Category: The Outlook

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

French Prime Minister Manuel Valls,

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

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

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

Major Investment Considerations

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

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

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

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

Investment Implications

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

Mobility and the Cloud

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

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

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

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

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

Defense

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

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

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

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

Healthcare

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

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

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

Financials

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

Improving Global Consumer

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

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

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

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

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

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

The United States – a Magnet for Capital Flows

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

Federal Reserve Press Release, September 17, 2015

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

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

Currencies, Monetary and Fiscal Policy Responses

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

The Outlook, April 9, 2015

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

China

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

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

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

Europe

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

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

Investment Implications

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

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

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

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

“In Europe, the only way to proceed is to proceed as we have always done, namely by following a pragmatic, step-by-step, flexible and rectifiable approach; proceeding only ever as far and as fast as the peoples and governments of Europe actually desire.”

– German Finance Minister, Wolfgang Schauble, article in the Frankfurter Allgemeine Zeitung, 7/4/15

“Major debt overhangs are only solved after deep write-downs of the debt’s face value. The longer it takes for the debt to be cut, the bigger the necessary write-down will turn out to be. Nobody should understand this better than the Germans. It’s not just that they benefited from the deal in 1953, which underpinned Germany’s postwar economic miracle. Twenty years earlier, Germany defaulted on its debts from World War I, after undergoing a bout of hyperinflation and economic depression.”

– Eduardo Porter, NY Times 7/7/15

The global economy suffers from too much debt and too little growth.  According to the McKinsey Global Institute, global debt from 2007 to the second quarter of 2014 had grown by $57 trillion to approximately $199 trillion or 286% of Gross Domestic Product (GDP) while global GDP has grown by roughly $17 trillion during that period.  While a tentative deal was reached on July 12th between Greece and its creditors, the terms are onerous and will be difficult to implement at best.  If economic recovery continues to disappoint there will inevitably be write-downs of debt globally, particularly for Greece, as the financing required to generate sufficient growth renders the debt dynamics unsustainable.  The sooner politicians and creditors come to accept that write-downs will be required, the lower the ultimate economic cost will be and the sooner economies will return to sustainable growth.  Greece, which has been the poster child of the broader debt problem, has seen its GDP of $319 billion in 2007 decline to an estimated $207 billion in 2015 while its debt has grown from $349 billion to approximately $380 billion as years of political and economic malpractice now have the nation on the brink of collapse.  The current global economic and geopolitical dynamics strongly suggest a continuation of low interest rates, low inflation rates and low growth for the foreseeable future as the global economy cannot tolerate a normalization of interest rates to historical levels under  present conditions. The ongoing divergences continue to place strains on the world’s economy and capital markets leading to continued periods of volatility.

The chart below highlights the changes in the major global economies and Greece in GDP, debt and current accounts from year-end 2008 to projected year-end 2015 as well as the estimated 2015 population and unemployment figures.  It illustrates the divergences between the stronger economies and the weaker ones.  Some countries were able to grow GDP with debt growth at manageable levels such as the United States, Germany and the UK, while achieving improvements in unemployment.  At the same time, the chart helps explain the challenges for the 19 members of the Eurozone as well as the specific challenges facing Greece and Italy which have significantly lower GDP, rising debt ratios and unemployment.  The “no” vote by the people of Greece in its national referendum sent a resounding message to its creditors, European leaders (particularly Germany and France) and the rest of the world that the debt problems that have plagued the global economy since 2007 are not being effectively resolved with current monetary and fiscal policies.  The vote expressed the frustration of the Greeks with the current situation as the majority of voters actually want to stay in the Eurozone, but cannot tolerate the continuation of austerity-driven policies which have put them in a depression without the hope of a positive future.  Years of austerity, rising unemployment and growing income inequality in Greece have sown the seeds for contagion to other weak economies in the Eurozone.  The issue of inequality has become a concern for politicians globally.

Ultimately, an agreement was reached at the Euro Summit held on July 12th – 13th between European and Greek leaders. Greek Premier Alexis Tsipras accepted worse terms than were previously offered to his predecessors (which he severely criticized), and the last one that the voters rejected in the referendum.  At the time of this writing, the deal must be voted on by seven governments including the Greek parliament.  We remain skeptical that the agreement will allow Greece to service its debt and return to sustainable growth without debt relief.  European politicians continue to struggle with balancing Europe’s best options with complicated domestic politics.  The remainder of The Outlook will address the resurgence of U.S. economic leadership, the complexities involved with reaching a positive outcome in Europe, China’s economic struggles, a proposed economic solution from the Bank of International Settlements (BIS) (known as the central bankers’ bank) and the investment implications for the second half of 2015.

The United States

“Looking further ahead, I think that many of the fundamental factors underlying the U.S. economic activity are solid and should lead to some pickup in the pace of economic growth in the coming years. In particular, I anticipate that employment will continue to expand and the unemployment rate will decline further.”

– Federal Reserve Chair Janet Yellen, 7/10/15

For some time, we have written that the United States has been and remains the standout global economy because of its many strategic competitive advantages over all other major economies.  The strength of an economy is reflected in its currency and the U.S. dollar’s position as the world’s reserve currency has been strengthened recently as the structural flaws of the other reserve currencies, the Euro and the Yen, have been underscored.   As a result of the debt crisis playing out in Europe, the Euro has been losing some of its status as a reserve currency as central banks have been selling Euros and buying Dollars.  Similarly the structural challenges of Japan continue to call attention to its long-term ability to promote growth, and thus adding uncertainty to its currency status.  At the same time, China’s reserve currency aspirations for the Renminbi need to be reset as the recent government actions of stock market manipulation will certainly raise questions about whether its capital markets system is ready to support reserve currency status.

The fact that the Federal Reserve has ended its quantitative easing program and is moving closer to gradually raising interest rates while these others are continuing their quantitative easing programs is supportive of the U.S. dollar’s continued strength and indicative of an improving economy.  The United States has seen gradual improvements in employment, wages, various housing measures, consumer net worth and consumer confidence.  Aside from keeping inflation rates and interest rates low, the benefits of low oil prices remain supportive of consumers and manufacturers as well.  As a more domestically-driven economy, the U.S. does not need a weaker currency to stimulate growth.  The reliance on exports for growth is why so many nations have embarked on competitive currency devaluation over the years.

The United States for all its flaws is a remarkable economy because of its resilience and adaptability.  In his fascinating book titled “Strategic Vision”, Zbigniew Brzezinski put U.S. assets and liabilities into perspective.  Interestingly even our liabilities look relatively good compared to those of most of the other leading nations.  Debt, social inequality and decaying infrastructure are common issues for most nations, and our financial system for all its imperfections has the world’s deepest and most mature capital markets system.  Our assets are equal or superior to any nation, and in challenging times they allow the United States to rebound and prosper.  The positive attributes of the U.S. cannot be taken for granted, especially our democratic appeal and our innovative potential.

Europe

“On the brink of bankruptcy, Greece is in a worse state than before the bailout … The effort to restore Greece to normalcy has been a failure, because of poor policies, fundamental problems in Greece’s dysfunctional state and a pitiful lack of leadership in Greece and among policy makers in Europe and at the I.M.F. The collapse of the parties that had mismanaged Greece for decades created a vacuum that Syriza, a coalition of the radical left, filled with promises: It would continue to procure bailout funds, scrap austerity, undo reforms and still keep the country within the Eurozone … Those citizens (and taxpayers in other countries) have paid a price for the failed bailout; now the Greeks face even greater hardship, whether we stay in the euro or are forced out.”

– Nikos Konstandaras, in a WSJ Op-ed on 7/4/15

The debt problems of Greece and other nations in the EU have exposed philosophical and institutional flaws of the European unification program.  In a reversal of its previous position, the IMF issued a report on July 2nd that stated that haircuts on Greek debt are probably necessary to resolve its economic problem.  This report was critical for two reasons.  First, it represented a shift in thinking at the IMF in the ability of austerity programs and reforms to achieve the goal of a realistic return to growth putting the IMF at odds with Germany and its finance minister.  Second, it puts debt relief on the table in a meaningful way as it is not just being requested by those with the debt, but put out by one of the most important creditors.  The suggestion of debt relief by the IMF at that stage of the negotiations created added problems for European leaders, especially Angela Merkel as the Germans have been staunchly against write-downs and softening the financial discipline required of nations as specified in the Euro agreement.   In recent years, Germany has solidified its political and economic leadership role within the EU and globally.

“There’s no question that the Eurozone has lost credibility.”

– Wolfgang Schauble, 7/14/15 press interview reported by CNBC

The Euro Summit highlighted the power and influence that Germany has within the Eurozone and the European Union, but it has come at a cost and at a time when the European project faces existential decisions with respect to social (employment and immigration), strategic (defense spending and financial integration) and political (Euro-sceptics versus the anti-austerity) issues that must be addressed.  The coalition governments and parliamentary structure of most European nations can now suffer greater fragmentation making it particularly challenging to implement long-term reforms to achieve sustainable growth.  Politics and economics are not mixing well as diverging short-term needs and long-term solutions are rarely aligned, particularly in a “union” where only the currency is common.  In fact, many believe, including the Germans, that Greece would be best served by having its own currency.  You cannot have a successful union when the economic circumstances of its members are so divergent.  Angela Merkel, one of the most highly regarded world leaders today, continues to find herself in the difficult position of deciding what is best for Europe, for Germany and for her political future as the right solution will not be viewed equally by all.

China

After growing into the world’s second largest economy over the past 25 years, China is experiencing both a decelerating economy with growing debt burdens and a severe stock market correction.  Since the financial crisis of 2007, China has been aggressively exerting itself as a military, political and economic power on the global stage.  This push has included its previously stated desire to achieve reserve currency status.  While Greece has captured much of the headlines and has investors worried about contagion risks, China is also of concern.  Just as China’s rapid growth benefited so many countries including Brazil, Australia, Germany and Canada, its slowdown has been equally painful to those same nations.  As most developing economies have experienced, transitioning from investment and export-led growth to consumption-led growth is difficult at best.  In China’s case, this effort will be augmented by its creation of the Asian Infrastructure Investment Bank (AIIB) which will have initial funding of $100 billion.  Interestingly, the U.S. as well as Japan has refused to participate in the AIIB in what is now a 57 country membership.

To add to its economic challenge, China’s stock market has declined roughly 30% in the last few weeks after a 100% plus gain in the previous 6 months.  In an unusual sign of panic, the Chinese government has taken a series of extreme actions to stem the decline.  As developed as the U.S. capital market system is, the actions to manage its stock market decline provide a reminder to investors that China’s capital market system is far less developed.  However, it is worth noting that China is not the first country to aggressively intervene in its stock market, nor will it be the last.  China is clearly struggling as an economy in transition, but it has a long-term plan that it is executing against, a growing middle class and an ability to learn and adapt.

The BIS Solution to the Debt and Growth Problem

“The aim is to replace the debt-fuelled growth model that has acted as a political and social substitute for productivity-enhancing reforms. The dividend from lower oil prices provides an opportunity that should not be missed. Monetary policy, overburdened for far too long, must be part of the answer, but it cannot be the whole answer.”

– Excerpt from the BIS 85th Annual Report

Established on May 17, 1930, the Bank for International Settlements (BIS) is the world’s oldest international financial organization with 60 member central banks, representing countries from around the world that together make up about 95% of world GDP.  The mission of the BIS is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks. Since the start of the financial crisis in 2007, central banks have played a major role in working to return the global economy to a sustainable growth path, but highly accommodative monetary policy alone has proven insufficient and meaningful fiscal policy is required.  Therefore, strong political leadership must emerge to move the global economy out of the current debt problem. The dilemma for voters is that the message and actions required for appropriate change are not the populist ones that win elections.  Any politician can make promises, but the world needs statesmen now more than ever as the solutions are hard and the reform process takes time.

The Bank for International Settlements (BIS) states that “the current malaise may to a considerable extent reflect a failure to come to grips with how financial developments interact with output and inflation in a globalized economy.  For some time now, policies have proved ineffective in preventing a build-up and collapse of hugely damaging financial imbalances, whether in the advanced or in emerging market economies.  These have left long-lasting scars in the economic tissue, as they have sapped productivity and misallocated real resources across sectors and over time.” The BIS argues that there is too much emphasis on short-term demand policies and not enough effort on addressing the social issues.  In its report, the BIS highlights that what is required is “a triple rebalancing in national and international policy frameworks; away from illusory short-term macroeconomic fine-tuning towards medium-term strategies; away from overwhelming attentions to near-term output and inflation toward a more systemic response to slower-moving financial cycles; and away from a narrow own-house-in-order doctrine to one that recognizes the costly interplay of domestic focused policies.”

Interestingly the BIS report argues that the current low interest rate policies are creating a prolonged cycle of lower interest rates.  The report also suggests that the global economy must work to limit or reduce the highly damaging financial booms and busts which tend to scar the global economy for some time and impede the ability to return to a healthy and sustainable expansion.  We note that in recent years, there has been a visible increase in the shorter-term orientation of many market participants which has led to price volatility that creates a distortion of business valuations. Investors have to distinguish between price changes due to short-term trading (speculators) versus changes in the underlying business fundamentals. This volatility can lead to investor confusion about the quality of their holdings due to exaggerated short -term moves in portfolio values.

The Investment Implications

“Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy … Let me stress that this initial increase in the federal funds rate, whenever it occurs, will by itself have only a very small effect on the overall level of monetary accommodation provided by the Federal Reserve … Because there are some factors, which I mentioned earlier, that continue to restrain the economic expansion, I currently anticipate that the appropriate pace of normalization will be gradual, and that monetary policy will need  to be highly supportive of economic activity for quite some time.”                   

