Brian Barry

Difficult Choices; Quality Opportunities

Difficult Economic and Political Choices Lie Ahead 

“Future shock is the disorientation that affects an individual, a corporation, or a country when he or it is overwhelmed by change and the prospect of change.”

Alvin Toffler, Futurist and author of the book titled “Future Shock”

We live in a world of global disequilibrium and distortions which are likely to be with us for many years, and for clients the key question is how do you preserve and build capital under these conditions? In 1970, Alvin Toffler argued that society was undergoing tremendous structural change from a technological and social perspective that would overwhelm people leaving them disconnected and disoriented. Some 46 years later, the rapid rise in anti-establishment sentiment in Europe and the United States reflects the frustration of many people who are experiencing lower living standards, growing income inequality, a loss of confidence in government and declining optimism about the future. In addition to these issues, the Brexit vote reflects a growing sentiment of loss of sovereignty and self-determination. Globalization and technological advances have not benefited populations equally leaving many feeling disenfranchised.

The global economy remains volatile and unbalanced, but in the face of the many challenges the S&P 500 and Dow Jones Industrial Indices continue to make new highs. In light of the current geopolitical, economic and social conditions, investors should expect the continuation of the historically low interest-rate environment. Low rates are limiting options for capital to achieve returns and pushing investors to seek alternatives. We would caution market participants not to make investment decisions today using only traditional investment thinking with respect to current interest rates and equity valuations given the characteristics of the global economy. In a growth-challenged environment, investors should expect the United States to remain among the healthiest economies with the U.S. dollar and treasuries continuing to be in high demand. The U.S. economy is improving as indicated by the strength of consumer spending and housing activity. Many U.S. corporations had previously lowered earnings expectations for Q2, and therefore are able to meet or exceed expectations leading to higher share prices. In our view, the outlook for current interest rates, inflation rates and corporate profits continues to create favorable conditions for the second half of the year for well-positioned U.S. businesses.

(Please see PDF for full Outlook)

________________________

Brian P. Barry, CIMA

Portfolio Manager

A.R. Schmeidler & Co., Inc.

