October 7, 2016
Slow economic growth and low global interest rates prolonged the low volatility environment. Thus we maintained our overweight in cash and large caps US stocks. We are looking at small cap and international equities.
Global monetary and fiscal policies put a lid on trading volume and volatility. Equities outperformed fixed income. The tech-heavy NASDAQ led the way, followed by small caps and international markets. The Dow and S&P 500 hit new highs but couldn’t sustain their peaks. Bonds were flat. Natural gas gained while oil, gold and other hard commodities fell. Bumper harvests led to lower crop prices globally.
What happened? Profits seemed to bottom as revenues, ex-energy, were up 1.6% and 71% of companies beat earnings expectations. Manufacturing may be shaking off its malaise as the energy sector seems to be recovering. The US rig count turned positive and prices stabilized between $40 and $50. Consumer confidence was helped by low energy prices and a labor market still moving forward. Unemployment fell to 4.9% and wages increased 2.4% year-over-year. Retail sales climbed 2.4% annually with auto sales stabilizing near record levels and new home sales up 13%. Existing home sales fell in July and August, but the National Association of Realtors was quick to emphasize weakness was due to lack of supply, not lack of demand. Contrary to post-Brexit expectations, the dollar fell making US exports more attractive. But, heavy taxation and increasing corporate regulations influenced corporate behavior. Corporations refused to repatriate over $2 trillion of overseas profits, and GDP growth was hit by broad inventory liquidations and flat durable goods orders. Management prefers to support earnings per share by borrowing to execute stock buyback programs. Our opinion, the quarter was stable but unspectacular.
Washington loves to regulate as it appears they are actually doing something, while costing them nothing. They ignore the real cost. During the Obama administration, there have been 229 major regulations, 470,000 pages with more to come, with an incremental cost of $108 billion annually. The estimated cost of government regulations to business is in excess of $2 trillion per year. Meanwhile, elected officials struggled to pass a spending bill to keep the government open until December 9th. Across town, the prelude and actual Fed meeting was full of sound and fury, but rates remained unchanged. Can you spell dysfunction?
The international picture followed a similar scenario. Eurozone heavy-handed regulation was underscored when the Competition Commissioner told Ireland they “had” to charge Apple $14.5 billion in back taxes. Add negative interest rates and there is a banking profits situation (no one calls it a crisis). European banks are under fire with Deutsche Bank, Europe’s preeminent bank, the poster child. China put out myriad economic reports, but we feel the total picture is misleading and analysts are too optimistic. The government is propping up state-owned enterprises (SOEs) in the industrial and property sectors by opening the debt faucets. SOEs prioritize national interests over profitability. Their investments increased by 21%. Private company investments, a better gauge of China’s economy, grew by just 2%. It is unrealistic to believe this is sustainable. Finally, the Middle East has many problems, ISIS and low oil prices are two examples.
Going forward – We see an improving picture as the 18-month profit recession seems to be ending. Our scenario has several positive forces. First and foremost, the US consumer has finally recovered from the damage caused by the financial crisis, so consumer confidence hit a nine-year high. Next, jobless claims, a leading indicator, are at historically low levels and should translate in a tighter job market and higher wages. Solid consumer balance sheets with rising incomes will sustain growth with more typical spending on durables and housing. The continued improvement in housing should be part of the virtuous cycle where new home construction will support growth in industries as diverse as manufacturing, commodities and transportation. Finally, we see rising wages a key catalyst for capital spending, and thus productivity. We expect an improved earnings cycle as commodities and international economies strengthen. In contrast to the consensus, we see stronger growth in the coming years and recent data shows business investment beginning to recover. This should reframe the past months as a typical US mid-cycle slowdown.
The race for president is in the home stretch with both candidates focused on personal attacks while running substance-light campaigns. It’s tough to know where the candidates stand, but both agree on rebuilding infrastructure. Monetary policy can no longer carry the economy, so November elections should be decisive for fiscal policy. Infrastructure spending is needed and has the potential to drive growth. This is a win-win. More-hawkish talk at the Fed should translate into a rate hike by year end. Even so, we expect rates to be lower for longer as the Fed will remain accommodative to support fiscal policy.
Clouds abroad are lifting. European QE has mostly resolved the Euro crisis. Credit conditions are improving and Mario Draghi indicated QE will be ending in 2017. Growth needs banks and banks need growth. Eliminating negative interest rates should help the banking situation (nobody calls it a crisis), and fiscal policy should take over the heavy lifting for growth. We see a solid European situation. On the other hand, China has been over-stimulated with fiscal and monetary policy. We see it facing a steady decline in growth, but not a collapse. China’s structure indicates a western-style crisis is unlikely, but their trajectory is negative for heavy industries, commodities and energy. We see conditions in emerging markets, specifically commodity-based economies, facing a multi-year workout; but they seem to have bounced off the bottom. Overall, slow global growth should help oil prices and thus resolve one issue in the Middle East, but their politics and ISIS more complicated issues.
Our Bottom Line – Clearly, we think investors are excessively bearish, which increases the potential for volatility. Dips should be buy opportunities. We expect yields to rise and bond prices to fall. Investors will start to move away from their bond proxies: utilities, consumer staples and telecoms. These sectors are “risk-off” and will lag if the global economy exhibits more-normal growth. Finally, we see value in Europe and specific emerging markets. All of this means a more broadly and globally diversified asset allocation.
As always, we appreciate your trust. This letter provides our outlook of the most probable events, but at best is a summary. If you have any questions, please call us. Better yet, we would enjoy meeting with you to discuss our outlook and your current situation.
George Bernard Doug Woods
President Director of Research
 NASDAQ is a market-cap weighted index of more than 3,000 companies listed on the NASDAQ Stock Market and does not reflect reinvestment of dividends.
 Dow Jones Industrial Average is an unmanaged index of the common stock prices of 30 widely held stocks, not including reinvestment of dividends.
 S&P 500 is an unmanaged index of the common stock prices of 500 widely held stocks and does not include reinvestment of dividends.