Counterpoint Commentary

Two Worlds

2017 was a year marked by the strange juxtaposition between an improving global economy and buoyant financial markets, and a distressing geopolitical landscape.

Depending on your vantage point, to paraphrase Dickens: it was truly the best of times and the worst of times, an age of wisdom and foolishness, of belief and incredulity, light and darkness, hope and despair.

Tax Reform and Infrastructure

With improving economic fundamentals, low interest rates, and a lack of good alternatives, investors continued to tune out the geopolitical world in favor of the economic one, allocating money to risk assets around the globe in search of income and capital appreciation.

From an economic standpoint, 2017 was one of the best years since the financial crisis. For the first time since 2010 we saw synchronized global economic growth, with most countries in most regions reporting positive and accelerating growth. Consumer and business confidence levels are near all-time high levels. Barring an exogenous shock, these growth trends are likely to continue and even accelerate into 2018.

Global financial markets also delivered strong results. In the United States, the benchmark S&P 500 stock index rose 21.8%. Outside the United States, stocks did even better. The MSCI All Country World Index (ex the United States) rose 27.2% and the MSCI Emerging Markets Index rose 37.5%, its best return in seven years. Bonds also produced decent returns, with the Barclays US Aggregate Bond Index rising 3.5%. Corporate, high yield and global bonds all returned between 6% and 7%.

From a geopolitical standpoint, 2017 looked quite different. Most of the domestic headlines focused on the often dysfunctional and disheartening political scene here in the U.S., as well as the growing threat of conflict with North Korea.

Beyond this, we have seen an overall retreat from globalization and a rise of nationalist parties and groups, especially in Europe, further threatening the cohesion and stability of the European Union. We have also seen a further deterioration in many of the relationships and institutions that have bound nations together since the end of World War II as well as the role of the United States as the de-facto global hegemon. The growing void of U.S. leadership has allowed other actors like China, Russia and Iran to step in and left the world a much less centered, unified and stable place. In his year-end message to the world, U.N. Secretary General Guterres issued a sobering Red Alert for the world and a call to action for global cooperation to battle disease, famine, refugees, and climate change. Sadly, his plea was eclipsed by non-stop coverage of the Tax Reform bill.

Tax Reform

Within the United States, the Republican Congress and President Trump were able to pass a new tax bill. The final bill signed into law is a sprawling mess of legislation designed to cut taxes and create jobs. It will almost certainly guarantee full employment for anyone in the accounting profession for years to come.

On a positive note, it does lower the tax rate for U.S. corporations to help make them more competitive globally. This is a good thing. It also allows them to repatriate offshore cash earnings back to the United States at a favorable tax rate. On a less positive note, a number of the provisions of the bill are one-time or temporary in nature. Like a sugar rush, any benefit to economic growth they create will be short-lived, and followed by economic drowsiness or even a nap (aka a recession).

The biggest criticism that we have of the tax bill is that it reforms little and solves problems we don’t really have while not addressing problems that we do have. With an unemployment rate already at 4.3%, nearing full employment, and an economy already growing close to 3%, the economy is doing fine and we don’t really need to boost near-term economic growth further, other than to score political points. In fact, doing so may result in higher rates of inflation and higher interest rates.

The Bill also likely results in significantly higher deficits in the long-run – likely adding between $1 to $1.5 trillion to the national debt over the next ten years according to the bipartisan Congressional Budget Office. So, we are borrowing a trillion dollars from our kids to give ourselves a tax break that we don’t really need, while our infrastructure is crumbling around us. This is no way to run a company or a country for long-term success, but it is the way things currently are. And who knows, now that the Republicans have shown a willingness to incur deficits to give out tax breaks, they may also be game to borrow additional money for infrastructure. If so, this would provide an additional boost to U.S. economic growth over the next few years.

Looking Forward:

We think that 2018 should be another strong year for economic growth around the world. In the United States, the tax bill will provide an additional turbo boost to economic growth, at least into the first half of 2018. In Europe and Asia, current growth trends should also continue.

