2018 Economic Themes: Machines, Bitcoins, Space and Technology.

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Dear Friends,

We trust you’ve had a wonderful holiday season and a good start to the New Year.

As we dig ourselves out from one of the first winter storms and a biting cold front, we have been considering the year ahead and what it may bring for investors. 2017 ended with a remarkable rally in December. This was fueled by the passage of a tax bill that generally favors investors and corporations. Though this tax-bill may have provided some short-term boost to the markets, we believe it’s long term impact will be quite mixed. The bill is estimated to create an unfunded deficit of approximately $1.5 Trillion. This amount of deficit spending would generally give rise to fears of inflation, which seem to have been largely ignored. We are also skeptical about the claim that the bill simplifies the tax code significantly. It is true that a larger proportion of individual filers will now claim the standard deduction, but there are several other complexities introduced by the bill for both individual and business filers which will be argued over by tax accountants for years.

In many other countries, the tax authorities prepare a return/statement at the end of the year for tax-filers which can then be contested/corrected. No such mechanism for low/middle-income Americans is anticipated in this bill. We are also skeptical about claims that the corporate tax cuts embedded in this bill will spur investment or boost anemic wage growth. Corporations are already holding record cash reserves, and wage growth in the US has been slow for decades, largely due to the legislature’s failure to increase the minimum wage. As such, we believe the tax bill will have a limited impact on medium-term prospects. Given our view on the 2018 mid-terms, there is a good chance many provisions will be reversed within a year.

A list of the top 10 economic themes we expect to see this year follows. A graded ranking of our themes from last year is also available.

Regards,

 

Subir Grewal, CFA, CFP                   Louis Berger


 

2018 Economic Themes: Machines, Bitcoins, Space and Technology.

 