– Federal Reserve Chair Janet Yellen, 7/10/15

As discussed in our last three Outlooks, the current global economic and geopolitical dynamics strongly suggest a continuation of low interest rates, low inflation rates and low growth for the foreseeable future as the global economy cannot tolerate a normalization of interest rates to historical levels under the present conditions.  Investors should expect volatility to persist as the debt problem and divergences continue.  Under these conditions, investors should expect an extended business cycle which should result in higher corporate earnings and healthy equity valuations over time.  The United States remains the standout economy and we should see moderate improvement in economic activity in the second half of the year.  As we have written about for over a year, investors should not be concerned about the Federal Reserve raising rates this year, but the focus should be on the rate of the increases which Ms. Yellen has stated will be gradual and policy will remain highly accommodative.  Only much stronger growth rates (resulting in higher corporate profits) in the U.S. would warrant a more rapid increase in interest rates by the Federal Reserve.  Under present conditions, areas of focus include:

1. Technology companies that are benefiting from unprecedented innovation and are helping their corporate customers drive down operating costs. These companies are familiar with operating successful businesses in price competitive environments.  In addition, opportunities are developing from rapid technological advances including the large increase in the availability of wireless spectrum and the dynamic growth in mobility, connectivity, search, device sales, memory, data management and storage;
   
2. Financial companies that benefit from continued low interest rates and easy access to financing such as real estate related companies as well as those businesses that have generated strong profits in recent years despite a falling interest rate environment, such as the banks which stand to benefit from a stabilization in net interest margins, and a continuing decline in costs;
   
3. Healthcare companies with technology-enabled breakthroughs, strong product pipelines and growing dividends;
   
4. Consumer companies with pricing power that can increase profit margins, improve overall profitability and benefit from lower input costs and stronger consumer spending;
   
5. Company-specific stories—companies with compelling valuations and strong company-specific catalysts or growth drivers; and
   
6. Industrial investments with well-defined end-market demand, including defense, power generation and aerospace companies.
   

As always there are risks to our investment Outlook that we factor into our views.  These include higher stock market valuations, illiquidity in the bond market, slowly rising labor costs, structural headwinds in developed markets (including demographic challenges and heavy debt burdens), rising student loan debt in the U.S., slower growth in China and ongoing geopolitical risks.  We view the set up for the second half of 2015 as an environment which will favor active management and domestically-oriented companies.  Our research continues to identify strong businesses that are well positioned to benefit from the conditions described.  At the present time, client portfolios reflect companies with the following characteristics: market share gainers, improving margins, increasing free cash flows, ability to increase pricing power and growing dividends.  In a low-growth environment, we also expect the market to assign premium valuations to high-growth companies due to the scarcity value of such assets.

“There are going to be market reactions whenever you’re shifting from an economy that has had very low interest rates for a long period of time to an economy that has more normalized interest rates. While that is a positive story overall, there is a possibility that it will be a bumpy ride.”

– Boston Federal Reserve President, Eric Rosengren in a recent WSJ interview

The shifting and uneven global recovery and ongoing divergences continue to place strains on the world economy and capital markets. In our April Outlook, we described a global economy that was undergoing an adjustment process that would lead to increased volatility as the rapid changes in currencies, oil prices, interest rates and central bank policies work through the system.  Since that writing, the markets have not disappointed as evidenced by the sharp increase in the yields of government bonds as the amount of sovereign debt with negative yields decreased from approximately $3 trillion to an estimated $1.7 trillion.  The 10-year German bund yield rose from a multi-year low of 0.03% on April 17th to 0.70% on May 12th.  This likely contributed to 10-year Treasury yields backing up by approximately 0.50%, while the popular strong U.S. dollar/weak Euro trade, which had become quite crowded, reversed as well.  Notwithstanding these recent short-term moves, the current global economic and geopolitical dynamics strongly suggest a continuation of low interest rates, low inflation rates and low growth for the foreseeable future as the global economy cannot tolerate a normalization of interest rates at historical levels under the present conditions.  Due to the recent volatility, we wanted to remind our clients what we believe should matter most for investors in the coming quarters:

1. Longer term, the U.S. is and should continue to be the standout economy due to a number of structural advantages described in past Outlooks;
2. The U.S. economy, which slowed in the first half of 2015 due to weather, a stronger dollar and the west coast port problems, should continue to improve in the second half;
3. It would not surprise us to see a cyclical improvement in overseas economies  (as signaled by strong international stock markets in recent months) as the benefits of lower oil, expansionary monetary policy and lower interest rates finally work their way through these systems; however, we view these to be transitory factors as the structural challenges for these economies remain unresolved;
4. A prolonged period of low interest rates will extend this business cycle and should result in higher corporate earnings and equity valuations over time;
5. We anticipate the recent increase in government bond yields can only go so far before higher rates eventually cause a slowdown in economic activity, but we have likely seen the near-term lows;
6. The low interest rate environment combined with rising concerns about illiquidity in the bond market and price distortions caused by what is essentially “forced buying” of sovereign bonds by many European financial institutions has raised concerns that bonds might be losing their value as an asset class; and
7. We share Mr. Rosengren’s view that it may be a bumpy ride, so we suggest that investors focus on companies that can improve profitability in a world of increasing pricing pressures and where such companies should command premium valuations in the market.

Valuations

“I guess I would highlight that equity market valuations at this point generally are quite high. Now they’re not so high when you compare the returns on equities to the returns on safe assets, like bonds, which are also very low. But there are potential dangers there.  And in interest rates, obviously not only short but long-term interest rates are at very low levels. And that would appear to embody low term premiums, which can move and can move very rapidly. We saw this in the case of the taper tantrum in 2013 where there was a very sharp upward movement in rates and you do have divergent monetary policies, potentially around the world.”

– Janet Yellen, interview with Christine LaGarde of the IMF

There has been a great deal of discussion about valuations with noted investors such as Bill Gross, David Tepper and Jeff Gundlach, each offering a different perspective on stock and bond market valuations.  On May 6th, Federal Reserve Chair Janet Yellen weighed in during an interview with Christine LaGarde, President of the International Monetary Fund (IMF), at a conference in New York in which she said equity valuations “are quite high”, which led to a selloff in the U.S. equity markets.  However, a complete reading of her comments would lead to a different conclusion and one with better context – equity valuations are not so high when you compare their returns to those of bonds.  Ms. Yellen was also preparing the markets for an eventual tightening move by the Federal Reserve which will impact not only the U.S. but also foreign markets as well.  It has been our view that bonds will be a difficult investment at best with rising concerns about liquidity.  Given the fact that the United States is moving closer to a tightening of monetary policy, it is likely that we will continue to see further volatility and movement toward a two-tiered market with clear delineation of the companies that benefit from those that do not, making security selection more critical than in recent years.

As a result of the strong dollar, the 15 largest emerging markets have experienced an estimated $600 billion of capital outflows during the past three quarters according to the Financial Times.  Foreign exchange reserves for these nations have dropped by over $350 billion which reflects the stresses facing governments.  The slowdown in China and the decline in oil prices have wreaked havoc on the finances of many emerging market economies.   The Saudis have reportedly seen their foreign exchange reserves of $750 billion at the start of the year decline by $36 billion in just a few months as low oil prices, entitlement programs and the cost of military actions in Yemen are straining their budget.  Elsewhere, the People’s Bank of China (PBOC), on May 10th, cut its benchmark lending rate and one-year benchmark deposit rate by 0.25% as it seeks to lower borrowing costs and support the slowing economy. Brazil and Russia have raised interest rates in recent weeks to combat currency and capital outflow issues.  The divergences in monetary policy and economic circumstances make the risks of chasing returns even greater which suggests that investment focus should be on markets with better liquidity and higher quality.  For our clients, that means continued focus on the United States which is home to the most liquid and mature capital market system in the world.

Greece

“There is always a risk that other areas of policy will shy away from unpleasant measures and rely on monetary policy to sort things out … Sustainable growth cannot be built on a mountain of debt.”

– Bundesbank President,  Jens Weidmann, 5/4/15

The ongoing negotiations between Greece, the IMF and the European finance ministers are reaching another critical point in addressing the Greek debt crisis.   On May 12th, Greece made a 750 million euro payment to the IMF with 600 million euros being paid with funds coming from Special Drawing Rights (SDRs) that IMF member nations can access in times of need from the IMF.  In effect, Greece paid the IMF with the IMF’s money.  Greece’s anti-austerity government, led by Syriza party leader Alexis Tsipras, was elected earlier this year with a mandate to end Greece’s economic crisis that has seen crippling unemployment and poverty.  The inability of the parties to reach agreement may push Mr. Tsipras to hold a referendum for the Greek voters to determine what austerity terms the people might be prepared to accept from their lenders in return for a bailout.  The terms would include pension cuts and new laws that make it easier to lay off workers, similar to what the Germans implemented under the “Agenda 2010” program under Chancellor Schroeder.  A referendum would be a risky but possibly clever political move by Mr. Tsipras to avoid backing away from campaign promises while letting the voters choose to accept the terms proposed by creditors or the potential alternative of exiting the Euro.  Surprisingly, the idea of a referendum has recently received support from the German Finance Minister which is a sign of the frustration with the negotiation process.   With high unemployment and ongoing challenges, many European nations need to continue the process of implementing structural reforms in order to return to sustainable growth, but high unemployment, especially for the youth, continues to make social stability a challenge for policymakers.

The Long Term Impact of Student Debt on U.S. GDP Growth

“For the moment, the depressing reality is that there is little chance of the $1.3 trillion debt shriveling. That is bad news for millions of households. But it is also unwelcome for the American economy, which can ill-afford to be weighed down by this oft-ignored debt mountain.” 

– Gillian Tett, Financial Times 5/8/15

There has been a lot written about the growing amount of student debt in the United States and the escalating costs of college education.  Today, student loan debt exceeds $1.3 trillion and has risen from less than $325 billion in 2004.  It is estimated that more than 20% of the payments are in deferral, delinquency or default which is a difficult way to build the foundation for future financial success.  In 2012, 71% of college graduates left college with an average debt of over $30,000.  The student debt problem has huge implications for the future as it keeps young people from starting families, buying houses and taking risks on new businesses.  It also exacerbates the growing problem of wealth inequality and declining social mobility, since it gives debt-free graduates from wealthier families an enormous head start over their peers.  Today’s college graduates and younger workers are facing an improving, but challenged job market with stagnant wages.  Federal and state budget cuts, meanwhile, have spiked tuition costs and cut public services that aid young workers, such as transportation and affordable housing.  Unlike mortgage interest, interest on student loans has a maximum tax benefit of $2,500 and is not deductible for those earning over $80,000 as single filers and $160,000 as joint filers.

A different way to look at the impact of the student debt problem would be to compare the cost of servicing the debt to the potential loss of its contribution to GDP growth.  Assuming the average student loan carries a 6.75% interest rate and has a 12.5 year term; the cost to service the debt is roughly $92.5 billion a year which is approximately 20% of the forecast for 2015 U.S. GDP growth of $450 billion.  Given the aging demographics of the U.S., it is critical that our young people pick up the productive consumption spending that we are losing as the 11,000 baby boomers retiring each day will no longer spend at the same levels as they did during their working years.  While the U.S. secondary education system is the envy of many nations around the world, the spiraling tuition costs are making it difficult for students to make a sufficient return on their investment if debt costs remain at these levels.  More importantly, will students be able to justify the cost of college and graduate school in an environment of improving but still high youth unemployment and stagnant wage growth?

Investment Implications

As discussed in our last two Outlooks, the current global economic and geopolitical dynamics strongly suggest a continuation of low interest rates, low inflation and low growth for the foreseeable future as the world economy cannot tolerate a normalization of interest rates to historical levels under the present conditions.  That being said, rates may not return to the recent lows and volatility is likely to persist.  Under these conditions, investors should expect an extended business cycle resulting in higher corporate earnings and equity valuations over time.   The United States remains the standout economy and we should see improvement in economic activity in the second half of the year.  Under these conditions, areas of focus include:

1. Technology companies that are benefiting from unprecedented innovation and are helping their corporate customers drive down operating costs. These companies are familiar with operating successful businesses in price competitive environments.   In addition, opportunities are developing from rapid technology advances including the large increase in the availability of wireless spectrum and the dynamic growth in mobility,  connectivity, search, device sales, memory, data management and storage;
2. Industrial investments with well-defined end-market demand, including defense, transportation, power generation and aerospace companies;
3. Consumer companies with pricing power that can increase profit margins, improve overall profitability and benefit from lower input costs and stronger consumer spending;
4. Financial companies that benefit from continued low interest rates and easy access to financing such as real estate related companies;
5. Healthcare companies with technology-enabled breakthroughs, strong product pipelines and growing dividends; and
6. Company-specific stories with compelling valuations and strong company-specific catalysts or growth drivers.

As always there are risks to the investment outlook that we factor into our views.  These include higher stock market valuations, illiquidity in the bond market, slowly rising labor costs, structural headwinds in developed markets (including demographic challenges and heavy debt burdens), rising student loan debt in the U.S., slower growth in China, the eventual interest rate increases by the Federal Reserve and ongoing geopolitical risks.  However, our research continues to identify strong businesses that are well positioned to benefit from the conditions described above.

The global economy is undergoing an adjustment process that has increased market volatility while presenting specific investment opportunities for investors who understand the complexity of today’s paradigm shift.  There is a lack of pricing power, and in certain industries there are deflationary forces resulting from surplus capacity, aging demographics, excessive borrowings and rapid technological advances. Therefore it is important to have an understanding of the subtle impacts that pricing changes will have on corporate profits and to identify industries and companies that are positioned to prosper in this environment.  A focus of our team in 2015 is to target investments in companies that can maintain or even improve profit margins.  Importantly, companies that can improve profitability in a world of increasing pricing pressures should command premium valuations in the market, and those shares should be purchased on any market pullbacks.

Against this backdrop, the U.S. is and should continue to be the standout economy as evidenced by the strength of the U.S. dollar.  The stronger dollar is enabling the U.S. to import goods at lower prices which, in turn, translates into a rise in real purchasing power for consumers.  According to Visa, the U.S. fuel price decline since last June amounts to approximately $60 per month for the average consumer.  The typical consumer saves about 50% or $30 per month, pays down debt with 25% and spends approximately 25%.  These statistics on fuel savings would indicate an outlook for continued, gradual consumer repair in the U.S.  We currently favor undervalued companies whose earnings are primarily domestically driven as well as multinationals with above-average growth potential to offset the impact of foreign exchange headwinds on earnings.  While we still favor companies with stable and growing dividends, our focus is  on finding companies that can demonstrate solid profitability in an economy that will prove somewhat more challenging for corporate profits overall.  The strong dollar is also making exports more expensive and less competitive fostering the need for further technology investments in order to lower costs.  Under these conditions, technology companies should continue to benefit from the need for businesses to improve productivity and efficiency.  Additionally, equity markets in Europe and Japan are benefiting from the aggressive monetary policies of the European Central Bank (ECB) and the Bank of Japan (BOJ) to offset deflationary pressures and inflate assets in an attempt to promote growth.

