2017 Macro Outlook

***OLD FORMAT. PLEASE CONTACT US IF YOU WOULD LIKE AN ORIGINAL COPY***

In the early 1900’s, Albert Einstein famously wrote, “The definition of insanity is doing something over and over again and expecting a different result.”¹ This saying could be argued as the rallying cry a near century later in 2016 for democracies across the globe. Of course, it is too early to say whether the actions of the past year will bring changes desired (or undesired), but it is a certainty that the year of 2016 marks a complete pivot in economics and policies since the last crisis. Since the economic cycle reset in 2008, monetary policy in the US has been ‘full throttle’ while fiscal policy has been relatively absent. The Eurozone has been in the same boat, arguably to a larger extent. Emerging economies have been battling the same side effects from their larger counterparts for nearly 10 years. Terms like ‘new normal’ & ‘stagnation’ (both we have actively used) were solely born because things were being done over and over again and we finally figured out that it wasn’t going to produce a different result. Well, it seems 2016 was the year democracies voted to try something different.

Different. Unlike. Change.

These words have no connotation of good or bad, better or worse. They cannot possibly see the outcomes of the future, so there is no way to determine whether the ‘actual’ change fell short or exceeded the ‘desired’ change until the effects of said change are realized. This concept is imperative to investing. Markets constantly weigh the probability of future outcomes and adjust as actual results are realized. If a change is very large or is expected to be realized over a long period of time, the higher the chance a market is pricing the said change incorrectly. Now to make this complicated concept into a complex one, imagine a marketplace of investors, inherently emotional & bias, pricing in multiple changes all at once, simultaneously and independently. Hopefully this provides some clarity into Benjamin Graham’s famous quote, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”ⁱ

Nevertheless, our role as market strategists is to assess all known variables, remove as much emotion and bias as possible, and assign appropriate probabilities to various outcomes. Sometimes when change is marginal or calculated this can be fairly straightforward – this is not one of those years. The Trump Administration and its republican congress, Theresa May and her Brexit plans², and the German and French populous and their elections³ will all disrupt the status quo in a very large and lagging way. These material changes to the powerhouse economies of the world make a pointed forecast to financial markets near impossible with the information we have today. Hence, our S&P 500 range between the bull and bear case is just over 1400 points – nearly double the spread of last year. We are the first to admit that these ‘targets’ are next to useless since the net cast is so large; however, the underlying message stands strong: material global changes are occurring and a wide range of future outcomes are possible, better or worse than currently expected.

In short, our 2017 theme can be summed up into one sentence: A battle between late-cycle economic forces and Trumponomics⁴. In slightly more detail: wage pressures, inflationary forces, higher cost of capital, and a strong USD (i.e. late-cycle forces) versus the net effect of changes in tax policy, fiscal spending, deregulation, and trade policy (i.e. Trumponomics).

[It is now ok to quit reading]

Casting a Wide Net

As useless as each ‘target’ is in our S&P 500 forecast, each scenario still paints a vivid picture of our 2017 theme. As value (or ‘weighing machine’) investors, we constantly focus on an equation that looks something like this: cash flows + expectation for future cash flows + intangibles = long term value. Every macro data point and policy implication is viewed through the lens of this equation so we can attempt to gauge how different variables may affect the valuation of a current or future investment. Using the table above as an example, our quick rationale for the ‘base case’ is as follows:

Our bull case assumes larger tax cuts, a more positive net effect of policy changes & economic headwinds, and a greater willingness by investors to pay for future cash flows. The bear case inverses these assumptions, focusing on trade wars, bigger headwinds, and a smaller appetite for risk by investors. Since the degree of ambiguity is more elevated than in prior years, our S&P 500 earnings matrix can provide a helpful way of viewing all the possible combinations of outcomes.

2016 Lookback

While 2016 was very unkind to pollsters, political strategists, and high probability sport bettors (the Cleveland Cavaliers and Chicago Cubs both came back from a three game deficit to win their respective titles in a seven game series), it actually shaped up fairly close to our outlook provided 12 months ago (yes, we are thankful we do not project political elections). 