  1. Slow But Steady Rate Rise.  The Fed has signaled no intention to halt its program of bond sales and interest rate hikes. Over $400 billion worth of the Fed’s Treasury bond holdings will come due in 2018. The normalization program announced in 2015 suggests the Fed will not reinvest most of the principal. Many billions in principal repayments on the Fed’s MBS (mortgage-backed securities) holdings will also not be reinvested. In aggregate, we expect the Fed’s normalization actions will withdraw $300-$400 Billion from money supply in 2018. We expect the Fed to maintain the normalization plan and continue tightening rates in 2018 with the Fed Funds rate ending the year in the 2%-2.5% range. Both these actions will place additional pressure on stocks.
  2. Year of the Donkey.  We expect the mid-year election of 2018 to mark a sharp reversal for Republicans, who currently control all three branches of federal government. We expect the Democratic party to win a majority in the House of Representatives and we suspect there is a real possibility (40%) they will take the Senate as well. Such a result would stall or reverse the Trump administration’s legislative agenda. We expect congressional investigations of the administration to intensify as a result.
  3. The Bull Runs Out of Steam.  We expect 2018 to be a difficult year for equities markets given the extremely high levels attained over the past two years. Margin debt is now at all time highs, at 1.6 times the peak reached in 2007. We have been advising caution for the past few years while the market has continued to rise. However, we see no reason to change our short/medium term forecast given stretched valuations and the age of this bull market (now entering its 9th year).
  4. Rise of the Machines.  2017 saw various automation/AI technologies gain a firm foothold among consumers. Siri, Alexa, Google Home and several voice activated car-technologies have become second nature to millions of people. We believe this trend will continue in 2018 and we will see the initial emergence of voice-activated AI/automation being married with robots/machinery. This has already begun in cars, but we expect intelligent home devices to begin controlling autonomous vacuum cleaners, window washing drones and other small devices. As we did in 2017, we expect AI/Automation stocks to outperform consumer discretionary stocks.
  5. International Beats Domestic.  We expect international stocks, especially European markets, to outperform the US in 2018. Emerging market fundamentals remain broadly positive, and we expect these markets to perform reasonably well while we are expecting a negative year in the US.
  6. Bitcoin Bust.  2017 saw immense interest in crypto-currencies, particularly Bitcoin. Prices were driven up by sky-high demand and fixed supply (the total amount of Bitcoins in circulation increases only by a very small percentage each year). The sharp rise was partially fueled by speculation around new ETFs that seek to track Bitcoin prices and open up the market to more traditional investors. We believe some of the technologies embedded in Bitcoin, especially the peer-to-peer transactions and public ledger/blockchain, are innovative and do have a future. That said, Bitcoin prices themselves are in a speculative bubble which we expect will reset in 2018.
  7. Renewables Redux.  2017 saw renewable energy YieldCos outperform conventional fossil-fuel based electric utilities. We expect this trend to continue through 2018 as YieldCos will benefit from robust demand for renewably sourced electricity (by both the public and private sectors), increased efficiency from solar and wind power, newer fleets that require less maintenance and a smaller scale that allow them to operate more nimbly compared to their conventional peers.
  8. Organics Go Mainstream.  Organic food products are the fastest growing segment of the US food industry. Sales have increased by high single digits in recent years while the overall food market has remained stagnant. Though some of the major food behemoths have launched their own organic food lines or acquired smaller start-ups, they continue to play catch-up in this arena. We think organic food stocks will outperform conventional food stocks this year.
  9. New Dawn of Space Race.  2018 will see a number of commercial space ventures mark milestones, including manned-flight into low-earth orbit and potentially a lunar orbital space tourism mission. As commercial space missions become routine and the prospect of mining asteroids and the moon becomes a reality, we expect a secular rethinking of the prospects for natural resource mining enterprises that are earth-bound. The trend itself will take a couple of decades to reach fruition, but we expect earth-side mining for certain materials to decline over time in favor of extraction in space. We realize this sounds far-fetched, but technological changes over 20 year cycles can be immense (for example, compare internet ubiquity with where we were in 1997). The technology to permit the creation of largely automated mines on the moon or an asteroid are largely available today.
  10. Net Neutrality Fallout.  Though the revision of net neutrality rules was overshadowed by the tax bill negotiations, it was a landmark change. We expect to see tangible impact to the way consumers experience the internet as a result of the FCC’s contentious decision to remove net neutrality.  This reversal tilts the playing field towards telecommunications companies and away from content providers. We expect telecommunications firms will seek to exploit the ability to meter bandwidth and extract rents from content providers. ISPs will start to create fast lanes and we may see some of the large content firms seek to create their own networks. Telecommunications firms have risen in the past month as a result of this ruling, but we believe the medium and longer term prognosis is less rosy, with the prospect of new entrants and even more consumer dissatisfaction.

Review of 2017 Themes: The Doldrums

2017 was an uneven year for our market predictions. We were right on five calls, half right on one call and wrong on four calls. Continued bullishness and investor support for the Trump administration (despite abysmal poll numbers) torpedoed three of our calls.

