rate of $98.7 billion and is forecast to be over $16.3 trillion, while wages and salaries rose $45.2 billion in October. U.S. consumer net worth rose to an estimated $92.8 trillion in the third quarter, and unemployment declined to 4.6% in the most recent report.

The Trump campaign platform identified four major economic policies which have created excitement about the future – infrastructure spending, corporate and individual tax reductions, lowering regulatory burdens and the repatriation of corporate cash held overseas. In 2016, taxes on corporate income were forecast to be $565 billion which represents a 25% rate as many large corporations were paying well below the 35% statutory rate.  The President-elect has proposed lowering the rate to 15%, while the House plan targeted a 20% rate.  Even a 10% reduction in corporate taxes would improve after-tax profits by over $56 billion with small and medium sized businesses benefiting significantly.  For consumers, any reduction in personal income taxes would be welcome.  Personal income taxes are estimated to be $1.99 trillion in 2016, and much of the benefit of lower taxes would likely be spent.  Additionally, if the new Administration is effective in its commitment to reduce unnecessary regulatory burdens, small and mid-sized companies would again benefit significantly as would large corporations.  In speaking with small-business owners, lowering regulatory requirements for them may be the most important element of the Trump platform as it would make doing business less complex and costly.    Estimates vary for the total amount of U.S. corporate cash held overseas ranging from $2-3 trillion dollars.  If corporations are incented to bring home some portion of this cash, there could be a significant ripple effect throughout the economy.  If $1.5 trillion were to be repatriated at a 10% tax rate, the government would receive $150 billion and corporations would have $1.35 trillion for increased capital expenditures, dividends and/or share buybacks.

These policies are forecast to widen the deficit by anywhere from $3-6 trillion over the next decade, but those numbers could vary significantly depending on the ability of these fiscal policies to raise GDP growth and tax receipts.  It remains to be seen whether the President-elect’s campaign anti-trade rhetoric becomes a reality, but this would likely offset the positives of the fiscal policy initiatives described above.  Given the selection of Rex Tillerson, the CEO of Exxon Mobile, as Secretary of State as well as other Cabinet appointments, we anticipate that the Trump Administration trade policies will be more pragmatic than the campaign rhetoric would suggest.

Investment Implications

This Outlook highlights the positive potential for change in key areas over the medium term.  With investor sentiment potentially getting ahead of itself in recent weeks, we approach the New Year a little guarded but with an opportunistic bent.  Over the medium term, however, we see investment opportunities in many of the areas we have emphasized over the past year, including companies with strong secular growth characteristics, high quality companies with attractive and growing dividend payouts, opportunistic investments in out-of-favor areas in the market, industries with special catalysts, and U.S. domestically-oriented businesses (especially small capitalization companies).  Recently we have also increased exposure to companies that will be direct beneficiaries of new administration priorities, such as infrastructure investment and defense spending.  We are also focused on defensive, divided-paying stocks that have been discarded by the market and have become more attractive since the election.  With the U.S. economy and consumer confidence improving, the outlook for small capitalization stocks has also improved.  As previously mentioned, the more domestically-oriented, smaller market capitalization companies should be major beneficiaries of the proposed tax cuts, the stronger U.S. dollar, infrastructure spending, lower regulatory burdens, repatriation of overseas cash from larger corporations and increased merger and acquisition activity.  The combination of these forces should increase after-tax earnings for these companies.  In the New Year, we will take advantage of any market dislocations to build positions in the beneficiaries of our Outlook.

Important Update

We are also pleased to announce that effective December 20, 2016, the firms of Somerset Capital Advisers, LLC led by Michael Schaenen and Ross Taylor and Artemis Wealth LLC and PS Management, Inc. led by Sean Lawless, have formally merged with A.R. Schmeidler & Co., Inc.  The firm has been renamed ARS Investment Partners, LLC.  The combination of our firms will allow us to better service our clients’ evolving needs  in the coming years.  In January  2017, we will be introducing two new investment strategies which leverage the collective capabilities of our expanded team – the ARS Focused Small Cap Strategy and the ARS Focused ETF Strategy.  The ARS Focused Small Cap Strategy intends to invest in companies with market capitalizations ranging from $100 million to $2.5 billion.  The strategy employs a high-conviction approach resulting in a portfolio of 15-20 small-cap companies.  The portfolio is long biased, while attempting to mitigate risk via cash levels, prudent short sales, inverse ETF’s (Exchange Traded Funds) and option strategies.

The ARS Focused ETF Strategy is designed to concentrate investments in ETFs that provide the greatest exposure to ARS’ highest-conviction themes.  This may lead to investments in “narrow” industry ETFs.  Typically, the portfolio will focus on 5-10 themes that will result in 10-20 ETF investments.  These new offerings are just one example of the benefits of our firms coming together.  We are delighted to expand our investment and service capabilities with these talented and experienced managers whom we have known for several years.  We look forward to introducing you to our new colleagues at the earliest opportunity.

We want to wish all of our clients and readers Happy Holidays and a healthy, joyful and prosperous New Year!

The World is at an Inflection Point – Update

Outlook Notes – November 14, 2016

Our October 13th Outlook was titled “The World is at an Inflection Point” as we believed that the global anti-establishment sentiment had become so strong that we were closer to major shifts than many had realized. The Trump win combined with the Republican sweep of the Senate and House was the strongest statement yet of the anger and dissatisfaction with the status quo. The United States election results reflected the frustration of large segments of the population who were left behind and felt underserved by government institutions.  While many details of the new administration’s economic and foreign policy initiatives remain unknown, it is our expectation that long-awaited fiscal and structural reform is coming.  We have long believed that such reform is necessary to support accommodative monetary policy.  There are several policy responses under discussion which, if implemented, will stimulate growth, including increases in infrastructure and defense spending, reductions in corporate and personal taxes, a reduction in regulatory burdens on companies, and the repatriation of approximately $2 trillion dollars of cash held overseas by U.S. corporations. The effect of these initiatives would lead to increases in corporate investment, consumer spending, employment growth and wages.  For some of these policies to be effective, the new administration needs to dial back its anti-trade rhetoric.

Overseas, the U.S. election outcome is being viewed as a wake-up call for government leaders to act to avoid similar election results. Consequently, investors should anticipate shifts in policy initiatives by European governments, especially in Germany, as anti-establishment pressures continue to build.  Investors should also expect market volatility over the coming months as the impact of the U.S. election unfolds and as we learn which campaign slogans become actual policy initiatives.  Failure by governments to follow through with substantive change could lead to further economic, social and political stresses.  However, if in fact the U.S. and Europe begin to embrace fiscal reform, it could prove to be the most defining moment of the post-crisis period for the developed and developing worlds.

The United States remains the largest economy, and the collective strengths of the nation should help keep the U.S. in that position.  It is now time for political ideology to be put aside and to get on with fixing the areas that need fixing.  The current record-low interest-rate environment has been giving governments, both at home and abroad, a unique opportunity to use low-cost debt to make the needed investments essential to foster a return to a stronger growth environment.  The opportunity will not be with us indefinitely and now is the time to capitalize on this low interest-rate structure.  Importantly for investors, if this inflection point results in our addressing our needs through the implementation of effective fiscal policy and the structural reforms mentioned in our recent Outlooks, the economic prospects for the U.S. would change dramatically.

The World is at an Inflection Point

Strong anti-establishment pressures have brought the global economic and geopolitical situation to an inflection point leaving investors wondering where we go from here? The statement above from the International Monetary Fund report prepared for the G-20 Finance Ministers and Central Banker Governors’ Meetings held in China this past July sums up the concerns quite appropriately – action is needed and it is needed now.  Without proper fiscal policy, investors should expect more of the same low growth, low interest rate and low inflation economy we have experienced for some time.  It is our expectation that should the long-awaited fiscal policy response begin, the impact would be quite positive.  The global economy has been suffering from a basic lack of demand relative to supply.  Moreover, the increase in economic and political uncertainty has lowered confidence, suppressed investment and spending, and contributed to the insufficient fiscal policy response.   Moreover the inability of political systems to respond has been fueling the mounting resentment and anger among broad segments of the population. As a result of the global challenges, monetary policy initiatives have been the most accommodative in history and will remain highly accommodative for an indeterminate period.  Yet in spite of unprecedented monetary support for the system, the global economy continues to struggle with growth that has been too slow for too long, with the benefits shared unequally.  On October 4th, the IMF updated its forecast for global growth projecting 3.1% for 2016 with a slight increase to 3.4% in 2017.  Leading central bankers, including Federal Reserve Chair Janet Yellen and ECB President Mario Draghi, have been imploring governments to implement strong fiscal policy actions to support monetary policy initiatives as only fiscal policy and structural reforms can solve the secular problems facing the global economy.   Any observer of the world’s infrastructure conditions cannot fail to see the enormous opportunity for positive change that would result from immediate investments in this area.

Summary of FOMC

The chart above illustrates the economic projections from the recent Federal Open Market Committee (FOMC).  The committee forecasts U.S. growth to run between 1.8% and 2.0% for the next three years.  Amid significant global uncertainty, market participants are now spending considerable time trying to determine the effect of the U.S. presidential election and Federal Reserve policy on investment strategy.  Given the many problems facing the world including rising and excessive debt levels, worsening demographics, growing pension liabilities and increasing hostilities to name a few, the world is at an inflection point both economically and politically.  Widespread dissatisfaction likely will make the above FOMC projections wrong and should force politicians to act in favor of expansion rather than contraction or the status quo. In this Outlook, ARS will briefly frame the problem of growth for the global economy and the U.S., discuss several critical policy initiatives required by leaders to create higher and more sustainable growth, and finally describe the investment implications for our clients.

Critical Policy Initiatives to Return to Growth

Global Growth Initiatives

“To lift growth and counter risks, G-20 policymakers will need to follow a broad-based approach that simultaneously provides better-balanced demand support where needed, address private sector balance sheet items, and implement structural reforms.”

Global Prospects and Policy Challenges, International Monetary Fund

One of the main challenges of a prolonged period of low growth accompanied by eight years of aggressive and highly accommodative monetary policy is that politicians have had the cover to avoid taking necessary policy actions.  Without a crisis to prompt an immediate policy response like the world experienced following the Lehman Brothers collapse, it has been impossible to get meaningful action from politicians. As a consequence, anti-establishment sentiment has risen to extremely high levels across the developed world, and many elected officials are afraid to sponsor the programs or enact the structural reforms they know are needed to return to growth. Christine LaGarde, Managing Director of the IMF, in a recent speech once again implored governments to use structural reforms, fiscal and monetary policies in a “country-specific way to make them mutually reinforcing”. Ms. LaGarde discouraged protectionism, encouraged inclusiveness in growth, and even suggested cooperation and, if needed, coordination between nations.  However, the economic challenges, particularly those of the developed nations, are fueling populist sentiment against global trade and immigration because they are perceived to be costing jobs and growth particularly for young people in nations where unemployment is very high.  Businesses and individuals are fed up with politicians who have allowed ideological beliefs to prevent the application of sound business and economic judgment.  Free trade and immigration are two of the key issues for political parties around the world and also for politicians in the U.S. election.

