What Matters Now: Too Much Pessimism or Not Enough?

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Disruptions and Opportunities

“Russia’s invasion of Ukraine has dealt a blow to the global economy – weakening the post-pandemic recovery and aggravating already high inflation. Even if the worst fears of rising geopolitical tensions and larger economic disruptions do not materialize, private forecasters anticipate an inflationary slump for the world economy… The war’s economic damage will partly depend on the persistence of high inflation and economic “scarring” over the medium to long term.”

– Excerpt from Dallas Federal Reserve Bank, May 17, 2022

The global economy is facing a series of destabilizing shocks intensified by the Russian invasion of Ukraine. In addition to creating a tragic humanitarian crisis, the war is disrupting global supply chains, food, energy, trade, and geopolitics.  While the current environment bears some resemblance to past periods such as the 1970s, it also has several distinctive characteristics. As we said in our last Outlook, the world has changed as the global economy and markets are undergoing a series of critical transformations.  Prior to the Russian invasion of Ukraine, some countries were returning to pre-pandemic economic activity, but many other countries were facing severe economic, social, and political challenges which the war has only exacerbated. As the duration and severity of the war in Ukraine remains highly uncertain, the potential risks to the downside have market participants and policymakers worrying about an inflationary slump and possibly a deep recession for the world economy. While a deep recession is not our base case, investors should proceed with caution given the variability of outcomes and the possibility of a major policy miscalculation. At the same time, the recent market pullback now has any number of the highest-quality businesses selling at valuations typically available only during periods of severe economic stress. 

For much of the past decade investors across asset classes have benefited from the most aggressive monetary and fiscal policy regimes in history that had been appropriate for the circumstances at that time, but no longer exist today. Presently, central banks around the world have been forced to shift from a highly accommodative policy to a restrictive policy to counter a rapid increase in inflationary pressures much of which began on February 24th with the invasion of Ukraine.  Concurrently, governments are facing several significant budgetary constraints in the face of many necessary big-dollar investment programs including the green energy transition, strengthening and reorienting supply chains, fixing aging infrastructure, and enhancing national security, among others.  After kicking the can down the road for decades on many critical investments which can no longer be postponed, the bill has now come due, and it could not have happened at a worse time for many politicians.  The combination of the lingering effects of the pandemic and the invasion of Ukraine by Russia is undoing much of the work done by policymakers since 2008 as rising inflation and slowing growth are damaging consumer and business confidence. For politicians, it will be exceedingly difficult to do the right (and likely unpopular) thing to address the multitude of problems and still get re-elected. Meanwhile, there is growing dissatisfaction among voters around the world which is forcing politicians to be even more short-term oriented which will make enacting effective legislation even more difficult.

One key to a solid investment strategy is to invest in the beneficiaries of the problems. The secular trends we have identified in recent Outlooks will continue to be fundamental to improving the economy One key to a solid investment strategy is to invest in the beneficiaries of the problems. The secular trends we have identified in recent Outlooks will continue to be fundamental to improving the economy and living standards, but there will be a time lag between the future benefits and current conditions as reflected in the stock prices of the beneficiaries.  Just to remind our readers, the trends are in digitalization, electrification, lowering healthcare costs, productivity improvements and the need to enhance national security. The equity markets, both public and private, are dealing with an unknown outcome of the war and COVID related disruptions and cannot value with any certainty these circumstances. This uncertainty, combined with tightening of financial conditions, suggests further contraction in price/earnings multiples followed by earnings declines which are likely to persist until inflation levels off and interest rates stabilize or decline.  Those investors with the knowledge, experience, and conviction to look beyond the immediate period will be able to recognize rare buying opportunities.  Accordingly, we have been taking advantage of the choices available to initiate positions in some of these companies or to add to existing positions in client portfolios

From QE to QT

“The Committee is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The Committee’s commitment to restoring price stability— which is necessary for sustaining a strong labor market—is unconditional.”

Federal Reserve Monetary Policy Report, June 17, 2022

The above statement from the Federal Reserve’s Monetary Policy Report highlights one of the major transformations occurring today as the Fed transitions from trying to stimulate the economy to trying to manage a tightening of conditions to bring inflation back down and avoid a recession. In addition to the Fed, most major central banks, with the exception of the Bank of Japan and the Peoples Bank of China, are tightening financial conditions aggressively to counter inflationary pressures. The Federal Reserve Bank of Dallas recently produced a paper which illustrates how the outlook for growth and inflation has shifted since the start of the war. In the Dallas Fed’s report, global growth projections (Chart 1) declined by 1% for 2022 and 0.3% for 2023 since February 18th, while the CPI inflation forecast for 2022 increased by 2.3% and by 1% for 2023. What a difference a few months made in the forecast.