What we got correct:
Oil stabilizes in between $50- $60 per barrel
As our highest conviction theme in 2016, this proved to be very accurate – albeit not without volatility. We remain very favorable on the oil market for the long term; however, we believe the supply and demand dynamics should remain relatively balanced in the short to medium term.

Momentum trades slow & ‘value over growth’
We were early on this call in 2015, but correctly carried it forward to 2016. Market breadth was too expanded for this not to correct itself at some point. Since Election Day, we have actually seen momentum and consumer staple stocks perform worse relative to the overall market.

2140 S&P 500 Index year-end target
Yes, the index will likely end the year nearly 100 points higher due to the post-election rally, but we are going to take a little credit anyways. On Nov. 7, the index came in around 2100 and current year earnings should amount to $123 versus our $121 projection.

2.45% Real GDP growth in 2016
While we will not know final 2016 GDP readings until late in the first quarter, the Federal Reserve of Atlanta’s GDP Now tool tracks 2016 GDP at 2.6%. Backing out the unusual boost by soybean exports in Q3 (roughly 0.12%), real GDP seems to be on forecast.

What we got wrong:
Rising wages & healthcare will compress profit margins
This simply did not happen in 2016. Wages & healthcare costs did rise, albeit less than expected, but the index’s net margin actually improved throughout the year. However, this is our ‘early, but not wrong’ call. This should be the biggest headwind to ‘Trumponomics’ going forward.

Favor economies in the early/mid stage vs. late stage
This call is in the ‘wrong’ box merely because there is no way we could have properly executed this idea given the massive currency volatility. Mexican and British markets performed great in their respective currencies, but not so great priced in dollars. The Nikkei (Japan) did well priced in dollars, not so well priced in yen – and in China, the mainland (Hang Seng Index) outperformed while the Shenzhen Index (Shanghai) underperformed. Luckily we rarely invest in country indices; nevertheless, this call wouldn’t have gotten us anywhere.

2017 Outlook

The Battleground

2017 is shaping up to be a head to head battle between late-cycle economic headwinds and a flood of fiscal stimulus measures, with trade policy being the ‘wildcard’. As previously laid out, our base case lies in between the two extremes and shows slight bias toward fiscal stimulus gains offsetting the economic headwinds. However, we believe a very large fiscal stimulus at this point in the cycle would have a very high probability of overheating the economy, shown by our above 3% and near 3% projections in 2018 and 2019 respectively. We find the claims for 4%+ real GDP growth to be extremely difficult to achieve.⁵

Disclaimer: US GDP can be influenced by many factors and can change rapidly. Forecasts greater than 2 years out provide little value other than framing an economic cycle.

As we have clearly established, many things can take place in the coming years and volatility should be elevated. As we look under the hood at both contenders and the wildcard in our 2017 battle, note that all assumptions are tied in our base case, unless otherwise noted. Above all, 2017 may be a function of the following equation: ƒ(x) = wage pressure (-), inflation & interest (-), strong USD (-), deregulations (+), tax policy (+), fiscal spending (+), & trade policy (+/-).

Contender #1: Economic Headwinds

Full employment and subsequent wage growth

This is the behemoth of our 2017 playbook. Whichever direction the relationship between full employment and wages go, many economic factors follow, including the level of influence certain fiscal programs wield. The chartⁱⁱ below is showing labor market slack⁶ (left axis) compared to y/y wage gains (right axis). Here, labor market slack is defined as U3 (the commonly quoted unemployment rate) minus NAIRU⁷ (natural rate of unemployment). Put simply – the number of workers displaced in the prior recession that want to go back to work. When this number goes below 0 [note: the axis is inverted], bargaining power shifts from the employer to the employee. This occurs because workers are no longer abundant in the economy, making positions harder to fill. As shown, 2017 will mark the first full year in this cycle that the US labor market will be without slack – shifting the bargaining power to employees. Therefore, it is no coincidence that wages increase, sometimes rapidly, near full employment. As employment overshoots, we see no reason why wages would not approach 4% y/y growth as in prior cycles.