Specific examples of sectors that benefit from our Outlook include:

In this Outlook we will discuss the ramifications of the adjustment process underway in the global economic system, describe the complex geopolitical forces at work in the Middle East, address the impact of technological change on our lives, and we close with the key investment considerations affecting our investment decisions in 2015.

Adjusting to Rapid Economic Change

“The extraordinary monetary policy accommodation that the Federal Reserve has undertaken in response to the crisis has contributed importantly to the economic recovery, though the recovery has taken longer than we expected … But a smooth path upward in the federal funds rate will almost certainly not be realized, because, inevitably, the economy will encounter shocks—shocks like the unexpected decline in the price of oil, or geopolitical developments that may have major budgetary and confidence implications, or a burst of greater productivity growth, as the Fed dealt with in the mid-1990s.”

–  Stanley Fisher, Federal Reserve Vice Chairman, March 23, 2015

The global economy has entered a period of adjustment resulting from the rapid changes in currencies, oil prices, interest rates and central bank policies which will take time to work through the system.  The economic

imbalances have been best exemplified by the rapid rise of the U.S. dollar and the sharp decline in oil prices since last June.  On a global trading basis, currency moves make imports and exports either more or less expensive.  In this case, a stronger dollar makes imports into the United States less expensive and exports more expensive.   For the U.S., the stronger currency means that our $2.9 trillion of imported goods cost less which will benefit consumers’ spending power.  This is an important dynamic for the U.S. economy which is 70% consumer driven, and when combined with lower gasoline prices, increases discretionary income and purchasing power.   The lower import prices also enhance the purchasing power of those living on a fixed income in a near-zero interest rate environment.  For Europe, the weaker Euro makes its exports more competitive providing a much needed boost for the Eurozone.  China, whose currency is tied to a rising U.S. dollar making its exports more expensive, is becoming less competitive at a time when it needs to increase exports to slow its decline in GDP growth to a more manageable level.  If the U.S. dollar remains strong, China may find it necessary to devalue its currency to support its exports.  A strong dollar also has important implications for the global bond market as there is more than $9.2 trillion of dollar-denominated debt held by foreigners.  As the dollar has appreciated against other currencies, the cost of servicing dollar-denominated debt  has become   more difficult to manage.   Since many of these holders were already experiencing economic difficulties and capital outflows, the higher cost of debt has increased economic stress and pushed more capital to the U.S. and other strong economies.

“The U.S. is recovering faster than many have expected, which would make it the No.1 engine of growth for the global economy.”

– China Investment Corp. Chairman Ding Xuedong   discussing increasing U.S. investment this year

The U.S. is now the engine for growth in the global economy, and it is essential for the nation to maintain growth even at a slower rate given the fragility of the global system.  This translates into the need for the Federal Reserve to continue a highly accommodative monetary policy for the foreseeable future.  One of the challenges facing leaders is to implement monetary and fiscal policy changes while the global economy is in the midst of this adjustment process.  In a speech on March 27th Federal Reserve Chair Janet Yellen stated that, “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”  Ms. Yellen is clearly concerned that the global recovery remains fragile and the risk of the U.S. acting too early is greater than acting a little too late.  We are experiencing interest rate adjustments as the nearly 1.8 percentage point spread between the German 10-year bund and the U.S. 10-year treasury demonstrates in the chart above.  In a yield-starved world, investors can earn approximately 9 times more income by shifting from bunds to treasuries which would tend to attract more capital to the U.S. Furthermore, over 16% of government debt globally currently carries a negative yield.  The major implication is that an increase in rates by the Federal Reserve will tend to attract foreign flows to the U.S. and these capital flows should act to suppress the rate increases,  if not actually promote  lower rates and a still stronger dollar.  It is for this reason that we hold to our conviction that the overall level of interest rates in the U.S. will remain low for the foreseeable future. A prolonged period of low interest rates will extend this business cycle which should result in higher corporate earnings over time.

Growing Conflict in the Middle East

A growing geopolitical risk to the economic outlook is the increasing conflict in the Middle East. The complexity of the problem cannot be overstated.  After the Arab Spring, these nations were left without the proper institutional structures to effectively govern, and therefore tribal structures are now filling the leadership void.  Religious, political and sectarian hostilities built up over a millennium have reached a boiling point and have entered a military stage of conflict among the major regional powers.  Suffice it to say, the Iranians view this as an opportunity to realize their long-term aspirations to become a hegemon in the region.  ISIS, a Sunni-group, has secured significant territory in Iraq and has acted as a magnet drawing Iran, a Shiite-group, into the power struggle.  A potential shift of control in Iraq and Yemen by the Iranians acting by proxy is altering the balance of power in the region and has major implications for the global oil market.  The Iranian-supported actions in Yemen, which have toppled the government, have forced Saudi Arabia to take military action to protect its porous 1700 mile border with Yemen.  With a Gross Domestic Product of only $36 billion in 2013, Yemen is one of the poorest and most economically underdeveloped nations, but is strategically

important bordering on the Red Sea and the Gulf of Aden which are transport routes accounting for 8% of global trade and 4% of global oil transport.  In previous Outlooks, we discussed the potential for higher oil prices resulting from an upset in the Middle East.    At this time, the effect on oil prices is unpredictable and will depend on the duration and severity of the conflict.

This is occurring as Russia continues its aggressive actions toward its neighbors with no signs that economic sanctions have thwarted Mr. Putin’s desire to reassert Russian control and influence.  In a recent op-ed article in a Danish newspaper, Russia’s ambassador threatened Denmark with nuclear action if it signed up for the NATO missile defense program.  “If it happens, then Danish warships will be targets for Russia’s nuclear weapons. Denmark will be part of the threat to Russia,” said Ambassador Mikhail Vanin.   The increasing aggressiveness of nations and terrorist groups are making national security and defense spending higher priorities for most governments even while budgets are under intense pressure.  This comes at a time when governments are attempting to reduce debt and deficits, and struggling to create the growth required to satisfy their people and avoid social unrest.

Technological Advances Are Being Felt Everywhere

In this Outlook, we also highlight one of the major investment themes for client portfolios.  The rate of technological change continues to be disruptive for many industries as old leaders are forced to reinvent themselves or lose position, while new leaders experience rapid growth in market share and market capitalization.  “And so what we want to do at Apple, that’s our objective, we want to change the way you live your life,” said CEO Tim Cook, at the Goldman Sachs Conference discussing the potential for the Apple Watch.  Industries disrupted by companies such as Apple and Google include computer, music, mobile phone, laptop, publishing and advertising, with the TV and watch industries now in various stages of disruption. Technology companies increasingly benefit from global consumers’ thirst for instant information and need for greater mobility and connectivity.  Greater connectivity is being driven by the improvements in the functionality of mobile devices, expanded global coverage, and increased options for smartphones, tablets and computers.  The availability of 3G and 4G mobile networks is making it possible to access and store unprecedented volumes of data at faster speeds, and companies now are working on the next generation of 5G technologies.

“The numbers tell one part of the story. There are currently almost 7 billion mobile phone subscriptions globally, or one for every person on Earth. More than a third of these are smartphone subscriptions. Global smartphone sales are expected to have grown 18 percent in 2014, led by big emerging markets such as China, India, and Indonesia, as average unit prices fall. Mobile Internet penetration worldwide has doubled from 18 percent in 2011 to 36 percent today; by 2017, mobile access will exceed fixed-line access, with 54 percent penetration compared with 51 percent. At that point, mobile will account for almost 60 percent of all spending on Internet access.”

– Excerpt from a recent Boston Consulting Group report of   growth of global mobile internet economy

From the introduction of the iPod in October 2001 to this year’s introduction of the Apple Watch to research on self-driving cars and connected homes, technology continues to change the way we live and work.  For an aging global population, technology is also changing many aspects of the healthcare industry from diagnosis to treatment and delivery.  Client portfolios are represented in many of the leading technology, healthcare, pharmaceutical and consumer companies that are the primary beneficiaries of these changes.  Conversely, the telecom industry among others is experiencing powerful deflationary pressures with consumers increasingly wanting more services and paying less as companies compete with each other to lower prices to maintain and increase market share.  At the same time, businesses are consuming greater amounts of data each day and need to store, retrieve and manipulate far more data than before. The beneficiaries of these trends are content providers, data storage and cloud-computing companies, semiconductors and semiconductor manufacturers, and those that make amplifiers and filters that allow data to be transmitted without interference.  These devices are changing the way we live and conduct business, and therefore portfolio strategy should reflect such shifts in information and mobile technology.

Key Considerations for Investment Strategy

“In other words, just because we removed the word “patient” from the statement doesn’t mean we are going to be impatient. Moreover, even after the initial increase in the target funds rate, our policy is likely to remain highly accommodative to support continued progress toward our objectives of maximum employment and 2 percent inflation.”

–  Janet Yellen, Chairwoman of the Federal Reserve

Emerging from the financial crisis, the global system needed to reduce debt or deleverage.  Unfortunately the global economy has not been growing fast enough to outpace the cost of debt servicing and deleveraging.  To make matters worse, global debt has grown by an estimated $57 trillion to approximately $199 trillion (or 286% of global GDP) since 2007 according to a report by the McKinsey Global Institute.   Global central banks, including the Federal Reserve, the ECB and BOJ as well as the People’s Bank of China (PBOC), have been aggressively fighting the deflationary forces and buying time, but monetary policy alone has not been enough. If the growth problem just required low interest rates and monetary stimulus, then the problem would already be solved.  But the problem is structural in nature and requires fiscal policy to augment the monetary actions to increase demand, reduce unemployment and stimulate growth.  Significant changes to fiscal policy are required to support Central Bank initiatives and address the structural impediments to growth.  The combination of the economic and geopolitical dynamics discussed above strongly suggests a continuation of low interest rates, low inflation and low growth for the foreseeable future.

Core to our investment Outlook are the following six key considerations for investors in 2015:

In the past two weeks, two big economic changes and one big political change occurred in Europe.  On January 15th, the Swiss National Bank (SNB) surprised the markets by freeing its currency, the franc, from its link to the euro causing the franc to instantly increase in value and setting the stage for Switzerland’s export-driven economy to go into recession.  This recent change was in anticipation that the European Central Bank (ECB) would expand its quantitative easing (QE) program to ward off deflation and recession in the Eurozone. The ECB, on January 22nd, did exactly that announcing monthly purchases of 60 billion euros through September 2016 or until the ECB sees a sustained adjustment in the inflation rate to its target of below but close to 2%.  Then on January 25, 2015, the people of Greece elected the anti-austerity party setting up a fight between Greece and its creditors.  The SNB policy action is emblematic of the currency wars which are a consequence of insufficient global demand resulting from the lack of appropriate fiscal policy.  The ECB policy action is illustrative of the challenge facing governing institutions in the Eurozone as they attempt to address the growing imbalances, structural deflation and insufficient fiscal policy support.  The very important Greek election is the direct result of seven years of a shrinking economy which has led to record high levels of unemployment, particularly for youths. Shrinking economies have also resulted in lower living standards and increased resentment throughout the European community. This is a tipping point for Europe’s governing bodies in determining the outlook for the Eurozone.

These changes serve as a reminder of the interconnectivity and interdependency that exists not only within Europe but also within the global economy.  Monetary policy has been the primary tool used to stimulate global growth and stave off deflationary forces brought about by excess debt, overcapacity and insufficient demand.  With interest rates at record lows and still falling in many developed nations, central banks are running out of tools for policy implementation and it is time for political leadership to finally use fiscal policy and face up to the need for proper structural reforms to generate economic growth.   Our two most recent Outlooks addressed the disequilibrium in foreign exchange rates, interest rates, oil prices and inflation rates which are creating distortions in the global markets.  The key takeaways for investors from the SNB and ECB policy actions and the Greek election are:

1. Increased volatility should be expected
2. Interest rates should remain below historical norms for some time
   
3. Structural deflation should be the primary concern of central banks and governments in most developed countries and is being underestimated or perhaps confused with cyclical deflation by many government leaders and market participants
   
4. Fiscal policy needs to be more focused on addressing the structural deflation challenge, as monetary policy alone is insufficient
   
5. The transmission mechanism for the European economy has been broken due to lack of aggregate demand,  demand for loans stemming from high unemployment and an unwillingness of banks to lend
   
6. Of the developed nations, the growing U.S. economy remains best suited to deal with today’s challenges (refer to the January 9, 2015 Outlook for details)
   

Swiss Franc Currency Actions – Then and Now

“The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development. If the economic outlook and deflationary risks so require, the SNB will take further measures.”

– Excerpt from the SNB press release, September 6, 2011 

“Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar.”

– Excerpt from the SNB press release, January 15, 2015

Back in 2011, the SNB acted to defend its currency as it viewed the franc as significantly overvalued and posed the risk of deflation.  The Swiss were attempting to “achieve a substantial and sustained weakening of the currency”.   An expensive franc was hurting the Swiss economy which relies on exports for 70% of its GDP, so the SNB introduced a policy to fix (peg) the exchange rate at 1.20 per euro.  The Swiss acted to remove the peg as a large scale QE program by the ECB would have made it even more difficult for the SNB to maintain its peg.  The removal of the currency peg roiled the currency markets and led to a large decline in the Swiss stock market. Back in 2011 when the financial markets were in turmoil, safe-haven currencies like the Swiss franc were attracting significant inflows which made the currency more expensive.  As with most currency interventions, this policy helped the Swiss economy for a time as it made the franc less expensive and the economy more competitive. However, the need to print francs in order to purchase euros caused the balance sheet of the SNB to expand to a size almost equal to its GDP.  This became unsustainable for economic and political reasons.  Broadly speaking when currencies are fixed to inherently weaker currencies, they ultimately set themselves up for recession and deflation.

The ECB and the Greek Election – One Step Forward and Two Steps Back

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough… And I think the key strategy point here is that if we want to get out of this crisis, we have to repair this financial fragmentation.” 

