Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
Fourth Quarter: October 2016

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Uncomfortably Numb

“Leopards break into the temple and drink the sacrificial chalices dry; this occurs repeatedly, again and again; finally it can be reckoned upon beforehand and becomes part of the ceremony.”

Kafka’s famous parable, describes an extraordinary, if not scandalous event that, with repetition, becomes accepted as normal and incorporated into a new set of baseline expectations.

The Wall

This feels somewhat analogous to the world today, especially from an economic and political perspective. Things that even a few years ago would have seemed extraordinary and shocking, are increasingly becoming accepted as normal even though they are anything but.

This is human nature to some extent. We seek to cope by trying to make the abnormal normal, or as in the case of the protagonist in Pink Floyd’s epic album “The Wall”, by building walls - mental or physical - to shield us from things that frighten us.

In the process, we risk becoming comfortably numb to those things that should rightly make us uncomfortable. We also risk isolating and desensitizing ourselves from reality, which, for better or worse, is often quite different from what we perceive or choose to believe.

From an investment standpoint it is especially important to keep this in mind. In a world where crazy seems to be the new normal and we feel like we have fallen through the looking glass into an alternative reality where up is down, right is wrong and fiction is fact, it is ever more difficult and yet important to find a grounded and objective perspective.

Consider, for example that major central banks around the world are participating in the function of economies and financial markets in unprecedented ways. They are maintaining artificially low, and even negative interest rates and buying vast amounts of bonds and even stocks to support and elevate the prices of financial assets. This is not normal and it creates abnormal behavior and unintended consequences. First, it rewards borrowers and holders of riskier financial assets, and penalizes conventional savers and lenders who earn very little return on their saved and lent money. In many parts of the world, a mattress provides a better return on your money than a bank. Second, it almost certainly elevates the price of stocks and bonds and real estate beyond where they would be without this extraordinary monetary support. Third, it creates a dependency that is very hard to break and, like most other dependencies, will ultimately end badly, although it is not clear when. Finally, it leaves central banks very little additional ammunition to do more to help stimulate growth when an economy inevitably falls into the next recession.

These conditions can persist and go to even greater extremes than they rationally should, but it would be a mistake to assume they are normal, sustainable and without consequences. At the very least they create a higher level of risk that needs to be factored into investment decision-making.

Geopolitics

The Geopolitical world has also become a stranger and less harmonious place. The trends towards globalization and openness and engagement and tolerance, of tearing down walls and building bridges have given rise to unsettling counter trends of populism, nationalism, isolationism, and outright xenophobia and racism.

The vote this past June for Britain to “Brexit” the European Union was a case in point. It was remarkable in underscoring the countertrend of discontent with the status quo that pervades large population blocks throughout the world. It was also remarkable in the speed with which the financial markets digested and then shrugged off the news.

Part of the reason for this underlying discontent is a feeling of disenfranchisement and lost opportunity. The spread between the haves and the have-nots around the world has only gotten greater and the extraordinary monetary efforts of the Central Banks around the world definitely favor the haves at the expense of the have-nots. There are other important sources of growing division including access to education, safe food, clean water, and healthcare.

Finally, war and strife, especially in the Middle East, and the rise of ISIS and a new age of terrorism has led to a major refugee crisis, especially in Europe, a rethinking of immigration policy around the world, and a growing culture of fear and intolerance of others.

The irony is that the developed world actually needs and benefits from immigration. With aging populations, developed economies need a growing population of younger workers to displace and support older generations of workers as they retire from the labor force.

US Politics:

Which brings us to the U.S. Political circus and especially the bizarre phenomenon of Donald Trump. It seems crazy that the election would be down to two of the most disliked and polarizing choices in history, but here we are.

It is clear to us that Donald Trump could not have gotten to where he is without a strong undercurrent of disaffected voters who feel frustrated with the status quo and want to shake things up. For them Donald Trump is their galvanizing champion, giving voice to their frustrations, fears and insecurities and selling the promise of radical change and easy solutions to “yuuuge” problems.

Trump could also not have “happened” without the codependent cooperation of the news media to provide him with all the air-time he wants to promote himself and give legitimacy to his views.

He has turned normalcy on its head: constantly spinning and re-spinning his reality like some Jedi mind trick (“these are not the tax returns you are looking for”). The idea of fact checking Trump seems almost a pointless exercise, like counting snowflakes in an avalanche.

What is most alarming has been his ability to say incredible and incendiary things that in any other time, would have disqualified any other candidate. He has done this so frequently that, as a nation, we have become increasingly inured to his outrageousness. If you hear something enough, maybe it’s true or acceptable? This can be a dangerous thing.

Our expectation is still that Hillary Clinton will prevail in November, but this has been a year of unexpected things happening and conventional wisdom being turned on its head.

