InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
FEBRUARY 8 , 2017
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We continue our focus, in this issue of IntelDigest, on The Economy and Investing in the “New World Order.” Today, we discuss new opportunities in Emerging Markets, Infrastructure proposals in the United States, inflation and interest rates. Next week, we will revisit Gold, and explain its resurgence in the new year.
As we pointed out last week, we expect small-cap stocks to outshine multinational corporations this year. Small-caps would benefit from increased earnings produced by reduced government regulation and lowered corporate income tax rates. Most small-caps should be generally unaffected by conflicts over trade policy.
Several sectors which rallied following the election … including multinational corporations in financials, industrials, materials, and energy … will likely underperform in 2017. These sectors have been characterized by lackluster or negative earnings and sales growth … investors can see that these companies don’t have the fundamentals to support the year-end surge.
These sectors have already experienced a pullback from their frothy market highs post-election, as investors see extreme contentiousness from the new Administration, and reluctance in Congress to dive head-first into the Trump Agenda. Markets have been spooked by potential bottlenecks on tax reform, healthcare reform, and the vaunted Infrastructure spending spree (which we discuss later in this issue).
Combined with concerns about the fundamentals in these sectors, investors have taken profits on the year-end market surge.
Emerging Markets
We believe that one of the best opportunities in the markets is to look overseas. Emerging Markets have lagged American markets since the 2008 Financial Crisis, but fundamentals are improving and the situation looks promising for 2017.
Emerging Market fundamentals are illustrated by the Purchasing Managers Index (PMI) for the Eurozone, which recently rose to its highest level in nearly six years. Manufacturing growth is up in Germany, France, and Italy; this is a good indicator that the long battle against deflation in Europe is coming to an end.
Inflation is now rising faster than expected for the first time in years. The “Global Inflation Surprise Index” at Citigroup has been surging higher in recent months, along with consumer prices. The index compares actual consumer price data with market expectations, and has been in positive territory in the last few months.
After years of falling short of analyst expectations, global inflation is suddenly moving much faster than predicted, which should be bullish for equities (in the short-term) and precious metals (in the long-term).
BRICs
Like the rest of the Emerging Markets, the BRICs markets (Brazil, Russia, India, China) are due for a rebound from the Financial Crisis, and they have significant advantages over other countries. The BRICs are the four largest Emerging Markets, and have the potential to be among the largest economies on the planet in future decades. Their stock markets soared in the early years of this century; a moderate recovery in these markets now would be profitable for investors.
China is now the second largest economy in the world, behind only the U.S. India is seventh largest, and Brazil is number nine. Even Russia, with all its financial troubles and the decline in the oil market, is the twelfth largest economy in the world.
The BRICs Bull Market in the early-2000s followed a decade of underperformance compared with the U.S. in the 1990s. During that Bull Market, the the MSCI BRIC Index rose 745% from its low in 2002 to its high in 2007.
We believe that this year will be good for The BRICs, so we have invested in the iShares MSCI BRIC Fund (BKF) which tracks that Index.
Infrastructure Projects in the U.S.
Both the Trump Administration and the Democratic opposition have new Infrastructure Proposals on the table, so it is relatively certain that Billions of Dollars will be spent on Infrastructure over the next four years.
The Administration has published its “Priority List: Emergency & National Security Projects,” which lists 50 projects to be tackled early in Trump’s Presidency (originally put out by the Transition Office). Total federal spending would exceed $137 Billion Dollars, and The Administration would encourage the private sector to add a similar amount for vital national projects.
The paper and its details can easily be found on the Internet. Highlights of the Plan include: road and bridge repair and replacement; updating and expansion of the electric grid; energy storage projects; upgrades to airports in St. Louis, Seattle, and Kansas City; modernizing the Air Traffic Control System from radar to satellite-based tracking; rail and transit projects, including the Washington-New York corridor; reinstatement of the Keystone and Dakota Access pipelines; addition of the Atlantic Coast Pipeline from the Marcellus Shale in Pennsylvania to utilities in Virginia and North Carolina; and various other projects, including dams, waterways, et al.
The Democrats’ Plan is set out in the “Blueprint to Rebuild America’s Infrastructure,” which would spend A Trillion Dollars on the Trump projects and many more.
Infrastructure spending obviously has support from both parties. Whatever combination of projects comes out of Congress later this year, Billions of Dollars will be spent and many jobs will be created. We will discuss possible investment opportunities later this year as the Plan begins to take shape.
Long-term Credit Problems
As we have written in several issues, a long-term Credit Crisis looms over the horizon, which will make investing very challenging in 2018 and 2019.
The Wall Street Journal recently published an interesting analysis of The Federal Reserve, highlighting an unusual consequence of the Fed’s Quantitative Easing (QE). Recall that, in the wake of the 2008 Financial Crisis, the QE program involved The Federal Reserve buying up Trillions of Dollars of bonds (mostly government securities) in an attempt to lower interest rates and increase the money supply to spur the economy.
The program did not achieve the stated goals, but some would argue that it stopped the world economy from plunging further into crisis.
The Fed stopped buying new debt in 2014, but it still holds more than $4 Trillion in debt, including nearly $2.5 Trillion in U.S. Treasury securities. The Fed holds mostly longer-term debt, meaning relatively little of this debt has matured. The Fed has been reinvesting the cash from maturing bonds back into new Treasury debt.
The Journal notes that the average duration of the Fed’s Treasury holdings has fallen from nearly eight years in 2014 to just six years today. In other words, the Fed has been reinvesting in shorter-term debt than it had been. And this has helped push interest rates higher.
Janet Yellen, the current Fed Chair, asserts that this has had the same impact as if the Fed had raised short-term rates two additional times.
According to the Journal, The Fed now intends to cut the size of its bond portfolio … it will stop reinvesting the cash from maturing bonds back into Treasuries. This would put even more upward pressure on rates.
Moreover, much of The Fed’s Treasury debt is set to mature over the next five years.
Long-term rates will soar higher as inflation begins to stir for the first time in years and the Bull Market in bonds rolls over. This would result in much higher borrowing costs in the next few years. High-grade borrowers would be forced to pay unusually high rates; many firms will be unable to borrow at all
Expect the benchmark 10-year Treasury to rise from 2.35% to 6% over 2-3 years.
Next week, we’ll address this problem in more detail … the time frame for onset of such a crisis … steps to be taken ahead of time to protect our assets.