– Speech by Mario Draghi, President of the European Central Bank, July 2012

“This assessment is underpinned by a further fall in market-based measures of inflation expectations over all horizons and the fact that most indicators of actual or expected inflation stand at, or close to, their historical lows. At the same time, economic slack in the euro area remains sizeable and money and credit developments continue to be subdued … As a consequence, the prevailing degree of monetary accommodation was insufficient to adequately address heightened risks of too prolonged a period of low inflation.”

– Remarks by Mario Draghi, President of the European Central Bank, January 22, 2015

The European region is once again at a crossroads.  At the time of the creation of the euro as a common currency, there was little, if any, recognition of the possibility of member nations having to deal with structural deflation, high unemployment, high debt levels and virtually zero interest rates as the member nations were experiencing structural inflation and growth.  In fact the developed world, until the financial crisis in 2008, had been characterized by credit-fueled growth which fostered inflation which became structural over many years.  The financial crisis effectively marked the end of the structural inflationary period as the use of credit to foster demand has shrunk to a fraction of what it was in pre-crisis times.  Europe has entered into a structural deflationary environment.  Because current economic forces present in the European economy were not contemplated at the euro’s inception, the ECB has had to rely on unconventional measures to stimulate the economy.  Today there are some positives for Europe as it is benefitting from lower oil prices which support real disposable income and corporate profits, and the region should also see domestic demand increase due to the expanded monetary measures being put in place.  However, these positives are being offset by fiscal tightening resulting from austerity policies.  In his remarks following the most recent QE announcement, Mr. Draghi stated that “the euro area recovery is likely to continue to be dampened by high unemployment, sizeable unutilized capacity, and the necessary balance sheet adjustments in the public and private sectors.”

Mr. Draghi once again highlighted the need to repair the financial fragmentation that exists in Europe. There are two critical and related factors weighing on the European economy that make the solution to this structurally deflationary environment much more difficult.  The first is the multi-country framework for the coordination and implementation of fiscal and monetary policy. Unlike in the one-country framework such as the U.S. where the central bank implements monetary policy and the treasury executes fiscal policy, the ECB has to rely on the 19 member nations to execute fiscal policy.  The second is the requirement for austerity and structural reform on highly-indebted member nations.  Given the divergences between the strong and weak economies in Europe, it is extremely hard to employ a one-size-fits-all fiscal policy as the the requirement to reduce deficits in the weaker countries has fostered an environment for anti-European political groups to gain support.  Greek voters elected a new government this past Sunday with the anti-austerity opposition party Syriza winning and moving quickly to form a coalition government.  The Greek election is an outright rejection of the core policy as devised by the country’s biggest international lenders – the European Union (EU), International Monetary Fund (IMF) and European Central Bank (ECB) also referred to as the Troika. Greece sets up another challenge for European leaders as the new Prime Minister Alexis Tsipras wants to renegotiate Greece’s debt while remaining a member of the EU.  These negotiations will be closely watched by other anti-austerity parties including members of Spain’s anti-establishment party, Podemos, which is currently leading in the polls ahead of elections later this year.  Germany has already stated that it expects the new Greek government to live up to its existing commitments to creditors. This is hardly the recipe for an end to political friction and financial fragmentation.

What this Means for Investors

Against a backdrop of a highly accommodative central bank policy in Europe, investors should expect to see increased dissatisfaction from both sides of the austerity debate as well as additional changes in party leadership in governments across Europe.  Parties representing the far left and far right will be gaining traction as Mr. Draghi’s concerns of financial fragmentation play out in the coming months with the Greek debt negotiations framing the debate as to how structural reform is addressed.  While the long-term outlook remains uncertain, investors should not be surprised to see European financial assets appreciate in the near term based on the QE program of the ECB.  As stated in our Outlook, we expect the current low growth, low inflation and low interest rate environment in the developed world to persist for a considerable period of time, perhaps through the end of the decade. The aforementioned risks to the European economies, other global risks and rising deflationary pressures may well make the Federal Reserve hesitant to raise interest rates this year.  We would use the higher than normal cash positions in client accounts to take advantage of price distortions created by increased market volatility to buy or add to quality businesses that have the ability to maintain and raise profit margins. Based on our Outlook, we continue to expect the U.S. to be a primary beneficiary, but certainly not immune to the global challenges.

As we enter 2015, the fundamental economic forces in the developed world are the strengthening of the U.S. dollar against the euro and yen, declining interest rates, collapsing oil prices and falling inflation rates.  In the developing economies, we are witnessing decelerating growth accompanied by declining currencies and rising interest rates.  These forces have led to increasing market volatility and are defining our current Outlook for investors.  Against a backdrop of a prolonged period of slowing global growth, the United States has reaffirmed its role as the most vibrant and dynamic major economy after several years in which global growth was driven by the developing world.  The U.S. resurgence is a consequence of its resilience and technology leadership as well as its reduced dependence on imported oil which are contributing to its growing productive capacity.  The U.S. is better positioned to meet its energy needs today than at any time in the past 45 years.

At the same time, risks to the international economy are growing.  In the developed world, secular deflationary challenges remain, including heavy government debt burdens, aging populations and inflexible labor markets.  We expect these headwinds to persist for some time.  In spite of efforts around the world to reduce debts and deficits, the ability of many governments to meet their obligations is being hampered by anemic growth rates and a strengthening U.S. dollar, which is making it more expensive to repay dollar-denominated debt.  Emerging economies are holding some $1.95 trillion of dollar-denominated debt out of an estimated total debt of $2.6 trillion, making debt servicing more difficult for many of these borrowers.  Moreover, many emerging and developing economies are oil exporters who depend on oil sales to help balance their budgets.  The recent 50% decline in oil prices is raising concerns about the ability of these countries to service their debts. This Outlook describes the competitive advantages supporting the U.S. growth in productive capacity relative to other nations, the ripple effects of the oil price collapse on the global economy, the near-term risks to the economic outlook and the subsequent investment implications for client portfolios.  The U.S. equity markets have performed well for several years and should continue to do so in the intermediate term because the outlook for the three elements that drive equity valuations, which are corporate profits, interest rates and inflation rates, remain favorable.  We would use any pullbacks related to international concerns as a buying opportunity because we view the current outlook to be very favorable for the US economy.  This Outlook also discusses the importance of the recent wireless spectrum auction on client portfolios.

The Growing Productive Capacity of the United States

In a world of uncertainty and economic disequilibrium, capital is flowing to the United States.  The U.S. has long been the leading economy in the world due to its productive capacity.  Productive capacity is defined as the maximum amount of products and services a nation can produce given a set of resources and constraints.  It is the relationship of what a nation is capable of producing to what it actually produces.  The productive capacity of a nation is reflected in the strength of its currency, and the U.S. dollar has recently hit multi-year highs.  Productive capacity varies greatly from country to country as it depends on several factors including:

• The quality, size and growth dynamics of its workforce
• The productivity or output of each worker which depends on education levels, training, worker skills and entrepreneurial culture
• The capital used in the production process including machinery, factories and transportation infrastructure
• The availability of raw materials and natural resources such as oil, gas, coal and iron ore
• The ability to innovate and use technology efficiently
• The institutional structures that allow business to function with dependability such as the rule of law
• The strength, depth and effectiveness of its financial and capital markets systems

While far from perfect, the United States has many advantages over its competitors starting with the Constitution which provides the foundation for our laws as well as our social, political and economic platforms. The U.S. also ranks highly on all of the factors listed above that determine productivity.  Periodically, other major nations will excel in one or two of these factors, but no nation has been as consistently represented across all of these factors as the U.S. has been.  In the 1980’s, Japan challenged the U.S. economic role for a period, but its economy has been without any meaningful growth for two decades as it struggles to fight deflation and an aging population.  For most of the past decade, China’s double-digit GDP growth was achieved through its policy of undervaluing its currency to foster export-driven growth enabling the government to accumulate more than $3 trillion of currency reserves.  This, combined with a weaker U.S. dollar and easy Federal Reserve monetary policy, drove massive capital flows to other emerging economies.  Those nations are now experiencing a painful economic adjustment as China’s growth has steadily slowed in the past two years and it is now focused on domestically-driven growth rather than export driven.  China’s success was in part due to its low labor costs which have risen significantly and no longer provides the same competitive advantage.  On the other hand, the reduced reliance on foreign oil imports and the reduction of energy costs has benefited the U.S. manufacturing sector and the consumer who accounts for 70% of the U.S. economy.  Today, the U.S. is more economically autonomous than it has been in many years.

Europe has been struggling since the financial crisis to avoid deflation as its complex and fragmented governance structures make it difficult to form consensus on fiscal and monetary policy among the 18 member nations (19 with the recent addition of Lithuania).  The diverging economic fortunes of its member nations continue to foster political and social stresses which are adding to the inability to gain traction in the Eurozone and are creating instability in the region.  Europe’s financial system is not functioning effectively as efforts by the European Central Bank (ECB) to stimulate lending with record low interest rates have not proven effective as banks are not lending enough.  On January 22, 2015 the ECB will meet again and could announce a program to make large-scale asset purchases to pump money directly into the economy.  This policy action, depending on the amount, could well provide a boost to European asset prices.  So while Europe benefits as a commodity consumer from lower energy prices, the drop in oil prices also adds to the deflationary forces the ECB is trying to counteract.  Europe continues to face restructuring issues which are limiting its ability to improve its productive capacity.  It continues to be hampered by a lack of investment, an aging labor force, high labor costs and lack of labor mobility, skills mismatches and poor demographics.  Chronic youth unemployment in many European nations not only impacts the current outlook for growth, but also mortgages the future productive capacity of the region.

The global divergences are being expressed by different central banks’ policy actions.  The Federal Reserve has kept a low interest rate policy to stimulate growth, the ECB has implemented an inadequate policy to prevent deflation, while the Bank of Japan has embarked on a highly accommodative policy to end deflation and promote growth. Further limiting the growth potential of Europe are the economic sanctions imposed on Russia which are particularly difficult for the German economy, Europe’s biggest and most productive.  These divergent policies are leading to greater market volatility, and we view any market weakness as opportunity to benefit from the continuing growth of the U.S. economy.

The Importance of Wireless Spectrum Auction for Portfolio Strategy

“We’re talking about a platform that is still growing by leaps and bounds – five times as many devices in front of us – and the categories of devices are undergoing a huge evolution, I really try to look at what are the sensors on these new devices, as they enable us to reimagine experiences.”

– Adam Cahan, Senior VP of Mobile for Yahoo on mobile devices

People living in major cities or rural areas of the United States have experienced the frustration of dropped phone calls, crossed lines or delays in downloading data and videos also known as “buffering” as the demands on the system have been overwhelming the networks.  Data usage has grown fivefold over the past five years and is expected to triple over the next five years according to network-equipment maker Cisco.  Looking ahead, Cisco projects that global internet traffic in 2018 will be equivalent to 64 times the volume it was in 2005.   An industry trade group CTIA report cited that U.S. data usage grew over 700% to 388 billion megabytes from 2010 to 2013.  As 3G and 4G networks advance globally and as wireless traffic increases, carriers need to increase the amount of wireless spectrum because we are consuming and sharing far greater volumes of data over smartphones, tablets and increasingly in cars and other devices.

Gartner, a technology research firm, predicts that device shipments will exceed 2.5 billion in 2015 according to a June 2014 research report with PCs and tablets exceeding 600 million and mobile phone shipments over 1.9 billion.  The use of these devices and the associated demand are having a profound impact on capital expenditures of businesses as evidenced by the recent wireless spectrum auction in the U.S. To help service providers meet the growing needs of U.S. businesses and consumers, the Federal Communications Commission (FCC) recently held an auction this past November and December  for licenses for wireless spectrum to allow service providers to handle increasing growth of data usage and to offer more reliable wireless service.  The auction was for spectrum designated as Advance Wireless Services or AWS-3 spectrum, which is well suited for downloading videos, and works particularly well in densely populated cities. The wireless spectrum auction was expected to raise about $18 billion, but actually raised over $44 billion with Verizon, AT&T, T-Mobile, and Dish likely among the major bidders.   These companies are under intense competitive pressure to provide customers with faster speeds, increased data volumes and all at lower costs.  The telecom industry is experiencing powerful deflationary pressures with consumers increasingly wanting more services and paying much less as companies compete with each other to lower prices to maintain and increase market share.   Businesses are consuming greater amounts of data each day and need to store and retrieve far more data than before.   The beneficiaries of these trends are content providers, data storage and cloud-computing companies, semiconductor manufacturers, and those that make amplifiers and filters that allow data to be transmitted without interference.  Some industry estimates suggest that there will be 5 billion mobile phone users globally in 2017 with 2.5 billion smartphone users.  These devices are changing the way we live our lives and conduct business, and therefore portfolio strategy should reflect shifts in mobile technology.

The Ripple Effects of the Oil Price Collapse

“It is not in the interest of OPEC to cut their production, whatever the price is. Whether it goes down to $20, $40, $50, $60, it is irrelevant.”

– Mr. Ali al-Naimi, Saudi Arabia’s Oil Minister speaking to the Middle East Economic Survey

As the quote above indicates, there is a high probability of oil prices remaining lower for longer than many expect.  In the October 31st Outlook, we described the supply and demand dynamics of the oil market putting downward pressure on oil prices.  The supply-demand imbalance that caused the sharp decline in prices does not seem likely to be corrected any time soon barring a major supply disruption, which given the geo-political situation in the Middle East should not be underestimated.  Importantly for investors, the ripple effects of the oil price collapse are just beginning to be felt by the global economy as revenues shift from oil-producers, countries and companies, to oil-consumers.  The U.S., Europe, India, China, Japan and Turkey are large oil importers and the lower costs will help their economies and improve their trade balances all other things being equal.  Some oil exporters, on the other hand, are in a highly compromised and significantly weakened financial position as outstanding dollar debts will be difficult to service as the dollar continues to strengthen and their oil receipts decline.

Beneficiaries

Among the biggest winners is the United States which is best positioned to take advantage of the price decline as the world’s largest energy consumer.  Additionally the lowest-cost OPEC producers (Saudi Arabia, Kuwait and the United Arab Emirates) have the largest monetary reserves, $1.5 trillion collectively and have the ability to maintain and gain market share in a low-price environment which could last longer than many believe.  The U.S. industries benefitting from lower prices include specialty-chemical, packaging and container, housing and home-furnishing, restaurants, financials, automobile and auto-related, transport and travel-related companies.  Manufacturing plants are also benefitting from lower energy input costs which are helping to attract foreign companies to relocate plants to the United States.   For the U.S. consumer, it is estimated that the lower prices for gasoline at the pump, below $2.00 in parts of the country, are adding an estimated $200 billion this year to consumers’ wallets.

