April 12, 2017
Despite media focus on high political drama, markets, especially global equity markets, were steady and positive. This supported our view on the economy, so we maintained our market positions.
Tranquil markets ruled from before Halloween to St. Patrick’s Day. The Dow passed 20,000 and 21,000 with volatility the lowest since 1965. The S&P 500 had its best quarter in two years and NASDAQ’s results best in four years. International equity markets, both developed and emerging, outperformed US markets, and bonds surprised with minor gains. Natural gas and crude prices were down for the quarter. Gold and copper climbed. Farm commodities bounced 1%+/- after three years of bumper crops pushed prices down.
What happened? Positive economic data and a pro-growth agenda revived the economy’s animal spirits. 80% of corporate earnings beat or met expectations. Profits were up 8% year-over-year, emphatically ending the earnings recession. The promise of reduced regulations and taxes fueled business confidence. The Institute for Supply Management showed manufacturing and services at multi-year highs. The NFIB survey, built on 325,000 small business owners, showed optimism near a 43-year high. Unemployment sank to 4.5% while wages accelerated, helping consumer confidence reach a 17-year high. Energy’s recovery and manufacturing growth means the economy is starting to fire on all eleven cylinders. We see the end of the profit recession indicating conditions for an economic decline are not present.
Most thoughtful people are not thrilled by President Trump’s style; but they are thrilled by his economic ideas. His first 90 days were tumultuous, but saw little legislative progress. Executive orders removed some regulatory burdens, but House Republicans failed to get a vote on healthcare. Our view, it took nine months to pass the Affordable Care Act. This was Round 1. Down the block, the Fed is giving way to fiscal policy. They raised interest rates in March and are now on a path toward normalization.
The global economy has been converging in a synchronized growth upturn for the first time since the financial crisis. Political risks, like Brexit, are masking real economic progress. Eurozone PMIs recently hit a 6-year high with business and consumer sentiment much improved. Most European banks built a significant capital cushion and now the Eurozone economic growth rate is approaching that of the US. Meanwhile, Asian companies continue to benefit from growing Chinese household consumption. Other emerging markets like Brazil, Africa and Russia are benefiting from rising commodity prices and showing growth. Our conclusion is as economic risks subside, political risks are coming to the fore.
Going forward – US leading economic indicators are at their highest levels in over a decade, indicating an improving economy in 2017. If President Trump can pass his pro-growth agenda, US growth could increase to 3%. Energy is making a comeback based on three factors: tech, Trump and synchronized global growth. Fracking technology dramatically increased productivity driving the break-even price of oil to $36/barrel. Deregulation has already green-lighted three pipeline projects and streamlined approval of infrastructure projects. This has enhanced access to supply so the industry could benefit from synchronized global growth. At the end of March the US exported 5.3 million barrels of oil and 2 billion cubic feet of natural gas per day – the comeback continues. Corporate tax cuts will incent businesses to stay in the US and repatriate $2 trillion cash. A stable dollar should energize US exports. Small and mid-size companies traditionally were a key domestic growth engine. They have been MIA the past decade and deregulation and tax cuts should provide much-needed relief to help them to again be a growth engine. There is a lag between executive orders and their impact, so expect growth to accelerate into this year. This virtuous cycle will support employment, wage growth and home prices; which should boost consumer confidence and spending. The key question: How much of the pro-growth agenda will be implemented? We believe more than half should get passed, which should support our growth expectations and make earnings more sustainable.
The President’s agenda faces opposition from his own party and across the aisle. Nothing comes easy. There are three paths: a watered-down tax reform to avoid a $2 trillion shortfall, avoid the shortfall through healthcare reform and a border adjustment tax, or explode the deficit to achieve desired tax reform. The House has not delivered healthcare reform, creating a $1 trillion hole. Our view is we are seeing sausage being made, an ugly process which should deliver a desirable outcome. The Fed’s focus on rate normalization provides an opportunity to be preemptive against inflation. We expect a cautious Fed, but feel rates will head higher in response to stronger growth.
Fears of a more-protectionist US have abated, but political risks in Europe and elsewhere are moving to the front of investors’ lists. We’re fascinated to see populist issues rising up to some degree globally, while political elites call this trend a local issue. The underlying driver is simple, debt burdens around the globe are so big that their paydown causes slow economic growth, lack of jobs and kills hope for the future. We see this clearly in Greece while developing in Italy, Spain, Japan and China. This leads to the question which frightens every career politician: Why are you in charge? Growing public discontent is stressing the relationship between governments and citizens. We feel the solution is not turning to government or money-printing, but is starting the process where individuals are empowered to build a smarter economy.
Our Bottom Line – We see opportunities and challenges. President Trump promised to ‘Make America Great Again,’ but he can’t make us younger. Growth traditionally has been the sum of labor-force growth and increasing productivity. We know demographics need a generation to change and/or immigration, so we believe the growth agenda is the only reasonable path. We believe over 50% of the agenda will pass meaning an opportunity in US equities, specifically small and mid-cap. Europe is cheap but they face demographic, debt and populist political issues. We need to see more before increasing our positions. Emerging markets are cheap and have a growing workforce with access to new technology. Clearly, we need to see improvement in corporate governance policies and transparency, but view this as an opportunity. We feel interest rates are going up and maintain only short to mid-duration fixed income positions.
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
 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.
 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.