Greetings, and here’s hoping you saw a great fireworks show on July 4th!
After a constructive quarter for our clients, it appeared all would be undone as we neared quarter-end and voters in the U.K. made the historic decision to back out of the European Union. Notables such as former Fed Chairman Alan Greenspan, former Treasury Secretary Lawrence Summers, George Soros and Bill Gross worried that we may be entering an era of high vulnerability for the health of the global economy. Equity markets, often a barometer of sentiment, slipped precipitously for two days after the “Brexit” surprise. I’m glad to report that our client portfolios were minimally affected, then recovered as if nothing had happened. It appears stock investors are being selective, discounting companies with significant income from Europe and/or Great Britain but seemingly unconcerned about companies not significantly exposed (such as Rollins, VCA Antech and energy transportation names). More telling than equity behavior may be the fall of interest rates back to their lows of the post Great Recession period. Is this something that may signify investors fear, a new economic slump….or, rather, in the case of U.S. and Japanese denominated bonds, are we seeing a “flight to quality.” That is, money exiting British Pound denominated bonds and seeking home in stronger currencies. Ten Year U.S. Treasury bonds touched 1.41% in the wake of the Brexit vote, an historic low. It’s a great time to own fixed income investments (and to refinance a mortgage)!
So should you be worried? There is near- universal agreement that in the short-to-intermediate term, leaving the Euro zone will be detrimental to the British economy, perhaps catastrophic. Will this dampen profits for U.S. companies? Britain is a relatively small trading partner of the United States. Currently we sell about $5BB worth of goods and services to the U.K. each year. Compare this with our exports to the rest of Europe, about $24BB and with Canada and Mexico at about $40BB. It is also important to understand the transition away from membership in the Euro zone is going to take place over a period of years, giving companies, currencies and psychology time to adjust. Legislation has to be passed by the British Parliament and negotiations with Brussels conducted around many, many issues. Equity markets tend to overreact to short term news. I agree with the consensus that Brexit is not a direct threat to U.S. corporate earnings. The real question is the long term effect of this historic vote – does it portend a trend away from globalization or as it used to be called “free trade” and toward nationalization?
A century ago, forces of nationalism were putting the world through the first of two absolutely catastrophic world wars that originated in Europe. The concept of the European Union came alive in the wake of the Second World War with the goal of developing partnership and economic integration between historic enemies like Germany, France, and Great Britain. Given the Brexit vote, there is fear of a disintegration of the euro zone and return to the bitter rivalries of the past. But other forces are at work here. It appears the desire of many Britons to escape European Union regulations stems from the violent disintegration of the Middle East. This has created a massive influx into the Euro Zone of people seeking asylum, but with vastly different cultural traditions than those of Europe.
Students of economic history are more focused on the financial implications of rising barriers between nations. The Great Depression was triggered in part by legislation in the United States (Smoot-Hawley) designed to protect domestic industries from cheap imports. Retaliatory tariffs were then erected by our trading partners so that while some industries in the United States perhaps benefited from protective tariffs, the overall economy suffered because the U.S. exports, especially agricultural exports, were disadvantaged. World trade spiraled downward and among the bad effects were the rise of two demagogues named Hitler and Mussolini who blamed high unemployment on ethnic and religious minorities while promising the moon to their suffering populations.
The United States was burdened with many regulations often designed to protect special interests and many of these special interests were unions. Semi-trailers would carry a load in one direction but be unable to pick up additional loads for the return trip. Air travel was strictly regulated, including pricing. Farm subsidies, originated as a socialist approach to propping up rural states during the Roosevelt administration were soon championed by Republican elected officials from those far states. A consensus developed in the 1970’s that stagnation (combined with inflation) were the result, in part of antiquated over regulation. The airlines were de-regulated under Jimmy Carter! Freer trade and the dismantling of protective tariffs and regulations were championed as a way to create a virtuous economic cycle of expansion by free marketeers under the Reagan administration and both Bush administrations. Business supported free trade because it allowed access to cheaper foreign raw materials and perhaps more importantly, to cheaper (non union) foreign labor. Despite objections from organized labor, Bill Clinton adopted the mantra of free trade when he supported the North American Free Trade Agreement (NAFTA). The more recent Trans Pacific Partnership has been negotiated under another Democrat, Barack Obama. It seemed that trade expansion was viewed as a universal good by the Washington Establishment. Today, the presumptive Presidential nominee of the Republican party is pledging to protect American jobs from “unfair” foreign competition by a get tough trade policy perhaps returning to a Smoot-Hawley approach. The financial markets can be forgiven for being confused!
Free trade has lifted much of the Third World and has benefitted many American companies: think of Apple, Incorporated, held in many client accounts, a company the embodies the free trade idea of American ingenuity creating products that are then manufactured cheaply by foreign workers. But in places like Indiana, Detroit, and western Pennsylvania, blue collar workers who have not received training for highly technical professions have been left out. This group, often unionized, usually votes Democrat. Surprising many, Donald Trump is going after these voters. His appeal is age-old: ban competition from foreigners and your jobs will return. Hillary Clinton essentially represents that same mentality and has been driven to rejecting free trade, something she has at times supported, by the Bernie Sanders wing of the Democratic party.
Economists and financial wonks worry that economic borders are about to be re-erected, something that is not generally good for economic activity, and not good for the investor class. It is actually surprising, given the current political atmosphere, that equity markets are doing as well as they are!
But let us focus on the past quarter.
Despite these puzzling and worrisome events and possible trends, a few of our common stock positions (American Tower, Rollins, Johnson & Johnson, Henry Schein) were sitting near all-time highs as the quarter ended. All of our Vanguard managed mutual funds have more than recovered from the downdraft of January and are also standing at or near all-time highs. Equally exciting, to me, is that the preferred stocks we added to client holdings this year have all risen above purchase price. All in all, it’s been a decent quarter and a decent year, as compared to the strangely downbeat way in which it began.
Our focus is on value investments that generally are returning regular income. Income oriented investments often fare poorly in an environment of rising interest rates, such as was promised to us at the end of 2015, after the Federal Reserve raised the Fed Funds rate for the first time in seven years. I feel vindicated for not believing the oft-repeated warnings that interest rates are about to rise, with the corollary admonition to flee bond and fixed income positions. I’ve been hearing this conventional wisdom since the Great Recession began to turn upward in 2010…six years of wrong thinking by the consensus of economists. Why my persistence in holding a high allocation to fixed income investments? Demographics. Worldwide, from China to Japan to Europe to the USA, the fastest growing segment of the population is people over age 65 We are in the midst of the summer, often a tough time for equities, and in one of the strangest political years in history. I appreciate the opportunity to manage your investments in such a time! Your individual quarterly report will be sent within the next two weeks and I may add some color to this report at that time. In the meantime, we remain cautious, a little defensive, but not seeing signs of an economy in trouble! Thanks for your business and as always please contact me personally with any questions. June 30, 2016 – Politico – “Trump Makes Protectionism Great Again” [1] Yes, the Third World is growing rapidly, but they are absorbers of capital not lenders as is the Northern Tier.