U.S. Growth Initiatives

“The U.S. lacks an economic strategy, especially at the Federal level. The implicit strategy has been to trust the Federal Reserve to solve our problems through monetary policy. A national economic strategy will require action by business, state and local governments, and the Federal government… Overall, we believe that dysfunction in America’s political system is now the single most important challenge to U.S. economic progress.”

Harvard Business School Survey on U.S. Competitiveness

Slowdown in Economic Growth

As the following chart highlights, our nation has experienced a slowdown in economic growth over many decades. According to the recently released Harvard Business School (HBS) report entitled “Problems Unsolved and a Nation Divided”, U.S. economic growth averaged 4.3% annually from 1950-1969, then declined to 3.2% from 1970-1999 and recently has been around 2%.   With both presidential candidates struggling to articulate their economic programs, it is appropriate to share the Eight-Step Plan of federal policy priorities highlighted in the HBS report.  The report puts forth the following policy recommendations:  simplify the corporate tax code with lower statutory rates and no loopholes; move to a territorial tax system like other leading nations; ease immigration of highly-skilled individuals; aggressively address distortions and abuses in the international trading system; improve logistics, communications and energy infrastructure; simplify and streamline regulation; create a sustainable federal budget, including reform of entitlements; and responsibly develop America’s unconventional energy advantage.  The report cited public education and health care as two other areas that need to be addressed on a state and local level.

While there is nothing new or earthshattering about the areas highlighted, it is clear from the recent presidential campaign process that Americans are fed up with the status quo and want Washington to act more responsibly.  At least three of the priorities from the HBS plan – tax reform, easing the immigration of skilled individuals and investing in our infrastructure – are fairly straight-forward opportunities.  More importantly, these issues require immediate action.   In a recent CNBC interview, former President Bill Clinton called for a lowering of the current corporate tax rate.  During his presidency the rate was around the international average of 39% but it is well above the average of 24% today.  Mr. Clinton proposed lowering corporate taxes as close to the international average as possible with all corporations paying a minimum tax rate. He also favored repatriation of overseas cash.  In the U.S., small businesses are often not able to receive the same tax benefits as multinationals, yet small businesses are the key drivers for employment growth and productivity improvement.  With minimum wages rising and increasing regulatory burdens, small business formation and the associated job creation have been lackluster in recent years.  A lower and more competitive corporate tax structure would provide an important boost to the economy.

A recent Deloitte study estimates that there are three and a half million manufacturing jobs needed to be filled over the next decade with two million of those job openings likely going unfilled due to the skills gap.  Throughout the school systems there needs to be a change: students need to be taught the skills required for the jobs based on 21st Century technology.  In the short-term, the U.S. should be easing the immigration of skilled labor through the H1-B visa process.  Canada, for example, allows for almost three times as many visas to be issued annually than does the U.S. and has approximately one-tenth of the population.

The growing need to improve our infrastructure has been developing for more than a decade as the required spending has risen from $1.3 trillion to nearly $4 trillion today.  Last month’s train accident in Hoboken, New Jersey is just the most recent example that the U.S. can no longer postpone making these critical investments.  This is one area that Mr. Trump and Ms. Clinton can both agree on as they each have made infrastructure spending a prominent feature of their economic platforms.  The key issue is whether either candidate can get the necessary support from the House and Senate to act.

Investment Implications and Opportunities

With the presidential election less than one month away and a possible interest rate hike by the Federal Reserve before year end, investors should expect volatility to be with us following a fairly quiet few months.  Our portfolio strategy remains consistent with the themes prominent currently in client portfolios with some important additional considerations. The first is that we believe the global economy could be at an inflection point as fiscal stimulus is critical at this stage to support growth.  We believe this would be a significant positive for the economy.  Consequently, there has been an increase in activity in our client portfolios reflecting the desirability of investing in the beneficiaries including technology, energy and materials companies. A second is that there are several investable areas where the opportunities are not necessarily dependent on the outcome of the election or economic growth, but rather benefit from individual industry or company-specific tailwinds.  One such area is in computer technology as the fast-growing memory and storage space is experiencing a tightening in the supply and demand dynamics leading to increased pricing power for providers, some of whom also offer very attractive dividend yields.  In the healthcare sector, the medical device companies are benefiting from strong demographic demand, as they are not subject to the growing negative narrative over drug pricing. The third is the buying opportunity that is developing in high-quality dividend stocks, including utilities, whose prices have pulled back in anticipation of interest rate increases by the Federal Reserve. The fourth is the expectation of the strengthening U.S. dollar which tends to act as a contractionary force for overseas economies to the degree that they need to import commodities which are traded in dollars. In addition, dollar-denominated debt becomes more expensive to service in a rising dollar scenario, particularly for emerging economies.  The equity markets will react negatively if the dollar strengthens too quickly or too much. The final consideration relates to the structure of the market as mutual fund and hedge fund liquidations combined with seasonal tax-selling between now and year end can create mispricings of shares and potential buying opportunities.

Portfolio Emphasis

Our portfolio strategy continues to focus on three areas of emphasis – high-quality growth, high-quality dividend payers and opportunistic investments.  Our focus remains on selecting companies benefitting from positive trends in cloud computing and mobility, changes in the healthcare industry, rising defense spending, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India.  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 growing dividends.  Companies that are able to more aggressively invest in the future growth of their businesses will be more highly rewarded.  This is an environment that will continue to reward companies with strong, qualitative fundamentals.

The United States remains the leading nation from a geopolitical and economic perspective, and the collective strengths of the nation should help keep the U.S. in that position.  However, we are at an inflection point and now is the time for political ideology to be put aside and to get on with fixing the areas that need fixing.  Tax reform, infrastructure, education, job creation, health care and entitlement programs, including state and local pension plans and inequality need to be addressed immediately.  The current record low interest-rate environment has been giving governments, home and abroad, a unique opportunity use low-cost debt to make the needed investments essential to foster a return to a stronger growth environment.  The opportunity will not be with us forever and now is the time to capitalize on this historic interest rate structure.  Importantly for investors, if this inflection point results in our addressing our needs through the implementation of smart fiscal policy and the structural reforms mentioned above, the outlook for the United States economy becomes materially better.

Difficult Economic and Political Choices Lie Ahead

We live in a world of global disequilibrium and distortions which are likely to be with us for many years, and for clients the key question is how do you preserve and build capital under these conditions?  In 1970, Alvin Toffler argued that society was undergoing tremendous structural change from a technological and social perspective that would overwhelm people leaving them disconnected and disoriented.  Some 46 years later, the rapid rise in anti-establishment sentiment in Europe and the United States reflects the frustration of many people who are experiencing lower living standards, growing income inequality, a loss of confidence in government and declining optimism about the future.  In addition to these issues, the Brexit vote reflects a growing sentiment of loss of sovereignty and self-determination.  Globalization and technological advances have not benefited populations equally leaving many feeling disenfranchised.

The global economy remains volatile and unbalanced, but in the face of the many challenges the S&P 500 and Dow Jones Industrial Indices continue to make new highs.  In light of the current geopolitical, economic and social conditions, investors should expect the continuation of the historically low interest-rate environment.  Low rates are limiting options for capital to achieve returns and pushing investors to seek alternatives.  We would caution market participants not to make investment decisions today using only traditional investment thinking with respect to current interest rates and equity valuations given the characteristics of the global economy.  In a growth-challenged environment, investors should expect the United States to remain among the healthiest economies with the U.S. dollar and treasuries continuing to be in high demand.  The U.S. economy is improving as indicated by the strength of consumer spending and housing activity.  Many U.S. corporations had previously lowered earnings expectations for Q2, and therefore are able to meet or exceed expectations leading to higher share prices.  In our view, the outlook for current interest rates, inflation rates and corporate profits continues to create favorable conditions for the second half of the year for well-positioned U.S. businesses.

GDP Growth Forecast

The chart above from the International Monetary Fund shows the most recent lowered growth projections for many of the developed economies.  Governments are facing many difficult choices from geopolitical, economic and social perspectives in the months ahead.  To deal with the economic challenges, central banks will continue to employ the most aggressive monetary policy actions in history.  These policies have been implemented in various forms and to varying degrees of success.  Unfortunately as aggressive as monetary policy has been, fiscal policy has been insufficient to support growth, and in some countries including several in Europe, it has been contractionary.  While perhaps well-intended, austerity policies have had the effect of virtually guaranteeing slow to no-growth outcomes and high unemployment, especially among youth.  A strong fiscal policy response is required to match monetary policy efforts which are nearer their limits.  While we have written about the need for productive fiscal policy initiatives for several years, the level of frustration expressed by populations around the world may finally force politicians to act as voters are determined to challenge the political status quo.

The Post-Brexit EU and the UK

“The unique feature of the EU is that, although these are all sovereign, independent states, they have pooled some of their ‘sovereignty’ in order to gain strength and the benefits of size. Pooling sovereignty means, in practice, that the Member States delegate some of their decision-making powers to the shared institutions they have created, so that decisions on specific matters of joint interest can be made democratically at European level. The EU thus sits between the fully federal system found in the United States and the loose, intergovernmental cooperation system seen in the United Nations.

 Excerpt from EU publication “How the European Union Works”

The European Union (EU) was created in the aftermath of the Second World War based on the ideals of a peaceful, united and prosperous Europe.  The intent was to foster economic cooperation with the idea that countries that trade with one another become economically interdependent and so more likely to avoid conflict.   The EU functioned relatively well from an economic perspective when economies were doing better, but when the strains of slow growth and rising unemployment manifested themselves in recent years, resentments and doubts developed about the European project.  The series of economic crises experienced by the region since 2009 highlighted the structural flaws of the EU initiative.  There are three primary issues complicating the current situation in Europe and the UK.  First, the emphasis on austerity programs for many nations fostered deep resentments toward Brussels (headquarters of the EU) and Germany, and allowed anti-European parties to rise in influence.  Second, the economic recovery has been uneven and slow to materialize in part because the European approach, in contrast to the U.S. one, did not properly recapitalize the banking system.  Third, the civil war in Syria, with the disruptive involvement of Russia, led to the massive migration of refugees to Europe, and the Union was unprepared for the challenges and not unified in its approach to address them.

For voters in the United Kingdom (UK) and many others in Europe, concerns about sovereignty, self-determination, immigration, employment and a loss of national identity have fueled populist movements.  In October, Italy is holding a referendum on the proposed structural changes of Mateo Renzi, its Prime Minister. While at the same time, the Italian government wants to bail out the banks with capital injections, but under EU rules a bail-in must occur whereby shareholders, bondholders and bank depositors share in the losses.  We believe that the ECB will try to finesse an arrangement that protects bank depositors, shareholders and creditors for Italy as a one-off situation.  Italy, which is the EU’s third largest economy, otherwise could at some point be the next shoe to drop after Brexit.  Furthermore, the recent coup attempt in Turkey could heighten immigrant flows into Europe which in turn could result in rising nationalistic sentiment, further weakening the Euro and slowing economic growth.  With many leading nations facing elections in the next 12 months, politicians must carefully weigh their policy options.

As things stand today, the future of the European Union (EU) is uncertain as is its relationship with the UK.  Undoing 40 years of political and economic integration would be a complex and difficult process.  Fortunately, the leadership transition in the UK was expeditious as Theresa May was introduced as David Cameron’s successor on July 13th and many of the key cabinet positions have already been filled.  This will allow plans for the Brexit process to begin to be formulated with the current relationship between Norway and the EU potentially being used as a model.  The Brexit process could take some time to be completed as negotiating trade agreements and the free movement of individuals are complicated issues with important implications for the involved nations.