  1. ? Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017. The Fed started 2017 with a target interest rate of 0.50%-0.75% and finished the year with a target rate of 1.25%-1.50%. While the Fed raised rates, they met but did not exceed 1.50%, so we’re giving ourselves half a point on this one.
  2. × Equities Caution: We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year. We were dead wrong on this call as US equities continued their bull market run through year eight.
  3. ? Artificial Intelligence: We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call. Artificial Intelligence-related companies had a very strong 2017 as the Global Robotics and Artificial Intelligence Index was up 57.62%. Comparatively, the S&P 600 Consumer Discretionary Index was up 17.13%.
  4. ? Continental shifts: Over the next several years, we expect Indian markets to outperform those in China and the developed world. We were right on year one of this call. The S&P BMI India Index was up 29.56% in 2017. This compares to 26.67% return for the S&P Greater China Index and 21.83% return for the S&P 500 Index.
  5. × European upheavals: We believe European stocks to be more attractively priced than US equities…we expect European stocks to outperform US equities. While European stocks performed in-line with our expectations — S&P 350 Europe Index was up 10.75% on the year — the unexpectedly strong performance of US stocks (21.83% return for the S&P 500 Index) easily outperformed this total.
  6. × Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. Despite rising interest rates, the USD weakened against a basket of international currencies in 2017.
  7. ? Drones are going to be delivering much more than bombs: We expect companies building these technologies to outperform the freight and shipping transportation companies. While we view this as a long term trend, 2017 saw drone-related companies outperform. The Solactive Robotics and Drones Index was up 38.7% while the S&P 500 Transportation Index was up 23.52%.
  8. ? Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. YieldCos saw a strong rebound in 2017 and handily outperformed traditional utilities. The Global YieldCo Index saw returns of 22.87% while the S&P 1500 Utilities Index returned 12.16%.
  9. ? Retail Real-Estate: We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments. This prediction came to fruition as brick and mortar stores, and particularly malls, continued to see a decline in foot traffic and a loss of market share to online shopping in 2017. The FTSE NAREIT Regional Malls Index was -2.68% and the FTSE NAREIT Shopping Centers Index was -11.37%. Meanwhile, the FTSE NAREIT Composite was up 9.29%.
  10. × Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises. As we expected, President Trump has been unable to follow through on his campaign promises, and his approval ratings are among the lowest ever recorded for a first year presidency. However, a strong economy, robust corporate profits and the prospect of a tax cut allowed investors to shrug off his policy failures, chaotic management style and a criminal investigation to send equity markets to all-time highs.

Powering down the Fed’s bond buying engine.

We trust you’ve had a restful and enjoyable summer.

This was a difficult hurricane season for many of our fellow Americans, especially those in Puerto Rico and across the South. A number of category 4 and 5 hurricanes made landfall in the US, causing enormous damage in Puerto Rico, Houston, Florida and the Virgin Islands. Several Caribbean islands have suffered almost complete devastation. Aside from the enormous human toll exacted by the loss of lives and homes, the hurricanes have also impacted US industry. Several sectors were impacted, including tourism, oil and pharmaceuticals (Puerto Rico is home to several pharmaceutical plants). Many hourly workers missed work for days or weeks, affecting their earnings. The impact is visible in the September jobs report, which shows a loss of 33,000 jobs.

This loss breaks a consecutive streak of 83 months of employment gains, stretching back to 2010. Markets largely shrugged off the terrible jobs report due to these effects, which are believed to be temporary. We expect October’s report will be skewed in the other direction as many workers head back to work.

Taking a longer term view, it seems clear that man-made climate change leads to warmer ocean and air temperatures. These conditions produce larger, more destructive storms which arrive with greater regularity. In the West, we have seen a series of destructive forest fires this year. Climate change has also expanded the range of invasive insect species which have killed off large stands of trees in our forests. Under hot, drought conditions brought on by global warming, these dead trees become kindling for forest fires. Our changing climate will pose major issues for insurers/re-insurers and local governments, particularly in flood and drought-prone areas. Communities will have to review zoning regulations in the face of these fires and storms. The cost of adaptation and recovery will be high, and doubtless some communities will be unable to recover fully.

The Fed has signaled it will treat the September jobs report as an outlier and stick with its plan to normalize monetary policy. This is almost certain to include one more interest rate hike before year end, likely in December. The Fed has also indicated it will proceed with its plan to reduce its 4.5 Trillion dollar holdings in bonds. These were purchased between 2008 and 2014 as part of the “quantitative easing” program, in an effort to stabilize financial markets. Based on its published plans, we expect the balance sheet to shrink by 250 Billion in 2018 and up to 400 Billion in 2019 and subsequent years, depending on economic conditions. These are substantial numbers, and we expect them to maintain steady upward pressure on interest rates across the maturity curve. We expect Janet Yellen will be replaced as Fed Chair when her term ends at the end of Jan 2018. This raises critical questions about the Trump administration’s ability to nominate and confirm a candidate who is credible and seen as independent of political pressure.