212.687.9800

bbarry@arschmeidler.com

A.R. Schmeidler & Co., Inc. • 500 Fifth Avenue • New York,
NY 10110 • 212-687-
9800 • www.arschme
idler.com © 2016 A.R. Schmeidl
er & Co., Inc. All Rights Reserved
1
July 28, 2016
Difficult Economic and
Political Choices Lie Ahead
“Future shock is the disorientation that affects an individual, a corporation, or
a country when he or it is overwhelmed by change and the prospect of
change.”
Alvin Toffler, Futurist and author of the book titled “Future Shock”
We live in a world of global disequilibrium
and distortions which are likely to
be with us for many years, and for clients the key question is how do you
preserve and build capital under these conditions? In 1970, Alvin Toffler
argued that society was undergoing tremendous structural change from a
technological and social perspective that would overwhelm people leaving
them disconnected and disoriented. Some 46 years later, the rapid rise in
anti-establishment sentiment in Europe and the United States reflects the
frustration of many people who are experiencing lower living standards,
growing income inequality, a loss of confidence in government and declining
optimism about the future. In addition to these issues, the Brexit vote reflects
a growing sentiment of loss of sovereignty and self-determination.
Globalization and technological advances have not benefited populations
equally leaving many feeling disenfranchised.
The global economy remains volatile and unbalanced, but in the face of the
many challenges the S&P 500 and Dow Jones Industrial Indices continue to
make new highs. In light of the current geopolitical, economic and social
conditions, investors should expect the continuation of the historically low
interest-rate environment.
Low rates are limiting options for capital to
achieve returns and pushing investors to seek alternatives.
We would
caution market participants not to make investment decisions today using
only traditional investment thinking with respect to current interest rates and
equity valuations given the characteristics of the global economy.
In a
growth-challenged environment, investors should expect the United States to
remain among the healthiest economies with the U.S. dollar and treasuries
continuing to be in high demand.
The U.S. economy is improving as
indicated by the strength of consumer spending and housing activity. Many
U.S. corporations had previously lowered earnings expectations for Q2, and
therefore are able to meet or exceed expectations leading to higher share
prices. In our view, the outlook for current interest rates, inflation rates and
corporate profits continues to create favorable conditions for the second half
of the year for well-positioned U.S. businesses.
In this issue of
THE OUTLOOK. . .
The Post–Brexit EU and
the United Kingdom
Global Disequilibrium
and the Upcoming
Elections
Global and NATO
Defense spending
Testing the Limits of
Monetary and Interest
Rate Policy
Investment Implications
July 28, 2016
Investors should expect
the continuation of the
historically low interest-
rate environment
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NY 10110 • 212-687-
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idler.com © 2016 A.R. Schmeidl
er & Co., Inc. All Rights Reserved
2
July 28, 2016
The chart above from the International Monetary Fund shows the most recent
lowered growth projections for many of the developed economies.
Governments are facing many difficult choices from geopolitical, economic
and social perspectives in the months ahead. To deal with the economic
challenges, central banks will continue to employ the most aggressive
monetary policy actions in history. These policies have been implemented in
various forms and to varying degrees of success.
Unfortunately as
aggressive as monetary policy has been, fiscal policy has been insufficient to
support growth, and in some countries including several in Europe, it has
been contractionary. While perhaps well-intended, austerity policies have
had the effect of virtually guaranteeing slow to no-growth outcomes and high
unemployment, especially among youth. A strong fiscal policy response is
required to match monetary policy efforts which are nearer their limits. While
we have written about the need for productive fiscal policy initiatives for
several years, the level of frustration expressed by populations around the
world may finally force politicians to act as voters are determined to
challenge the political status quo.
The Post-Brexit EU and the UK
"The unique feature of the EU is that, although these are all sovereign,
independent states, they have pooled some of their ‘sovereignty’ in order to
gain strength and the benefits of size. Pooling sovereignty means, in practice,
that the Member States delegate some of their decision-making powers to
the shared institutions they have created, so that decisions on specific
matters of joint interest can be made democratically at European level. The
EU thus sits between the fully federal system found in the United States and
the loose, intergovernmental cooperation system seen in the United Nations.
Excerpt from EU publication “How the European Union Works
To deal with the
economic challenges,
central banks will
continue to employ the
most aggressive monetary
policy actions in history
The outlook for current
interest rates, inflation
rates and corporate profits
continues to create
favorable conditions for
the second half of the
year for well-positioned
U.S. businesses
A.R. Schmeidler & Co., Inc. • 500 Fifth Avenue • New York,
NY 10110 • 212-687-
9800 • www.arschme
idler.com © 2016 A.R. Schmeidl
er & Co., Inc. All Rights Reserved
3
July 28, 2016
The European Union (EU) was created in the aftermath of the Second World
War based on the ideals of a peaceful, united and prosperous Europe. The