Chart 1. Weakening Global Growth, Higher Inflation

Source: Consensus, Economics: authors’ calculations.

Among the biggest challenges for the Fed and other central banks are the high degree of uncertainty which must be factored into their decisions and the limitations for future policy maneuvers. The outlook for inflation will depend on several factors including the COVID-19 lockdowns in China, how and when the invasion of Ukraine ends, potential strikes this summer of workers at the Ports of L.A. and Long Beach as well as railroad workers, and labor costs where worker shortages will command higher wages to compensate. These factors could lead to more persistent inflation for certain parts of the economy leaving the Fed in the position of raising rates beyond market expectations. Again, this is not our base case as we expect the Fed to respond to slowing growth by backing off on the number of expected rate hikes as inflationary pressures ease.  Regardless of when inflation peaks, the result for consumers and corporations will be higher prices than before the pandemic and the war. 

Chart 2. Signs Wage Pressures May Be Easing

Source: Piper Sandler, Marco Economic Research, July 2, 2022

We have already seen a pickup in layoff announcements (Chart 2) as well as hiring freezes which should ease wage pressures in some industries and slow growth, reducing the need for central banks to tighten as aggressively as currently expected and may even require a policy reversal later in 2022 or 2023.  However, as we have seen in many industries, there are still shortages of skilled labor which will take time and policy changes to moderate.  As we mentioned in our April Outlook, “the Fed will likely raise rates fewer times and to levels below what the Fed and market participants currently project, as the slowing global economy will naturally reduce demand and dampen inflationary pressures. It is too soon to determine the full impact of the war on growth and inflation given the broad range of possible outcomes, and therefore, investors should expect the Fed and other central banks to be flexible in setting the course for policy actions.”  For example, a strong dollar will slow U.S. export activity which will slow global growth even further.  As business and consumer confidence declines, behavioral changes in the form of reduced spending typically follows, which should support an easing of inflationary pressures.

Risks and Global Economic Prospects

“The outlook is subject to various downside risks, including intensifying geopolitical tensions, growing stagflationary headwinds, rising financial instability, continuing supply strains, and worsening food insecurity. These risks underscore the importance of a forceful policy response. The global community needs to ramp up efforts to mitigate humanitarian crises caused by the war in Ukraine and conflict elsewhere, alleviate food insecurity, and expand vaccine access to ensure a durable end of the pandemic.”

Excerpt from the World Bank Global Economic Prospects Report, June 2022

Chart 3. Rising Risks to Global Systems

Source: World Bank, Global Economic Prospects, June 2022

In its most recent Global Economics Prospects Report, the World Bank highlighted several risks facing the world today and these risks are highlighted in Chart 3. The world is facing rising risks of an increase in geopolitical tensions as the U.S. Department of Defense recently identified Russia and China as the primary threats with North Korea, Iran and terrorist states representing other main concerns.  The war has layered on additional problems for the global supply chain system as nations are scrambling to ensure that they can access dependable and secure supplies of materials necessary for national security (including food, energy, cyber and military) through re-shoring (bringing manufacturing back home), onshoring (bringing in new production capabilities) or “friend shoring” (running supply chains only through countries that are close political partners) which Treasury Secretary Janet Yellen has discussed recently.  The world continues to work to arrest the COVID-19 pandemic, but much more needs to be done there even before we start to address potential future pandemics. Higher inflation coupled with weaker long-term growth prospects will create added stress on societies and greater demands for government support at a time where government finances are stressed.

Concurrently, climate-related disasters are increasing in both frequency and severity, while the clean energy transformation is not progressing as hoped and will require far greater reliance on fossil fuels to power the world for longer than originally planned to effect the transition. The problems are many, but innovation is one of the keys and the reason the battle for technological supremacy between the United States and China has grown so intense. Perhaps the greatest area of concern is the intensification of geopolitical tensions which could further disrupt economic activity, increase policy uncertainty, and potentially lead to a significant fragmentation as nations form blocs with like-minded nations for economic and security purposes.

Opportunities – Quality and Innovation on Sale

“For long-term investors, it will prove beneficial over time that markets are exiting an artificial regime that was maintained for far too long by the Fed and that resulted in frothy valuations, relative price distortions, resource misallocations and investors losing sight of corporate and sovereign fundamentals. The promise now is one of a more sustainable destination. Unfortunately, it comes with an uncomfortably bumpy and unsettling journey.”

