THE WINTER LETTER
When the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill-done.”
– John Maynard Keynes
Economic Perspective
Substantial corporate tax cuts sparked vigorous business expansion and corporate income gains in 2018. But expanded infrastructure spending did not materialize. The political landscape is fraught with incalculable risk. Call it political volatility or risk of a Twitter tantrum or the erratic outbursts of a narcissist, but the peace of the world is at its greatest risk since the end of the Cold War. A misstep could also have dire economic consequences.
The current economic risks including a pointless Federal government shutdown on top of the needless tariff war with China look to shave first half economic growth significantly. It remains to be seen how the tariff war with China gets resolved in light of mutual criminal prosecutions. The Federal Reserve’s shift to a more neutral stance on interest rates postpones a recession inducing rate rise.
Struggling with the headwinds of a rising dollar which reduces foreigners’ appetite for more costly American goods, the US industrial economy endured multiple quarters of sluggish growth. The overheated leveraged loan market is the US financial system’s current Achilles heel, especially in a climate of deteriorating lender behavior.
Fourth quarter 2018 GDP only grew at 2 1/2% annually well off the midyear pace. Hidden within that statistic was tepid consumer spending. Despite the growth outlook abroad improving, the US economy will be lucky to sustain its current 2% growth path.
Our primary trading partners, Europe, Japan, China, offer little support for global economic expansion. Europe remains mired in a growth recession and China, transitioning to more emphasis on consumer spending rather than capital investment, is struggling with declining economic growth rates.
In a global environment of weak economic growth and negligible inflation, only the Federal Reserve has successfully raised rates. Fiscal stimulus has been anemic. Corporations, while willing to acquire scale through mergers, have been unwilling to invest in additional capacity.
Market Prospects
The surprise in 2018 was that despite the best economic growth of the post-Great Recession decade, a surge in corporate profits and half century record low unemployment, the stock market registered its worst year in a decade.
In the long run, financial markets exist to facilitate the efficient allocation of capital. Short term they give market participants premature ulcers. The year opened with a rise in global stock prices. As January goes so goes the year; but history suggests that we may have witnessed the year’s entire net advance in US stock prices in this first month. However, we will not be spared further intermittent volatility.
Geopolitical risks cloud the outlook: populist demagoguing and anti-globalist sentiment from Brexit to Hungary’s increasingly authoritarian President Orban’s anti-immigration policies. With Trump’s announced exit from Syria, the Turks appear poised to crush the Kurds. In an effort to navigate the treacherous market waters we emphasize sectors like: more resilient large cap names (Illinois Toolworks, Air Products and Chemicals); financials (Bladex, Alleghany, White Mountains); the out-of-favor pharmaceuticals and biotech (Eli Lilly, Bristol-Myers, Pfizer, Gilead); entertainment (Liberty Media, Disney, Comcast); technology (Microsoft, nVidia, and Google), dividend plays like ProLogis; and specialty manufacturing (Amphenol, Hexcel, and Wabtec).
Stephen K. Bache, CFA
Sources: Business Week, The Economist, New York Times, The Wall Street Journal; Richard Thaler, Misbehaving, (New York, 2015); Robert D. Richardson, Jr., Emerson: The Mind on Fire, (California, 1995)
