Jan 26, 2016

Buckle Up

My list of Ten Surprises for 2016 has a gloomy tone.  I generally think of myself as an optimist, but some concepts that I have been brooding about for a while seem to be converging.  I have been worrying about the impact of China’s slowdown on the rest of the world, the ramifications of the refugee crisis on the stability of Europe, the peaking of profit margins in the United States, the surfeit of goods around the world coupled with insufficient demand, the dependence of developed economies on central bank monetary easing for growth, the accumulation of public and private debt, income inequality and terrorism. 

Many of these issues are integrated into this year’s Ten Surprises.  My definition of a Surprise is an event that I believe has a better than 50% chance of taking place, but which the average professional investor would only assign a one in three likelihood of happening.  Usually I get five or six of the Surprises generally on target, but last year I fell somewhat short of that score.  They are not designed to prove that I can predict the future.  Nobody can do that.  The Surprises are intended to provoke serious thought about important issues.

This is an election year, so offering a Surprise on the November outcome is mandatory.  I have Hillary Clinton beating Ted Cruz.  Clinton’s being chosen as the Democratic candidate would not be a surprise, or even her victory, because her party has a significant lead in likely Electoral College votes.  The Surprise would be on the Republican side.  Donald Trump and Ted Cruz, two extreme candidates, are leading the establishment pack by a wide margin.  The conventional wisdom within the party is that neither of these candidates can win in a general election and that a ticket made up of Marco Rubio and John Kasich would have a better chance because they might bring in the electoral votes of Florida and Ohio.  My view is that the extreme candidates not only have Republican supporters, they are also attracting some independents and Democrats.  If the extreme candidates were still far ahead in the polls at the time of the convention, denying one of them the nomination would be very difficult.

Trump may be too controversial and some of his campaign exaggerations may make him an excessively risky candidate.  Cruz, while not well-liked by many members of his party, may be more acceptable to traditional conservatives.  He is smart, savvy, organized and determined.  What’s more, he has been gaining momentum in the days leading up to the primaries.  The second part of this Surprise is that the Democrats take back the majority in the Senate.  A number of Republican seats are being contested in states with an historical leaning towards the Democrats.  If Clinton wins with a reasonable margin, many of the Democratic Senatorial candidates may be carried over the top with her.  Because of disenchantment with the whole political process, voter turnout may be low.  A number of Democratic voters are negative on Clinton because of, among other issues, the Benghazi controversy, lapses relating to her personal e-mail and backlash to her involvement in containing Bill Clinton’s scandals relating to women.  On the other side, many Republicans have been turned off by the inflammatory positions of Trump and Cruz.

In my second Surprise I expected the Standard & Poor’s to suffer a loss for the year.  I do not anticipate a bear market (down 20% or more), but something short of that.  I believe that earnings will be pressured by a combination of limited pricing power and increasing wages and that profit margins, near an all-time high now, will be lower.  While the price-earnings ratio of the index is not excessive, disappointing earnings will be the key factor driving the decline.  The disturbing geopolitical uncertainties around the world also have an influence on multiple contraction.  Investors have a feeling of apprehension about the dangers of terrorism, oil price softness, emerging market recessions, the refugee crisis and armed conflicts in the Middle East, Africa or possibly elsewhere.  As a result, they are likely to maintain higher than usual cash balances. 

I focus on the Federal Reserve in the third Surprise.  When the Fed raised rates in mid-December, they said that it was probable that there would be four rate increases in 2016 and that by 2017 the federal funds rate would be 1.35%.  I believe the Fed will reconsider that statement as the economic data flows in.  I think they may raise rates by 25 basis points in March, but they will not raise rates again during the remainder of the year.  While the consensus for economic growth in the U.S. is that real GDP will increase 2.0% to 2.5% in 2016, the trajectory that I see developing would make a rate below 2% more likely.  Last year vehicle sales were 17.5 million units, an impressive performance.  We may find that some of those sales were borrowed from 2016.  If energy capital spending stays low and housing does not surge, growth could be disappointing.  If the economic weakness that I suspect actually develops, we may find the Federal Reserve actively considers reducing rates later in the year rather than raising them.

