Over the Christmas weekend, instead of enjoying time with family at home, our Senior Analyst found himself making a quick round-trip from Los Angeles up to California’s snowy far north and back again. The mission was to deliver a sweet old dog to a new home -- in fulfillment of a promise made to the dog’s previous owner on her deathbed. As we all know, this is sometimes how it goes: commitment can take us to unexpected and sometimes uncomfortable places. But it feels good to follow through with integrity. Being willing to get out of our familiar routine often brings us the best rewards, whether that’s a financial reward or just the satisfaction of honoring a promise we’ve made.
2016 was certainly a year in which familiar routines went by the wayside. Political, cultural, and economic events took the experts by surprise -- as well as anyone who was listening to those experts. Taken together, 2016’s unexpected twists and turns have set up a very different set of expectations and worries for the coming year than we had just a few months ago. On balance, it seems, the positive expectations are winning, at least where markets and economics are concerned. Consumer and business confidence have both risen strongly as the year comes to a close.
We can’t offer much guidance when it comes to predictions about artists who might pass from among us in 2017 -- though we hope we don’t have another year where we lose so many luminaries. (We envy whatever angels got to listen in while Bowie, Prince, and Leonard Cohen gave their celestial concert over the holidays -- maybe conducted by Sir Neville Marriner.)
But however worried you may be about what lies ahead for the markets in 2017, we can offer a helpful perspective on where to find some of the opportunities and how to steer clear of some of the dangers. And we see a lot of opportunities.
After 2016’s Changes, Here’s What We Think Won’t Work In the New Year…
Where do we see the risks for investors?
First, avoid big, established companies who make more than 10% of their sales to the U.S. government. Since Donald Trump’s election victory, we have devoted some time to studying The Art of the Deal. One of Mr. Trump’s primary messages in that book could be stated thus: “If you sell to me, you will get good volume but low profit margins.” Judging from some of his tweets since the election, he obviously wants to apply that approach to all the purchasing done by the U.S. government. Probably no one would take exception if we said that the U.S. government has long been famous for overpaying for products and services.
Second, avoid companies who are insiders with strong Republican or Democratic connections, and who have thus qualified for special treatment. Watch out for out for these: Mr. Trump now views himself as the CEO of the United States, and wants his firm (i.e., the public) to benefit -- not well-connected political insiders.
Third, avoid companies that import lots of goods from abroad. Tariffs or threatened tariffs would cause the price of imported goods to rise. Watch out for retailers who sell imported products: almost all of them are at risk of facing new tariffs.
Fourth, avoid companies which depend on exports to trading partners with whom we may have trade friction -- for example, contentious renegotiation of trade deals. These countries may retaliate, and send your export stocks down.
Fifth, avoid companies that depend upon exports and will be hurt if the U.S. dollar remains as strong as it has in the last few months. (Remember that when the U.S. dollar gets stronger versus our trading partners’ currencies, it gets more expensive for them to buy U.S. goods and services, and they can trim back their purchases -- leading to challenges for U.S. exporters.) Since its low in May 2016, the U.S. dollar has appreciated by about 13% versus a basket of currencies which compete with the dollar for exports. A higher dollar is bad for exports.
… And Here’s What We Think Will Work
First, financial companies. We like financial stocks. (Did we say that one too many times? OK, we’ll say it again: we like financial stocks! And did we mention that we like financial stocks?)
We are bullish on financial companies partly because of those members of the new administration who are pro-business, and have direct, practical experience of how the financial system operates. They have run medium-sized banks (Treasury Secretary Mnuchin), or have run companies that employ leverage (President-elect Trump himself, Commerce Secretary Wilbur Ross, Labor Secretary Andrew Puzder, National Economic Council Director Gary Cohn, advisers Harold Hamm and Carl Icahn).
We’re also bullish on financial stocks partly because of the prospect of higher interest rates. About six months ago, we believe, interest rates hit the bottom of their multi-decade decline, and rates will move up for the next several years. Rising rates are fundamentally good for most financial stocks, since the sector’s life-blood is the difference between the interest rates they pay to their creditors, and the interest rates they receive from their borrowers. On balance, that “net interest margin” will at last begin to expand after many years of painful contraction.