Global Disequilibrium and the Upcoming Elections

One of the key questions facing European leaders is whether the Brexit vote leads to an unraveling or forces greater integration of the EU given the large cultural differences and different histories of its members.  Germany is determined to see the EU remain intact.  Competing interests make a solution difficult, but not impossible.  Aside from the economic benefits of the Union, the EU provided a stronger foundation for the security of its member nations.  However, the fourth terrorist attack in France in the past 12 months will advance the position of Marine Le Pen, the far-right leader who is President of the National Front (FN), a national-conservative political party in France which has made immigration and national security a key element of its platform.  As the chart below highlights, several of the key decision makers will be forced to balance doing what is right for their own nations with doing what is right for Europe while also trying to get re-elected.  The favorability ratings for many incumbents are deteriorating, and key elections in France, Germany and Italy will complicate matters while lengthening the process.  In the US, the improbable rise of Donald Trump as the Republican nominee for President and the surprising showing of Bernie Sanders on the Democratic side are reflections of the anti-establishment sentiment here at home which is an outgrowth of the inability of Congress to effectively address the needs of the nation.  The likely change of leadership in so many nations has added an element of unpredictability and uncertainty to the outlook.

Global Election

However, there seems to be one area of common need globally and that is the need to invest in infrastructure to stimulate growth and increase productivity.  Unlike the previous 30 years, the global economy can no longer rely on credit-fueled growth by the private sector to the same degree as in the past because of the excessive debt already in the system.  Two critical elements required for stronger growth are infrastructure spending and structural change. Both Donald Trump and Hillary Clinton have made infrastructure spending a prominent part of their platforms to drive economic growth for the U.S. In Europe, the challenge will be whether Germany can make the ideological shift with respect to supporting a move away from austerity for the Southern tier nations by increasing spending to promote economic growth in the EU.  The need for increased infrastructure spending is real and no longer able to be postponed.  McKinsey Global Institute in a 2013 report estimated that the required global infrastructure spending needs by 2030 were in excess of $57 trillion and growing.  At the time, it was estimated that the required global spending was greater than the total value of the existing global infrastructure.  For the United States, a 2013 American Society of Civil Engineers report projected the spending needs to be in excess of $3.6 trillion and rising.  The current record low interest-rate environment has presented governments a unique opportunity to use low-cost debt to fund the needed investments essential to foster a return to a stronger-growth environment.  Importantly the return on investment would be higher than the cost of capital.

Global and NATO Defense Spending

The disequilibrium discussed in this Outlook is being manifested in many areas with a critical one being that the world is a less-safe place with the tragic terror attack in Nice and the failed coup being the most recent examples.  As a consequence, global defense spending is likely to increase from the current levels of approximately $1.7 trillion.  The United States, which accounts for 39% of global defense spending at approximately $670 billion annually, had slowed spending in recent years as a result of the financial crisis and the budget sequestration.  That trend is now reversing and the initial policy statements from each presidential candidate support the need for an increase in U.S. defense spending.  The target amount for NATO nations, ex the United States, is 2% of GDP or an estimated $320 billion per year.  From the Middle East to Europe to Asia, countries are increasing defense spending at a significant rate with Russia planning $320 billion by 2020, China intending to increase spending over 7% annually, and now Japan is considering a constitutional change to increase its spending as well.  The United States is also working to enhance South Korea’s Ballistic Missile Defense (DMB) system as North Korea continues its aggressive development of its nuclear program.

At the recent NATO Summit in Warsaw, participants highlighted that member nations were facing “a range of security challenges and threats that originate both from the east and from the south; from state and non-state actors; from military forces and from terrorist, cyber, or hybrid attacks.”  The group cited Russia as the most significant threat and has committed both personnel and increased spending to protect its members from Putin’s highly aggressive actions.  NATO nations are committing additional ground forces to the Baltic region. NATO also stressed as a critical security issue the shifts in tactics by ISIS to bring terrorism to Europe and in particular to France and Belgium. The instability of the Middle East and North Africa are contributing to the ongoing refugee crisis. This is also adding to security concerns for members as most are unprepared to handle the volume of refugees which is taxing domestic security forces.

From an investment perspective, U.S. defense companies represent a relatively small percentage weighting in the S&P 500, so most institutional portfolios have a representation in defense of approximately 1.8% or less.  The top 5 defense companies have a market capitalization of about $280 billion.  It is our view that these businesses represent important investments that generate significant cash, maintain high and/or growing backlogs, improving profit margins, raising dividends and repurchasing stock.  These businesses are not as dependent on economic activity as are others, but rather on national security needs and geopolitical conditions.

Testing the Limits of Monetary and Interest Rate Policy

The absence of supportive fiscal policy is forcing central banks to rethink the limits of monetary policy initiatives.  Following meetings between Ben Bernanke, the former Federal Reserve Chair, and the heads of the Bank of Japan to discuss its battle with deflationary pressures, there has been increased speculation regarding the possible introduction of “helicopter money”.  This is an unconventional policy that blends elements of monetary and fiscal initiatives by printing large sums of money to finance government programs in order to stimulate the economy.  The central bank gives the government money with no interest and no expectation of payment at a later date to distribute in the form of spending.  While many are skeptical about the likelihood of its being introduced, we would caution that investors were also skeptical of the likelihood of quantitative easing and “lower-for-longer” interest rates as well.  Prior to the financial crisis, interest rates were always a positive number.  With $11.5 trillion in government bonds outstanding carrying negative interest rates, the historic level of interest rates is no longer the standard.  Due to the development of negative interest rates as a policy tool and the prospects of even further unconventional monetary policy initiatives, gold has become of greater interest to investors in 2016.  While there are divergent views regarding gold, the economics of the current environment have arguably made gold less expensive to own then at any time in the past.  Gold is considered a hedge against excessive currency creation as well as economic, geopolitical and financial instability.

Investment Implications

“America has been dealt an extraordinary hand, and I am optimistic about our future. Our universities are second to none. We have many of the best businesses on the planet – small, medium and large. Americans are among the most entrepreneurial and innovative people in the world, from those who work in entry-level jobs on the factory floor to Bill Gates… We face many challenges. But they can be overcome…”

                         Jamie Dimon, Chairman and Chief

Executive of JPMorgan Chase in a recent NY Times Op-ed

Portfolio Emphasis

As we have often stated in previous Outlooks, the resilience and adaptability of the U.S. have and will continue to make our economy standout relative to others and perpetuate the view as a safe haven for capital.  These attributes become even more important in times of the global disequilibrium we see today.  Even with the many challenges we face, opportunities exist to build and protect capital.  Our portfolio strategy continues to focus on three areas of emphasis – high-quality growth, high-quality dividends and opportunistic investments.  Our focus remains on selecting companies benefitting from positive trends in cloud computing and mobility, changes in the financial and healthcare industries, rising defense spending, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China and India.  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 will be more highly rewarded as there is a growing view that many corporations have only been able to financially engineer their performance improvements through share buybacks.  This is an environment that will reward companies with strong, qualitative fundamentals.  Furthermore with more than $11.5 trillion of government debt carrying a negative yield, central bank bond buying is creating distortions in the bond market forcing rates even lower, crowding out individual bond buyers and forcing investors to seek alternative sources of income in the equity markets.

Potential leadership changes could have a profound impact on the economic policies implemented in 2016 and beyond.  For the United States specifically if the upcoming election brings about fiscal and structural changes which have been deferred for a long time, the result would be a material improvement in the economic outlook.  The current record low interest-rate environment is giving governments a unique opportunity use low-cost debt to make the needed investments essential to foster a return to a stronger growth environment.  With slow growth and deflationary pressures, we expect markets to continue to ascribe greater value to companies with the best industry-demand fundamentals and internal growth characteristics.  The dynamics of the global economy strongly suggest an environment which offers investors the opportunity to build capital and protect income.  The disequilibrium discussed in this Outlook has been adding to market volatility over the past few years, temporarily distorting the values of quality businesses and presenting investors with attractive buying opportunities.  We expect this trend to continue.  Investors should remain focused on taking advantage of the businesses that are benefitting from the positives in the U.S. and global economies.

Building Capital in the “New Mediocre” Global Economy

“The good news is that the recovery continues; we have growth; we are not in a crisis. The not-so-good news is that the recovery remains too slow, too fragile, and risks to its durability are increasing. Certainly, we have made much progress since the great financial crisis. But because growth has been too low for too long, too many people are simply not feeling it. This persistent low growth can be self-reinforcing through negative effects on potential output that can be hard to reverse. The risk of becoming trapped in what I have called a “new mediocre” has increased.”

Christine Lagarde, Managing Director of the IMF, April 5, 2016

Our recent Outlooks discussed the monetary policy actions being implemented and their investment implications. Today there are almost as many perspectives on the global economy as there are stocks and bonds traded in the markets, but there seems to be consensus that the world will be challenged to achieve sustainable growth based on the debt, demographic, social and political headwinds.  Recently the International Monetary Fund (IMF) downgraded its projections for global growth from 3.4% to 3.2% for 2016 and from 3.8% to 3.5% in 2017.  Whether we are in Ms. Lagarde’s “new mediocre” or Larry Summer’s “secular stagnation” camp, it has been clear to us for several years that the global economy requires more support than the accommodative and, in some cases, aggressive monetary policies that have been implemented to date.  In her recent speech, Ms. Lagarde suggested that the interconnectedness and internationalism of the global economy will require a three-pronged approach involving structural reforms, growth-friendly fiscal policies and continued support of monetary policies to achieve growth targets.   Critics suggest that the answer lies with less government, not more.  A stronger argument can be made for better regulation, a more harmonized global tax system, support for smart infrastructure programs and continued monetary policy support.  Today’s reality is that technology and globalization have made the world much smaller and more interdependent, and too many policies in place today are not reflective of the world we live in.  This Outlook continues to focus on building capital in the “new mediocre” economy described by Ms. Lagarde.

The global economy continues to undergo an adjustment process that is fostering significant changes in foreign exchange rates, interest rates, and commodity prices.  As a consequence investors should expect continued shifts in capital flows.  It is our view that one of the defining characteristics of investing will be a return to “P.O.S.S.” or plain old stock selection.  In our March 23rd Outlook Note, we described the key characteristics of companies we require for inclusion in client portfolios.  Key areas for emphasis are on owning high-quality growth and high-quality dividend growth companies as well as undervalued beneficiaries of the current environment.  Our focus remains on selecting companies benefitting from positive trends in mobility and cloud computing, changes in the financial and healthcare industries, rising defense spending, improving U.S. consumer spending and the shift to a more service-oriented global economy led by China.  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 organic or acquisition growth for their businesses will be more highly rewarded.  This is an environment that will favor companies with strong, qualitative fundamentals.  New companies or old ones with the ability to promote change, disrupt the competition and gain market share will be among the most attractive opportunities.  Our investment professionals are required to answer the following questions.

