1st Quarter 2016 Commentary


The North American Free Trade Agreement (NAFTA) went into effect in 1994. Most economists would hail the agreement as a breakthrough, which has helped propel the world’s economy for the past two decades.  We agree.  Since NAFTA, other free trade agreements have been signed based on NAFTA’s “broad based success” of delivering goods and services more inexpensively than had been the case when trade barriers existed.  Optimization of capital and labor have been enhanced.  The economic “friction” of trade duties have been lowered or eliminated.  People who had desperately wanted work and who would work for pennies found work in new factories or providing services.  As a result, inflation, heretofore a perennial risk, was seemingly relegated to the past.  New middle classes in Mexico, China and India were created.  New consumers were created.  New capitalist economies were created.

But the transition from being an employed American worker to an unemployed American worker and then importantly back to an employed American worker has been a tough transition for quite a few.  It has been for too many like shifting from 1st gear to reverse and then to 1st – without using a clutch.  It has been grinding.  Economic prognosticators in the nineties presumed that a flexible American capitalist system would adjust in a relatively short period of time.  Displaced workers would be retrained for new jobs.  Transferable skills would be transferred.  There might be a “hiccup” in some workers’ lives – but it would not last long and the “retooled” American capitalist system would “roar” another time after a cleansing irrigation.  This was the theory and if the transition had taken five years, it probably would have been OK.  But we are now twenty years “down the road” and it is not OK for the displaced but not re-employed. Please do not misunderstand our position – economically the world is in a better spot and we are firm believers in free trade.  The world has prospered – but those who lost their jobs with no replacement opportunity have not.

So why are we “blathering on” about free trade agreements?  We think that an unexpected result of these agreements has been the uprising of Donald Trump and Bernie Sanders – two very odd bedfellows.  But they are “bedfellows” nonetheless due to their populist rhetoric and they are political forces with which to be reckoned.  The Donald and Bernie come at the unemployed American worker from almost diametrically opposed positions and arrive at the same philosophical point – get rid of the trade agreements.  The shrillness of their arguments is upsetting to markets, which have adapted to and embraced free trade.  While it would take the agreement of Congress to upend any free trade agreement already put into law, thus the chances of success extremely low, having a voluble President that was seeking to alter in place treaties would not be well received by markets – something of a minor worry right now.

Since we last wrote, the oil markets have had a “rollercoaster” of a ride.  New lows came in the early months of 2016 and the first quarter looks as though it will close with oil up some 40% off its lows.  A few seers are saying that “a bottom” has been put in.  We would agree and said as much in our year end writing, because demand for oil and oil products (think gasoline) has continued to be strong and supply is falling with the drilling rig count at a decade’s low level.

Gasoline demand in the US


                                                      Global Demand for the rest of the World


Much like oil, other markets around the world have unnerved quite a few investors with their volatility.  As we have written in the past, “walls of worry” need to be climbed for markets to progress.  It is only after complacency has been eliminated that money can be made. It is hard for investors to remain steadfast in the face of declining prices – but “riding out” a storm with good assets will usually “win the day”.  Below, the reader will note the performance of the S&P 500 in comparison to the VIX/10-yr ratio (a measure of risk).  When the ratio jumps (i.e. risk rises) the stock index falls and vice versa.  During 2016, we have seen risk rise and fall with the end of the quarter being back to levels at which we started the year – lots of action, but not much progress.


Valuation is always a “touchstone” in our work.  We have thought for some time that US equities were fairly valued in an absolute sense.  Current P/E ratios are a bit above the long term norm, but not as high as has been the case.  On a relative basis, when compared to the bond markets, stocks look cheap.  In the chart below, the risk premium equity investors demand to be paid versus a 10 year Treasury is near its highest point since 1962.  It suggests that stock market investors are wary – a bullish sign.



Three influences have been a “headwind” for equity markets for months now – the US dollar, interest rates and oil prices.  We have already said that we think oil prices have put in a bottom and thus energy company earnings should be a help and not a drag on market earnings going forward after Q1.  The Federal Reserve recently had a meeting and “steered bond market makers” to two interest rate hikes this year, not four and small ones as opposed to large ones.  Other central banks around the world are lowering rates, not raising them.  So international bonds might well go up in price, while US bonds might be “soggy” at best – certainly no theoretical competition to US stocks.  Finally, the dollar probably had most of its run last year as interest rates around the world should be relatively stable throughout 2016.  So if the “headwinds” dissipate, perhaps stock markets will rally.  We still think this will be the case.

P.S – . Political mudslinging is not attractive, but neither is it new. American politics right from the start has been mired in the less than politic.  Some of our Founding Fathers (Adams, Jefferson and Monroe) were some of the worst with regard to name calling and scare mongering.  In a newly secular nation, Adams called upon Christians to reject Jefferson as an atheist.  Jefferson in return used a surrogate (who was later tried and convicted of sedition) to defame Adams.  Andrew Jackson’s wife, Rachel, was attacked as a bigamist because she and Andrew married unwittingly before her divorce from her first husband was complete.  So the “fireworks” of the current political season might seem crude, off topic, immature and nonsensical.  But they are not original.


  • Economic growth will continue at a pace of around 2.5% – 3%.     No – Q1 could be <1%, but we still believe
  • Inflation will remain quiescent.     Yes
  • The dollar will stabilize, perhaps strengthen a bit more.     Yes – Dollar is not on a “march”
  • During 2016, oil’s price will find a bottom not far away from now and will rally into 2017.     Yes
  • Interest rates will rise – but the rate of increase will be slow.     Yes – Still believe
  • Political reform will grow in South America.     Yes – Big changes are “in the wind” (think Brazil)
  • It will be another “Banner Year” for mergers and acquisitions.     Yes
  • Consumer spending will improve.     No – Has not yet happened
  • Émigrés will continue to be a “hot potato” politically around the world.    Yes
  • Amongst the popular investment alternatives, equities should do the best.    No – Not yet, but still believe


Q1 IMAGE 5     Q1 IMAGE 6


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