The most crowded trade in the current investment landscape is being long the dollar.  Almost everyone agrees the U.S. is going to grow faster than any other developed country or region, has a mature and fair legal system, is not likely to impose currency controls and has a democratic (if dysfunctional) political system.  That’s why the dollar has been strong.  If the economy were weaker than now projected and if the equity and real estate markets soften, there may be less enthusiasm for buying U.S. assets.  Capital flows into America from Russia, China and the Middle East may also diminish because of economic problems in those areas.  I could see the dollar declining in value to 1.20 against the euro.

In the fifth Surprise I expect growth in China to slow below 5% but avoid a hard landing.  Most estimates continue to be 6% or better, although there are some bears out there who see growth as low as 2%.  I believe the Chinese continue to have the resources to stimulate the economy using both fiscal and monetary tools.  Data on the drawdown of foreign currency reserves supports the view that policymakers are making every effort to offset the loss of momentum in the economy.  Debt to Gross Domestic Product has, however, climbed to 250% and many of the loans held by regional banks are non-performing.  In recent weeks the exchange rate for the renminbi has gradually declined against the dollar.  I expect the ratio to descend to seven against dollar, but I have seen estimates close to eight.  I make every effort to make the Surprises consistent with each other.  This one is a little tricky because it is not likely that both the dollar and the yuan would be weak at the same time.

The European Union has been under strain for at least the last five years.  The original concept was that the loose alliance of nations would form a political union over time, but that was probably never going to happen.  I did believe that a banking union would be developed for practical reasons, but that proved too optimistic also.  When the so-called Southern Tier countries got into economic trouble after the Great Recession of 2008-9, the whole project was in question.  Nevertheless, the European Union has managed to stay together with help from Germany and the European Central Bank because the consequences of a break-up are likely to be severe.  The sixth Surprise is that now, with more than a million Middle East asylum seekers in Germany and at least another million seeking refuge throughout the continent, the region is again in danger of breaking up.  I do not think it will happen this year but it will be actively discussed.  The reasons behind it are the general difference in prosperity between the northern and southern countries, the Greek financial condition and the philosophical and political movement to the right across all of Europe.

For the seventh Surprise I have the price of West Texas Intermediate oil languishing in the $30s throughout the year.  The consensus view is that crude will drift toward $50 in the second half.  One of the reasons behind the possible rise is a lack of exploration for new reserves, as reflected by a two-thirds drop in the drilling rig count. Offsetting the reduction in the number of rigs, however, are huge inventories in storage facilities and tankers which could come onto the market at any time; the unwillingness of Saudi Arabia to cut production; and additional supply coming on the market both from Iran and as a continuous flow of oil from domestic producers that need the cash to pay down debt or to fulfill lease obligations.  Three or so years from now we will see prices in the $70s because the depletion of existing wells (at a rate of five million barrels a day over the course of a year), the failure to explore for new reserves and the increase in demand from the developing world will result in supply/demand strains.  But for 2016, I believe prices will remain low.  Thinking that the price of oil will rise this year is the second most crowded trade in the market today.

The high-end residential real estate market in New York and London has been surging the past few years as buyers from China, Russia and the Middle East move capital to places they believe are physically safe and financially secure.  Economic conditions in those countries have weakened considerably and my eighth Surprise is that the expensive condominiums and other residential properties in those two cities have trouble finding buyers.  As a result, the real estate developers of those projects run into financial trouble.  This is not as broad a problem as the sub-prime crisis in the United States in 2008 that rippled throughout the world financial system.  I still think real estate investment trusts invested in commercial and moderately priced apartment complexes will continue to provide reasonable returns, partly because of their high yields.