If Trump were to win, we think that it would be a destabilizing event for financial markets. Some of his plans, such as spending on infrastructure and cutting taxes would likely be positive and could provide a boost to capital investment. Other plans, such as replacing Janet Yellen as head of the Federal Reserve, renegotiating global trade agreements, getting rid of Obamacare and starting a trade war with China would create a large cloud of uncertainty and would likely destabilize global financial markets and slow economic growth.

Conversely, Hillary Clinton, despite all of her well-known baggage would very likely offer a more stable and predictable path forward. She would certainly represent “more of the same,” but she might be able to effect positive change in corporate taxes and infrastructure spending, both areas where there is strong bipartisan support. Despite her negative ratings and the expectation of gridlock under Clinton, her reputation as a senator was as a pragmatist who was willing to compromise and work across the aisle to get things done.

In any case, markets like predictability and dislike uncertainty. The devil you know is better than the one you don’t, and Clinton is definitely the devil you know. On top of a market and economy that is already somewhat unstable, Clinton is less likely to capsize the boat.

A more optimistic view:

Regardless of the outcome, economies tend to be more diverse and resilient than they are given credit for being, regardless of who is president. Listening to the campaigns you would think that we were in a deep economic funk. Not true.

Much of the campaign rhetoric has been geared towards more economically challenged “swing” states and voters and the idea of bringing back lost manufacturing and other jobs to these areas. The narrative is that these traditional jobs have been shipped off-shore or displaced by immigrants. In fact, most of these jobs have been displaced by robots and software. It takes a fraction of the people to build a car, tractor or an airplane today than it did twenty years ago. These 20th century jobs are gone and will not be coming back. Immigration and off-shoring is not the problem; education is. Displaced workers need new skills to do 21st century jobs.

Also missing from the narrative is the discussion of the millions of new jobs that have been created in the technology, biotechnology, healthcare, and services fields. The idea that we don’t make or create anything in this country anymore is crazy. The U.S. continues to lead the world in technological, scientific, medical and industrial innovation, as well as media and entertainment, and these sectors represent a major part of the U.S. economy.

Moreover, these industries are truly global and dependent upon access to the best and brightest engineers and talent from around the world. The political discourse is far out of step with the reality of global trade and commerce and one of the reasons we remain positive about the future despite the current geopolitical situation.

Investment Outlook:

After a rough beginning to the year, and a brief hiccup over the Brexit vote, stock markets around the world powered higher in the third quarter. Markets outside the U.S. outperformed the U.S., led by emerging markets. Within the U.S. stock market, technology and biotechnology stocks delivered especially strong performance. Bonds were flat.

Overall economic data was mixed but generally positive, suggesting sluggish growth. Corporate earnings generally met or beat expectations, but revenue growth in most parts of the economy continues to be slow.

Meanwhile, with traditionally safe assets like government bonds yielding little or no return in the U.S. and negative returns in parts of Europe and Japan, investors remain willing to set caution aside and invest in more risky assets like stocks, driving equity prices higher.

Overall valuation levels for most asset classes are full and don’t allow much of a margin of safety. Yet, without good alternative sources of income or potential return, investors remain willing to suppress their fears and buy stocks.

And, the markets are not uniform. Pockets of value and opportunity remain. The most overvalued parts of the stock and bond markets are ironically the parts that are perceived as the safest and most defensive. This includes longer-term government bonds and dividend-yielding stocks. Conversely, areas of higher perceived risk such as bank, healthcare, technology and emerging market stocks actually offer reasonable value and growth potential.

After the election, there is a scenario that we could see a resurgence of growth. The natives are restless and incumbent politicians are running scared. Talk of austerity has shifted to talk of new fiscal spending on infrastructure, not just in the U.S. but around the world. A little more stability and certainty, a little more spending and some progress on corporate tax reform could do a lot to stimulate new investment and growth. In this scenario, we could see markets head higher on a stronger fundamental outlook.

And there is the scenario that things head south, with greater political and economic uncertainty and consumers and companies hunkering down. This would not be a good scenario for the investment markets.
In either case, we expect higher levels of volatility, especially around the election. We do not think that risks are adequately priced into markets overall, which makes them vulnerable to shocks, setbacks and disappointments.

Investment Strategy:

Putting it all together, we continue to see a world generally characterized by slow growth, high valuation levels and heightened volatility and investment risks. This is the same as we wrote last quarter, except that prices are now even higher.

During the quarter we made a few adjustments to trim risk exposure but continue to emphasize areas of higher long-term growth such as technology, healthcare and emerging markets, balanced with more defensive stocks and alternative investments that can benefit from rising and falling markets.

Although we have no special insight about what the markets will do next, we do not think this is a time to be overly comfortable or numb to the world around us. Nor is it a time to sell the U.S. or global economy short and build a wall to hide behind. It is just a time to be more cautious in portfolio positioning and engaged with reality.

As always, we focus and invest for the long-term, balancing diversified investments focused on areas of long-term growth and innovation with more defensive equity, alternative and bond strategies to mitigate volatility and risk.

We thank you for your ongoing interest and welcome your questions and comments.

Jurika, Mills & Keifer, LLC
October 2016

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.