But there are clouds on the horizon. The U.S. expansion since the global economic crisis in 2008 has been long and shallow, lasting over 40 quarters, but it is likely in late innings. As in nature, there is a cycle to economies and sustained periods of economic growth tend to fall victim to their own success. It is not a matter of whether this will happen, but when.

As noted above, employment is tight and inflationary pressures are on the rise. Economic growth requires a pool of available and productive workers. If the pool dries up, workers are harder and more expensive to hire, wages rise and growth tends to slow.

In addition, a significant rise in inflationary expectations in the U.S. could force the Federal Reserve to act more aggressively to raise short-term interest rates. This would likely take the wind out of the sails of economic growth and financial markets.

Thus far, inflation rates have been fairly benign in the U.S. and around the world, with global inflation rates running around 2.2%. But the preconditions for higher inflation levels are rising.

Europe and Asia have lagged the U.S. in their recoveries and likely have more running room to go, but they are still highly dependent upon the health and well-being of the U.S. economy. Their Central Banks are also highly sensitive to inflation and inflationary pressures would cause them to have to move more quickly to normalize monetary policy.

Finally, although the economic and geopolitical worlds may seem very different, they are inextricably linked. Long-term economic stability is dependent on global political stability. Similarly, long-term economic growth is dependent on vibrant public institutions, robust infrastructure, a healthy environment, safe food and water, scientific investment and advancement, a diverse and educated workforce, and rule of law. It is also dependent on fiscal prudence and manageable levels of indebtedness. If these conditions are allowed to deteriorate, economies and markets tend to falter, and politicians tend to lose their office and sometimes, even their heads.

To be sure, some of the political news is overstated. President Trump’s rhetoric is far more inflammatory than actual U.S. foreign and trade policy. We have not abandoned NATO or NAFTA, and are not likely to. We probably aren’t going to build a wall.

Investors have rightly learned to tune out the noise and focus on things that are immediate and measurable like economic growth, corporate earnings, tax and interest rates. But, many of the geopolitical problems are real and important. We may be able to ignore them for a while, but not without long-term consequence.

Investment Strategy

We think that for the near term, the combination of global economic growth rates, rising corporate earnings, low interest rates and accommodative Central Banks, should support modestly rising equity markets.

The strong performance of global stocks last year already reflects a lot of good news, and valuation levels are quite high relative to history. But corporate earnings results and forward guidance should be strong, especially as companies factor the new tax bill into their forecasts. Talk of an infrastructure bill would also provide additional lift to equities, especially more cyclical stocks.

At some point, there will be a correction. We are overdue for one and as we have written many times, corrections are both normal and healthy. We also know that significant corrections rarely occur without a recession. We do not currently foresee an imminent recession.

Also, although major Central Banks, led by the Federal Reserve, are moving to normalize monetary policy and are sensitive to inflation, the absolute level of interest rates is low. Central Bankers will not be keen to intentionally pull the rug out from under the economy.

All that being said, given current valuation levels, expected returns should rationally be lower going forward. We know from experience that markets are not always rational and often overshoot in whatever direction they are headed. The higher markets rise, the more investors want to join the party, and the lower they fall, the more investors want to sell. Some things never change.

But as the song goes, the fundamental things apply, as time goes by. Fundamentals like earnings and valuation matter and the idea of buying low and selling high still makes sense to us as an investment practice.

We still continue to prefer stocks to bonds for the long term investment, but think this is a good time to be somewhat more defensive, despite rising markets and rosy economic news.

There are real risks in the geopolitical world that could easily impact the world economy and financial markets. With higher valuation levels and general investor complacency, the current level of risk in the market relative to the potential rewards is not overly attractive.

Over the long-term, we continue to invest with a global focus, balancing investments targeted towards areas of long-term growth and innovation, such as technology, life sciences and the developing world, with more defensive equity, alternative and bond strategies aimed at mitigating volatility and risk.

As always, we welcome your comments, questions and referrals.

Jurika, Mills & Keifer, LLC
January 2018

Important Disclosures

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

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. The net performance represents performance figures net of all fees including management, performance fees, transaction costs and commissions. Past performance is no guarantee of future returns, which may vary. Please note that one cannot invest directly in an index.

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.