intent was to foster economic cooperation with the idea that countries that
trade with one another become economically interdependent and so more
likely to avoid conflict.
The EU functioned relatively well from an economic
perspective when economies were doing better, but when the strains of slow
growth and rising unemployment manifested themselves in recent years,
resentments and doubts developed about the European project. The series of
economic crises experienced by the region since 2009 highlighted the
structural flaws of the EU initiative.
There are three primary issues
complicating the current situation in Europe and the UK. First, the emphasis
on austerity programs for many nations fostered deep resentments toward
Brussels (headquarters of the EU) and Germany, and allowed anti-European
parties to rise in influence. Second, the economic recovery has been uneven
and slow to materialize in part because the European approach, in contrast to
the U.S. one, did not properly recapitalize the banking system. Third, the civil
war in Syria, with the disruptive involvement of Russia, led to the massive
migration of refugees to Europe, and the Union was unprepared for the
challenges and not unified in its approach to address them.
For voters in the United Kingdom (UK) and many others in Europe, concerns
about sovereignty, self-determination, immigration, employment and a loss of
national identity have fueled populist movements. In October, Italy is holding
a referendum on the proposed structural changes of Mateo Renzi, its Prime
Minister. While at the same time, the Italian government wants to bail out the
banks with capital injections, but under EU rules a bail-in must occur whereby
shareholders, bondholders and bank depositors share in the losses. We
believe that the ECB will try to finesse an arrangement that protects bank
depositors, shareholders and creditors for Italy as a one-off situation. Italy,
which is the EU’s third largest economy, otherwise could at some point be the
next shoe to drop after Brexit. Furthermore, the recent coup attempt in
Turkey could heighten immigrant flows into Europe which in turn could result
in rising nationalistic sentiment, further weakening the Euro and slowing
economic growth. With many leading nations facing elections in the next 12
months, politicians must carefully weigh their policy options.
As things stand today, the future of the European Union (EU) is uncertain as
is its relationship with the UK. Undoing 40 years of political and economic
integration would be a complex and difficult process.
Fortunately, the
leadership transition in the UK was expeditious as Theresa May was
introduced as David Cameron’s successor on July 13th and many of the key
cabinet positions have alre
ady been filled. This will al
low plans for the Brexit
process to begin to be formulated with the current relationship between
Norway and the EU potentially being used as a model. The Brexit process
could take some time to be completed as negotiating trade agreements and
the free movement of individuals are complicated issues with important
implications for the involved nations.
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idler.com © 2016 A.R. Schmeidl
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4
July 28, 2016
Global Disequilibrium and the Upcoming Elections
One of the key questions facing European leaders is whether the Brexit vote
leads to an unraveling or forces greater integration of the EU given the large
cultural differences and different histories of its members.
Germany is
determined to see the EU remain intact.
Competing interests make a
solution difficult, but not impossible. Aside from the economic benefits of the
Union, the EU provided a stronger foundation for the security of its member
nations. However, the fourth terrorist attack in France in the past 12 months
will advance the position of Marine Le Pen, the far-right leader who is
President of the National Front (FN), a national-conservative political party in
France which has made immigration and national security a key element of
its platform.
As the chart below highlights, several of the key decision
makers will be forced to balance doing what is right for their own nations with
doing what is right for Europe while also trying to get re-elected.
The
favorability ratings for many incumbent
s are deteriorating, and key elections
in France, Germany and Italy will complicate matters while lengthening the
process. In the US, the improbable rise of Donald Trump as the Republican
nominee for President and the surprising showing of Bernie Sanders on the
Democratic side are reflections of the anti-establishment sentiment here at
home which is an outgrowth of the inability of Congress to effectively address
the needs of the nation. The likely change of leadership in so many nations
has added an element of unpredictability and uncertainty to the outlook.
However, there seems to be one area of common need globally and that is
the need to invest in infrastructure to stimulate growth and increase
productivity. Unlike the previous 30 years, the global economy can no longer
rely on credit-fueled growth by the private sector to the same degree as in the
past because of the excessive debt already in the system. Two critical
elements required for stronger growth are infrastructure spending and
structural change. Both Donald Trump and Hillary Clinton have made
infrastructure spending a prominent part of their platforms to drive economic
growth for the U.S. In Europe, the challenge will be whether Germany can
Governments are
being presented a
unique opportunity to
use low-cost debt to
make needed
infrastructure
investments
Several of the key
decision makers will
be forced to balance
doing what is right for
their own nations
with doing what is