The Challenge for Commodity Producers

The reversal of a commodity boom is painful and swift, and the adjustment process is even more challenging for economies with an over-reliance on commodity prices to meet these nations’ budget and debt obligations.   According to the Russian Finance Minister Anton Siluanov, the Russian economy could contract by 4 percent next year and their budget could have a deficit of more than 3 percent of gross domestic product if Brent oil prices average $60 a barrel.  For oil producing nations, the decline in prices means lower revenues which tend to increase deficits while reducing investment and increasing unemployment and social stresses.  For nations that require higher oil prices to balance their budgets, the ability to service debt comes into question particularly if those debts are denominated in appreciating U.S. dollars as evidenced by the recent downgrade of Russia by S&P. The effect of the rapid decline in oil prices is also being seen in Russia’s currency, the ruble, which has declined over 40% recently and forced its central bank to raise its benchmark interest rate to 17%.  Russia is flirting with economic disaster due to the combined effects of economic sanctions imposed by the Western governments and the impact of the oil price decline as oil revenues account for between 50-60% of its budget.  Another “bad actor” is Iran which is losing $1 billion a month in oil revenues for an already troubled economy.   Additionally Brazil’s currency, the real, has lost more than 17% of its value and pushed the central bank to increase interest rates by 4.5%.  The nation has also experienced massive capital outflows with rising inflation and growing social and political stresses.  At home, the states that have been involved in the U.S. energy renaissance the past few years such as Montana, North Dakota, Colorado, Oklahoma, Louisiana and Texas will be impacted as lower prices translate into lower revenues, slowing growth, less investment spending and diminished employment opportunities.

The Capital Market Impact

The impact of lower oil prices is also beginning to be felt in the capital markets as energy companies have borrowed more than $550 billion since 2010, and have recently represented over 15% of high yield debt issuance.  Lower oil prices call into question the ability of some of the producing nations and marginal producing companies to meet their debt obligations which could lead to write downs for the lenders (banks).  The high-yield bond market is projecting that default rates on energy-related bonds will increase dramatically. The knock-on effect will impact banks and some foreign governments as well.  For example, the Brazilian government with its high levels of dollar-denominated debt is exploring ways to assist Petrobras, its leading oil company, to meet its debt obligations.  Petrobras has approximately $189 billion in debt, much of which is held in bond funds at major U.S. mutual fund companies.  In addition Russia’s state-owned oil companies are tapping into the government to help meet debt obligations, and its two sovereign wealth funds will be stretched to meet these debt obligations as well as support the broader economy. It is estimated that Russian banks and companies owe foreign creditors more than $600 billion, a problem that becomes more serious as western sanctions bar most of these borrowers from refinancing with U.S. or European banks.  For Venezuela, oil accounts for an estimated 90% of export revenues and some estimate that the country needs oil prices of around $100 a barrel to balance its budget.  In order to help offset the revenue losses, Venezuela must increase its production.  Credit default swaps suggest that the likelihood of a Venezuelan default within the next two years is around 70 per cent.   As oil prices rose the past few years, debt investors have benefitted. The question on the minds of creditors now is what happens if prices remain low for an extended period?

A Potential Game Changer for the Middle East

The potential exists for a redrawing of the map of the region which was established by the Sykes-Picot Agreement of 1916.  This agreement was the basis for the subsequent carving up of the predominantly Arab countries of the region between the British and French following the anticipated collapse of the Ottoman Empire.  One of the flaws of the agreement was establishing arbitrary borders for the people of the region without understanding the existing religious, tribal and sectarian differences.  As we enter 2015, the economic hardships created by the decline in oil prices will add to the social stresses in the region as government instability, high unemployment, rising inflationary pressures, ongoing corruption and growing sectarian differences are the tinder for a potential blow up that could draw economic and military powers into a conflict.

While promoting aggression and instability with its neighbor states, Iran is negotiating to have the western sanctions that were imposed over its nuclear program lifted by the June 2015 deadline.  Even before the oil price collapse, these sanctions were having a devastating effect on the economy.  Given the potential for prices to remain low or even go lower, the incentive for Iran to strike a deal with the west to remove sanctions is high as it would allow Iran to sell more crude and access its frozen foreign exchange reserves.  With the world’s fourth largest oil reserves, Iran could significantly increase production adding up to 2 million barrels per day into the market.  The Saudis might counter by increasing production to drive prices down even further in order to protect their national interests and market share.  The Middle East has been one of the most volatile regions in recent years as the economic consequences of the Arab Spring, the ongoing civil war in Syria, the rise and aggression of ISIS or ISIL, and many leadership changes in almost every nation have sown the seeds for major changes in the area.

Near-term Risks to the Global Economic Outlook

As a result of the current divergences in the global economy, the near-term risks to the outlook involve depreciating currencies against a strengthening dollar.  This could increase credit default risks by oil exporting nations such as Russia, Venezuela and Malaysia, and have the potential to roil credit and derivatives markets.  Another risk is that the lower oil prices prompt a physical or cyber-attack on a leading oil producer which would immediately cause prices to spike.  Budget needs will force some countries, with excess production capacity, to put more oil into the market to compensate for the lower prices which will add further to downward price pressure on the oil market.  In either case, lower oil prices or a price spike will cause further economic adjustments.

From a geo-political perspective, Europe risks a change in the status quo if the anti-austerity movement gathers momentum and gains political traction against current European austerity policy. This will likely accelerate the deflationary pressures, further weaken the euro currency and make it more difficult for the ECB to have a more aggressive monetary policy.  The anti-austerity movement could force a modification or less likely a break-up of the European Union.

For many emerging economies, a rapid rise in the U.S. dollar will be a negative, raising the cost of imports, increasing inflationary pressures and further promoting capital outflows.  As a result, the markets face the potential for increased volatility early in 2015.

Investment Implications

We expect the current low growth, low inflation and low interest rate environment to persist for a considerable period of time – perhaps even through the rest of the decade.  The aforementioned risks to the global economy may well make the Federal Reserve hesitant to increase interest rates this year.  Notwithstanding the potential for a market pullback in the first half of 2015, the conditions for 2015 are positive for equity markets as an enduring low interest rate structure coupled with rising corporate profits is constructive for equity valuations.  We would use higher than normal cash positions to take advantage of any pullbacks stemming from potential capital market disruptions.  Current economic conditions are supportive of U.S. corporate profits, which should in turn lead to increasing capital expenditures, gradual improvement in employment, and a further strengthening in equity returns relative to other investment choices.  Short of an exogenous event, the current positive trends in place are supportive of equity valuations and further multiple expansion, particularly in the second half of 2015.  After the strong returns in the stock and bond markets in recent years, today’s investment opportunities will require greater selectivity, with bond investing offering little in the way of current compensation due to the low level of today’s yields.

The persistent deflationary pressures present in the global economy argue for a broadening of portfolios targeting the drivers and beneficiaries.  This past quarter, we have reduced our weighting in energy holdings.  Technology remains a disruptive and deflationary business as it increases productivity and hence demand for its products, and as such will remain an overweight in the portfolio.  As corporate profits continue to improve and companies take advantage of low rates to finance debt, investors should expect increasing capital expenditures with tech and infrastructure companies to be among the primary beneficiaries as well as continued merger and acquisition activity.  Client portfolios will reflect the beneficiaries of this Outlook including:

“No one in society remains untouched by a situation of high unemployment. For the unemployed themselves, it is often a tragedy which has lasting effects on their lifetime income. For those in work, it raises job insecurity and undermines social cohesion. For governments, it weighs on public finances and harms election prospects. And unemployment is at the heart of the macro dynamics that shape short- and medium-term inflation, meaning it also affects central banks. Indeed, even when there are no risks to price stability, but unemployment is high and social cohesion at threat, pressure on the central bank to respond invariably increases.”

Excerpt from Jackson Hole speech by Mario Draghi, President of the ECB, 8/22/14

The United States has the most positive economic outlook among the developed nations. Each quarter U.S. corporations continue to report strong and rising earnings in the face of tenuous and uneven global growth.  U.S. corporations and consumers will continue to benefit from persistently low interest rates and declining commodity prices which are positives for the outlook and equity investments.  For several months, Chair Janet Yellen and the Federal Reserve have been the primary focus of the markets, but in recent weeks the attention has shifted to Germany and the European Central Bank (ECB).  Mr. Draghi’s above-referenced comment from his Jackson Hole speech captures the key challenge facing not only Europe, but the many leading nations as each struggles to get its economy on a sustainable growth trajectory.  Developed nations are fighting high unemployment while deleveraging, and emerging market economies are adjusting to slowing growth and capital outflows in a rising dollar environment.  The fears of Europe slipping into a recession are leading to broader concerns about deflation and a material slowing of global growth with the outbreak of Ebola also disquieting the markets.  The weakness in the global economy has been evident in the decline of oil and natural gas prices, global bond yields and stock market indices.

The last Outlook (August 8, 2014) described an environment of mounting deflationary pressures in the global economy which were promoting lower inflation, lower commodity prices and foreign currency weakness.  With interest rates already at historically low levels and the Federal Reserve moving gradually closer to a less accommodative policy, the pressure is building for government leaders, especially those in Europe, to quickly implement pro-growth initiatives while supporting the structural reform agendas required for sustainable, long-term growth.  In order to avoid slipping into a global recession, raising current and future growth should remain the top priority for governments in the developed and developing world as high unemployment and indebtedness have led to a system beset by significant excess capacity, stagnant wages, and growing social stresses.  Unfortunately, policy makers have been unable or unwilling to address the issues due to either political ideology or a lack of sufficient understanding of economics.

Global divergences and stresses are challenging the mindset of citizens who are becoming increasingly disillusioned with the status quo.  From Scotland to Catalonia to Hong Kong to the Middle East, people are expressing dissatisfaction with government leaders as the world continues to struggle to recover from the “Great Recession” that began in 2008.  Weighing heavily on the world’s population are ineffective political leadership, incorrect or insufficient fiscal policies, anemic growth, high unemployment, corruption and the general frustration with the lack of progress in dealing with the issues facing many countries.  People are dissatisfied with the lack of government policies to address income inequality, create jobs and improve overall living standards. To date, much of the burden to address the economic challenges has fallen on central banks, particularly the ECB, the Federal Reserve, the Bank of England (BOE) and the Bank of Japan (BOJ).  In the recently-released World Economic Report (October 2014), the International Monetary Fund (IMF) lowered its 2014 forecast for global growth by 0.4% to 3.3% and its 2015 forecast by 0.2% to 3.8% which reflects the downside risks to the global economy at this time.  It has been clearly demonstrated that monetary stimulus alone is not enough and that thoughtful, pro-growth fiscal policy initiatives are essential.

This Outlook addresses key issues impacting investment decisions today including the global need for fiscal policy adjustments, global infrastructure investments, the strengthening dollar, thoughts on the oil market and the investment implications of the current environment.  The recent market pullback notwithstanding, ARS believes that the United States continues to be one of the most solid growth opportunities globally, and that as the market adjusts to the concerns discussed in this Outlook, investors should take advantage of equity valuations which have become more attractive.

Fiscal Policy Adjustments

“The aggregate fiscal stance must be supportive of aggregate demand in the current cyclical position, this can and should be achieved within the existing rules… Simply put, I cannot see any way out of the crisis unless we create more confidence in the future potential of our economies. Reform and recovery are not to be weighed against each other. The combination of policies is complex, but it is not complicated. The issue now is not diagnosis, it is delivery. It is commitment. And it is timing.”

  Except from Mario Draghi, Brookings Institution, 10/9/14

As concerns of the European economy slipping into recession rise, one of the biggest challenges facing governments is balancing policies to reduce deficits with those to stimulate growth.  Monetary policy has been the primary tool for developed nations to stimulate economic growth following the financial crisis, but it alone has not been enough to achieve a sustainable recovery. This is particularly true in Europe where the lack of a unified institutional structure has made it difficult to implement the policies necessary to foster a sustainable recovery.  This month’s German export numbers disappointed adding to recession and deflation fears as the effects of the sanctions against Russia and general slowing in Europe are reducing its growth potential. The German business confidence IFO Institute survey dropped for the sixth consecutive month providing further evidence that an adjustment process is underway.  Germany has been one of the most productive economies in the world as well as the economic anchor for Europe.  Angela Merkel stood tall politically in leading the European efforts to deal with the ongoing Russian aggressions in the Ukraine.  Germany has also been a strong voice in favor of forcing strict adherence to structural reform targets for the European Union, and its finance minister has been at odds with the ECB with respect to the appropriateness and legality of quantitative easing.

Fiscal policy issues are a key topic for world leaders, but more so for those in Europe as philosophical and ideological differences in approach to solving the problems remain critical impediments to the European recovery.  Because Europe does not have deep and liquid capital markets, it is more dependent on fiscal policy to promote the needed growth as the private sector cannot access capital as easily as can corporations in the United States.  France, Italy and the ECB have very different views from Germany regarding their rigidity in adhering to budget targets based on current economic conditions as each nation has submitted budgets above European Union mandated targets.  A policy of continuing austerity in Europe will guarantee more contraction for the federal governments.  The insistence on a balanced budget in a contracting economy will result in lower living standards, decreased tax revenues, and greater deficits.

It remains to be seen whether a recession in Germany would lead it to change its views with respect to allowing greater flexibility in fiscal policy and be more supportive of the ECB’s efforts to adopt a more stimulative monetary policy (quantitative easing).  France, Italy and the ECB have joined forces in insisting that Angela Merkel and Germany change course on fiscal policy to stimulate growth.  Time is not on Europe’s side as the political and ideological standoff is taking a toll on its people and its economies and fracturing support for the euro.

The Global Need for Infrastructure Spending

“By failing to recognize the proper role of public investment, it has pushed governments to stop building infrastructure just when they should have built more.  What is needed is not the flexibility to deviate from the rules, but rules that are economically and morally rigorous. The virtue of fiscal discipline is that it protects future generations from the abuses of current politicians… If that country decides to forgo such investment, as Germany is doing today, is it not acting against the interest of future generations?”