As wages rise due to full employment, inflation most often goes with it. This is because employers are forced to raise prices to meet higher wage obligations. However, in a competitive environment, this is usually not sustainable and employers end up forgoing some excess profits. To quantify this on a macro level, we like to focus on the composition of GDI (Gross Domestic Income), specifically the ratio between corporate profits and personal income. When this ratio is above one, a worker is commanding a higher share of GDI in relation to history – when below one the inverse is true. It should come as no surprise that corporations currently hold a larger share of GDI relative to history seeing as they have had the bargaining power against workers for the last 8 years. 2017 should start a change in this trend.

This section somewhat describes the inner workings of the ‘Phillips Curve’.⁸

Implications…

Labor market slack has vanished. Wages will climb higher. Inflation will rise in tandem, which will cause the US dollar to weaken. Interest rates will move higher to combat expected inflation, but strengthen the dollar in the process.

…in financial markets?

What’s good for workers is usually bad for profits – sometimes. The coming environment is one where casting a large net on all stocks may not work like it has the past 8 years.ⁱⁱⁱ When workers make more money, they spend more money (we are Americans after all) – but this is where it gets complex. The post-2008 consumer is more price conscious & brand aware. Millennials are shifting from downtown lofts in San Francisco to homes in Seattle. Grocery stores will trump restaurants.⁹ The ‘spending ramp’ from higher wages should create disparity between companies – half will see margins degrade as demand does not keep up with wages, while the other half sees demand exceed higher wage costs. Those who have pricing power¹⁰ and/or hold profit margins should be clear winners in the coming years.

Contender #2: Trumponomics

Pillar 1: Fiscal Spending (specifically infrastructure spending)

We start here because the potential benefit of infrastructure spending is directly related to employment and wages, which we just covered. Rebuilding America’s infrastructure is a concept all political parties have been rallying behind, and for good reason. US infrastructure needs help. But a government doesn’t just spend $500bn+ because of need, they also utilize it as a way to stimulate the economy – in other words, a large infrastructure bill would kill two birds with one stone. Bridges, roads, pipes, etc. would be refreshed and the government would inject money into the economy by way of creating paying jobs (see: FDR or Eisenhower)¹¹.

This is at least three years too late.

We argue that a hefty infrastructure bill might do more harm than good. As illustrated in the section above, the US economy does not need jobs.

Yes, this contrasts with rhetoric elsewhere, but for a proper perspective look at the math: Take the lowest unemployment reading since 1954 of 3% and multiple that by (US population * Labor force participation), or 0.03*(330*.64) = 6.3 million.
So even at drastic overemployment¹² (3% U3), 6.3 million people will be without a job and will not get one (for multiple reasons). This is not a bad thing.

Despite the lack of need for jobs, we assume the new administration and congress will pass a bill anyways – meaning a tight labor market is about to becoming tighter. We believe this will be a huge drag on productivity because workers will leave their current job for a better paying (& safer) government one, yet there are no excess workers to fill the void these workers leave behind. To use an anecdotal example:

An avocado grower quits to become a wall builder (gov. paying), but no one to steps in and grows the lost supply of avocados. Either 1) we import the lost supply of avocados, 2) avocado prices soar to attract more growers, which pull these workers away from other industries. This cycle would continue until the weakest industry dies (ultimately by imports), or 3) consumers decide they do not want avocados anymore.

This silly example ultimately demonstrates that any stimulus provided is offset by an increase in imports. And then the drag hits when the stimulus expires (project completed) and the workers return to their less paying jobs.
Secondly, most tax payers want their money to be spent wisely. Again to reiterate the point from the prior section, 2017 will be the year where workers have bargaining power. A large infrastructure bill would certainly go much farther if this were not true, as it wasn’t the past 8 years. Clearly, it would be much more advantageous for a large infrastructure plan to be done at the start of the next recession, but we don’t work on Pennsylvania Ave. Therefore, we expect this ‘stimulus’ to occur soon and do everything but stimulate. 

Pillar 2: Tax Policy

This one seems simple. Cut all taxes. Everyone makes more and spends more. Corporations invest more. Economy does great. Next. If economics worked like this, these quarterly notes would be one page.