Mohamad El-Erian, Bloomberg, July 5, 2022

Notwithstanding relief rallies due to periodically oversold conditions, markets will likely continue to struggle to find firmer footing until inflation and Treasury yields begin to peak.  For investors, the current conditions are resulting in a significant reset of valuations across asset classes to reflect a vastly different monetary and fiscal policy regime from that of just a few quarters ago. The reset has been painful as the NASDAQ has lost over 30% from its recent high, cryptocurrency Bitcoin is down from a high of over $66,000 to around $20,000, the big mega cap tech stocks are down anywhere from 25-75%, mortgage rates have spiked up from 3.25% to almost 6%, and the S&P 500 has fallen into bear market territory.  For ARS clients, it is important to keep in mind that the secular trends we have identified in recent Outlooks will continue to be fundamental to an improving economy. We remain focused on the beneficiaries of the trends in electrification, digitalization, lowering healthcare costs, and those delivering on the need to enhance national security (food, energy, cyber, and military) at home and abroad. There will be a time lag between the future benefit as reflected in the stock prices of the beneficiaries and the present economic pressures weighing on the markets overall.

Excessive focus on near-term concerns distracts from the subset of companies that stand to benefit from the current environment, especially those experiencing pricing power and inelasticity of demand for their products. An important fundamental concept for investors to understand at this time is that price inelasticity reflects goods and services that typically tend to have few substitutes, few competitors and are considered necessities by users. Given the ongoing supply-chain woes, inflationary pressures and a strong dollar, the ability of companies to offset any increase in production costs will enable them to increase earnings and cash flow from operations and should be worth more over time. Among the areas of investment opportunity are semiconductor chips and equipment, cloud providers, select commodities producers including steel, rare earth materials, chemicals, copper and even some fossil fuel producers as each should continue to see strong pricing power, demand, and earnings growth.  In addition, our research has identified a number of public companies which have announced significant, multi-year stock buyback programs of 15-20% of their outstanding shares annually with an eye toward potentially taking their companies private over time. These companies have the financial strength to thrive against their competitors in this particularly challenging environment.

There is a growing separation between the corporate haves and have-nots making security selection the most important it has been in a long time.  The shift from near-zero interest rates will require portfolio managers to be much more selective to invest in those companies that benefit from this policy regime change.  The winners will be those companies whose product demand is inelastic as those will continue to have better pricing power – an important theme that we touched on in prior Outlooks – as well as those with strong balance sheets which allow for continued investment, merger and acquisition activity, increased buybacks, and – importantly – growing dividend payments.  Due to surging inflation, higher input costs, and a strong dollar, market participants should expect analyst estimates to be reduced when companies report second quarter earnings as more corporate executives are likely to announce lower guidance, and in some cases, withhold guidance completely.

At some point, inflation will ease.  The result will be a higher level of interest rates than before the war and aAt some point, inflation will ease.  The result will be a higher level of interest rates than before the war and a higher cost of living.  Considering that the dollar has lost around 83% of its purchasing power since 1974, asset class and security selection need to protect purchasing power even more effectively than at any time in the last 50 years.  While the natural tendency during times of economic stress is to shift to a more conservative approach such as increasing fixed income exposure, we believe that this will only work as a short-term decision as well-selected equities will be the only way to offset higher living costs over time.  In addition, the current conditions suggest that market winners will be a narrow subset of the overall market whereas for much of the past decade it was more beneficial to own the entire market.  In the current economic environment, indexing will capture both the winners and the losers, something we and most investors will find unsatisfactory.  This is a time for focused and targeted security selection regardless of whether you are in the public or private markets.  Many companies are on the lookout to purchase undervalued companies to enhance their competitive positions and business prospects.  Given the amount of liquidity still present in the global system and the excess cash flow being generated by many corporations, the window of opportunity for investors in these mispriced companies may not be available for long.  As great investors know, the best investments are presented when the markets are under extreme pressure and most market participants are not emotionally able to act to take advantage of exceptional circumstances.   

Published by the ARS Investment Policy Committee: Stephen Burke, Sean Lawless, Nitin Sacheti, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

The information and opinions in this report were prepared by ARS Investment Partners, LLC (“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. This report may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable. However, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.

ARS and its employees shall have no obligation to update or amend any information contained herein. The contents of this report do not constitute an offer or solicitation of any transaction in any securities referred to herein or investment advice to any person and ARS will not treat recipients as its customers by virtue of their receiving this report. ARS or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments mentioned herein.

This publication is being furnished to you for informational purposes and only on condition that it will not form a primary basis for any investment decision. These materials are based upon information generally available to the public from sources believed to be reliable. No representation is given with respect to their accuracy or completeness, and they may change without notice. ARS on its own behalf disclaims any and all liability relating to these materials, including, without limitation, any express or implied recommendations or warranties for statements or errors contained in, or omission from, these materials. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances. This report may not be sold or redistributed in whole or part without the prior written consent of ARS Investment Partners, LLC.

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.


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.


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.

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