April 2017

 

Global government changes from Brexit to new presidents in the US, Brazil and South Korea are leading to several policy changes. More changes are expected as four French elections, a German election and a possible Italian election may affect EU sentiment this year.

The potential for broad fiscal policy changes in the US include: corporate taxes, defense spending, immigration, individual taxes, infrastructure spending, repatriation tax, regulatory reform and trade policy. While the first attempt at healthcare reform was unsuccessful, further attempts are expected. On the other hand, border adjustment tax (BAT) proposals have little potential of passage.

Over the next two years, President Trump could be the first president in modern times to nominate five of the seven Federal Reserve board members. These positions have 14 year terms, but due to prior vacancies, a resignation and upcoming term expirations, there is an unprecedented ability to change the leadership of the US central bank.

Despite wide partisan differences in the US, both business and consumer confidence is increasing. By some measures, domestic consumer confidence and small business sentiment are at 17-year highs. This is partially due to a strong labor market, with jobless claims reaching a 44-year low.

MONETARY POLICY – RISING INTEREST RATES

Central banks enact monetary policy by controlling overnight interest rates and printing money. Their end objectives can include taming inflation, raising employment and steadying currency.

In the developed world, central banks have printed money and kept interest rates extremely low for years to encourage economic growth. Last year, the central banks of the European Union (EU), Japan, Switzerland and the United Kingdom (UK) created over $2 trillion in new currency. Most of this was used to purchase bonds and keep long-term interest rates low.

With one of the better economic growth rates, the US Federal Reserve (Fed) did not print money last year. Moreover, it has been the only major central bank to increase interest rates. After three rate increases, overnight rates are now ¾%, however many savers have not noticed a change.

The Fed expects to increase rates two more times this year (¼% each time). If this pace continues, domestic overnight interest rates will not reach more normal 3% levels until 2020. Todays below normal interest rates can stimulate both the economy and stock markets.

FINANCIAL MARKET OUTLOOK: GLOBAL RECOVERY

The financial markets tend to discount uncertainty, and then ascend upon clarity. There is current uncertainty in the EU over upcoming elections and Brexit. In the US, it remains to be seen which domestic fiscal policy issues will be enacted and in what form. As uncertainty subsides, confidence should increase further, leading to increased consumer spending and business investment. Signs of economic recovery are now appearing in Europe and Japan. As growth in the developed world accelerates, activity in the emerging markets will improve, resulting in a coordinated rise in global growth.

A strengthening global economy will lessen the need for printing money and keeping interest rates low. Already, both the EU and UK are expected to print less this year, resulting in fewer bond purchases. In turn, longer term interest rates should start to rise.

While global economic cycles have similarities, they can also have differences. In this cycle, there remains excess production capacity in several commodities and basic industrials.

Changes in technology, demographics and globalization also affect this cycle differently. Automation and other technological advancements can leave behind some workers with lower skill sets. A wave of retiring baby boomers is exasperating a worker shortage in other fields. Future trade negotiations provide uncertainty as to the creation of new trade barriers.

FUTURE CHANGES: WHERE TO INVEST

Many people may remember the last sixteen years as bleak. When forecasting, it is normal to project the recent past forward. However, there could be several stark differences including:

  • Synchronized global economic growth vs. fear of deflationary economic spiral
  • Labor shortages in specific industries vs. high unemployment and stagnant wages
  • Return to normal interest rates vs. record low interest rates
  • Business reinvestment vs. retrenchment
  • Repatriation and use of foreign cash vs. offshoring and tax avoidance

As interest rates rise, investors can lose substantial money in high-quality long-term bonds. If the interest rate on the 30-year US Treasury bond rises from 3% to 4% over the next year, the market value of that bond will decline 17.5%. Other investments that may behave like long-term bonds include: preferred stocks, master limited partnerships, royalty trusts and utility stocks.

During periods of more normal inflation, dividend growth stocks can be a leading investment category. Dividend increases usually reflect positive company fundamentals. Moreover, a rising stream of cash dividends can protect investors against inflation.

Investors should focus on the stocks of leading companies in growing niches of the economy. In addition to having recurring volume growth, attractive companies will also be able to grow profit margins by maintaining or raising prices while controlling costs.

Despite above average US stock market valuations, attractively valued growth opportunities can still be found. Pinpointing several opportunities in different niches can yield a profitable portfolio that is diversified between economic sectors, geographic revenue and market capitalizations.

While the broad stock market can benefit from economic growth, volatility should remain. On average, the US stock markets have three pullbacks of 5% or more per year, one of which is a 10%+ correction.

One will always be able to think of reasons not to invest. Yet, many successful investors adhere to long-term investment disciplines proven to work over time. Buying and holding stocks of companies with long-term revenue, earnings and cash flow growth can result in a portfolio which compounds at rates above inflation and generates a rising stream of recurring cash dividends.