3rd Quarter Outlook, 2016
Brexit – The U.K. votes to leave the European Union
The 2nd quarter ended with the U.K. voting to leave the European Union. “Brexit” surprised many. It also leaves us wondering whether short-term market volatility will extend into something longer. It certainly could, especially in Britain itself. However, for the U.S stock market, we believe the volatility driven by Brexit will be short-lived. We suspect that in a year or two we will look back and wonder what the fuss was all about. We are even more confident in five years that will indeed be the case.
The elite European socialist policymakers are near unanimous: the world economies need “certainty”. In their minds, if the world were just more certain the economy would be doing much better. To us, this is a very odd way of thinking. For example, North Korea maximizes “certainty”. They have little flexibility, choice, and freedom. The North Korean certainty is the certainty of a prison cell, but it is certainty nonetheless.
By contrast, free-market capitalism is the opposite of a system built on certainty. No one knows for sure what will be invented or discovered, how an industry will be disrupted, or how consumer appetites will change in the future. In free-market capitalism, uncertainty is opportunity.
Obviously, not all certainty is bad. People are more industrious and inventive when they can rely on the rule of law – particularly those laws that protect their intellectual and real property. Governments that provide a firm foundation of law help maximize risk-taking. It is risk taking that boosts standards of living by creating more and better paying jobs. What the elite European socialist policymakers do not seem to understand is this: “confidence” more than “certainty” drives economic growth. If the people have confidence that the government will protect their freedoms, they will act in ways that ultimately boost economic growth.
This is why we believe the vote by the Brits to leave the European Union is not the problem many think it is. The British people have found themselves enmeshed in rules and regulations not of their own making. They lack confidence in the elite socialist policymakers of the E.U. housed in Brussels. At the time of the Brexit referendum, some 60% of British laws and 70% of its regulations were dictated by Brussels. Many Brits view these unelected bureaucrats as corrupt, arrogant, and incompetent. If the British are able to free their economy of over-bearing regulations, they may become an even more potent economic powerhouse.
The bureaucrats created regulations from the ridiculous (mandating the maximum curvature of a banana), to the socially threatening (requiring the British government to accept immigrants seeking welfare benefits similar to British citizens). Indeed, data from exit polling suggests that the British were most concerned about immigration – that the increased numbers of immigrants were pressuring the National Health Service to such a degree as to degrade the health care benefits of everyday Britons.
The struggle between individual liberty and central planning is not new. In the 1930’s, Austrian economist Friedrich Hayek watched Europe struggle with the ideas of Nazism and Soviet socialism. Hayek thought there were two safeguards that could protect the populace: first was the basic human instinct for individual freedom, second was the inherent inefficiency of centrally planned economic systems. He believed no bureaucrat or economist sitting at his desk could possibly come up with the best answers. Churchill’s famous quote “Democracy is the worst form of government, except all the others”, contains a basic truth. Economic freedom provides the optimum, but not perfect outcome. The dream of providing perfectly equal economic outcomes died with the fall of the Soviet Union in 1989. It’s less potent version is now crumbling in nations across Europe.
The coming weeks and months will bring angst over what the future holds for the U.K. and its effect on the world’s economy. Ultimately, we hope for a freer and more competitive Britain, one that has more control over its own political and economic destiny. Such an outcome is likely to bring a more prosperous Britain as well. The E.U., which runs a large trade surplus with the U.K, has an incentive to negotiate a workable trade deal. Meanwhile, the U.K. has an opening to expand free trade with the U.S. and Canada, which the E.U. was making more difficult before the vote. Only time will tell how this all works out.
Since the U.K. maintained the British Pound, they do not have the problem inherent to other E.U. nations – that of creating a new currency upon exit. Because of this very large hurdle, we do not believe there will be a domino effect with other countries, ultimately unraveling the E.U. Other countries in the E.U. would need to re-create their currency should they decide to exit. Perhaps the pressure coming from Brexit will tame the arrogance of the unelected Brussel’s politicians and others, resulting in some positives outside of the U.K.
Ultimately, we look for the U.K.’s position relative to the E.U. to evolve – perhaps toward that of Norway or Switzerland, who have voted not to be full members of the E.U. The E.U. created a “social” membership of sorts for these two countries with the European Economic Area. The E.E.A. allows free trade and easy border crossings, but created a buffer from the bureaucratic dictates of Brussels. The U.K. is bigger than Norway and Switzerland, which gives them more leverage to negotiate a version of social membership. Politicians love big bureaucracies and the E.U. now makes the costs of being a member greater than the benefits for the average citizen, at least in the eyes of Brits. This time the people spoke. All this is why we believe Brexit is good.
Why the Fed will not raise interest rates in 2016
The biggest impact of Brexit here at home, aside from a quick two-day drop in the stock market, has been the strengthening of the U.S. Dollar and the reduction in our interest rates. Though a drop in the 10-year Treasury Note to less than 1.5% seems exceptionally low (because it is the lowest in history) we believe there is a significant chance that it will drop even farther. After all, the U.S. still has the strongest economy with the preferred currency.
