What are the risks that growth expectations aren’t met?  Donald Trump has promised to cut corporate taxes, roll back regulations and reform the Affordable Care Act, along with pother business-friendly measures.  Investors are clearly ‘on board’ with his policies but we are a bit more skeptical as to whether he can deliver on his promises.   While there were major headlines made on his move to save 1000 Carrier jobs from moving to Mexico while also getting tough on Boeing and Lockheed Martin on the cost of their respective government contracts, it remains to be seen whether these deals can be replicated on a scale wide enough to make a difference in overall growth.  Since manufacturing employment peaked in 1979 at nearly 20 million, some 8 million of those jobs have been lost to automation and cheaper foreign labor markets. Those losses accelerated after the 2001 recession, when competition from China surged.  But while the level of U.S. manufacturing employment has fallen by roughly a third, overall manufacturing output has doubled, thanks to a surge in productivity brought by increased automation, better supply chain management and other efficiency improvements. Those upgrades aren’t going away.  As a result, U.S. manufacturers are able to make more of their product with fewer workers.  While improvements in productivity have slowed in recent years, those decades of efficiency upgrades aren’t going away. That means it’s unlikely that the U.S. will restore the bulk of lost manufacturing jobs.

Thanks, OPEC!  U.S. crude oil production surged by about 100,000 barrels a day last week, providing further evidence that American drillers are responding quickly to the higher prices that OPEC created by agreeing to curtail their own production.  The Organization of Petroleum Exporting Countries reached an agreement to cut production by 1.2 million barrels a day last month and got commitments from some non-members to 558,000 barrels a day in reductions.  American drillers were not among the non-members who agreed to cut. In the lower 48 states, they drove production to nearly 8.8 million barrels a day in the week through Dec. 9, according to the U.S. Energy Information Administration. That is up from the low of about 8.5 million in July, but well below the peak of 9.6 million in 2015.  The production surge follows an increase in the U.S. oil rig count of 21 rigs — the biggest one-week jump since a recovery in drilling activity began in June. Drillers have added a net 182 rigs since the count bottomed out at 316 rigs in May, according to data provided by oilfield services firm Baker Hughes.  The total U.S. rig count stood at 498 at last count, close the year-ago count of 524 rigs.  The bottom line here is that, while there is strong price momentum for oil prices in the short term, we expect that prices will peak early in 2017 and that they will remain stuck in this US$45-55 range, with more risk of a downside break.  OPEC compliance with announced production cuts has been dismal in the past and we expect the producers to begin cheating on their quotas relatively soon.  Moreover, the strength of the U.S. dollar will provide a headwind to further gains since prices in foreign currencies have already seen substantial gains.  U.S. shale oil products are already ramping up their production and are not part of any supply agreement.  Finally, we don’t see any robust recovery in oil demand due to continued sluggish global growth, particularly in the emerging economies which are the biggest source of demand growth.

One area where we have been adding to lately is the gold stocks.  This group surged by almost 100% in the first half of 2016 as gold prices rose by about 15% and the gold miners showed a new commitment to actually generating profits, as opposed to growing production.   As the U.S. dollar rallied back to new highs in the 2nd half of the year, the gold stocks came under pressure, with many mid-sized producers falling 30-40%.  With inflation expectations on the rise we see the potential for gold to recover recent losses.  Moreover, gold has rallied in the face of a rising U.S. dollar, which is a notable change in trend.   Finally, the stocks are actually showing decent cash flow growth and trading at more reasonable valuations than they have in decades.   We added to positions in Detour Gold, Kirkland Lake and Barrick Gold in late December.

Summing up all of the above comments, our strategy going into 2017 continues to advocate caution in financial markets, despite the strong short-term momentum in stocks.  Global economic growth remains weak, profit margins have peaked for this cycle and input costs, most noticeably wages, are starting to rise again.  Despite those risks, stocks are trading near record valuations!  However, they are losing support from interest-rate comparisons as rates rise on fears of higher inflation.  Trump’s ‘tough on trade’ and ‘return to growth’ election promises will be hard to realize.  Globalization has reduced manufacturing costs and expanded markets for many firms in consumer products, industrials and technology over the last decades and those gains are at risk if global trade deals and immigration are threatened and companies are forced to move manufacturing back to the U.S. where manufacturing costs are higher.  Rising interest rates have lessened the ‘TINA’ (There Is No Alternative) argument for owning stocks.  We have seen bear markets in stocks early in most presidencies.  While initial reaction has been extremely bullish, we now see greater risks to global economic growth at a time when earnings growth is negligible and stock valuations are high.  We are cautious on the outlook for stocks and are reducing positions in the energy and materials sectors.  Technology stocks have been under short term pressure but we still see growth in the sector longer-term at reasonable valuations and look to add to this group first.  Financials will benefit from a ‘normalization’ of interest rates, but the stocks have already moved higher in anticipation of this and are less attractive at current levels.  We also see much more political risk in 2017 which could impact financial markets.  Elections in both France and Germany could further strain the unity of the Euro Zone, with negative potential fall-out on the weaker players, such as Italy and Greece, that rely on the larger players for financial support.   Trump’s relations with China and Russia provide further areas of risk as do his proposed trade policies.  The U.S. trading partners should not be expected to sit still and accept new tariffs and/or trade restrictions without countervailing measures.   After eight years of stock market gains, investors should be wary; 2017 could bring a whole new round of volatility!

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