January 13, 2017
A surprise Trump election stirred optimism about the US economy, global economic growth, improved personal finances and lower for longer interest rates. This led us to increase our equity weightings.
WOW! US equities suffered the worst January in history, but ended strongly. Small companies outperformed large. The Russell 2000, the Dow and S&P 500 hit new highs in December. International markets were off slightly for the quarter. Bonds rallied early then had the biggest quarterly selloff in over twenty years to end the year flat. Natural gas had its largest gain in a decade. Crude and copper climbed, while gold fell.
What happened? Q4 started with a string of positive data. After six quarters of declining profits, corporate earnings surprised with 3.1% year-over-year growth. 72% of companies beat expectations. Q3 GDP grew 3.5%. Unemployment held at decade lows and wages grew 2.9%, the highest rate in seven years. The Trump election ended the most contentious election in history. It seemed to reduce uncertainty and raised consumer and business confidence. All the above helped existing home sales hit 10-year highs. Also, retail sales were up 3.8% year-over-year with manufacturing indices at two-year highs. The US dollar also surged, a mixed blessing – cheaper imports, lower inflation, a stronger consumer, but less competitive exports.
Donald Trump won the presidential election, dispatching the Bush and Clinton political dynasties in what can be called, “America’s Brexit.” The silly season is over but the vicious season has begun. Opponents were quick to point out their issues and perceived shortcomings of the administration – no rest for the victorious. Finally, the Fed approved the first interest rate hike in a year and foresees more to come. The committee emphasized the path will be gradual and data-dependent. Steady as she goes.
There are three areas of concern in the international arena. The Eurozone, despite Brexit, has seen industrial production and GDP growing steadily. Unfortunately, the feeble financial condition of their banks, specifically in Italy, are an impediment to future progress. In China, more investors now suspect, as we have, the #2 economy’s high debt levels and real estate bubble could foment economic tumult. Finally, the strong dollar is exerting a negative influence on emerging markets – especially those with debt denominated in US dollars. The strong dollar will also impact the Middle East and Russia as commodities, specifically oil, are priced in US dollars. Overall, the international economies are growing but face real challenges. In particular, increased militarism in China and Russia and ongoing terrorist activities.
Going forward – We view the Trump election as a major policy change that will shift away from an era dominated by central banks. It will be replaced by a more business-friendly administration focused on accelerating growth, jobs and improving infrastructure. The most positive policy would be a corporate tax cut. Experts estimate reducing the rate to 25% would boost S&P earnings by 10%. Next would be reforming regulatory burdens. The Obama administration enacted over 600 regulations which added over $743 billion of cost (larger than the GDP of Norway and Israel combined). These savings could be spent on hiring and investment. Increased military and infrastructure spending should drive employment and rising wages. Key is how this spending will be financed. We could pay for new highways through tolls and higher gasoline taxes. Improved airports and ports could be financed through increased fees. We expect a combination of public and private financing. These changes should increase productivity and accelerate growth, which would pressure commodities, gas prices and wages. This could lead to higher interest rates, which in turn could strengthen the dollar. We do not expect runaway inflation, but think CPI could go to 2.5%+/-.
DC is atwitter with inauguration plans, predictions of policy missteps and potential Cabinet appointments. Trump’s proposed team reminds us of a Warren G. Harding quote from the 1920 depression: “We need less government in business and more business in government.” A prime concern is trade. To ease worries, we suggest looking at Trump’s trade advisor Dan DiMicco, the former Nucor CEO, America’s largest steel company. He delivered a decade of sterling results in a very competitive global industry. He advocates returning to a more activist approach where all countries play by the same rules. This is similar to Reagan’s policies, which ushered in an era of rapid global growth – nothing to be afraid of. Not all will be smooth on the policy front. Trump’s agenda could easily get bogged down by regulatory agencies or Congress. There are a lot of dogs in this fight, but we are optimistic. As focus shifts to fiscal policy, the Fed will face a diminished role and any rate moves will be constrained by exceptionally easy global central banks.
Global political risks are on the rise. The Brexit vote highlighted debates around sovereignty, trade, immigration and globalization. Europeans are asking whether the Eurozone bureaucracy really benefits them. These are perfectly reasonable questions that will not go away before the nine EU elections in 2017. These complex issues requiring thoughtful and balanced solutions for the Eurozone to continue to evolve. Their banking system is a problem that needs action. The European Commission is very defensive and not shy about creating new anti-competitive regulations. Foreign competitors trying to take advantage of the weakened European banks are likely to meet an impenetrable regulatory wall. As for China, we don’t see a financial crisis as their authorities have a long track record of tightly managing the economy. More troubling is the recent escalation of Chinese military activity in the disputed South China Sea. This not only impacts relations with the US, but could hurt the Asian emerging markets which are a critical part of the global supply chain. Quoting the old Chinese proverb: “May we live in interesting times.”
Our Bottom Line – We see accelerating growth, not a recession, for the US. This should pressure interest rates so we continue to focus on floating-rate and short-term fixed income securities. We see opportunity in US equities and are starting to shift our focus to mid and small-cap stocks. Steady but the slower growing Eurozone represents value and we are starting to build equity positions. Emerging markets represent better growth, but there are greater risks. Our conclusion – a diversified portfolio emphasizing equities over fixed income investing in the US, Europe then emerging markets.
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
Russell 2000 is an unmanaged index generally representing the US market for small capitalization stocks and does not include 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.