  •  What is going to drive the business going forward?
  • Is management of high quality?
  • Is the business getting better or worse?
  • Are margins, earnings and free cash flows improving or getting worse?
  • Is the business gaining or losing market share?
  • What is the risk and reward to purchasing at the current price?
  • In terms of portfolio construction, is it purposely adding a similar exposure to other companies already owned or is it providing exposure to a new area?

The Next Phase of Technology Disruption

“The entrepreneurs of this era are going to challenge the biggest industries in the world, and those that most affect our daily lives. They will reimagine our healthcare system and retool our education system. They will create products and services that make our food safer and our commute to work easier. The Third Wave of the Internet will be defined not by the Internet of Things; it will be defined by the Internet of Everything. We are entering a new phase of technological evolution, a phase where the Internet will be fully integrated into every part of our lives… As the third wave gains momentum, every industry leader in every economic sector is at risk of being disrupted.”

Steve Case, excerpt from

“The Third Wave, An Entrepreneur’s Vision of the Future”

The Three Waves of the Internet

There are many examples of how technology is being tested globally to help change the way public and private sector entities do business, and we are in the early stages of understanding the potential to improve efficiency, lower costs and increase quality.  As we transition to the Third Wave as described by Steve Case, the United States is arguably best positioned due to its ability to innovate and adapt.  Three examples of potential technology disruption are occurring in national security, healthcare, and insurance as discussed below.  Los Alamos National Laboratory (Los Alamos) is a multidisciplinary research institution engaged in strategic science on behalf of national security which enhances national security by ensuring the safety and reliability of the U.S. nuclear stockpile, developing technologies to reduce threats from weapons of mass destruction, and solving problems related to energy, environment, infrastructure, health, and global security concerns.  Los Alamos is partnering with a major U.S. tech company to research a new storage tier to enable massive data archiving for supercomputing.  The joint effort is aimed at determining innovative new ways to keep massive amounts of stored data available for rapid access, while also minimizing power consumption and improving the quality of data-driven research.  These companies are working together on power-managed disk and software solutions for deep-data archiving, which represents one of the biggest challenges faced by organizations that must juggle increasingly massive amounts of data using very little additional energy.

The healthcare industry is another area ripe for the type of change that Steve Case described in the Third Wave.  At roughly 17% of U.S. GDP, spending on healthcare is one of the best opportunities for technology to raise the quality of care at lower costs.  In a recent research study by Technavio, global big data spending in the healthcare industry is expected to experience a compounded annual growth rate of 42% over the period from 2014-2019.  According to the report, “Big data in the healthcare industry is tremendous because of its volume, variety, and velocity required to manage it.  This includes a wide variety of data ranging from patient data in electronic medical records, clinical data, data from sensors monitoring vital signs, emergency care data to news feeds… It also supports a wide range of healthcare functions such as disease surveillance, clinical decision support, and population health management.”

Finally, the Financial Times recently reported that “a new wave of gadgets is set to wipe $20 billion off car insurance prices globally over the next five years. Growing use of collision-warning systems, blind-spot information and sophisticated parking assistance will be so successful in cutting accidents that insurers will have to lower their rates.”  Swiss Re and Here, a mapping company, reported that by 2020 more than two-thirds of cars will have some connectivity and could lower accidents by an estimated 25-50% on roads and highways. (This highlights both the deflationary aspect of technology advances and the quality-of-life benefits.)

Very importantly as we look ahead, the existing price structure that is built into today’s global system is undergoing displacement by these disruptive technologies which lower costs at a potentially accelerating rate.  As this transpires all businesses are subject to these deflationary forces and must evolve to compete.  Three important implications of the third wave are increased productivity, growing unemployment pressures, and the need for improved education and training for workers to be able to adapt to changing labor market requirements.  A critical negative consequence is that technological advances may also foster greater inequality as education and skills differences in workers are exacerbated.  The abnormally low interest rate structure augments this trend as the lower cost of capital helps to promote investment in these disruptive businesses.

Areas of Portfolio Emphasis

In the “new mediocre” environment, key areas for emphasis in portfolios are on owning high-quality growth and high-quality dividend growth companies as well as undervalued beneficiaries of the current environment.  Our focus remains on selecting companies benefitting from positive trends in cloud computing and mobility, changes in the financial and healthcare industries, rising defense spending, increasing U.S. consumer spending and the shift to a more service-oriented global economy led by China.  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 will be more highly rewarded as there is a growing view that many corporations have only been able to financially engineer their performance improvements with strong, qualitative fundamentals.  The following details many of the reasons for our portfolio emphasis.

Mobility and Cloud Computing

“Initially described in the 2010 National Broadband Plan and authorized by Congress in 2012, the auction will use market forces to align the use of broadcast spectrum with 21st century consumer demands for video and broadband services. It will preserve a robust broadcast TV industry while enabling stations to generate additional revenues that they can invest into programming and services to the communities they serve. And by making valuable “low-band” airwaves available for wireless broadband, the incentive auction will benefit consumers by easing congestion on wireless networks, laying the groundwork for “fifth generation” (5G) wireless services and applications, and spurring job creation and economic growth.”

From the FCC website on the “Broadcast Incentive Auction”

The global economy is benefiting from rapid technological advances including the dynamic growth in mobility, connectivity, search, memory, data management, storage and devices. Over the next several years, the technological advances of multi-tracking capability, the more efficient usage of battery power and an even more connected world means that the internet will experience no letup in its disruptive power over more traditional ways of living and conducting business.  About 70 percent of Americans use data-enabled smartphones, and the total number of connected devices now exceeds our population. Globally, connected devices are forecast to increase from 15 billion in 2015 to 28 billion in 2021.  Three of the most important beneficiaries are cloud computing, data colocation and mobile-service providers. The resulting content demand is accelerating the development of devices that can process and transfer data with high speed while storing ever-increasing amounts of data as shown in the chart below.

The Growth of Worldwide Mobile Data Traffic

In the U.S., the Federal Communications Commission (FCC) is in the process of holding an incentive auction for valuable 600 MHz spectrum to help wireless providers meet the growing demand for data consumption.  Spectrum is the range of electromagnetic radio frequencies used to transmit sound, data, and video across the country.  It is what carries voice between cell phones, television shows from broadcasters to your TV, and online information from one computer to the next, wirelessly.  The last auction generated significant demand and companies paid over $45 billion to acquire spectrum, and this auction has a wide range of expectations as spending may be as low as $18 billion and as high as $60 billion.  This auction is important as it will make available “low-band” airwaves for wireless broadband. According to the FCC, “the incentive auction will benefit consumers by easing congestion on wireless networks, laying the groundwork for “fifth generation” (5G) wireless services and applications, and spurring job creation and economic growth.” 5G or fifth-generation is the next wireless broadband technology and will provide better speeds and coverage than the 4G technology. Huawei, a major player in the Chinese mobile market, believes 5G will provide speeds 100x faster than 4G LTE offers. 5G also increases network expandability up to hundreds of thousands of connections. The need for faster speed and great volume of data usage is why the spectrum assets are so highly valued. Investors should also anticipate increased demand for the devices that are best able to meet these requirements and satisfy growing consumer demand.

It is estimated that corporations spend about $3.7 trillion annually on information technology (IT) and will be shifting spending to adjust to the realities of a more connected world with far greater data.  As a result, the adoption of the cloud, which began slowly, has started to rapidly accelerate.  The benefits for businesses of moving their IT workloads to the cloud include reduced costs, greater flexibility, more scalability and better services.  Over the long term, companies moving to the cloud avoid having to build, expand, maintain and upgrade data centers, can be faster to market with new products and services and react more quickly to competitive threats.  Among the areas which benefit will be data centers, cloud service providers, data analytics and management providers, cyber-security companies, semiconductor producers, mobile advertisers and device makers.

Financials

While low interest rates in the U.S. and negative interest rates in some parts of the world have been weighing on bank stocks, our research continues to identify certain financial companies, including real estate-related companies, that should benefit from the continuation of a low interest rate environment and the easy access to financing as capital from around the world seeks higher returns.  Select financial businesses with differentiated models that have generated strong profits, despite a falling interest rate environment, should remain attractive investments relative to peers.  These include select regional banks and insurers. A potential game-changing technology for financial institutions lies just over the horizon. It is the “blockchain” technology which essentially provides a virtual transaction system and is referred to as a “distributed ledger technology”.  Major financial institutions are making multi-billion dollar investments in this technology which may radically change the way companies process transactions on behalf of customers in the future.  The Australian Stock Exchange (ASX) has announced that US-based firm Digital Asset will help it develop solutions for the Australian equity market using blockchain technology as the Exchange is looking to replace or upgrade its main trading and settlement systems.  A World Economic Forum white paper issued in June 2015 stated that “decentralized systems, such as the blockchain protocol, threaten to disintermediate almost every process in financial services.”  While the technology may be a few years away from broad usage, the potential impact is not to be underestimated once concerns about security, scale and confidentiality have been addressed.

Healthcare

Notwithstanding concerns about government involvement in setting prices for the industry, the healthcare sector also aligns closely with our longer-term Outlook as an aging global population will provide a strong secular tailwind for healthcare demand.  According to the World Health Organization (WHO), in most countries, the proportion of people age 60 or older is growing faster than any other age group due to longer life expectancy and declining fertility rates.  The U.S. Census Bureau estimates that in the U.S., the number of people age 65 years and over will increase by 30% between 2012 and 2020.  The Affordable Care Act is having the effect of adding to the number of people covered in the healthcare system.  These factors are expected to drive demand for healthcare services, including pharmaceuticals and medical devices as well as the companies that provide these services.

An aging population will also drive healthcare demand in large developing countries such as China. Moreover, demand in these markets will also benefit from increased per capita spending as their populations insist on better quality care.  In August 2015, China unveiled plans to roll out medical insurance to cover all critical illnesses for its population of 1.4 billion by year-end.  China has a two-fold problem of having to deal with the consequences of air and water pollution that are affecting a large part of its population.  China drug spending is expected to grow by nearly 8% per year through 2020, and according to McKinsey & Co. China’s overall healthcare spending will nearly triple to $1 trillion by 2020, up from $357 billion in 2011.  Greater spending suggests greater volumes of healthcare consumption, but there will also be a “trade up” from drugs and devices that are locally-sourced or generic to best-in-class patented drugs and devices sold by the leading global pharmaceutical and device companies. We expect a select group of pharmaceutical, biotech and medical device companies to be beneficiaries of these spending trends. We also favor companies with strong balance sheets and healthy dividend coverage.  These companies should benefit from investor demand for sustainable income streams as well as their ability to raise dividends and make accretive acquisitions.  Although we are mindful of the increased political attention being placed on drug pricing in the U.S., we believe that those companies with healthy research and development budgets that can demonstrate genuine superiority for their drugs and innovate breakthrough therapies will see less impact from pricing pressures.  Additionally, device makers should not be impacted by the negative political narrative regarding pricing.  On the contrary, they stand to be beneficiaries.

Global Defense Spending

“Europe faces a very different and much more challenging security environment, one with significant, lasting implications for U.S. national security interests.  Russia is blatantly attempting to change the rules and principles that have been the foundation of European security for decades.  The challenge posed by a resurgent Russia is global, not regional, and enduring, not temporary.  The situation on the ground in Eastern Ukraine is volatile and fragile, and we remain convinced the best way to bring the conflict to an acceptable, lasting solution is through a political settlement, one that respects state sovereignty, and territorial integrity.”