The third most crowded trade out there today is based on the view that, with the Federal Reserve raising short-term interest rates, medium- and longer-term yields are likely to increase.  Many think that the 10-year U.S. Treasury yield will reach 3% before the end of the year.  Given market and geographical instability, my view is that the combination of investors looking for a safe place to park their money and the general desire to maintain a high level of liquidity in uncertain times will keep high quality fixed income interest rates low.  My ninth Surprise is that the 10-year U.S. Treasury yield does not exceed 2.5% during 2016.

For the final tenth Surprise I took a broad look at global growth.  Most estimates, including that of the International Monetary Fund, are for growth to be about 3%, but I believe that is too optimistic.  If I am right and U.S. growth is below 2%, Chinese growth is below 5%, Europe’s growth is below 2%, Japan’s growth is just above 1% and many of the emerging markets are in recessions, it is hard for me to see how world growth can be much above 2%.  This estimate has relevance to my oil Surprise (#7) as well, since there is a high correlation between the pace of the world economy and the price of crude.  Slow world growth, resulting from reduced overall demand, is usually associated with declining prices for energy.

Every year I always have a few Surprises that don’t make the list of ten.  There are two reasons for this: some of the “also rans” are not as relevant as the ten I have picked, and for some I cannot bring myself to have conviction that they are probable, with a better than 50% chance of taking place.

The first of these is that there is no major terrorist attack in the United States or Europe in 2016.  I know most of us believe the spread of terrorism has gotten to the point where a significant event is inevitable and we have to be prepared for one to take place.  I think many people feel some anxiety as they go about their daily activities, knowing that somewhere a plot to inflict harm in their community is under development.  Even so, I think many underestimate the effectiveness of various law enforcement agencies in preventing attacks.  New York City has 1500 people devoting their careers to preventing terrorism.  To be sure, officials would be the first to say it is a combination of skill and luck that has kept us safe since 2001 from a major event.  Let’s hope that combination continues. 

The second “also ran” is related to Japan.  I did not include this one in the basic ten this year because I had included a Surprise on Japan in the Ten Surprises of 2015 and I only readdress the same topic in a Surprise in very rare instances.  Last year, Japan did well relative to most global markets, and I am more constructive on the country this year.

For a long time I have been concerned that corporations have been using financial engineering to increase earnings.  Growing revenues in an economic environment with relatively low demand from consumers and weak capital spending has been very hard.  Companies have been buying their own shares back and making strategic acquisitions (where sales and administrative staffs can be cut) in order to increase earnings per share.  They are also using inversions to decrease their taxes.  So far investors have applauded these activities because they have worked to increase the stock price.  I think portfolio managers are beginning to realize that these steps do not indicate that sustainable growth is taking place.  Since I do not detect widespread concern about this issue yet, I left it out of the basic ten because I did not believe investors would penalize companies this year for excessive financial engineering by trimming back multiples.  We will see if more concern develops in the future.

Biotechnology has long been an interest of mine and I believe there are going to be major breakthroughs in developing drugs for cancer, heart disease, Parkinson’s, diabetes and memory loss.  If a pill can replace a hospital stay, it is worth a lot.  This is my fourth “also ran.”  Coupled with it is the growing realization that attacking the pharmaceutical industry for excessive pricing while ignoring the research and development costs associated with the breakthrough drugs is unfair.  I left this one out because I did not think it was as important as the ten I had picked.

Finally in the fifth “also ran” I said that commodity producers would cut production, prices would stabilize, recessions in the developing world would end and it would be safe to invest in emerging markets again.  I put this one in the category of wishful thinking.  I think it will happen sometime, but not this year.

There it is: the explanation of the reasoning behind The Ten Surprises and the five “also rans.”  The year is off to a rough start for the financial markets, and the Surprises, which were completed in December, look like I had a hint of what was coming.  But a year is a long time and a lot could, and is likely to, happen between now and next Christmas.  This is the year where I hope I am too pessimistic.  

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