  Mario Monti, former Prime Minister of Italy

It has been suggested by many that one of the best initiatives to move towards sustainable global growth would be to increase infrastructure spending.  In a 2013 report, the McKinsey Global Institute (MGI) estimated that $57 trillion in infrastructure investment will be required to be spent by 2030 just to keep up with projected global GDP growth which is equivalent to an amount nearly 60% more than the $36 trillion spent globally on infrastructure over the past 18 years.  Investments in roads, rails, ports, airports, power, water, and telecommunications infrastructure have averaged about 3.8% of global GDP or $2.6 trillion annually and would need to rise to about $3.35 trillion over the same period.  MGI estimates that “the $57 trillion required investment is more than the estimated value of today’s worldwide infrastructure.” As we have written about for many years, the United States also has significant infrastructure issues that have been neglected for far too long with an estimated spending requirement of $3.6 trillion by 2020 to maintain the U.S. infrastructure.  In its October World Economic Outlook, The International Monetary Fund (IMF) supported a substantial increase in well-designed, public infrastructure investment in much of the world. The IMF report cited that $1 of infrastructure spending increases output by nearly $5, puts many unemployed to work, creates tax revenues and increases productivity.  The study suggested that infrastructure investment is especially effective when excess capacity exists so that the spending does not come at the expense of other initiatives.

With growth opportunities so large and the cost of capital so low, it is regrettable that governments in partnership with the private sector are not taking advantage of the unique opportunity to reverse these trends.  With interest rates at historic lows, the opportunity exists for countries like Germany and the United States to finance infrastructure spending with low-cost debt to foster economic expansion.  The IMF report stated that Germany has the budgetary leeway to raise spending on items such as road and bridge maintenance by half a percentage point of its approximately $3.5 trillion GDP per year over 4 years which equates to more than $67 billion.  Kurt Bodewig, a former German transportation minister, led a federal commission that recommended Germany must spend $9.7 billion a year more on infrastructure just to maintain its current network, while the budgeted plans were for less than $2 billion. Similar to the United States, about half of Germany’s bridges and one-fifth of its highways are considered to be in poor condition.  This type of spending would increase productivity and raise living standards in Germany, while having a positive spillover effect on the slower-growing Eurozone nations.

Lawrence Summers, the former U.S. Treasury Secretary, wrote in a recent article in the Financial Times that, “If we are entering a period of secular stagnation, unemployed resources could be available in much of the industrial world for quite some time. While the case for investment applies almost everywhere – possibly excepting China – … the appropriate strategy for doing more differs around the world.”  Emerging economies need more spending, but the key is choosing the right projects that will be productive. The same holds true at home in the United States.  New York City is one example of the challenges facing the U.S. as damage caused by Hurricane Sandy to the four century-old rail tunnels will disrupt travel for commuters for at a few years between Manhattan and Long Island.  Additionally, the two tunnels under the Hudson River were also damaged and the repairs could reduce capacity by 75% for several years.  The total costs of repairs are estimated at $689 million for these projects.  Elsewhere China and 20 other nations recently agreed to create an infrastructure development bank to offer financing for infrastructure projects in underdeveloped countries across Asia.  China has promised to contribute $50 billion in capital as part of a much larger fund.  In 2009 the Asian Development Bank estimated that the region would need $8 trillion in infrastructure investment by 2020.   ARS has written extensively about the need for infrastructure spending that is critical to ensuring a more productive society while reducing political and social instability.

Elements of Disequilibrium

Globalization and technology have many implications for the world economy with the primary characteristics of making the world smaller, more interconnected and interdependent.  Global trade and capital flows cross borders at far greater speeds than previously experienced.  The disequilibrium in foreign exchange rates, oil prices, interest rates and the deflationary pressures are being reflected in greater market volatility.  In the short term, market participants are adjusting to these shifts, and the world works in such a fashion that each action causes a reaction in the areas we have identified above.  While some had predicted the recent decline in oil prices and interest rates, few had anticipated the rapidity of the decline and reversal of the U.S. 10-year Treasury yield.  Moreover the rise of the U.S. dollar versus the euro occurred as a consequence of the European Central Bank working to reduce the Eurozone’s labor costs by devaluing the euro  to stimulate its economy.  This was accompanied by the view that the Federal Reserve will raise interest rates sooner than later.  There have been concerns about the effect of an increase in U.S. interest rates on the global economy because a rise in U.S. interest rates would draw capital to the United States strengthening the dollar further and increasing deflationary pressures on the European economies and other nations.  This is a particular fear of the emerging and commodity-producing economies as they are already dealing with the economic impact of China’s slowing growth.

Another example of the disequilibrium relates to Russia which has experienced approximately $75 billion of capital outflows for the first 6 months of 2014 and will need to continue to draw on its currency reserves to fund its government spending and support its currency, the ruble. In order for Russia to preserve its currency reserves, it may be forced to stop supporting its currency which would lead to further devaluation of the ruble and increase inflationary pressures.  Moreover in response to the sanctions, the Russian government has reacted by taking an aggressive stance against dozens of Fortune 500 companies.  The imposition of sanctions on Russia has slowed trade for Europe and Germany in particular.  In response to the sanctions, Russia has negotiated new trade agreements with China to help fill the void.

The Strength of the U.S. Dollar Highlights Growing Divergences

Against this backdrop, the United States remains the standout economy as evidenced by the strengthening of the U.S. dollar and the record levels of profits of U.S. corporations, but it is not completely insulated from a further decline in global economic activity.  It is important to emphasize that the United States remains the best positioned major economy, and a U.S. recession is hard to envision given the industrial activity that is currently occurring and the future spending that is required to accommodate the move towards energy independence.  The dollar’s strength can be attributed to the following factors:

1. Better Relative Economic Outlook – the U.S. has been recovering at a faster pace and continues its modest rate of growth, especially when measured against economies of Europe and Japan.
   
2. Productivity Gains – fostered by low energy prices, technological improvements, increasing economic activity and improving profit margins leading to record profits for U.S. corporations.
   
3. Safe Haven Status – as often happens in times of uncertainty, capital flows to the U.S. due to its deep and liquid capital market system, its standards for rule of law and reserve currency status.
4. Relatively Higher Interest Rates – the 10-year U.S. Treasury bond is yielding significantly more than the 10-year bonds of developed nations including Japan, Germany and France. The yield advantage is attracting significant capital flows to the U.S. which strengthens the dollar and places downward pressure on yields.
   
5. Lower Commodity Prices – the recent decline in oil, industrial metals, food and gasoline prices have benefitted our consumer-driven economy by putting more discretionary dollars into the pockets of consumers.  Gasoline prices have dropped by 54 cents since the beginning of the year with some regions recently reporting sub $3 prices at the pumps. Lower oil prices have also been a huge boon for U.S. industrial companies as it highlights the important cost advantages relative to other nations thereby putting these companies in a stronger global competitive position.
6. Desire by the ECB to Devalue the Euro – the ECB is attempting to weaken the euro to make the Eurozone economy more competitive globally as the required structural changes have been slow to materialize.

Updated Thoughts on Energy and Inflation

In the past three months, the price of Brent has declined from around $110 to around $85, while the price of WTI has declined from around $100 and is currently just above $80.  This decline can be attributed to several primary factors including slowing global demand, increasing supply driven primarily by the energy revolution in the U.S. and growing Organization of the Petroleum Exporting Countries (OPEC) member discord.  OPEC produces about a third of world oil supplies and historically has acted to stabilize prices during supply disruptions.  Recently Saudi Arabia, the world’s leading oil producer, implemented a unilateral price decrease for crude deliveries without consulting other members of OPEC in an effort to maintain market share in the face of increased production from the U.S.  Historically, the Saudis would adjust output to keep prices stable, but this present move sent prices lower.  From an economic perspective, a handful of OPEC members such as Saudi Arabia and Kuwait can afford lower prices, but many OPEC and non-OPEC producers cannot.  The drop in oil prices is particularly worrying for OPEC producers in Latin America and Africa that depend on oil revenues to support their budgets.  It also has the effect of extending the long-term value of Saudi Arabia’s reserves while reducing the economic viability of high-cost exploration and production.  Two of the biggest beneficiaries of lower oil prices are the U.S. consumer and energy-starved China.  An added benefit of the Saudi price decrease is that it gives them an opportunity to grab greater market share of Chinese energy demand as the lower prices discourage the Chinese from pursuing alternative sources to meet their energy needs.  While China is reducing its reliance on coal as a primary source of energy, the European sanctions on Russia combined with lower Brent crude prices come at an opportune time as China is taking advantage of the price decline to add to its Strategic Petroleum Reserves and has formalized a long-term energy deal with Russia likely at very favorable terms.

There is another critical issue driving the Saudis to promote a lower price.   The United States and Saudi Arabia are in effect waging an economic war on “bad actor” nations.  Russia’s Putin, the leadership in Iran and the terrorist group ISIS, each use oil revenues to fund aggressive actions and each requires high prices to fund their budgets and initiatives.  It is believed that Russia’s budget for 2014 is based on oil prices of $117 per barrel (oil revenues are approximately 50% of the budget) and its economy is already suffering from the sanctions imposed by Europe and the U.S.  Iran’s supreme leader, Ayatollah Ali Khamenei, also relies heavily on oil revenues to fund the economy, and Iran is in talks with the West to have its sanctions reduced as part of nuclear negotiations.  So declining oil prices only add to the economic and social problems facing these nations.  Geopolitical stresses in the key producing nations in the Middle East and Africa continue to add uncertainty to supplies from these regions as evidenced by the swings in output from Libya, Iran, Iraq and Nigeria.  Brazil and Venezuela are also struggling with high-cost projects and political disharmony.

The energy revolution in the United States has been a key factor for oil prices as the country continues to increase its production and reduce its imports of oil.  To put this in perspective, U.S. production has grown in recent years by nearly 3.3 million barrels per day which is an increase equivalent to the production output of Iraq, one of the world’s largest producers. It is anticipated that the U.S. will add an additional 1 million barrels of oil next year which must be absorbed by the markets tending to put downward pressure on prices.  Absent a major supply disruption, such as an attack on a major production facility in Saudi Arabia or Kuwait or a decision to dramatically cut production by a leading nation or a significant reversal in global growth trends, we anticipate an increased probability of downward pressure on global oil prices.

Investment Implications

After several months of below average volatility, the markets are adjusting to the global disequilibrium discussed in this Outlook. From a portfolio perspective, rising deflationary pressures argue for a broadening out of portfolios targeting the drivers and beneficiaries of those pressures.  We have harvested some tax losses and raised some cash in accounts in the past month.  We have been lightening our weighting in energy holdings while continuing to focus on those companies with strong reserve replacement and high growth projects which are, by the nature of their business characteristics, attractive merger and acquisition candidates.  Also technology remains a disruptive and deflationary business as it increases productivity often at the cost of jobs, and as such will remain an overweight in the portfolio as will industrial companies.  As corporate profits continue to improve and companies take advantage of low rates to finance debt, investors can expect increasing capital expenditures with technology and industrial companies to be among the primary beneficiaries.  The decline in commodity prices brought about by the end of the China-driven commodity boom has shifted the focus from commodity producers to commodity consumers.  U.S. industry and the consumer are big beneficiaries of lower interest rates and lower energy prices. Other common themes for businesses are their focus on improving safety, productivity, efficiency and increasing environmental awareness.  Our research continues to identify leading businesses that stand to benefit from these trends.

During times of higher volatility, it is important to bear in mind that quality securities can have large price movements that reflect the structure of today’s markets which involve fast money and leveraged speculation as hedge funds with total assets of $2.8 trillion and Exchange Traded Funds (ETFs) are focused on taking advantage of short-term market moves.  Great businesses can then become temporarily mispriced distracting investors from the true underlying value of these assets while creating great buying opportunities.

From an economic perspective, we expect the current low growth, low inflation and low interest rate environment to persist for a considerable period of time – perhaps even through the rest of the decade.  While the United States will be among the standout economies with growth rates at or above the global average, the Federal Reserve will be hard pressed to raise rates meaningfully unless the U.S. economy becomes much stronger and global growth accelerates.  Under these conditions the Federal Reserve will be hesitant to increase interest rates much next year if at all.  We see positive dynamics driving corporate profits over the next 12 months.

The U.S. remains the best major economy with many significant drivers which will continue to propel corporate profits and the economy in the later part of this year and next as long as the country remains in a low growth, low interest rate and low inflation environment.  Based on current forecasts for the mid-term elections which call for a Republican congress, it is conceivable that positive changes could occur in the areas of trade, some tax reform and regulation.  Even with the challenges described in this Outlook, we are positive on the U.S. continuing to demonstrate its economic leadership as it benefits from the most innovative, entrepreneurial society in the world, the most liquid capital markets and positive demographic characteristics. Investing in U.S. equities should continue to be rewarding for those who approach security selection as the purchase of businesses and who take advantage of opportunities presented by today’s volatile markets.

The market has reached record levels this year in the face of geopolitical events in Ukraine, the South China Sea and throughout the Middle East, which in other economic cycles would have likely led to a significant pullback.  Clearly, the current market is being driven by other forces.  Russia’s aggressiveness in Ukraine and conflict in the Middle East now pose major risks to political stability.  While the term “complacency” has been used to describe the stock and bond markets this year, we believe that today’s market reflects a more complex set of dynamics resulting from the combination of a prolonged low-growth economic expansion, a lack of sensible alternatives available for investors (given the low and declining yields on fixed income) and the deflationary forces which exist in the global economy.  The disequilibrium present in the global economy continues as the major economies struggle with muted growth due to excess capacity and debt in the system.

Against this backdrop, the United States remains the standout economy as these global forces are being countered by record and growing U.S. corporate earnings, cash balances and profit margins.  The U.S., which was the first major economy to enter a recession during the financial crisis, has been among the first to recover due to the resilience of the economy and aggressive policy actions. U.S. corporations are using their strong balance sheets to invest heavily in technology to increase productivity and to maintain or reduce labor costs.   The China-led emerging economies in contrast are dealing with the problems of slowing growth, rising debt levels, capital flows and ongoing concerns about social unrest.  Europe is in the early stages of what appears will be a lengthy fight to implement the structural changes required to make the region competitive, while at the same time battling significant deflationary pressures and struggling to reduce debt burdens.