General Philip Breedlove, NATO’s military commander,

Department of Defense Press Briefing, February 25, 2016

As a consequence of greater global conflict, global defense spending is likely to increase from the current levels of approximately $1.7 trillion after several years of spending cuts following the Great Recession.  The United States, which accounts for 39% of spending globally at roughly $670 billion annually, had slowed spending in recent years as a result of the financial crisis and the budget sequestration. That trend is now reversing.  NATO defense spending for 2015 is estimated to be $892.7 billion, and this figure should rise in 2016. The target amount for NATO nations is 2% of GDP yet only a handful of the member nations (the U.S., Poland, Greece, Estonia and the United Kingdom) are at that level.  It was recently recommended that the United States increase support of Europe as concerns about Russia’s intentions mount.  As global tensions continue to rise, it is expected that the United Arab Emirates (UAE), Saudi Arabia, India, France, South Korea, Japan, China, Russia and other affected governments will increase purchases of next-generation military equipment in response to threats to their national interests.  Additionally China plans to increase its reported spending by 7% annually between now and 2020 which would bring it to $260 billion.  Russia, in spite of its severe economic difficulties, has pledged to spend $300 billion by 2020 to rearm and modernize its military although that plan will likely be challenged by its budgetary issues given current oil prices. At the same time, it has been reported that Russia’s Vladimir Putin has plans to establish a new national guard which may number between 350,000-400,000 members as he prepares for potential social unrest.

The U.S. defense companies represent a relatively small percentage weighting in the S&P 500, so most institutional portfolios have a representation to defense of approximately 1.8% or less.  It is our view that these businesses continue to represent strong investments that generate significant cash, have robust orders, maintain high and/or growing backlogs, and are raising dividends and repurchasing stock.  These businesses are not dependent economic activity, but rather on national security issues and geopolitical conditions.

Improving Consumer

The decline in oil and natural gas prices has lowered costs for many consumers around the globe, putting more discretionary income in their pockets.  At the same time, manufacturers and the producers of consumer products are benefitting from lower input costs as energy is a significant component of cost of goods sold.  The consumer staples companies in particular are well positioned to benefit in an environment of uncertainty and low inflation.  Because they sell the products that are consumed every day, their sales tend to be resilient, and their sizeable and growing dividend yields offer an attractive alternative to the low returns offered by fixed income securities.  While low interest rates have penalized savers, lower mortgage rates have allowed the equity value of U.S homes to rebound from around $6 trillion in 2008 to over $12 trillion today. The recovery in home values combined with improvements in the labor market have led to improved consumer confidence and spending.

Although we see opportunities for consumer companies with a domestic focus, our research is also focused on those businesses positioned to benefit from long-term growth in consumer spending in developing markets.  China in particular has seen a surge in its middle class over the past decade. According to Pew Research Center, the share of Chinese who are middle income jumped from 3% to 18% from 2001 to 2011.  Today, those whose incomes are described as middle, upper-middle or high-income now represent well over 20% of the population, or close to 300 million people – approximately the size of the entire U.S. population.  As China continues to rebalance its economy away from exports and infrastructure investment to consumer spending, we should expect consumer demand to continue to grow benefitting those multinational businesses with strong brands which are well positioned in that market.

In Conclusion

The U.S. economic outlook is positive but mixed, and the same may be said for the global economy. Investors should remain opportunistic in taking advantage of the businesses that are benefitting from the positives in the U.S. and global economies.  As the United States heads into an election year, the fiscal policy discussions will become more active as each party defines its platform.  Around the world, opposition parties have fared quite well in recent local and national elections as populations express their frustrations with the policies of incumbent parties.  Potential leadership changes could have a profound impact on the economic policies implemented in 2016 and beyond.  For the United States specifically, if the upcoming election brings about fiscal and structural changes which have been deferred for a long time, the result would be a material improvement in the economic outlook.  With slow growth and deflationary pressures, we expect markets to ascribe greater value to those companies with the best industry-demand tailwinds and internal growth drivers.  The dynamics of the global economy strongly suggest an environment which offers investors the opportunity to build capital and protect income.

The Federal Reserve’s Asymmetric Monetary Policy

Definition of asymmetry: Uneven or lacking balance.  In an asymmetrical situation, a portion of something does not have the same exact form as another portion.

Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric. If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.”

Excerpts from Janet Yellen’s speech on 3/29/16

The speech by Ms. Yellen, Chair of the Federal Reserve, at the Economic Club of New York has important implications for investment strategy as it was among the most detailed and succinct statements as to the Federal Open Market Committee’s (FOMC) position on its intensions for monetary policy for the coming quarters.   Based on Ms. Yellen’s speech this week, it was made clear that the Federal Reserve intends to maintain an accommodative policy stance for as long as domestic and global economic conditions warrant.  The Committee “anticipates that only gradual increases in the federal funds rate are likely to be warranted in coming years” and “monetary policy will, as always, respond to the economic twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals assigned to us by Congress.”  As the U.S. recovery has progressed following the Great Recession, market participants have been uneasy about any comments from Federal Reserve members with respect to the scope and timing of potential 2016 interest rate increases.  As long as the Federal Reserve feels it cannot return interest rates to a more normal level as had existed in the past, then investors must anticipate that interest rates will remain low for a prolonged period.

In her speech, Ms. Yellen commented that the U.S. economic outlook was somewhat mixed.  Among the many positives are solid job growth, increasing consumer spending, income gains, and improving residential and non-residential construction. These positives have been offset by weakness in manufacturing and exports, a stronger U.S. dollar and lower business investment.  The strength of the dollar has had the effect of putting downward pressure on the U.S. economy as lower-priced imports increase competitive pressures for U.S. companies.  A stronger dollar also has provided a headwind for the earnings of U.S. multinationals when they translate their foreign earnings into U.S. dollars.  Additionally, Federal Reserve Vice Chairman Stanley Fisher’s comments in January discussing the potential for four interest rate increases in 2016 further exacerbated the divergences among major central banks which were moving in opposite directions to the Federal Reserve.  In fact, Europe and Japan were shifting to negative interest rates, while China was taking steps to depreciate its currency.  The combination of these factors had the effect of increasing global economic disequilibrium.

In our view, this speech represented a sea change as Ms. Yellen expressed for the first time the asymmetric risks of conventional monetary policy.  This has reduced the divergences in monetary policy among the major central banks and should benefit many U.S. multi-national corporations and result in improving corporate earnings for the second half of this year.  In our view, the Federal Reserve did not make a mistake in its initial rate increase of 0.25% in December; however it seems clear to us that it miscalculated the fragility of the global economic system in communicating four possible rate hikes for 2016.  In the future, the most important expressions of Federal Reserve policy will be those from Ms. Yellen.  The beneficiaries of this environment remain the same as those expressed in our recent Outlook Note dated March 23, 2016.

The Implications of “Whatever it Takes” Global Monetary Policy

The challenge for investors is to understand the current economic environment which differs from any in the past.  The global economy is undergoing an adjustment process that, unlike others, is not easily self-correcting as the growing debt burdens and the deflationary impact of excess capacity and technological advances are not being offset by an adequate level of demand for goods and services.  These deflationary forces have led to an environment characterized by increasingly negative interest rates set by central banks in Europe and Japan as the “whatever it takes” monetary policies of both nations have shifted from highly accommodative to aggressive.  This is the backdrop for today’s market volatility, and investors should be prepared to move quickly to invest when volatile markets present compelling valuations.

“It is hardly unusual for financial markets, particularly those dealing in currencies and equities, to trend well away from economic fundamentals. After all, such excesses in the other direction were a major part of what built up bubbles and led to subsequent crashes in the EU and US crises. The current divergence in views is worthy of deeper scrutiny, however, since it is driven in substantial part by distrust of the credibility and capability of economic policy to respond to bad economic news.”

         Adam Posen, Peterson Institute, March 2016

The actions of market participants have been so episodic that they are distorting both the positive and negative views of the U.S., China, Europe and Japan.  As the standout economy, the United States demonstrates many positive attributes including improving employment, a turnaround in labor participation rates, better housing numbers, lower energy costs, an improving consumer and a relatively better economic standing than other nations as evidenced by modest GDP growth and a positive interest rate structure.  Unlike in the past when a gradual rise in interest rates was viewed as a sign of an improving economy by the markets, the discussion by the Federal Reserve earlier this year of a less accommodative monetary policy was viewed negatively.  While the United States cannot carry the global economy on its own, we do not believe that it is headed for a recession, and it should continue to do relatively well.  China, the world’s second largest economy, is undergoing a significant long-term economic transition.  Investors may be underestimating China’s ability to effectively manage this change and to have the financial resources to do so.  While China has several short-term challenges in transitioning from export-driven to domestically-driven growth, the government has a longer time horizon than most market participants.  Just recently, China targeted excess capacity in the steel industry by announcing planned shutdowns and 1.8 million layoffs over the next 5 years.  Excess capacity is one of the biggest issues for China and the global economy, and China’s actions indicate that the government is committed to addressing its problems.  The industrial sector of the economy, which drove China’s double-digit growth, is not working as it once did.  The service sector is now starting to take the leadership role as evidenced by the increase in travel and its growing middle class. As a result, the Chinese consumer arguably represents one of the most compelling investment opportunities for the next decade.

ZIRP to NIRP – The Latest Effort by Central Banks

The volatility experienced in the market this year is the unavoidable result of a deflation-prone environment lacking sufficient demand accompanied by large amounts of outstanding debt.  As exporting nations try to gain economic advantage by devaluing their currencies to the detriment of other nations, capital is flowing to the strongest currencies which is perpetuating and reinforcing the stresses in the global system.  In response to deflationary concerns, central banks have shifted from the most accommodative monetary policies (Zero Interest Rate Policy or ZIRP) in history to the most aggressive ones as evidenced by the recent announcements from the Bank of Japan (BOJ) and European Central Bank (ECB) to introduce or expand the use of a Negative Interest Rate Policy or NIRP.  NIRP involves the lowering of interest rates on government bonds to below zero in an attempt to more aggressively stimulate demand by forcing money into the system through bank lending.  It is designed to have investments made with borrowed money in order to generate growth.  In the first seven days following the announcement by the Bank of Japan in late January, more than $1 trillion of government debt moved from positive to negative yields, and today it is estimated that more than $7 trillion of global government debt outstanding has a negative yield.  That means that those who purchase these debt securities are guaranteed a loss if held to maturity.  Ironically investors could make money if the bonds are sold at even lower yields (higher prices) and would buy these bonds if they believed that central banks would be forced to push negative rates even lower.

In a negative interest rate environment, banks are charged to hold money with a central bank.  The goal is to stimulate economic growth by encouraging banks to lend more aggressively, corporations to borrow and invest, and consumers to borrow and spend.  For investors, the negative yields on government bonds force many income-oriented investors to seek alternative investment strategies to achieve their income goals.  Pension plans with long-term obligations, insurance companies and retirees living on a fixed income are among the most negatively impacted by this program.  On the other hand, it is providing governments the opportunity to make investments by borrowing at the lowest interest rates in history.

