Letter - January 2017

 

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The confounding electoral victory of Donald J. Trump has awakened animal spirits and the expectation that America is open for business again. After eight years of sluggish growth, burdensome regulation, ultra-low interest rates and convoluted tax polices, the president-elect proposes a pro-business agenda to “Make America Great Again.” With Republican control of the Senate and the House of Representatives, Mr. Trump may be able to pursue his novel agenda to create jobs and to stimulate growth. So far, judging by the stock market which has ripped higher since the election, Wall Street approves.

After the election, the country remains in a hyper-political state as the president-elect puts together his new government. The press has debated vigorously the merits of cabinet nominees, taking a generally negative view. Mr Trump's perspective seems to be that his choices are men and women who have been successful in their careers, pro-business, experienced and capable. To the chagrin of many, Goldman Sachs is well represented.

Over the past eight years, slow growth has exacerbated conflict in the country as constituent groups have fought for an equal or larger piece of a scarcely growing pie. Growth can be a great societal lubricant as it grows the pie for everyone and helps defuse conflict. For better or worse, Mr. Trump is to be our president and we wish him well in his search for growth.

As noted above, the stock market has rallied sharply since the election in anticipation of a pro-growth administration and a salutary effect on corporate earnings. But caveat emptor: the one thing politicians are great at is promises. It remains to be seen whether Mr. Trump can deliver on his promises. At the very least, it will take time to implement changes. It is unlikely that the impact of Trumpian policy will help growth much in 2017. If enacted, the much touted plan to spend $1 trillion on infrastructure will not begin to make itself felt before 2018.

There is a dark side to the Trump agenda. After having grown for eight years, albeit at a historically anemic pace, the economy is finally approaching full employment. (This assumes the labor market participation rate remains at a historical low.) Fiscal stimulus at this late stage of the economic cycle is bound to awaken inflationary pressures. With unemployment at 4.75%, home builders, for example, have repeatedly complained about a shortage of skilled workers, rising wages and pressure on profitability. While an inflationary jolt with higher wages may be a good thing in the short run, it is seldom good for long term, sustainable growth. One wonders where the workers will come from to man the proposed infrastructure program, or for that matter, to build The Wall. And with rising inflation comes rising interest rates, another threat to long term growth, corporate profitability and a rising stock market.

International relations is another potential hot spot. Growing international trade has underpinned post-war global prosperity. Bellicose words for China and Mexico threaten this success. We are sympathetic with Mr. Trump's desire to reset the relationship and counter China’s more aggressive ambitions on trade and regional influence in the Far East but we question his ability to finesse the nuances of the game. Hold on to your hat!

Similarly with Russia: Mr. Putin and his cronies are clearly bad actors, whether it be in Ukraine, Syria or in Russia itself. It is unclear what Trump has up his sleeve. He is right that it would be better to have improved relations with Russia. What is unclear is if he has an iron fist behind the scenes to curb Russia’s bad behavior.

Meanwhile, coincident with the improvement in investor sentiment, recent figures on the economy have begun to show growth. Unemployment remains low and wages are showing strength. After a decline in corporate earnings lasting five quarters, the cycle seems to have reversed itself as earnings began to grow again in the second half of 2016. These developments go a long way towards explaining the rally in the stock market.

Can the rally continue? Short term, the market is probably ahead of itself and will experience a correction. While valuations seem high, if we are in the beginning of a new cycle of economic growth, maybe they can be justified. And if we are now in a period of rising interest rates and declining bond prices, which we believe we are, investors should be incentivized to sell bonds and buy growth (stocks).

Gold and gold mining shares had a good year in 2016. The outlook for 2017 holds promise of more to come. This year could possibly see the collapse of the European Union. Elections are due in Italy, the Netherlands, France and Germany. In each case, the status quo is being challenged by ascendent right wing and nationalist movements. In the event of political chaos, gold should catch a bid as a hedge. In the US, support for gold could come from rising inflation as the economy, trying to grow, runs into a shortage of capacity particularly in labor markets.

Clients had a good year in 2016, outperforming the S&P 500 index, some by a large margin. We were surprised by the Trump victory, as were most investors, but have benefited from it so far. We remain over-weighted in cash, at about 20% of assets as we continually search for investable ideas. We remain opportunistic on the buy side and sell side as valuations dictate. These are turbulent times in terms of macro-economic and political developments and should be treated with caution.

* * *

For clients who may not be aware, Jon Ciaio has resigned his position at P.R. Herzig & Co. He received an offer from a pension management firm that was too good to refuse. That he will be working substantially closer to home was no mean enticement for a father of four small children. We thank Jon for his loyalty over the last fifteen years and wish him all the best. Arthur Pesner, Sumner Gerard and I will continue to meet client needs as usual, both in regards to investments and administrative matters.

 

Tom Herzig

 


 

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