We are now at a point where the growing divergences in the global economy are complicating policy decisions as deflationary pressures appear to be mounting in some areas highlighting the need for a continued easy monetary policy.  The size and duration of central bank policies have created uncertainty and made investment decisions more dependent on these policies than in previous periods.

Global deflationary pressures are being brought about by two primary forces: the mismatch in aggregate demand/supply and the impact of global deleveraging.  Excess capacity in labor markets has become a structural problem and employment/wages have not recovered to acceptable levels.  Wage increases have always been a major element in creating inflation where productivity improvements have not kept pace.   The low cost of capital continues to encourage corporations to substitute technology for labor, which increases deflationary pressures and has the effect of muting wage gains and therefore growth.  A technology-driven expansion has also made it difficult for many companies to increase prices.  A prolonged low-growth expansion would allow employment and wage growth to return to an acceptable level, which in turn would allow for the necessary deleveraging to occur and utilize the excess capacity in the system.

Importantly, while investors and the media speculate as to when the Federal Reserve will begin to raise interest rates, we are more focused on the pace of the eventual increases rather than the timing.  Based on the conditions that presently exist, it is our view that the pace of increase could well be slower than currently anticipated as slow economic growth is not supportive of either the speed or degree of increases witnessed in past rising-rate cycles.  Due to the fragility of the U.S. and global economies, the deflationary pressures and debt burdens as well as the unemployment/wage problems mentioned above, it is difficult to envision a scenario in which central banks could raise rates significantly and have the system maintain a growth trajectory.  Therefore the critical ingredient to address the current problems of the U.S. and Europe is to have an extended period of growth that is sufficient to avoid a Japan-like deflationary scenario but not so strong as to ignite inflation which would raise interest rates and stifle the expansion.

Due to the unique nature of the problems and solutions, many investors have been hesitant and confused about how to act to preserve and build capital as well as protect purchasing power.  This Outlook addresses the most common questions being asked by our clients today, and offers a roadmap for investing in this uncharacteristic cycle.

Following the downing of Malaysian Flight 17 in Ukraine, Europe and the U.S. imposed new sanctions on Russia that are creating an additional headwind for the European economies and posing a risk to global growth.  Germany is one of Russia’s largest trading partners, and Angela Merkel has chosen to accept near-term economic consequences in order to send Vladimir Putin the strongest message to date that Russia’s actions are not acceptable to the global community.  This is important because Mr. Putin has given indications that he would like to see Russians living in reunited Russian republics, so his aggression may not stop with Crimea.  The sanctions will result in some additional slowing of European growth, which can in turn weaken the Euro, suppress government bond yields, and further add to the structural challenges facing the European nations.

The sanctions come at a bad time for the European Union as it is struggling to form a common view for resolving the issues between the stronger and weaker members.  The region has to undergo significant structural reform as the employment issues in the chart above illustrates.  Overall unemployment remains a significant challenge.  For example, Spain likely faces 4 more years of 20% or greater levels of unemployment with long-term unemployed estimated to be 3.5 million and youth unemployment still in excess of 50%.  Based on the levels of youth unemployment in Spain, Italy, Portugal, Greece and Ireland as shown, Europe has a major unemployment problem across the broad population and also risks losing the productive capacity of a portion of the future generation as well.  This situation will require a prolonged period of steady growth supported by lower than historically normal interest rates and inflation rates.

What will happen when the Federal Reserve finally begins to raise Interest Rates?

Investors are focusing significant attention to the timing and pace of the policy changes of the major central banks with the greatest focus on when the Federal Reserve will begin to raise interest rates.  Investors are attempting to anticipate the impact on the stock and bond markets.   Since 2009, the major central banks including the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BOJ) have employed unconventional policies in an effort to stimulate their respective economies.  These have included the use of two primary tools – monetary creation through quantitative easing (QE) and historically low interest rate policies.  Today, central banks have increased their assets by nearly $6 trillion in the past six years which would not have been possible in the past as the market would have feared inflation and interest rates would have increased sharply.

The current divergences in monetary policy represent an important consideration for investors as the Federal Reserve is on pace to end its QE program in the fall and will raise rates before the ECB and BOJ.  Conversely the ECB may launch a formal QE program in the coming months.  One could argue that the ECB has been implementing a back-door QE program by using its negative interest rate policy to encourage banks to increase lending and to incentivize the banks to purchase European sovereign debt resulting in lowering bond yields and allowing member governments to borrow at lower costs.  Japan is attempting to reverse a 25-year deflationary cycle through yet another, although far more aggressive, QE program after the earlier efforts were too timid to work.  It is likely that the ECB and BOJ will be considerably behind the U.S. in becoming less accommodative.

Notwithstanding the inevitable increase in benchmark interest rates by the Federal Reserve, the likely outcome of the policy change will be a rate well below historical norms as the U.S. economy cannot support anywhere near a 5% nominal rate.  There are three primary reasons why U.S. interest rates should remain low for some time including: 1) the lackluster employment and wage recovery, 2) the debt overhang, and 3) global yield differentials. The chart below shows the yield differentials of some of the major economies which highlights the divergences. It is notable that the U.S. 10-year treasury is approximately 1.30% higher than German yields and 1.00% higher than yields on French debt.  The yields for many European nations now stand at levels not seen in more than 100 years.

At the June meeting of the Federal Open Market Committee (FOMC), the Committee highlighted that both labor market conditions and inflation expectations moved closer to their longer-term objectives, and that economic activity will expand at a moderate pace.  One important consideration for the Federal Reserve or any other central bank as to timing the shift to increase interest rates is that central banks would rather be somewhat late to raise rates and be forced to address inflation, than to be forced to backtrack to lower interest rates again because the economy was not healthy enough to maintain its growth trajectory or worse face deflation which would undo all the previous efforts.  Given the nature of this low-growth expansion, investors should think about the pace of rate increases rather than the inevitable first rate increase itself.  Investors should anticipate that the pace will be slower than in the past with the end point likely to be lower.  Equity investors should be aware of the fact that in the past five tightening periods, the commencement of rate increases hurt the equity and bond markets but after this temporary negative initial reaction, equities then went on to rise meaningfully as increases in rates signified an improving economy.

What is the Impact of the U.S. Energy Transformation on Oil Prices and Geopolitics?

In recent outlooks, we have written extensively about the energy and industrial transformation which is taking place in the U.S.  Its importance cannot be understated, for without the improvement in energy production which has reduced our import needs, the price of oil would likely be much higher.  Energy prices are likely to be volatile but should remain relatively elevated with an upward bias due to a variety of factors.  Geopolitical stresses in the key producing nations in the Middle East and Africa continue to add uncertainty to supplies from these regions as evidenced by the swings in output for Libya, Iran, Iraq and Nigeria.  At the same time, reserve replacement from most of the world’s major oil companies remains challenged and production costs are anticipated to remain high as much of the lower-cost and easier-to-access oil has been produced.  With approximately 35% of world supply coming from increasingly aging fields, and much of the new supply coming from the more expensive deep water fields, production costs will be challenged in the years to come.   Labor force issues also remain a problem for the industry and skilled labor shortages are further increasing the costs as wages are rising for workers in this sector.  Additionally, the continued growth in global Gross Domestic Product means increased demand for oil which is now at 92.4 million barrels per day and is up 1.4 million barrels per day this year over last. In the past year, demand has exceeded supply by around 500,000 barrels per day.

Without the dramatic changes of the past few years in U.S. energy production, we believe that the current price would be significantly higher. This is especially important against the backdrop of growing geopolitical stresses including Russia’s annexation of Crimea, China’s aggressive  tactics for oil and other resources in the South China Sea, and the multitude of issues in the Middle East ranging from the Israel/Hamas conflict to ISIS actions in Iraq. Without the dramatically improving U.S. domestic energy position there would be a greater impact on energy prices and there would be increased equity market volatility.  To put this in perspective, U.S. production has grown in recent years by nearly 3.3 million barrels per day which is an increase equivalent to the production output of Iraq, one of the world’s largest producers. According to the Energy Industry Association, U.S. crude oil production in 2015 will increase to 9.3 million barrels per day, a level not seen since 1972.  That is up from 8.4 million barrels per day in 2014.  As European nations come to grips with the harsh reality that they must reduce their reliance on Russia as the primary source of their natural gas, there have been calls for Europe and the U.S. to form a long-term energy-trade relationship.  While it would take time for exported energy to make a large impact on Europe, formalizing such a relationship is hard to reverse and sends an important message to Russia.

How is the Portfolio Positioned Today?

The United States is reasserting its economic leadership after a nearly decade-long period of rapid Chinese growth.  The U.S. has been the largest economy for decades, and the country’s key competitive advantages – the world’s most liquid and mature capital markets system, positive demographic dynamics, democratic institutions, a culture of innovation and enterprise, high worker productivity and availability of critical resources (food, energy and water) – are coming to the fore.  The United States is in the midst of a multi-year economic and industrial expansion which we believe is not fully recognized as of yet. The economic growth going on in the central  part of the United States has been spectacular and has some economists calling parts of that region the “best emerging market” in the world.  United States corporations, many of whom have been the biggest beneficiaries of the low interest rate polices, are reporting record corporate earnings, cash balances and profit margins.  U.S. corporations are using their strong balance sheets to invest heavily in technology to increase productivity.  At this time, the U.S. should continue to attract capital to many areas of the economy especially the areas where critical investments can no longer be postponed.

After the strong returns in the stock and bond markets in recent years, we believe today’s investment opportunities will require greater selectivity, with bond investing an area of greater risk given the likelihood of higher rates in the coming years and little in the way of current compensation due to the low level of today’s yields.  At the same time equities are more likely to  represent a better opportunity to preserve and build capital under present circumstances.  In addition, rising shareholder activism is a strong indication that many corporations have the ability to unlock hidden value, and if that were not the case the managements would not be responding in the fashion that they are.  This year there have been over $1.7 trillion in deals announced and investors should anticipate a continuation of merger and acquisition activity as the current interest rate environment makes most transactions immediately accretive.

From a portfolio positioning perspective, we remain constructive on investments in the industrial, technology and energy sectors in addition to other select areas as our slow but relatively steady economic expansion is likely to continue for some time.  We have also increased our emphasis on companies that have particular internal dynamics that make them less dependent on the level of growth in the economy to generate increasing earnings and to realize higher values.  In addition, many of the holdings in the portfolio have the ability to unlock value by selling assets and redirecting the capital to the most economic and immediate projects.  Finally, many companies have been increasing dividends and stock buybacks creating additional value for shareholders.

One of the primary considerations for equity investors today is that capital must flow to the areas of the U.S. economy where the needs can no longer be postponed.  One of the key opportunities for the U.S. economy to continue its growth trajectory through the end of the decade is where three fundamental investment dynamics overlap: the energy renaissance, growing corporate profits, and large infrastructure needs which must be addressed.  U.S. growth is further supported by a unique combination of factors that exists today including:

• Historically low inflation levels
• The continuation of the low interest rate environment driven by a highly accommodative monetary policy
• Improving balance of payments through a declining energy trade deficit and improving manufacturing revenues
  
• Technology advances driven by the U.S. innovation edge
  
• Improving Federal and State finances supported by rising tax receipts
  
• Stronger consumer confidence
  
• Rising corporate profit margins
  
• Corporate actions to return cash to shareholders by buying stock and raising dividends
  

“The major powers have yet to undertake globally cooperative responses to the new and increasingly grave challenges to human well-being – environmental, climatic, socioeconomic, nutritional, or demographic. And without basic geopolitical stability, any effort to achieve the necessary global cooperation will falter… As China’s influence grows and as other emerging powers – Russia, India or Brazil for example – compete with each other for resources, security, and economic advantage, the potential for miscalculation and conflict increases.”

– Zbigniew Brzezinski – excerpt from “Strategic Vision”

The annexation of Crimea by Russia and the potential for change for other former Soviet Union Republics, particularly those with heavy minority Russian populations, has sparked the potential rise of separatism.  The interconnectivity and interdependency of Russia and Europe present a difficult challenge for world leaders and institutions including the IMF, the United Nations, the G-8 and G-20 in dealing with the immediate and long-term consequences. Concurrently, China’s economic slowdown and emerging financial weaknesses driven by the country’s bad debts are also weighing on the global markets.  As China reorients its economy to a more domestically-driven one, it is also facing critical water and air pollution issues which have become existential problems.  Elsewhere in the world, many other emerging nations are facing higher inflation and slower growth.  Additionally there is an ongoing battle for control of Syria as well as the lack of political, economic and social institutions in many Middle Eastern nations which are continuing a pattern of ongoing instability.  These unfolding events continue to significantly influence currencies, global growth, capital flows, immigration, trade and global energy policy.  In light of these dynamics, the United States is arguably better positioned in many ways for a prolonged period of growth than it has been at any time in the last 50 years.

The United States is in the midst of a multi-year economic and industrial expansion which we believe is not being fully recognized. This business cycle differs from previous ones and is attributable in large part to our growing energy independence which has led to the revitalization of the manufacturing sector.

• Historically low inflation levels
• The continuation of the low interest rate environment driven by highly accommodative monetary policy
• Improving balance of payments through a declining energy trade deficit and improving manufacturing revenues
• Technology advances driven by the U.S. innovation edge
• Improving Federal and State finances supported by rising tax receipts
• Stronger consumer confidence

Seizing the U.S. Moment

A critical element of our investment process is defining the global environment in which businesses operate and identifying key trends  driving investment capital.  For much of the last decade, the biggest beneficiaries of global capital flows were the BRIC economies led by China.  In recent quarters,  there has been a significant reversal of flows from these and other emerging economies into the U.S. and Europe as slowing emerging market growth, rising inflation and economic uncertainty have driven investors to seek safer havens.  As highlighted in our December 2013 Outlook, ARS believes that the United States is currently the best-positioned economy among the major economies.  It was among the first to enter the recession and the first to recover. Often overlooked in the discussions about the relative merits of the U.S. economy are the depth of our capital markets, the quality and dependability of our institutional systems and the commitment to the Rule of Law.  In conversations with clients, the status of the U.S. Dollar as a reserve currency is sometimes called into question.  However, it is fundamental that the strength of a currency is a product of an economy’s ability to produce.   Consequently, the reemergence of the power of the U.S. industrial base underpins the reserve status of the U.S. Dollar. (Look no further than the Sterling’s loss of currency reserve status after the fall of the British Empire).  At this time, the U.S. should continue to attract capital to many areas of the economy, in particular, industrial, energy and technology companies as well as other beneficiaries which include health care, financials and consumer discretionary companies.