We are in a new economic world. Our bonds no longer trade on domestic economic performance – they are a “yield haven” for foreigners. We believe that foreign currency will continue to flow into our equity market and also into our government treasury notes and bonds, forcing interest rates even lower. With Japan, Switzerland, and Europe in negative interest rate territory, a 1.5% rate on the U.S. Treasury Note in a strong currency is very attractive to foreign investors. Because of all this, we find it very unlikely that our Fed will raise rates anytime soon – very likely pushing a hike in the Fed Funds rate back to December, or even into 2017.
Our Total Return Strategy: “Babies thrown-out with the bathwater”
With low interest rates and slow overall economic growth, we believe investors will continue to hunt for companies that pay an attractive dividend yield. However, we have taken that search two steps farther. We have been searching not only for attractive dividend yields, but also growth in revenue and earnings with a relatively low valuation. Investing for dividends and capital gains – this is our Total Return Strategy.
Changes in market structure – the growth and popularity of ETF & Index Fund investing – has provided some unique opportunities which we have been seeking to exploit.
Using our institutional database tools, beginning in February we began finding companies that had similar characteristics: 1) they were included in Exchange Traded Funds (ETFs) which were out-of-favor and thus heavily sold; 2) they had increasing revenues and earnings; 3) they had attractive dividend yields and 4) in some cases the dividend had been raised while the stock price fell! In other words, these companies’ fundamentals, valuations and dividends were very attractive, but their stock price had suffered significant decline. Hence, we dubbed them “babies thrown out with the bathwater”.
The sheer dollar amounts invested in sector-specific ETFs and Index funds has created a new phenomenon, where capital flows can overwhelm a company’s fundamental financial performance in equity pricing. We expect to find more of such companies on an on-going basis. Due to the “ETF Effect”, when a sector of the economy goes out-of-favor, we believe that capital flows out of the related industry groups take the strong down with the weak. The biotech / pharma group is one such group suffering now from the ETF Effect, and we are watching it carefully for a turn. There will be other babies thrown out with the bathwater over time, and we will be on the constant look-out for them.
With our Total Return Strategy, we have been adding many high dividend yielding companies to our portfolios since February and have continued adding them through the end of June. Because of this, overall dividend income has been rising in the portfolios. We expect that you will notice the increasing impact of dividends to the total return of your portfolio over time. We encourage you to carefully study your Fidelity statement, as Fidelity calculates the actual dividends and interest paid each month.
QE has ended – Active Management will win again
From March 2009 thru October 2014, the U.S. Federal government and Federal Reserve went on a spending and money printing binge. Starting with a near $1 Trillion “fiscal stimulus” package and followed by successive rounds of Quantitative Easing (bond buying and zero interest rates), the banks and the country were awash in cash. Anytime a country creates an excessive amount of currency, you can bet on two things: the currency will devalue and assets will appreciate.
When investing in that kind of environment you want to throw open the sails and catch as much wind as possible. Those are the times that buying Exchange Traded Funds and market Index funds works extremely well. All you really need to do is maintain the fortitude to weather the occasional drops that occur during the interim. If you can do that, it is likely you will outperform most active managers. Since market indexes do not care about your comfort level or how well you sleep, passive investing has a distinct advantage in a strong uptrend. Active managers with a good sell discipline take action to prevent large losses that occur in big drawdowns (such as in 2008 or 2000-2002), but often miss some of the bounce-back when the market recovers.
The 5½ years which favored passive investing provided the ETF and Index fund management companies time and revenue to sell the idea of passive over active investing. It has worked beautifully for them – they are marketing geniuses. They needed that success too. Previous to that 5½ year period was “The Lost Decade”. For over 10 years the major indexes fought to get back to their 2000 highs. That was a period where active management had the upper hand, both in comfort and returns. There was a similar time from 1966 thru 1982 when it took 16 years for the indexes and their investors to get back to even. Passive investing in those times was very costly and painful.
We believe that we will look back on 2009 through 2014 as “The Golden Age of Passive Investing”. The main driver of passive investing outperformance – Quantitative Easing – is over. Company valuations now need to stand on their own fundamentals, but we believe that stock prices will continue to be buffeted by the ETF Effect of capital flows. In this environment, strong active management will likely outperform passive, and with sound portfolio construction, will likely experience less volatility. We do not believe this is a time to be diversified throughout the pie chart in a passive way. There are obvious areas to avoid now, but we believe those will eventually provide us the opportunity to find more babies thrown out with the bathwater.
A final note: recession talk is just talk
To close, we thought a brief comment on the likelihood of a recession would be in order. The energy sector has been a drag on overall market earnings, but oil production has dropped with the falling price of a barrel, resulting in a rise in oil prices from the $26 low. Energy company earnings should rise accordingly. Still, energy remains relatively inexpensive, helping earnings for most other sectors of the economy. Add the benefit of very low interest rates and a dollar that is lower than last year, and we see an opportunity for higher earnings in all but the financial sector.
Finally, the three-month moving average for new jobs has shown a steady increase of around 175,000 per month – a plow horse rate, but still it represents growth and additional paychecks. Due to this combination, we see very little chance of a recession this year.
If you have any questions about your portfolio, our outlook, or the state of the investing world please do not hesitate to call. Thank you for your continuing support.
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