right for Europe while
also trying to get re-
elected.
Global Election Cycle 2016-2018
Country
Legislative/Parliamentary
Presidential
United States
November '16, '18
November '16
Brazil
-
October '18
China
September '16
-
France
June '17
April '17
Germany
September '17
-
Italy
February '18
-
Russia
September '16
March '18
Austria
September '18
April '16
Portugal
-
January '16
Sweden
September '18
-
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5
July 28, 2016
make the ideological shift with respect to supporting a move away from
austerity for the Southern tier nations by increasing spending to promote
economic growth in the EU. The need for increased infrastructure spending
is real and no longer able to be postponed. McKinsey Global Institute in a
2013 report estimated that the required global infrastructure spending needs
by 2030 were in excess of $57 trillion and growing. At the time, it was
estimated that the required global spending was greater than the total value
of the existing global infrastructure. For the United States, a 2013 American
Society of Civil Engineers report projected the spending needs to be in
excess of $3.6 trillion and rising.
The current record low interest-rate
environment has presented governments a unique opportunity to use low-
cost debt to fund the needed investments essential to foster a return to a
stronger-growth environment. Importantly the return on investment would be
higher than the cost of capital.
Global and NATO Defense Spending
The disequilibrium discussed in this Outlook is being manifested in many
areas with a critical one being that the world is a less-safe place with the
tragic terror attack in Nice and the failed coup being the most recent
examples. As a consequence, global defense spending is likely to increase
from the current levels of approximately $1.7 trillion. The United States,
which accounts for 39% of global defense spending at approximately $670
billion annually, had slowed spending
in recent years as a result of the
financial crisis and the budget sequestration. That trend is now reversing and
the initial policy statements from each presidential candidate support the
need for an increase in U.S. defense spending. The target amount for NATO
nations, ex the United States, is 2% o
f GDP or an estimated $320 billion per
year. From the Middle East to Europe to Asia, countries are increasing
defense spending at a significant rate
with Russia planning $320 billion by
2020, China intending to increase spending over 7% annually, and now
Japan is considering a constitutional change to increase its spending as well.
The United States is also working to
enhance South Korea’s Ballistic Missile
Defense (DMB) system as North Korea continues its aggressive
development of its nuclear program.
At the recent NATO Summit in Warsaw, participants highlighted that member
nations were facing “a range of security challenges and threats that originate
both from the east and from the south; from state and non-state actors; from
military forces and from terrorist, cyber, or hybrid attacks.” The group cited
Russia as the most significant threat and has committed both personnel and
increased spending to protect its members from Putin’s highly aggressive
actions. NATO nations are committing additional ground forces to the Baltic
region. NATO also stressed as a critical security issue the shifts in tactics by
ISIS to bring terrorism to Europe and in particular to France and Belgium.
The instability of the Middle East and North Africa are contributing to the
ongoing refugee crisis. This is also adding to security concerns for members
Global defense
spending is likely to
increase from the
current levels of
approximately $1.7
trillion
The initial policy
statements from each
presidential candidate
support the need for
an increase in U.S.
defense spending
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NY 10110 • 212-687-
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idler.com © 2016 A.R. Schmeidl
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July 28, 2016
as most are unprepared to handle the volume of refugees which is taxing
domestic security forces.
From an investment perspective, U.S. defense companies represent a
relatively small percentage weighting in the S&P 500, so most institutional
portfolios have a representation in defense of approximately 1.8% or less.
The top 5 defense companies have a market capitalization of about $280
billion. It is our view that these businesses represent important investments
that generate significant cash, maintain high and/or growing backlogs,
improving profit margins, raising dividends and repurchasing stock. These
businesses are not as dependent on economic activity as are others, but
rather on national security needs
and geopolitical conditions.
Testing the Limits of Monetary and Interest Rate Policy
The absence of supportive fiscal policy is forcing central banks to rethink the
limits of monetary policy initiatives.
Following meetings between Ben
Bernanke, the former Federal Reserve Chair, and the heads of the Bank of
Japan to discuss its battle with deflationary pressures, there has been
increased speculation regarding the possible introduction of “helicopter
money”. This is an unconventional policy that blends elements of monetary
and fiscal initiatives by printing large sums of money to finance government
programs in order to stimulate the economy. The central bank gives the
government money with no interest and no expectation of payment at a later
date to distribute in the form of spending. While many are skeptical about the
likelihood of its being introduced, we would caution that investors were also
skeptical of the likelihood of quantitative easing and “lower-for-longer”
interest rates as well. Prior to the financial crisis, interest rates were always