Stock markets continued their upwards drift, hitting new highs this quarter. These moves were supported by steady economic numbers, including GDP and employment. Corporate earnings have also remained steady, though insurance sector earnings are expected to be down significantly in the third quarter. Gains have been led by the technology and financial services sectors, which have grown to become the largest components in the S&P500. Both sectors are cyclical, and in our view a long expansion and the increasing ubiquity of technology has driven some of these stocks to unsustainable levels.

The market seems to have largely ignored Washington, tuning out several dramatic weeks in Congress as major legislation to transform health-care, infrastructure and deregulation have stalled or collapsed. A Republican effort to pass a tax reform bill is still underway, but it looks increasingly unlikely that this effort will pass either. The tax reform package proposed has not been scored by the CBO, but most analysis indicates it will add to the deficit. The proposal includes several modifications to deductions and tax brackets. Overall, its impact would be to reduce the tax burden on the very wealthiest of Americans, and shift some of those charges on the poorest and on Americans earning less than 400k a year. The scale of the proposal, the major uncertainties involved, and the haphazard manner in which it was developed lower the chances of passage. We do not believe the tax reform proposal will be enacted in its current form. At best, we believe the administration may be able to pass a severely watered-down bill.

Looking ahead to the end of the year, we expect equities markets to largely ignore Washington DC, unless the administration managers to pass significant legislation. The prospect of interest rate hikes and the Fed’s plans to shrink its balance sheet are likely to exert downward pressure on stocks. We continue to maintain our defensive positioning, with lower than average allocations to higher-risk assets like stocks and long-term or high-yield bonds.

 

Regards,

 

Subir Grewal, CFA, CFP                           Louis Berger

2017 Q2 letter: A threat to human civilization

posted in: Bonds, Economics, Energy, Markets, Stocks, USA | 0

Dear Friends,

The 2nd quarter saw the Fed continue its strategy of withdrawing stimulus from the US economy. Since December 2016, the Fed has raised rates three times, bringing the target rate up to 1.25%. Their most recent statements suggest the target rate will continue to rise if unemployment and inflation stay relatively stable. There have been several statements this month from Fed governors indicating the central bank plans to begin selling or rolling off the 3.6 Trillion dollars in bonds it has acquired since the financial crisis of 2008/2009. The Fed’s decision to increase its bond holdings by 400% during the financial crisis was an unprecedented action, and the reduction to more normal levels has been expected for some time.

The net effect of these moves for investors will be a rise in interest rates, a reduction in liquidity, and a less attractive environment for risky assets. Bond investors should see rates continue to rise towards more normal levels, a relief since bond yields have been historically low for the past several years. The sale of the Fed’s bond portfolio will also reduce the amount of money in circulation (the money supply) as private investors purchase the assets the Fed sells. This is expected to put further pressure on stock prices and riskier assets as funds are directed into these purchases.

Over the past few days, we have also seen the risk of political instability in the US rise to remarkable levels. It seems increasingly likely that the various investigations underway may lead to very senior members of the Trump administration and campaign facing a variety of charges.

From a valuation perspective, stock prices continue to look overvalued. Remarkably, the top five components of the S&P 500 (Apple, Alphabet/Google, Microsoft, Facebook and Amazon) are all technology companies. What’s even more surprising is that with the exception of Apple, they are all trading at prices over 30 times earnings. Much of that gain has been recent, four of the  five have seen gains of over 20% in the past six months (the exception is Microsoft). Taken together, these five companies represent almost 12.5% of the index.