“Given continued high structural unemployment and low potential output growth in the euro area, the ongoing cyclical recovery should be supported by effective structural policies. In particular, actions to raise productivity and improve the business environment, including the provision of an adequate public infrastructure, are vital to increase investment and boost job creation. The swift and effective implementation of structural reforms, in an environment of accommodative monetary policy, will not only lead to higher sustainable economic growth in the euro area but will also make the euro area more resilient to global shocks.

Mario Draghi, President of ECB, March 10, 2016

As discussed above, the effectiveness of the NIRP initiative is dependent on bank’s willingness to lend more, corporations to invest more and consumers spending at higher levels to create greater demand for goods and services.  NIRP must also be done in conjunction with structural reforms and productive fiscal stimulus programs by governments. Monetary policy alone can only do so much to stimulate growth, and it is reaching its limits.  It is not a replacement for structural reforms that are needed in so many nations to achieve sustainable growth.  In 2015, McKinsey estimated that $57 trillion of infrastructure investment is needed globally. Well-defined infrastructure projects can be stimulative not just for the near term, but also for the long term as they create jobs, improve productivity, stimulate demand and increase needed government revenues. Governments around the world must take advantage of low interest rates to finance these critical investments, and those nations that do not will likely remain in the low growth mode and put themselves in an increasingly uncompetitive position. In an even more competitive global economy, those nations that make these investments will enhance their competitive standing.   Major nations that address structural reforms and embark on fiscal stimulus initiatives would bolster demand which would be a huge positive for the global economy.

Investment Implications

The Committee expects that economic conditions will evolve in a manner that will warrant only 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.”

Federal Reserve March 16, 2016 Press Release

Under current conditions, the environment of negative to low interest rates, low inflation rates, and slow growth will persist for an extended period in our view.  This was further supported by the Federal Reserve’s recent announcement to abandon its less accommodative interest rate policy as stated in December and January.  The key areas for emphasis in client portfolios are on owning high-quality growth and high quality-dividend growth companies.  Cash positons are meant to take advantage of opportunities when presented by volatile markets.  What matters for successful stock selection is often far less complicated than market participants make them out to be.  While not easy, it comes down to clearly understanding some salient characteristics.

  • What is going to drive the business going forward?
  • Is management of high quality?
  • Is the business getting better or worse?
  • Are margins, earnings and free cash flows improving or getting worse?
  • Is the business gaining or losing market share?
  • What is the risk and reward to purchasing at the current price?
  • In terms of portfolio construction, is it purposely adding a similar exposure to other companies already owned or is it providing exposure to a new area?

Our focus remains on selecting companies benefitting from positive trends in mobility and cloud computing, rising defense spending, healthcare, U.S. consumer spending and the shift to a more service-oriented global economy led by China. 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 will be more highly rewarded as there is a growing view that many corporations have only been able to financially engineer their performance improvements through share buybacks.  Given the distinct nature of the current economic environment, investors should be careful not to let short-term emotions divert them from making sound, longer-term investment decisions.  Investors should be buyers during times of market weakness.

Market Update

What we are observing in the markets today is closely following the views we expressed in our year-end Outlook, and events are unfolding in a more compressed timeframe.  The year began with the Chinese currency weakening, the Chinese Purchasing Managers Index (PMI) and the U.S. Institute for Supply Management Manufacturers Index (ISM) both disappointing, oil prices declining sharply, and the Saudi government executing a noted Shiite cleric. China’s slowing economy in tandem with lower oil prices is leading to reduced expectations for global growth and a stronger U.S. dollar, which in turn is placing stress on foreign dollar debts and countries needing to import goods that are traded in dollars. These events have combined to unsettle the markets, and conditions remain in place for volatility.

At the same time there are important positives for the global economy that should be recognized. An important support for global growth is the highly accommodative monetary policy from China, Europe and Japan. Lower oil prices benefit those developed economies which are more dependent on consumer spending, especially the United States. The U.S. remains one of the strongest economies and continues to attract capital. Among the many positives for the U.S. are continued improvement in employment, modest progress in wage increases, lower energy prices, and mortgage rates at or below 4%. Europe and Japan have also been beneficiaries of lower oil prices and interest rates, and their economies began to show improvement in the second half of 2015. These large developed economies are major trading partners of China, and their improvement should help China as well. Nevertheless in light of the headwinds described above, global growth should remain muted.

The risks to the global economy continue to be competitive currency devaluations, driven by China, leading to additional capital outflows from the emerging and commodity-producing countries to the United States, further declines in oil and other commodity prices, and the ongoing strength of the U.S. dollar. A strong U.S. dollar is a negative for the rest of the world as it makes U.S. dollar debts more expensive to service and imports traded in dollars more costly. Lower oil prices are raising concerns of potential debt defaults and bankruptcies in the commodity sector and stressing the finances of oil-producing nations such as Saudi Arabia, Iran and Russia. Due to the fragility of the global financial system, we expect the Federal Reserve to exercise caution with the timing of additional interest rate increases.

In this slow-growth environment, the key areas of emphasis for client portfolios are owning high-quality growth companies and high-quality dividend growers while maintaining or building at times reasonable cash balances to be opportunistic. From a portfolio perspective, we plan to take advantage of market volatility when price declines for good businesses make them more attractive investments. Our focus remains on owning select companies benefitting from positive trends in mobility and cloud computing, rising defense spending, healthcare, U.S. consumer spending and the shift to a more service-oriented global economy. We continue to target companies that are gaining market share, maintaining or improving profit margins, increasing free cash flow, increasing pricing power and/or growing dividends. Weak markets have always been the best conditions for purchasing the most undervalued assets to build long-term capital and generate income.

Please call us with any questions or comments.

Crises, Divergences, and Opportunities

“We have forgotten that history is fundamentally tragic. The French have to prepare for this threat, bear in mind that there will probably be more attacks. It’s a war, not a conventional one but a war. I know some countries have refused to use that term to avoid giving terrorists the pleasure, but we have to say things as they are.”

French Prime Minister Manuel Valls,

as quoted in the Financial Times on 11/26/15

The world is characterized by a series of crises which are the result of an accumulation of failed domestic, foreign, social and economic policies by governments globally. Following the tragic terrorist attacks in France and California as well as the downing of a Russian plane by the Turkish military near the Syrian border, we are reminded that the world is growing increasingly more dangerous and fragile. These events, as well as the deteriorating situation in the Middle East and the resulting refugee crisis, are undermining confidence as investors head into the New Year. Given the considerable shocks to the system this year, the global economy has held up fairly well in large part due to central banks delivering the most accommodative monetary policy response in history. Because monetary policy has its limits, new fiscal policy initiatives and structural changes are required to achieve a sustainable growth trajectory for the future. In light of the insufficient fiscal policy responses to date, current global economic dynamics strongly suggest a continuation of low interest rates, low inflation rates and slow growth for the foreseeable future as the global economy cannot tolerate a normalization of interest rates to historical levels under present circumstances, nor could the global economy withstand a recession at this time.

As we head into 2016, several themes are being reflected in client portfolios. These themes include: defense, mobility and cloud computing, healthcare, financials, and the shift to a more service-oriented global economy. The energy sector, due to the dramatic decline in oil and natural gas prices as well as stresses in the high yield market and increased violence in the Middle East which is the epicenter of global supply, is a developing opportunity. The search for safe income in a yield-starved world continues to be important. In addition to these themes, investors should seek to identify companies that reflect the following characteristics: improving business, market-share gainers, improving margins, increasing free cash flows, ability to increase pricing power and/or grow dividends. With slow growth and deflationary pressures, we expect markets to ascribe greater value to those companies with the best industry demand tailwinds and internal growth drivers. Moreover those companies positioned to benefit from the record merger and acquisition activity should continue to attract strong market interest. In 2016, investors should expect an environment of continued market volatility and a potential narrowing of investment opportunities. The United States is well positioned as its economy continues on its slow-growth path. Its consumers and companies benefit from lower energy prices, its dollar remains relatively strong and its interest rates stay well below historical standards. The following pages describe in greater detail the major considerations and the primary themes that benefit from this Outlook.

Major Investment Considerations

The global economy is undergoing significant changes from a social, political and economic perspective. This year global markets have faced a variety of issues, from the Greek debt crisis to China’s currency devaluation to the latest terrorist attacks, which have increased overall market volatility. Additionally Russia’s military involvement in Syria has changed the dynamics of politics in the Middle East and not necessarily for the better, while the recent terrorist attacks in Paris and San Bernardino provided a painful reminder that the fight against terrorism is ongoing and expanding, and one which will be waged not only on foreign soil but also at home. The fight could be a long one since we are dealing with extremists attracting new members from a growing pool of the disenfranchised ripe for radicalization.

Now that the Federal Reserve has begun the process of raising interest rates, this should further affect capital flows continuing to place strains on the world economy and capital markets. The International Monetary Fund (IMF) is projecting worldwide growth of 3.6% for next year which is greater than this year’s, however, we do not believe this is likely to be achieved. Nevertheless the continuing economic recovery in the United States has enabled the Federal Reserve to begin raising interest rates as it announced on December 16th. Short-term moves notwithstanding, this will likely keep the U.S. dollar relatively strong, and higher rates would then continue to attract capital from other markets. China has continued its accommodative monetary policy and fiscal spending to help achieve an acceptable level of slowing growth while it attempts to keep social stresses under control. Following its currency achieving reserve currency status at the IMF, it should be anticipated that China will manage its currency lower to support its exports and adjust to the recent Federal Reserve rate increase. However, other emerging market and commodity-producing nations, particularly those dependent on China for previous growth, will likely remain under pressure. Europe continues to see modest improvement in economic activity but also faces wide differences of opinion among its member nations regarding several critical policy initiatives, including fiscal, monetary and more recently refugee-related issues. In contrast to the Federal Reserve interest rate increase, Mario Draghi of the European Central Bank (ECB) has once again let the markets know that the ECB “will do what it must” to achieve its inflation targets by extending and expanding the current quantitative easing program. In addition, Japan has struggled to create inflation and continues its highly accommodative approach to its fiscal and monetary policy.

As we have been writing for some time, the level of global debt continues to remain elevated having risen by over $57 trillion since 2008 to an estimated total of $200 trillion. One of the biggest risks to the 2016 economic outlook are the emerging markets which have a long history of debt busts, such as the 1980’s Latin American crisis and the late 1990’s Asian crisis. Emerging markets may be stressed next year based on a strong U.S. dollar outlook combined with higher U.S. interest rates and an extended period of low commodity prices and reduced demand. Traditionally, these debt busts have ended suddenly and require a severe economic adjustment. European nations such as Greece continue to face debt troubles as well as a growth rate which has not been sufficient to allow them to work out of their problems. Here at home overall U.S. household borrowing has climbed to $12.1 trillion which is the highest level in over 5 years, and there have been $70 billion in subprime autos loans originated in the past 6 months alone according to a recent report from the Federal Reserve Bank of New York. In order to avoid a future global debt crisis, it is important that governments implement effective fiscal policies to raise national income and tax receipts allowing borrowers to better manage debt and reduce deficits.

In conclusion, the global economy requires a period of sustained growth improvement in order to begin to return to a more normalized interest rate structure. Short of this, we will require an abnormally low rate structure to persist for an indefinite period. Due to the concerns discussed in this Outlook, the actions of central banks and governments remain highly accommodative and pro-growth oriented to create a sustained level of demand with the aim of avoiding a global recession. This is a critical point as monetary policy is clearly nearing its limits, and government leaders may not have the political will to use fiscal stimulus to combat another global recession.