a positive number.
With $11.5 trillio
n in government bonds outstanding
carrying negative interest rates, the historic level of interest rates is no longer
the standard. Due to the development of negative interest rates as a policy
tool and the prospects of even further unconventional monetary policy
initiatives, gold has become of greater interest to investors in 2016. While
there are divergent views regarding gold, the economics of the current
environment have arguably made gold less expensive to own then at any
time in the past. Gold is considered a hedge against excessive currency
creation as well as economic, geopolitical and financial instability.
While many are
skeptical about the
likelihood of its being
introduced, we would
caution that investors
were also skeptical of
the likelihood of
quantitative easing
and “lower-for-
longer” interest rates
as well
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idler.com © 2016 A.R. Schmeidl
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7
July 28, 2016
Investment Implications
“America has been dealt an extraordinary hand, and I am optimistic about our
future. Our universities are second to none. We have many of the best
businesses on the planet - small, medium and large. Americans are among
the most entrepreneurial and innovative people in the world, from those who
work in entry-level jobs on the factory floor to Bill Gates... We face many
challenges. But they can be overcome...”
Jamie Dimon, Chairman and Chief
Executive of JPMorgan Chase in a recent NY Times Op-ed
As we have often stated in previous O
utlooks, the resilience and adaptability
of the U.S. have and will continue to make our economy standout relative to
others and perpetuate the view as a safe haven for capital. These attributes
become even more important in times of the global disequilibrium we see
today. Even with the many challenges we face, opportunities exist to build
and protect capital. Our portfolio strategy continues to focus on three areas
of emphasis – high-quality growth, high-quality dividends and opportunistic
investments. Our focus remains on selecting companies benefitting from
positive trends in cloud computing
and mobility, changes in
the financial and
healthcare industries, rising defense spending, increasing U.S. consumer
spending and the shift to a more service-oriented global economy led by
China and India. We continue to target companies that are gaining market
share, maintaining or improving profit margins, increasing free cash flow,
restructuring to gain more efficiency, increasing pricing power and/or growing
dividends. Companies that are able to more aggressively invest in the future
growth of their businesses will be more highly rewarded as there is a growing
view that many corporations have only been able to financially engineer their
performance improvements through share buybacks. This is an environment
that will reward companies with strong, qualitative fundamentals.
Furthermore with more than $11.5 tr
illion of government debt carrying a
negative yield, central bank bond buying is creating distortions in the bond
market forcing rates even lower, crowding out individual bond buyers and
forcing investors to seek alternative sources of income in the equity markets.
Central bank bond
buying is creating
distortions in the
bond market forcing
rates even lower,
crowding out
individual bond
buyers and forcing
investors to seek
alternative sources of
income in the equity
markets
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idler.com © 2016 A.R. Schmeidl
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July 28, 2016
Potential leadership changes could have a profound impact on the economic
policies implemented in 2016 and beyond. For the United States specifically
if the upcoming election brings about fiscal and structural changes which
have been deferred for a long time, the result would be a material
improvement in the economic outlook. The current record low interest-rate
environment is giving governments a unique opportunity use low-cost debt to
make the needed investments essential to foster a return to a stronger
growth environment.
With slow growth and deflationary pressures, we
expect markets to continue to ascribe greater value to companies with the
best industry-demand fundamentals and internal growth characteristics. The
dynamics of the global economy strongly suggest an environment which
offers investors the opportunity to build capital and protect income. The
disequilibrium discussed in this Out
look has been adding to market volatility
over the past few years, temporarily distorting the values of quality
businesses and presenting investors with attractive buying opportunities. We
expect this trend to continue. Investors should remain focused on taking
advantage of the businesses that are benefitting from the positives in the
U.S. and global economies.
The information and opinions in this report were prepared by A.R. Schmeidler & Co., Inc.
(“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its
original date and are subject to change. ARS and its employees shall have no obligation to
update or amend any information contained herein.
The contents of this report do not
constitute an offer or solicitation of any transaction in any securities referred to herein or
investment advice to any person and ARS will not treat recipients as its customers by virtue of
their receiving this report. ARS or its employees have or may have a long or short position or
holding in the securities, options on securities, or other related investments mentioned herein.
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it will not form a primary basis for any investment decision. These materials are based upon
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