Since the ‘Laffer Curve’ was accepted in 1974¹³, the US has only seen two material tax changes – Reagan in 1986 and Bush in ‘01/’03. Corporate tax cuts were only seen in ’86, so history doesn’t lend much of a guide here. We don’t see how widespread tax cuts could hurt, but in fairness, history does not show material signs of boosting overall GDP either.^iv
Nevertheless, we feel like the desired policy changes will boost some corporate bottom lines, at the least. Here, we have attempted to illustrate how different rates^v would affect profits and sectors, independently. Lacking further detail, three important themes to consider are:

• REITS and Utilities will be very hard pressed to see a benefit, if any.¹⁴
• Large retail, transports, and financials should benefit the most.
• Smaller C-Corps (not LLC’s) may see a smaller benefit than expected.¹⁵

Many of our colleagues see tax policy changes adding roughly 8% (or $10) to the S&P 500’s earnings per share in 2018, and we have no reason to disagree. This is incorporated in our base case.^vi

Just as we cannot see how tax cuts could hurt, we also cannot see how a ‘deemed repatriation’ policy could help. In short, we believe this could send large wrinkles across the fixed income market and would shrink total global assets.^viiviii Deemed repatriation means all foreign profits (deferred tax liabilities) would be taxed at a specific rate, regardless of where the money is at the time. There is roughly $2.5 trillion in deferred tax assets parked overseas, which is significant because an amount that large can influence markets easily. As the flow chart here shows, companies effectively move money around the world by issuing dollar dominated debt to one another. This constantly increases the size of global assets without creating excess leverage. Additionally, the interest earned often offsets the interest paid.

So if a deemed repatriation occurred, company ABC would pay a tax and be able to move cash freely. They would have no reason to own XYZ’s debt and XYZ would have no reason to own ABC’s. We are worried that this will have consequences across the bond markets. Is there enough global demand to swallow ~$1 trillion worth of sell orders? We do not feel comfortable knowing the global asset base will shrink. Looking to the flow chart for further clarity: ABC’s $700 actually created $1,400 worth of value. $700 went to shareholders, $700 created capital for XYZ (through debt). Unwinding all these positions would revert the $1,400 back to $700.

We have not assumed any implications from this in our models, simply because we do not know how. Global market participants may digest an unwinding just fine. Corporations may decide to not unwind or take a long time doing so [most likely]. Maybe not. This will be a focal point to watch throughout the year.
Note: We have heard “Companies with large foreign cash piles will increase buybacks!” We cannot imagine this to be correct. As shown above, companies are fully capable of issuing debt against cash to repurchase shares (and have done so at an astounding rate). Repatriation simply omits a step.

Pillar #3: Deregulation

Deregulation is potentially the most significant economic booster Trumponomics embraces, yet is unfortunately the one we know least about. At this point, we have detailed out late-cycle headwinds, ripped through fiscal spending, added an 8% profit bump because of tax policy, and discarded repatriation. Basically, the ‘big economic stimulus’ has amounted to if tax savings will offset wage pressure. We have ‘deregulation’ and ‘trade policy’ yet to review, but in terms of our base case we assume the two are negate each other. This is mainly adopted because of the uncertainty surrounding each, and broadly assumes deregulation helps unique sectors and adverse trade policy hurts unique ones.

Although not influencing our current outlook, the direction that the new administration takes on ‘deregulation’ will be one of the most important themes to watch in 2017. At a high level, removing red tape and cumbersome regulations should cut costs (sometimes drastically), encourage more competition (lowering the barriers to entry), and promote free market forces. Of course many regulations are very beneficial, but it is too early to speculate about specific cause and effects at this stage. It should be underscored that resetting certain regulations should provide positive near term effects, with consequences realized at a later date (when participants push set limits).

As shown by equity prices since the election, financials, small corporations, and energy companies should see the greatest benefit since they have shouldered a larger regulation burden in recent years. Yet, it is way too early to accurately assess the size and scope of any deregulation benefits, much less determine the amount of value this may add to a certain corporation. It is also very important to note:

Regulation often achieves its intended objective (which most likely needs to be addressed). It is the unintended consequences that may cause a burden larger than the initial problem. This remains true when the process is reversed.^ix

As long term investors, we are constantly in search of unintended consequences. While short term market movements can easily be attributed to policy commentary, the real market moving effects are usually buried under the surface.