Investment Implications

The conditions described above suggest that the opportunities for investors will be more focused than in recent years as the beneficiaries of such an environment will be fewer than the past 7 years making thoughtful security selection and asset allocation decisions even more important.  The Outlook also suggests that elevated volatility will remain present for three primary reasons: the global economy has become progressively more accident-prone and fragile; the post-crisis regulatory environment has affected liquidity in the markets; and the structure of the market has changed due to high frequency traders (HFT) and exchange traded funds (ETF). This volatility has led to price distortions which, in turn, create opportunities for those investors who are prepared to take advantage. Looking ahead to 2016, those companies that are gaining market share, improving profit margins, increasing free cash flow, increasing pricing power and/or growing dividends should be favored in the market. Coming out of the Paris Climate Change Conference, investors will now be seeking to identify the resulting beneficiaries. Based on the global divergences described in this Outlook, we expect United States markets to remain attractive from a risk/reward perspective. While other markets may outperform the U.S., we believe that there is better certainty at home as the United States remains the leading global economy. Below we will address each of the primary investment themes in greater detail.

Mobility and the Cloud

“Everything has the ability to become smart – a smartwatch, smart clothes, a smart TV, a smart home and a smart car. However, in almost all cases, this “smartness” runs on software in the cloud, not the object or the device itself.”

Werner Vogels, Amazon’s Chief Technology Officer in a recent blog

While we do not underestimate our reader’s understanding of the vast changes occurring with technology today, we believe that the growth and innovation we will experience over the next several years remain underappreciated. One of the biggest impacts of the technological advances is the shift taking place in the global economy as it moves from a manufacturing-based economy to more of a service-based one. Two of the most disruptive technologies today are mobility and cloud computing. Cloud computing is defined as the use of a network of remote servers hosted on the internet to store, manage, and process data, rather than a local server or a personal computer. The rapid growth of the “internet of things” and the resulting content demand are accelerating the development of devices that can process and transfer data with high speed while storing ever increasing amounts of data. Over the next several years, the technological advances of multi-tracking capability, the more efficient usage of battery power and the incorporation of the “internet of things” means that the internet will experience no letup in its disruptive power over more traditional ways of living and conducting business. The global economy is benefiting from rapid technological advances including the large increase in the availability of wireless spectrum and the dynamic growth in mobility, connectivity, search, memory, data management, storage and devices. Billions of people around the world, who currently have little or no access to internet, will become connected in the coming years. The introduction of 4G LTE is helping accelerate the growth of mobility. 4G means the fourth generation of data technology for cellular networks. LTE stands for Long Term Evolution and is short for a very technical process for high-speed data for phones and other mobile devices. Efforts are underway to develop the 5th generation version.

The Growth of Connected Devices

In a recently released Ericsson Mobility report (November 2015), Ericsson forecast that in 2021 there will be 28 billion connected devices and that almost 70 percent of all mobile data traffic will be from video. According to the report, today “there are as many mobile subscriptions as there are people in the world, and every second, 20 new mobile broadband subscriptions are activated.” As the numbers of subscribers grow and technology advances, so does data consumption as demonstrated by the 65% growth in Q3 2015 versus Q3 2014. As shown in the chart below, total monthly mobile data traffic growth is estimated to experience a 45% compounded annual growth rate between 2015 and 2021. These figures reflect greater adoption and use of mobility by both consumers and businesses.

The Growth of Worldwide Mobile Data Traffic

It is estimated that corporations spend about $3.7 trillion annually on information technology (IT) and will be shifting spending to adjust to the realities of a more connected world with far greater data. As a result, the adoption of the cloud, which began slowly, has started to rapidly accelerate. The benefits for businesses of moving their IT workloads to the cloud include reduced costs, greater flexibility, more scalability and better services. Over the long term, companies moving to the cloud avoid having to build, expand, maintain and upgrade data centers, can be faster to market with new products and services and react more quickly to competitive threats. Among the areas which benefit will be data centers, cloud service providers, data analytics and management providers, cyber-security companies, semiconductor producers, mobile advertisers and device makers.

Defense

There are at least three geopolitical issues that investors should consider as we move into 2016 – Russian relations with Europe and NATO, the progressively more complex dynamics of the Middle East and the threat of an incident in the South China Sea. The situation in Syria has created strange bedfellows with most involved countries supporting the fight against ISIS, but also on opposing sides in their support of President Bashar Hafez al-Assad or the Syrian rebels. As a consequence of greater global conflict, global defense spending is likely to increase from the current levels of approximately $1.7 trillion after several years of spending cuts following the Great Recession. The United Arab Emirates (UAE), Saudi Arabia, India, France, South Korea, Japan, China, Russia and other affected governments are expected to continue to increase purchases of next-generation military equipment in response to threats to their national interests. The United States, which accounts for 39% of spending globally at roughly $670 billion annually, had slowed spending in recent years as a result of the financial crisis and the budget sequestration. That trend is now reversing.

Additionally China plans to increase its reported spending by 7% annually between now and 2020 which would bring it to $260 billion. China’s actual spending is estimated to be much higher as it has been aggressively seeking to raise its profile on the global stage. Russia, in spite of its severe economic difficulties, has pledged to spend $300 billion by 2020 to rearm and modernize its military although that plan will likely be challenged by its budgetary issues given current oil price levels. As the sanctions are soon to be removed on Iran, the Saudis are increasing their spending in response to the proxy war being fought between these two nations in Yemen. On November 20th the U.N. Security council unanimously voted to call countries around the world to take “all necessary measures” to fight ISIS.

NATO defense spending for 2015 is estimated to be $892.7 billion and this figure should rise in 2016. The target amount for NATO nations is 2% of GDP yet only a handful of the member nations (the U.S., Poland, Greece, Estonia and the United Kingdom) are at that level.

The U.S. defense companies represent a relatively small percentage weighting in the S&P 500, so most institutional portfolios have a representation to defense of approximately 1% or less. It is our view that these businesses represent strong investment opportunities as they should continue to generate significant cash, have robust orders, maintain high and/or growing backlogs, and are raising their dividends and buying back stock. These companies do not rise and fall based as much on economic activity, but more so on geopolitical conditions. Therefore defense companies should have a more meaningful representation in client portfolios.

Healthcare

The healthcare sector also aligns closely with our Outlook as an aging global population will provide a strong secular tailwind for healthcare demand. According to the World Health Organization (WHO), in most countries, the proportion of people age 60 or older is growing faster than any other age group due to longer life expectancy and declining fertility rates. The U.S. Census Bureau estimates that in the U.S., the number of people age 65 years and over will increase by 30% between 2012 and 2020. This is expected to drive demand for healthcare services, including drugs and medical devices as well as the companies that provide these services.

An aging population will also drive healthcare demand in large developing countries such as China. Moreover, demand in these markets will also benefit from increased per capita spending as their populations insist on better quality care. In August 2015, China unveiled plans to roll out medical insurance to cover all critical illnesses for its population of 1.4 billion by year-end. China drug spending is expected to grow by nearly 8% per year through 2020, and according to McKinsey & Co., China’s overall healthcare spending will nearly triple to $1 trillion by 2020, up from $357 billion in 2011. Greater spending suggests greater volumes of healthcare consumption, but there will also be a “trade up” from drugs and devices that are locally-sourced or generic to best-in-class patented drugs and devices sold by the leading global pharmaceutical and device companies. We expect a select group of pharmaceutical, biotech and medical device companies to be beneficiaries of these spending trends. We also favor companies with strong balance sheets and healthy dividend coverage.

These companies should benefit from investor demand for sustainable income streams as well as their ability to make accretive acquisitions. Although we are mindful of the increased attention being placed on drug pricing in the U.S., we believe that those companies with healthy research and development budgets that can demonstrate genuine superiority for their drugs will see relatively minimal impact from pricing pressures.

Financials

Certain financial companies, including real estate-related companies, should benefit from the continuation of the low interest rate environment and the easy access to financing as capital from around the world seeks higher returns. Major real estate markets such as New York, London and Toronto to name a few, continue to attract foreign investors shifting assets from weaker economies to stronger ones. In addition, those businesses that have generated strong profits in recent years despite a falling interest rate environment, such as the banks, should become more attractive investments due to net interest margin improvement following future Federal Reserve rate increases. In addition, these institutions should see lower legal costs after years of intense regulatory scrutiny.

Improving Global Consumer

The decline in oil and natural gas prices is lowering fuel and heating bills for most consumers around the globe, putting more discretionary income in their pockets. At the same time, manufacturers and the producers of consumer products are benefitting from lower input costs as energy can be a significant component of cost of goods sold. The consumer staples companies in particular are well positioned to benefit in an environment of rising uncertainty and low inflation. Because they sell the products we consume every day, their sales tend to be very resilient, and their sizeable and growing dividend yields offer an attractive alternative to the low returns offered by fixed income securities.

Although we see opportunities for consumer companies with a domestic focus, our research is also focused on those businesses positioned to benefit from long-term growth in consumer spending in developing markets. China in particular has seen a surge in its middle class over the past decade. According to Pew Research Center, the share of Chinese who are middle income jumped from 3% to 18% from 2001 to 2011. Today, Chinese whose incomes are described as middle, upper-middle or high-income represent well over 20% of the population, or close to 300 million people – approximately the size of the entire U.S. population. As China continues to rebalance its economy from exports and infrastructure investment to consumer spending, we expect consumer demand to continue to grow, benefitting those multinational businesses with strong brands which have positioned themselves well in that market.

As the United States heads into an election year, the fiscal policy discussions will become more active as each party defines its platform for the United States. Around the world, opposition parties have fared quite well in recent local and national elections as populations express their frustration with the austerity policies of incumbent parties. These leadership changes could have a profound impact on the economic policies implemented in 2016. With slow growth and deflationary pressures, we expect markets to ascribe greater value to those companies with the best industry demand tailwinds and internal growth drivers. This is a secular trend, and strongly suggests a continuation of a low interest rate, low inflation rate and slow growth environment for the foreseeable future.

We wish our clients and friends a safe, healthy and happy holiday season and a prosperous New Year. We thank you for the trust you place in us every day, and assure you that we are committed to providing the highest level of investment management service to help you achieve your goals.

“The Future Ain’t What it Used to Be”

Central banks have been responding to an accident-prone and fragile global economy with the most accommodative monetary policy structure in history and are likely to continue this approach for some time.  However, monetary policy has its limits and market participants are becoming increasingly concerned that we may be approaching those limits.  The resulting uncertainty and volatility have led to distortions in the prices of businesses which create opportunities for patient, long-term investors.  This is a good time for investors to have higher cash balances, not as a market call, but rather to be in a position to take advantage of the opportunities presented.  Because this is not an environment where all businesses perform equally, actively managed portfolios should benefit.  The United States has been the primary beneficiary of this environment among leading economies.   As the largest economy in the world and a safe haven, the United States has been attracting significant capital flows as it is the most important, resilient and adaptive of all the major economies.  The U.S. is gradually improving in measures of industrial activity, employment, wages, housing, consumer net worth and consumer confidence.  However, despite these improvements the Federal Reserve recently declined to raise interest rates even a quarter of a point citing the weak overall global backdrop.  This continuation of record low interest rates for the past eight years should be proof enough that monetary policy alone cannot deliver sustainable growth without fiscal policy initiatives which are now needed to support more balanced growth.  For investors waiting for a normalization of interest rates, the wait will continue to be long as it requires a return to “normal” economic conditions which cannot occur under present circumstances.

