November 30, 2016

Stocks managed a small gain yesterday despite weakness in the oil market as traders worried that the Vienna OPEC meeting would end with no deal.  This morning, however, it appears a deal is near; we will know later today.  I wouldn’t put a whole lot of stock in any deal given the proclivity of member nations to cheat on quotas, but a deal is better than an environment where every producing nation lifts as much oil as possible out of the ground, creating a huge glut of excess supply.  Away from oil markets, bond yields are starting to creep up again.  Q3 GDP was revised upward to over 3% and corporate profits are starting to rise again.  What has been labeled as the Trump rally may, in fact, be a combination of Trump’s victory and better-than-expected current economic data.

We are starting to see a flood of new cabinet appointments.  If I can characterize them as a group, I would label most as change agents.  To be sure, some have advocated positions that the majority would label extreme.  Don’t worry about these extremists.  They simply represent a starting point in the negotiating process.  We aren’t going to privatize Medicare any more than we are going to see a wall built from the Gulf of Mexico to the Pacific Ocean.  But what we are going to see is more economic incentives woven into the mix.  Instead of telling young Americans that they must buy the same insurance policy that their sick parents are paying for, they will be offered a competitive set of alternatives that fit their needs.  If the products provide the right combination of services and price, the young will become willing buyers instead of walking away and risking tax penalties.  Similarly, small banks, who had nothing to do with creating the financial crisis of 2008, won’t have to be burdened by the same set of rules as the four huge banks deemed too big to fail.  Small businesses are our nation’s job creators.  Small businesses that are successful need capital and loans to grow.  By their very nature, a small entrepreneurial company is a bigger risk than lending to Apple# or IBM#.  Lenders should get compensated via higher interest rates and tighter loan covenants.  However, if the regulatory burden that must be crossed to make such a loan is too great, no bank will make it and job opportunities will be lost.  Steve Mnuchin, the new nominee for Treasury Secretary, bought IndyMac from the FDIC, a mortgage lender that failed during the financial crisis, along with such notable names as George Soros and John Paulson, renamed it OneWest and turned it into one of California’s most successful banks.  Yes, they had to foreclose on over 500,000 bad mortgages, loans Mr. Mnuchin and company inherited and didn’t make themselves, a process that brought about a lot of pain to affected homeowners.  But the bottom line is that he salvaged what no one else dared to try.  His group was the sole bidder for the IndyMac assets.  He is the sort of change agent that symbolizes the new Trump team.

Not all of the initiatives that the Trump administration will try will be approved and some of those approved will fail.  But trying to improve the economy, which means trying to give the vast middle class better opportunities, seems to be worth the gamble.  That is the obvious message of the election.  Pragmatically, we are almost certain to see a cut in corporate tax rates, some formula to repatriate money multi-nationals have sitting abroad, less burdensome regulation, and revisions to ObamaCare that will allow more effective economic incentives that can reduce costs and provide broad coverage.  Less certain are trade agreement revisions and infrastructure spending.

Wall Street has been celebrating the opportunity.  Whether or not it has been too optimistic will depend on the speed at which change gets done and how much legislation makes its way through Congress.  Peeling back certain regulations can happen overnight.  Some of those changes will have more psychological impact than economic impact at the beginning.  Tax reform needs Congressional action and will take many months at a minimum.  Markets look ahead, however, and if the path appears clear by mid-year, the message of the recent market action will be validated.

In my missives every week I concentrate on the economic issues.  But we also need to acknowledge that battles over cabinet nominees and the Supreme Court could suck some of the oxygen from efforts to invigorate the economy.  Mr. Trump’s proclivity to say the wrong thing at the wrong time may also get in the way occasionally.  Hopefully, the Secret Service will find ways to limit his future ability to Tweet from anywhere at 3:00 AM.  And, of course, I haven’t given the possibility of any intervening foreign crisis its fair due.  For sure, leaders in Russia, Iran, and North Korea will test him in some manner before too long.

To date, Wall Street has rotated heavily into sectors like banking that are obvious beneficiaries of Trump policies and shifted away from sectors like healthcare that might be hurt by cutbacks in Medicaid funding or revisions to ObamaCare.  But perhaps this rotation has been too simplistic.  Yes, banks will benefit from higher interest rates and less regulation, but banks have not suddenly been transformed into growth engines.  Talk of an economy capable of sustaining real growth of 4-5% or more has no solid factual backing.  Growth in any one quarter could get a boost from tax reform or less regulation, but sustainable growth of 4-5% or higher requires a huge jump in productivity that is hard, at least for me, to reconcile.  Less regulation could help to lift productivity, but to get a jump from close to zero to 3-4% or more and sustain such a move requires much more.  Japan has spent trillions in recent decades on massive infrastructure improvements from bullet trains to modern airports, but productivity has barely budged.  While modern roads, an updated air traffic control system, and improved GPS accuracy will help, dramatic and sustained rises in productivity need to come from the private sector.  The timing of major changes can be linked to either major transformative inventions such as the automobile or passenger plane, or technological advances that vastly increase output per man hour.  Recognize that driving down the cost isn’t the same as increasing the output per man hour.  Robotics can do both.  One can argue how much faster and cheaper computers can do to increase output.

Another factor that will impact future growth has to do with what happens worldwide if there is any sort of economic transformation in the U.S.  So far, the immediate reaction has been a rise in the value of the dollar and a movement of capital toward the U.S.  The rise in the value of the dollar negates some of the competitive advantage potentially gained by less regulation, lower taxes and greater economic efficiency.  But Mr. Trump’s rise didn’t occur in a vacuum.  The Brexit vote was a vote for change and a vote away from onerous regulation.  Italy has an important election on Sunday with a populist favored.  France will choose between two change agents soon thereafter.  Major transformative changes have been happening in India, Argentina and Brazil.  Japan has been trying to change, with mixed results, for a few years.   Even China is changing under new leadership.  Status quo exists in Russia, Germany (at least for the moment) and North Korea.  But they are exceptions, not the rule.

All the efforts to change, however, cannot override the laws of demographics.  The world is growing at a slower pace as it gets more populated and as more major countries start to emerge economically.  China and India are still growing. but neither can sustain the growth rates of the last decade.  Oil prices, no matter what OPEC decides, are going to stay well below the $100 per barrel level.  Oil producing nations will struggle to make ends meet for some time to come.  But even a small fraction of one percent change in world growth has a huge impact expressed in dollars.  Removing shackles feels good for everyone.  After years of heavy regulation in the wake of the worst financial crisis since the Great Depression, it is time for moderation.  That should bring more growth, and it should mean better times ahead for all.  That alone, suggest a lot of good investment opportunities lay ahead.

Today Kaley Cuoco is 31.  Ben Stiller is 51.  Mandy Patinkin is 64.  “Homeland” returns January 15th.

James M. Meyer, CFA 610-260-2220

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