The U.S. industrial sector is in a multi-year expansion, infrastructure rebuild and investment cycle as many neglected needs are no longer postponable.  The energy renaissance currently underway is nothing less than a game-changer.  A cyclical recovery in key industries combined with important secular trends is stimulating a U.S. industrial resurgence.  Pent up demand in autos, residential and non-residential construction is supporting a gradual recovery in those industries.  For the longer term, U.S. industry is benefitting from the availability of lower-cost energy and the renewed cost advantage of domestic production. The following will detail the infrastructure and industrial needs, the dynamics of the energy renaissance and the advantaged position for U.S. corporations to make the investments necessary to drive this growth opportunity.

Infrastructure and Industrial Needs

The need for adequate infrastructure investment is a topic about which we have written for many years as it is critical in meeting our societal needs as well as in maintaining our competitiveness in an increasingly global economy.  Every four years the American Society of Civil Engineers (ASCE) releases its updated report on the status of the U.S. infrastructure, and once again it is clear how far behind the U.S. has fallen on critical investments in areas including roads, bridges, rails, power generation and transit. The most recent report determined that the cost to bring our infrastructure to a state of good repair has risen from $1.3 trillion in 2001 to $2.2 trillion in 2009 and to $3.6 trillion in 2013. The report further details that current committed and funded budgets leave a shortfall of $1.6 trillion out of the $3.6 trillion needed to be spent. A lack of allocated funds continues to hold back adequate investment in infrastructure; however, these investments have been postponed for too long and now need to be addressed. There is increasing focus and dialogue in Washington as to how infrastructure investment should be funded while at the same time struggling with the federal deficit and future entitlement obligations.  In the past, the U.S. relied heavily on federal, state and local government spending, but now corporations are an increasingly important source of funding for these projects.  Corporations are sitting with record overseas cash balances which, because of our outdated tax code, are stranded in the face of these accumulating needs.  Under current tax policy, these funds are being used to create foreign jobs and take advantage of non-U.S. investment opportunities, often with foreign-born U.S. educated graduate students to the great detriment of the United States.

The ASCE report also highlights that the continued neglect of the U.S. infrastructure will cost U.S. businesses an estimated $1.2 trillion between now and 2020 through lost productivity and waste.  For example, the railroad system, which transports 43% of the nation’s intercity freight and about 33% of exports, is one area of need which is highlighted. The U.S. rail network is made up of more than 160,000 miles of track, 76,000 rail bridges, and 800 tunnels across the nation used for moving freight and passengers. While the railroads have increased investment over the past twenty years, the needs of a changing U.S. economy are not being met and will require significantly more investment.  The Association of American Rail Cars reported that major railroads delivered 9,300 carloads of crude oil in 2008 and this has grown to 434,000 carloads of crude oil in 2013.  Moreover, the growth of our energy sector has resulted in the requirement to upgrade the safety of railroad cars used to transport oil as the result of several accidents transporting oil.  New standards from the Department of Transportation (DOT) will require almost 80,000 railcars to be retrofitted or replaced.  Recently, the Burlington Northern Railroad, which is owned by Warren Buffett’s Berkshire Hathaway, ordered 5,000 tank cars at an estimated cost of more than $500 million; while the industry backlog for these railcars now extends into 2016.

Energy Renaissance

Since the 1970’s, the U.S. has had a growing dependency on foreign oil to meet its energy needs, which has had several negative implications for the country.  Now a shift is underway to rapidly move the U.S. towards energy independence.  The renewed vitality of this industry is being made possible by new technologies for extracting oil and gas from basins such as the Eagle Ford, Marcellus, Permian, Bakkan and Niobrarra. Geologists have known about the presence of additional hydrocarbons in these basins for decades but have only recently been able to access them economically. The result has been a surge in U.S. oil and gas production -from 5 million barrels of crude oil and 7 billion cubic feet of gas per day in 2007 to over 8 million barrels and 8.8 billion cubic feet per day today.  The revitalization of this sector is having a profoundly positive impact on the United States.  The increase in domestic production has reduced our need for imports and improved the U.S. balance of trade.  The rise in domestic production has also led to lower prices for energy, giving domestic manufacturers a critical cost advantage over their international competitors (with natural gas costs of less than $5 per mcf at home compared with prices of $9 to as high as $18 per mcf in Europe and Asia).  This cost advantage has led companies with high energy input costs to invest in new production plants in the U.S., particularly in the manufacturing and chemical industries. According to a report released recently at the IHS World Petro-chemicals conference in Houston, the energy-intensive manufacturing sectors added over 196,000 U.S. jobs between 2010 and 2012 due in large part to the energy renaissance.

At the same time that U.S. manufacturers are enjoying lower energy costs, rising wage inflation in China has reduced the labor cost advantage of relocating production there, which is significantly reducing and in some cases reversing the trend of offshoring. Corporations are planning on building an additional 48 factories and plant expansions at a cost of more than $100 billion as a result of the natural gas boom in the U.S.  In addition, IHS Chemical estimates that $125 billion in petrochemical investments related to U.S. shale gas have been announced to date with additional announcements likely to come. Foreign direct investment in U.S. manufacturing is on the rise.  As an example BASF, one of Germany’s most important industrial companies, is in the process of moving some of its operations to the United States from Germany. As European nations come to grips with the harsh reality that they must reduce their reliance on Russia as the primary source of natural gas, there have been calls for Europe and the U.S. to form a long-term energy trade relationship.  While it will take time for exported energy to make a large impact on Europe, formalizing such a relationship is hard to reverse and sends an important message to Russia.

Corporate Profits and Capital Expenditure Growth

“CEO expectations for overall economic growth are well below our economy’s potential. This underscores why the Roundtable put forward a clear, simple economic growth strategy earlier this year. It starts with the idea that increased private-sector capital investment is the critical foundation for economic growth, and its key planks are fiscal stability, business tax reform, expanded trade and immigration reform. These issues have broad support, they are critical to driving job growth and we urge Congress to act on them this year.”

– Randall L. Stephenson, Chairman of the Business Roundtable and CEO of ATT Inc. We expect U.S. corporate profits to continue to increase over the next several years.  As highlighted in the chart, pre-tax profits have risen from nearly $960 billion in 2003 to just shy of $1.35 trillion in 2008 to over $2.2 trillion today.  In past Outlooks, we have discussed the manufacturing renaissance that is taking place as evidenced by manufacturing pre-tax profits having doubled from $171 billion in 2009 to $392 billion in 2013.  With interest rates remaining at low levels, U.S. corporations have been able to refinance debt at reduced costs allowing
companies to repurchase stock, reinvest in their businesses and bring cost savings to the bottom line. Unfortunately for the unemployed, employment growth has substantially lagged the growth in corporate profits as companies are benefiting from
technology-driven productivity gains.

However, there are encouraging signs as corporate profits hit record levels and projections for capital expenditures are forecast to reach record levels of over $2 trillion this year.  The move to increase capital expenditures may last several years reflecting the continued recovery and more positive outlook of many businesses.  One area in which this can be seen is in the energy sector as international capital expenditures for exploration and production are expected to reach a record $524 billion this year – a 6.5% increase from 2013.  U.S. oil and gas businesses are planning to increase spending by 5.2% in 2014 to $338 billion.

The Business Roundtable’s CEO Economic Outlook survey of over 122 CEO’s of leading corporations projects increases in sales, capital expenditures and hiring over the next six months. Seventy-two percent of chief executives participating in the most recent survey anticipate that sales will increase in the next six months, while forty-eight percent forecast higher capital expenditures.  Interestingly, 56% of executives said “they would invest and hire more if Congress and the Administration were to cooperate on corporate tax and immigration reform and move forward on free trade agreements with the European Union and Pacific nations.”

Thoughts on Federal Reserve and European Central Bank Monetary Policies

 “The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

“When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

– Excerpts from the Federal Reserve March 19, 2014 Press Release

There were a few key points worth noting about the most recent Federal Open Market Committee meeting and the first press conference of Janet Yellen as Chair of the Federal Reserve.  The Committee judged the economy to be showing sufficient underlying strength to support improvement in labor market conditions but remained concerned about the ongoing challenges particularly for the long-term unemployed.  The Committee expressed the view that winter weather conditions had an adverse effect on economic activity.  We note that the release of pent up demand will have a positive impact on second, and possibly third quarter growth.  Notwithstanding the weather effect, the FOMC decided to make a further measured $10 billion reduction in the pace of its monthly asset purchases.  In a statement that surprised the market, Chair Yellen also suggested that the first rate hike could take place within six months after the bank ends its bond-buying program, which would mean that the first rate hike could occur as early as the spring of 2015 which was sooner than anticipated.  We expect short-term rates to stay low for longer than that timeframe based on our outlook for employment and inflation.  In changing its forward guidance, the FOMC adopted a more qualitative set of considerations rather than the quantitative measurement of a 6.5% unemployment rate target, because it had become too narrow a measure of true labor market conditions.  The Federal Reserve emphasized that the need for the continuation of the current low-rate environment will be warranted for a period well beyond a set unemployment rate level reflecting the decline in the labor force participation rate which is proving to be a distinct challenge for the recovery of the labor market.

As we have written since 2008, ARS expected that excess capacity in the domestic and global economy constituted a deflationary risk for the developed economies which would necessarily encourage the Federal Reserve and the European Central Bank (ECB) to maintain highly accommodative policies for a considerable period of time.  The ECB has been fighting deflationary pressures with one arm tied behind its back as Germany was not supportive of a quantitative easing program due to its historical experience
with inflation.  However, just recently Germany has become supportive of a bond buying program (QE) by the ECB.  The timing is noteworthy in view of the fact that Germany is a major trading partner of Russia, and economic sanctions will inevitably slow Germany’s growth as it is a highly export-driven economy.  The EU nations have significant trading relations with Russia, and we expect the Russian economy to contract under these circumstances putting further pressure on the ECB to be more accommodative in the near term.

Investment Implications

The United States is in a prolonged economic expansion, and the positive dynamics of the U.S. economy should remain in place for several years.  At this time, the U.S. should continue to attract capital to several areas of the economy, in particular, industrial, energy, technology, health care, financial and consumer-discretionary companies. The particularly harsh winter, highlighted by heavy snow and below average temperatures in much of the country combined with drought conditions in the West, had an impact on the economy in the first quarter.  Consequently, many industries should see a pickup in demand in the coming quarters. We share Ms. Yellen’s concerns for the slow pace of employment growth, particularly for the long-term unemployed.  We anticipate a continuation of the low interest rate and low inflation environment in place since 2008. Given the Federal Reserve’s statement about maintaining the target federal funds rate below normal levels for some time, we see a favorable longer-term environment for equity investing as rates will more likely rise slowly as the Federal Reserve becomes less accommodative and the economy grows.

Because of this Outlook, ARS has been transitioning equity portfolios by adding companies with more U.S.-centric businesses, while reducing or eliminating positions in companies with a high percentage of foreign revenues which could be adversely impacted by geopolitical events as well as the stresses in the emerging economies.  ARS portfolios include several key beneficiaries of the U.S. Industrial Renaissance from across the supply chain.  Beginning at the energy production level, we have been focused on low-cost producers in the most prolific U.S. basins with strong management teams and significant organic production growth potential.  ARS energy investments also have healthy balance sheets, minimal reliance on the capital markets and trade at significant discounts to their Net Asset Values.  Once oil and gas has been extracted from the ground, it needs to be safely transported to refiners who can convert the raw hydrocarbons into finished products, such as fuel and heating oil.  The
preferred method of transportation is by pipeline, and ARS investments with pipeline exposure enjoy both stable sources of cash flow as well as billions of dollars in growth projects over the next several years as new pipelines are constructed to connect our new oil and gas production to the nation’s refiners and end markets.

ARS also sees attractive opportunities in the refiners themselves.  With the growth in U.S.-based oil production, West Texas Intermediate (“WTI”) crude oil that once traded at parity to internationally-sourced Brent crude oil now trades at a significant discount.  As a result, U.S. refiners are able to purchase their raw materials (oil) at a discount to their global competitors and enjoy a significant cost advantage and thus higher margins. The U.S.refiners trade at low valuations relative to their earnings and cash flow reflecting the historical cyclicality of this sector, but we believe that these valuations do not adequately reflect the secular cost advantage that we expect these refiners to capture in the coming years.  The growth in U.S. oil and gas supply has brought with it an increased need for the companies that service the producers.  These energy service companies are essentially technology companies, dedicated to helping their clients extract the greatest level of production at the lowest possible cost.  We have identified leaders in this field with earnings growth prospects significantly in excess of the broader market but that trade at comparable or discounted valuations.

The U.S. Industrial Renaissance also means growth in the transport of goods. The Railroads are benefiting from growing shipments of construction and auto supplies, grains and other commodities as well as the increased need for intermodal shipments (i.e., shipments across both highway and rail), and even the shipment of crude oil by rail as oil supply exceeds pipeline capacity.  Railroads are among the most energy-efficient means of transport, capable of moving a ton of freight nearly 450 miles on a single gallon of fuel.  They also enjoy high barriers-to-entry (imagine the difficulty of starting a new railroad today) and importantly, attractive valuations on a price-to-earnings, price-to-cash-flow and dividend yield basis.  Lastly, ARS portfolios include the beneficiaries of the need to upgrade the U.S. infrastructure, including companies that supply crucial parts and services required for upgrading the U.S. electrical grid and transmission assets.

Our world is characterized by rapid change and increased uncertainty.  It is during times like these that our investment team draws on its decades of experience and knowledge as well as the investment principles that are the foundation of our investment process.  As always, ARS investments must stand on their own two feet, with strong management teams, high barriers-to-entry and enduring cost advantages, strong balance sheets and market valuations that we calculate are at discounts to fair value.  Client portfolios are positioned with the potential downside risks in mind, while being able to participate in the opportunities in businesses which are at the forefront of the industrial, energy, technology and health care changes.