In our view, banks, brokers, insurance companies, credit card issuers, financial intermediaries, and companies who make loans for the purchase of equipment and inventory will all see their profit margins increase. The price they pay to borrow money will rise and more slowly than the price they charge to lend money, and therefore the return on their lending will rise.
This means that after decades of falling interest rates, the pressure on their profit margins will be removed.
Also, the years after the Great Financial Crisis ushered in a more stringent regulatory environment for banks of all sizes. The additional regulations were necessary to rein in the misbehavior of big banks, but for smaller banks, they were overkill -- and that caused many small and medium-sized banks to go out of business, or sell themselves to a bigger bank in order to survive.
Now banks, especially small and medium-sized banks, have a chance to grow and provide the services that banks provide to any economy -- services that are critical to any economy’s vitality and growth.
Second, we like lean new entrants who can offer better deals to the government. This means companies that can provide goods and services to the U.S. government at lower prices. Mr. Trump believes that many companies who sell goods and services to the U.S. government are enjoying profit margins on those sales that are too high. He further believes, as do many of his cabinet appointees, that the U.S. could cut its budget deficit substantially by renegotiating contracts with vendors who sell everything from military equipment to every type of professional service -- and pay a much lower price. He and his cabinet appointees also believe that layers of bloated expenditure are imbedded into the government budgeting and procurement process. Probably the most egregious examples are found in the Defense Department, but every department can improve. They believe that lobbyists are a major reason that costs of operating the U.S. government are much higher than they need to be.
He will propose cutting hundreds of billions of dollars in costs by making government more efficient, and asking government employees to become more like private-sector employees. They will be expected to work more efficiently and become much more conscientious about spending the taxpayers’ money.
(We expect hiring freezes for Federal workers, and freezes on the use of outside consultants. We will not be surprised to see his cabinet members put hiring freezes on many government departments, and allow the workforce to shrink by attrition. Employees who do not wish to make government more efficient will rebel, and many will be laid off but with full pay -- as the employment guidelines for Federal employees can make it very hard to get rid of even grossly inefficient workers.)
Here’s who could win in such an environment. There are long-established companies with big bureaucracies who rely on intimate relations between their staff and lobbyists on the one hand, and the regulators and procurement officials who obligingly supply them with feasts from the “pork barrel” on the other hand. In the new environment, such companies will be challenged -- and any of them could find themselves on the wrong end of a blistering early-morning lecture from the new Tweeter-in-Chief. That could open spaces for new companies to sell to the government -- leaner and nimbler companies who can take advantage of the opportunity to grow their sales rapidly. One company's loss will be another's gain.
Investment implications: 2016 threw a lot of people for a loop -- especially opinion pollsters and election predictors. It was a year when many things didn’t go as expected. However, in the unexpected lies abundant opportunity. We offer our year-end rundown of how developments in 2016 have set the stage for 2017 -- and suggest how to dial up the rewards and dial down the risks. We see risks for old, established companies that do a significant part of their business with the Federal government; they are likely to be pressured by a new administration that’s determined to get rock-bottom prices when it spends from the public purse.
Cozy insiders are likely to suffer, as could big importers and those who do business with countries where trade frictions may flare from contentious re-negotiations. If the U.S. dollar remains strong, U.S. exporters will come under pressure. On the positive side, a new emphasis on lean procurement could make an opening for suppliers who can sell goods and services to the Federal government at a better price. And of course, as we have not tired of saying, chief beneficiaries of the new environment that 2016 will be financial companies of many kinds, supported by rising interest rates and the promise of a regulatory regime that is vigilant to risks, but understands the critical nature of a healthy financial system for economic growth.
Market Summary
1. We believe that the U.S. is the most attractive county in the world for investment.
2. We favor stocks over bonds, and we believe that higher interest rates in coming months and years will make bonds a very unrewarding investment.
3. We expect the U.S. dollar to continue to rise by another few percent in the next few months.
4. We are not attracted to Europe, but we believe that some countries in Asia will be OK for investment if you hedge the currency.
5. Gold continues to build a base. It is too early to add to positions in our view.