The Wildcard: Trade Policy

Trade policy goes in our wildcard slot for 2017 primarily because we have no idea what direction to take. Honestly, we do not know what ‘NAFTA has got to go’ actually means, nor can we interpret, ‘We’ll get better deals.’^x However, we are 99% certain that a trade war (embargo, tariff, etc.) with a major US partner¹⁶ would send most OECD countries into a recession, potentially a deep one. It is for this reason that we would be very surprised to see anything materially altered on this front (outside of political showmanship). In other words, we have faith that the current team assembled would not blindly steer the US economy off a cliff. If you catch yourself asking why a trade war would be so harmful, consider these three points:

• The US is consumer dominated (e.g. ‘service-oriented’). America has wide and vast resources, but we still could not maintain our current level of GDP if we had to do it all ourselves. Google comparative advantage.¹⁷
• The US is a net importer and ‘finished good’ focused.¹⁸ Basically, we import cheap raw materials, making something out of it, and sell it. No cheap parts = no cheap goods.
• The US government can only control just that, the US. If we tariff washing machines, the reciprocating country will embargo the raw materials needed to make the washing machine.

Nonetheless, we will continually monitor for marginal developments along this front and wouldn’t be surprised to see some minor casualties along the way. A couple of final points to note:

• China does a lot of things, but purposefully devaluing the yuan is absolutely not one of them. Since 2014, the USD has appreciated against nearly all major currencies in the world for a variety of reasons, the yuan included. In fact, market forces would like to depreciate the yuan further, but China is holding it up – they are actually appreciating their currency compared to the market! This is shown by the huge decline in China’s currency reserves, roughly $1 trillion since the beginning of 2014.^xi
• Since 1979, the US has displaced (lost jobs + jobs never created) 25 million manufacturing workers due to productivity gains.¹⁹ Since 2001, the US has lost 3.2 million manufacturing jobs to China. Bring back manufacturing jobs? Stop innovation.^xii

Valuation

Since Election Day, the financial markets have been on a tear, with every index gaining ground – even Mexico. We are not going to put as much emphasis on this section than in prior years because ‘animal spirits’ seem to have taken over in the near term. Many investors were incorrectly positioned for the recent rally, making it seem more violent than usual. Secondly, when a change is very large or is expected to be realized over a long period of time, the higher the chance a market is pricing the said change incorrectly at the onset. We are seeing this currently. If we wanted to, we could build a solid case for every one of the outcomes in our S&P 500 earnings matrix – the uncertainties at this stage are just too large. With that being said, we can make a couple of high conviction points:

• The P/E multiple will be lower in the future than it is today. It is hard to imagine why the equity multiple would increase with increased economic uncertainty.
• If one is true, then equity returns will be a product of earnings growth.
• Current index valuations are fair. It is always hard to know what is priced in, but we assume a healthy tax cut, a 2-3% tailwind from deregulation, and maybe a 1-2% tailwind from fiscal policy and wage growth are priced in.
• We would not be surprised to see a tumultuous first quarter, but assume the ‘buy on dip’ mentality remains unless the earnings outlook materially changes.
• The biggest risk to derailing the US economy remains consumer retrenchment. This risk is constant year over year, but extra emphasis is being used this year. As the chart above illustrates, the consumer is hardly getting any help from other GDP constituents.

The Weighing Machine

As the greatest investors in history continue to teach us, investing while focused on the ‘voting machine’ (short term market movements) yields far inferior results than investing while focused on the weighing machine (long term fundamentals).²⁰ In the simplest argument, the weighing machine requires only a few accurate variables, whereas the voting machine requires many (and often more difficult to predict). Obviously, Doxa Capital regularly favors the weighing machine over the voting machine as 1) the equation is simpler to predict, 2) it is driven by fundamentals, and 3) it has proved to be superior. As previously noted, the input to the weighing machine can be viewed as: cash flows + expectation for future cash flows + intangibles = long term value of asset. We persistently remind all of our investors to view changes through this lens.

Politics do not solely determine cycles, earnings, and fundamentals. While policies can certainly create headwinds or tailwinds, they cannot make a bad business great again. As we navigate through 2017, focus will undoubtedly remain on earnings, economics, and politics. In doing so, we will continue to favor those investments that meet our three mandates: pricing power or economic tailwinds, diversified product or geographical revenue, and a healthy valuation that shows a clear upside.