Overall market valuations are extraordinarily high, with the current P/E ratio for the S&P500 over 25. A longer term measure, which looks back at ten years of earnings (Cyclically Adusted or Shiller P/E) is illustrated in the chart below, alongside interest rates. Cyclically Adjusted P/E is at levels that have only been exceeded twice; before the tech-wreck of 2000 and Black Tuesday in 1929. This is partly because interest rates remain at historic lows. As discussed above, that is changing.

As a result of these factors, we continue to maintain a defensive posture and recommend clients an underweight allocation to high-risk assets.

Data source: Robert Shiller – Yale University

We would like to use the rest of our quarterly letter to discuss a longer-term risk, one that impacts not just the markets, but all of human civilization.

For several decades now, scientists focused on studying global warming and climate change have shared their increasingly dire findings about the impact of human activity on the Earth’s biosphere. It is now abundantly clear to all, except the intentionally obtuse and dishonest among us, that human activity has impacted the Earth’s climate in a significant way. Our species’ use of fossil fuels has released an extraordinary amount of greenhouse gases into the atmosphere, raising the average temperature across the world by 0.2° Celsius (0.36° Fahrenheit) each decade.

Economists have long understood that markets can mis-price public goods or services that have concentrated benefits for a few while costs are diluted among many. Within the economic literature, this is called the “tragedy of the commons”. The classic example is shepherds grazing their flocks in a meadow that is commonly owned. In standard political and economic theory, the government is meant to intervene to enforce a solution that furthers the general good and recognizes and allocates the true costs of such activity.

At this point, we should admit that US political institutions have failed to deliver on addressing climate change. The vast majority (85%) of greenhouse gases released into the atmosphere have been generated since World War II. Over that period, the United States has been, by far, the largest greenhouse gas emitter. So, much of the responsibility for climate change lies with us. Yet, we have been for decades, and still remain, the chief impediment to decisive action on climate change. The Trump administration has made a very bad situation even more dire by announcing a withdrawal from the Paris agreement.

Nature, of course, couldn’t be less concerned about human politics. The content of greenhouse gases like carbon dioxide and methane has continued to rise, driving surface temperatures higher. This has manifested itself in a variety of ways. Glaciers have retreated across the world. The five hottest years in recorded history occurred within this decade, and 2016 set a new record. Coral reefs across the world are bleaching as water temperatures rise, stressing the marine eco-system. Hotter summers are impacting humans as well, with extreme temperatures rising causing heat-strokes, dehydration and deaths.

Most climate change models have assumed a 0.2°C increase per year in surface temperatures will leave the Earth’s with an average temperature 2°C (3.6°F) higher by 2100. Those assumptions now look woefully inadequate. Since we have not measurably reduced our greenhouse gas emissions, and the Paris agreements seem to have collapsed, 2°C degrees is an underestimate and the case for a 3-4°C rise becomes stronger.

As climate change and research into it has advanced, the risks of a runaway feedback loop have become clearer as well. Permanently frozen ground in the arctic regions of Asia and North America traps a large amount of methane. As the ground gets warmer, this methane leaches into the atmosphere. As temperatures rise and water becomes scarce, plant life across the world will be stressed. The risk and incidence of forest fires increases, and the loss of trees leaves more CO2 in the atmosphere. If rising temperatures, fire and drought impact major CO2 sinks like the Amazon forest, temperatures will rise even faster.

There is a reasonable likelihood that temperatures will have risen by 4-6°C (7-10°F) by 2100. 90°F days will be 100°F days. 100°F days will be 110°F days. Phoenix saw temperatures rise above 118°F last month, grounding flights. What happens when temperatures approach 128°F? If such an extreme rise in temperatures were to occur, the world is looking at a series of major catastrophies that could largely destroy human civilization.

Drought and heat would cause widespread human suffering and deaths. Food stocks would be harder to grow with much of the world’s breadbasket regions in China, India, Central Asia and North America undergoing desertification. Much of the southwestern United States could become an uninhabitable desert. Tens of millions of people would need to be resettled. This pattern would be replicated across the world. A NASA study indicates the Middle East is suffering through a 20 year drought that is more severe than any in the past 900 years. There are indications that crop failure and rising food prices have contributed to societal upheaval in the region. The Mediterranean as a whole is susceptible to drought and desertification.