The goal of each Outlook is to define the supply and demand dynamics of economies to understand global capital flows and the prospects for interest rates, inflation rates and corporate profits which are fundamental to security valuation.  There are many forces causing shifts in these dynamics including, but not limited to, currency changes, economic divergences, and migration stemming from political upheaval.  For example, China’s currency devaluation on August 11th increased concerns about further competitive devaluations, deflationary pressures and slowing global growth.  These conditions have created growing imbalances and increased strains as a consequence of slowing growth and rising debt levels.  For much of the past 20 years, global growth was primarily driven by China’s rapid expansion that pulled along many emerging and commodity-producing nations.  Now those same nations are suffering as export-driven and debt-fueled growth has slowed precipitously, and the world economy is now experiencing a reversal of fortune as evidenced by the massive capital outflows from these nations to the United States and select European countries.  Based on the current Outlook, expect to see a continuation of low interest rates, low inflation rates and slowing growth.  The environment remains positive for the U.S. economy, while slowing global growth is placing a premium on those United States and European companies that can maintain their own growth dynamics.

The United States – a Magnet for Capital Flows

“The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

Federal Reserve Press Release, September 17, 2015

After nearly eight years of historically low interest rates, the Federal Reserve Open Market Committee (FOMC) on September 17th voted to maintain its current interest rate policy.  The strength of the United States economy is challenging the Federal Reserve to balance a modest interest rate increase against the unknown impact of China’s slowdown on global growth and the impact of a rate increase in draining additional capital from struggling emerging economies.  The U.S. continues to demonstrate positive, but muted growth.   In addition as one of the largest consumers of energy, U.S. consumers and corporations continue to receive a windfall in the form of lower energy prices which acts as a form of economic stimulus.  Unlike any other major economy, the United States benefits from the current global dislocations and China’s slowdown, but only up to a point.  The economy, while improving, is not immune to the challenges facing the world, and we cannot be the sole engine of global growth.  Raising interest rates at the same time other nations have weakened their currencies puts upward pressure on the U.S. dollar which results in our $2.8 trillion of imported goods and services coming in at lower prices and augmenting deflationary pressures.

Fed Res Int Rate Projections

Prior to the FOMC meeting, both the International Monetary Fund (IMF) and the World Bank voiced concerns that a rate increase by the FOMC would accelerate capital outflows from weakening emerging market nations – something they can ill afford.  While a 0.25% increase in short-term rates should not have had much of an impact on the United States economy, the decision to delay the initial rate increase speaks volumes about the fragility of the world economy.  Exhibit 1 represents the lowering of the FOMC’s average rate expectations from December 2014 to this month.  It suggests that regardless of the timing of a rate increase, the U.S. will experience abnormally low interest rates well into the future.

Currencies, Monetary and Fiscal Policy Responses

“China, whose currency is tied to a rising U.S. dollar making its exports more expensive, is becoming less competitive at a time when it needs to increase exports to slow its decline in GDP growth to a more manageable level.  If the U.S. dollar remains strong, China may find it necessary to devalue its currency to support its exports.  A strong dollar also has important implications for the global bond market as there is more than $9.2 trillion of dollar-denominated debt held by foreigners.”

The Outlook, April 9, 2015

While the U.S. stands out among the major economies, China, Europe, Japan and the emerging nations reflect the divergences we have written about for some time.  The uniqueness of the challenges facing each requires the use of different applications of currency, monetary and fiscal policy to return to sustainable growth.  As monetary policy tools are closer to their limits, policy makers have been using currency devaluation in attempting to support their economies.  As illustrated in Exhibit 2, these nations are not all equally equipped to attack the problems given their respective debts, currency reserves and trade balances.  The emerging economies are suffering from their reliance on China and struggling under debt burdens that accumulated during the China-led boom.  After attracting capital for many years, these countries are now experiencing a reversal of capital flows, rising debt servicing costs (as much of the debt is tied to a rising U.S. dollar), increasing inflationary pressures, political and social stresses.  The combination of the above is driving capital to the United States adding to fears that capital outflows can accelerate when the Federal Reserve actually raises interest rates.

Financial Snapshot of Leading Economies

China

The move by the People’s Bank of China (PBOC) to devalue its currency was a direct response to weaker July export data for the world’s largest exporter.  The move was in recognition of the fact that China could not and should not have its currency so tightly linked to a strengthening U.S. dollar which would make Chinese exports more expensive at a time when its economy has slowed from over 10% GDP growth for most of the last 20 years to 7% recently according to the government.  China is more likely growing at 5% or less as the government statistics are questionable at best.  No export-driven country should have its currency linked to a strong or rising currency if it wishes to protect its export business.

While China is dealing with some economic difficulties at this time, it has the fiscal and monetary resources to manage through these or at the very least to minimize them.  As highlighted in Exhibit 2, China has an estimated trade surplus of more than $350 billion.  It also has currency reserves of roughly $3.8 trillion, including $1.2 trillion in U.S. Treasuries.  From a monetary policy perspective, China has room for further interest rate cuts to stimulate growth.  In the past, the government also has demonstrated a willingness to use large-scale fiscal policy initiatives and may very well use this approach again if necessary.  While the last big fiscal stimulus initiative in 2009 helped the global economy, it sowed the seeds for some of China’s current difficulties because many projects were perhaps not such productive investments. Nevertheless China has the resources and the will to support its economic growth in contrast to other countries with the resources but not the will.

Recently China has been aggressively establishing itself as a military, political and economic power on the global stage.  It has aspirations for a more dominant role in the world from both an economic and political perspective.  It is China’s goal to become an IMF member, to have reserve currency status, and to exert its influence on the world monetary stage.  The recent actions to manage its stock market have set it back from achieving these goals.  Clearly China is struggling as an economy in transition, but it has a long-term plan that it is pursuing, a growing middle class and an ability to learn and adapt.  With the need to create over 10 million new jobs a year to maintain social stability, it should be expected that the government will do whatever it feels is necessary and leave the market to play its role at a later date.  Investors should bear in mind that China is playing the long game in its economic development.

Europe

Europe has been experiencing more positive but muted economic growth following the temporary resolution to the Greek debt crisis.  Based on the improving but fragile state of the European economy, President Mario Draghi announced on September 3rd that the European Central Bank (ECB) stood ready to extend, if necessary, its monetary program to stimulate the European economy especially if current developments in emerging market economies negatively impacted the region’s trade and confidence.  However, Europe is now facing another test from the growing refugee crisis.  With the ongoing civil war in Syria, the emergence of the Islamic State (ISIS) and the continued instability and poverty, refugees are fleeing the Mideast and North Africa to the shores of Greece, Italy and Turkey in overwhelming numbers.  Not only is it likely that the ECB will need to extend its quantitative easing program and low interest rate policy, it has been necessary for fiscal policy initiatives to be implemented to accommodate the influx of refugees.

The migration crisis poses a multi-dimensional problem for governments in Europe.  First, there exists a climate of resentment from those nations that have been forced to implement austerity programs, and are now being asked to accept a portion of refugees by the same countries that imposed the austerity in the first place.  Second, there are increased social strains of providing basic essentials to the refugees.  Nationalist parties are using xenophobic rhetoric to gain political support among those opposing the resettlement of the refugees.  Europe overall has a 12.2% unemployment rate with much higher youth unemployment.  In some countries the influx will create further resentment and social challenges in the nearer term.  Longer term, there is the potential positive impact from the refugees as most should eventually become valuable additions to Europe which has been facing a long-term demographic problem that these people would help offset.  For example, Germany has a 4.6% unemployment rate and as many as 1.1 million job openings.  At the present time, these refugees need food, housing, medical services and jobs in order to become productive members of society.  All this comes at a cost which suggests that the ECB monetary policy program will need to be augmented by stronger fiscal policy.

Investment Implications

Today volatility has increased in all markets due, in part, to the dislocations we are experiencing in the global economy.  There are other factors impacting volatility as well.  First, the global economy is progressively more accident-prone and fragile as it remains stressed by high debt levels and slowing growth.  Second is the post-crisis regulatory regime that requires financial institutions to hold higher levels of capital and make changes to their business models which have resulted in a reduction of capital market liquidity.  Many of the regulations enacted since 2008 were designed to prevent a recurrence of the financial crisis, but do not address the current and future needs of the capital markets.  Additionally, the structure of the market has changed with high frequency traders (HFTs) and exchange traded funds (ETFs) playing a bigger role in trading activity.  To take advantage of the resulting price distortions of securities in the markets, client portfolios are generally holding higher cash positions to move quickly as opportunities are presented.    The U.S. economy continues to do well, but we may decide to increase the cash position further if conditions in the emerging markets continue to deteriorate and spill over into the U.S.  In recent months, we eliminated from client portfolios any bond positions deemed to be less liquid or potentially vulnerable credits and replaced with high grade investments.

As discussed in our recent Outlooks, the current global economic and geopolitical dynamics strongly suggest a continuation of low interest rates, low inflation rates and slowing growth for the foreseeable future as the global economy cannot tolerate a normalization of interest rates under the present conditions.  To repeat, investors waiting for a normalization of interest rates, the wait can be long as it requires a return to normal economic conditions which cannot occur under present circumstances.  The United States remains the standout economy, and we should continue to see moderate improvement in economic activity.  Under present conditions, areas of focus include:

  1. Technology companies that are benefiting from unprecedented innovation and are helping their corporate customers drive down operating costs. These companies are familiar with operating successful businesses in price-competitive environments.  In addition, opportunities are developing from rapid technological advances including the large increase in the availability of wireless spectrum and the dynamic growth in mobility, connectivity, search, device sales, memory, data management and storage;
  2. Financial companies that benefit from continued low interest rates and easy access to financing such as real estate related companies, as well as those businesses that have generated strong profits in recent years despite a falling interest rate environment, such as the banks which stand to benefit from a stabilization in net interest margins;
  3. Consumer companies with pricing power that can increase profit margins, improve overall profitability and benefit from lower input costs and stronger consumer spending, including the rising middle class in China;
  4. Industrial investments with well-defined end-market demand, including defense, transportation and aerospace companies;
  5. Healthcare companies with technology-enabled breakthroughs, strong product pipelines and growing dividends, as well as those companies better insulated from potential pricing interference; and
  6. Energy investments whose valuations, due to the dramatic decline in oil prices, are becoming more attractive. ARS is reviewing the sector as the stresses in the market are creating differentiated opportunities for investors in the coming months.

As always there are risks to our investment Outlook that we factor into our views.  We view the remainder of 2015 as an environment which will favor active management and domestically oriented companies.  Our research continues to identify strong businesses that are well positioned to benefit from the conditions described. Client portfolios reflect companies with the following characteristics: improving margins, increasing free cash flows, ability to increase pricing power, market share gainers and growing dividends.  In a low-growth environment, expect the market to continue to assign premium valuations to high-growth companies due to the scarcity value.

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