The impact on agriculture worldwide would be many times more severe than seen during the dust-bowl. Marine life and fisheries would be devastated as ocean temperatures rise. And yes, sea-levels could rise 10 feet or more, making most coastal cities uninhabitable without civil works on a scale we have never seen before. Much of New York, London, Mumbai, Shanghai, Sydney, Rio De Janeiro, Singapore, Dubai, Miami, almost all of Bangladesh, and many island nations, would be lost.

It is virtually certain that such extreme conditions will lead to widespread forced migrations and fuel conflict between nations and individuals. This is one of the reasons the US Department of Defense treats climate change as the largest strategic threat to the country. Governments and political structures will undergo immense stress and opportunistic charlatans could come to power across the world.

All of this would significantly impact incomes, growth rates, earnings and most importantly health and well-being. We do not intentionally seek to be alarmist. However, the data and projections we have seen demand urgent responses and are alarming. There is a grave likelihood that we leave our children with a world in crisis. Without urgent, concerted action, large portions of our planet will become inhospitable to human inhabitation within our children’s lifetime.

Clearly, these events will impact investors and markets in profound ways. As we engage in long-term, inter-generational planning for clients, we want our clients to know that we take these risks very seriously and will continue to keep these considerations in mind.

 

 

 

Regards,

 

 

Subir Grewal, CFA, CFP                                                                                              Louis Berger

2017 Q1 letter: Renewable energy in the Trump era

Dear Friends,

The first quarter of 2017 was full of eventful news for markets. We saw a Fed rate hike, record low unemployment rates, all time highs for US equity markets and a new administration sworn in, with Republicans now in full control of Congress. In our view, this likely marks an inflection point for the current business cycle and market levels.

Since the election, we have received several queries from our socially responsible investors about the fate of environmental and climate change regulation under the Trump administration. We understand and share many of their concerns. We hasten to add, however, that infrastructure spending and projects are usually undertaken with long time frames in mind. Enterprises making decisions about what kind of power plants to build will consider the costs over a long term. They are well aware that the current administration and its policies are not set in stone.

We do not expect a raft of coal plants to be built over the next four years — in fact, 2017 has seen an acceleration of the closure of several legacy coal plants. Large plants typically take 3-5 years to build and operators have to factor in the possibility that they will face a changed regulatory environment just as the plants come online. Natural gas prices are likely to play a much larger role in determining what resource mix generates our electricity. The cost of utility scale renewable solar power continues to fall, and though it is not yet competitive with cheap gas, it is not far off either. The IEA estimated the average capital costs of photovoltaic solar plants under construction to be 35-45% higher than natural gas plants per unit of energy produced. An array of tax credits make solar competitive with gas. though the precise economics are driven by regional factors and weather. Wind and hydroelectric power are already competitive with natural gas.

At the risk of appearing sanguine, we think that technological advances, consumer preferences, and the economics of scale have brought us to the point where renewable energy will be competitive with conventional electricity generation going forward. Installed renewable capacity will continue to increase, with or without incentives. If fuel costs move higher, renewables will be become very attractive.

In our view, purchasing certain sectors based on the administration’s stated policy preferences is unlikely to lead to consistent gains. Our reasoning is based on the Trump administration’s penchant for changing direction at the drop of a hat, and secondly on the opposition to various aspects of their policy agenda from either side of the aisle in Congress. In the medium and long-term, valuations and the business cycle will determine investor success. Neither looks particularly fortuitous at the moment for risk assets (equities, or long-term/lower-quality bonds). We continue to recommend a defensive shift for clients based on these factors.

Regards,

Subir Grewal, CFA, CFP Louis Berger