Regular MoneyLetter columnist John Stephenson says the outlook for many emerging markets in 2017 is up, not sideways. India is headed for its third straight year as the fastest-growing major economy in the world. But, for those reluctant to invest in emerging markets, there are still great opportunities here in North America. Mr. Stephenson recommends a U.S. manufacturing stock, a Canadian oil and gas stock and a U.S. financial stock.
A powerful undercurrent of dissatisfaction with the status quo is running rampant throughout much of the developed world. In the United States there are 14 million people who are either out of work or stuck in part-time jobs when they would prefer to be working full-time. As well, there are about two million Americans who have dropped out of the labor market altogether and are no longer looking for work.
Economic insecurity in the U.S. is palpable despite the fact that the economy has grown for 88 straight months, one of the longest expansions on record. The national jobless rate is hovering near 5 per cent, a figure that economists consider close to full employment.
A winter of discontent?
The discontent felt by many middle class voters throughout the West has been manifested in the Brexit vote and in the election of Donald Trump. In this bitter and truly exceptional U.S. election, the state of the economy played a starring role. Donald Trump says he can return America to an age of economic glory by cutting taxes and ripping up trade deals. Many global investors are beginning to worry that a broad slowdown in world trade and growing populist opposition to new trade agreements are undermining corporate profits and could be the next big drag on the stock market.
Both presidential candidates in the U.S. election tapped into this sentiment by saying that they didn’t like the Trans-Pacific Partnership (TPP) trade deal. Donald Trump also said he would renegotiate, or even rip up, the North American Free-Trade Agreement (NAFTA).
In Europe, there are additional pressures caused by large refugee movements and the economic disparity that has grown between nations. This has resulted in increasing resentment of central control within the European Union.
The Brexit vote in June, in which the United Kingdom opted to leave the EU, was the most obvious manifestation of this anger. And the Canada-Europe free trade deal, known as the Comprehensive Economic and Trade Agreement (CETA), was also in trouble after a key regional parliament rejected the accord recently.
A recent quarterly C-suite survey of Canadian corporate leaders shows that more than 80 per cent say they are concerned that isolationist politics will slow the shift to freer trade and hinder the creation of new trade deals.
Equity prices have been helped in large part over the last three decades by an acceleration of global trade and a freer flow of capital that lifted economic growth and allowed companies to take advantage of new markets and economies of scale. The S&P 500 is up nearly nine fold since October 1986, according to FactSet Research Systems.
Global trade this year will grow at the slowest pace since 2007, according to the World Trade Organization, just as protectionist policies are on the rise and efforts to liberalize trade have stalled. The International Monetary Fund recently warned that anti-trade trends such as increases in tariffs could cause long-term damage to the world economy. Some are worried this could spill over to corporate profits.
Stock valuations spiked in the early 1990s after the fall of the Berlin Wall, which ushered in the end of the Cold War. World trade boomed. Ford Motor Co. could manufacture pickup trucks cheaply in Thailand and McDonald’s Corp. started flipping more burgers in China. U.S. stock valuations jumped above their 120-year average on the assumption of ever-increasing global trade and easier movement of goods, services and capital across borders.
The globalization premium meant that U.S. stocks collectively traded at a price/earnings ratio roughly one whole number higher than they otherwise would have, according to estimates by Baring Asset Management. Global fund managers such as Barings and others are becoming more selective, shunning the sectors and countries they view as most likely to suffer from the resulting slowdown.
Global container-shipping operators have already cited the slowdown in trade as a major drag on profits, with the shipping industry facing its worst year since the 2008 financial crisis.
Global stock-index provider MSCI estimates that if policies such as trade protectionism and government deficit spending increase significantly in the developed world in the next two years, U.S. stocks would shed more than 17 per cent, while European equity markets would fall close to 20 per cent. In a stress test the firm assumes that such policies would lead to stagflation, a toxic combination of higher inflation and lower growth.
There’s a sense among economists and chief executive officers that the developed economies in particular are drifting laterally toward another year of mediocre growth at best. According to Maurice Obstfeld, the chief economist at the International Monetary Fund, the 2008/09 financial crisis “has left a cocktail of interacting legacies—high debt overhangs, nonperforming loans on banks’ books, deflationary pressures, low investment, and eroded human capital—that continue to depress potential investment levels.”
The problem? Years of disappointing growth have caused the public to worry that this is the new normal and that governments and central bankers have no clue how to make it better. Pessimistic consumers are holding back on spending, while businesses aren’t putting money into buildings, equipment, or software. Their reticence slows things down even more. Disappointment breeds more disappointment.
That’s been the story for more than 20 years in Japan, where Prime Minister Shinzo Abe is struggling to root out deflationary psychology. It helps explain why voters in the U.K. rejected the advice of most economists and their prime minister and chose to exit the European Union. It accounts for the dwindling public support for free trade and open borders in continental Europe and it explains the phenomenon we witnessed in the United States election.
What I Recommend
While trade may be slowing in the West, pockets of the world continue to open themselves up to trade, creating new investment opportunities. Argentina, for instance, is a country that may benefit more from being more open even as other countries, such as the U.S., become more protectionist.
In many emerging markets, the outlook for 2017 is up, not sideways. India is headed for its third straight year as the fastest-growing major economy in the world, with the IMF projecting a 7.6 per cent jump in gross domestic product. Helped by lower oil prices, the Reserve Bank of India has succeeded in bringing inflation down to about 5 per cent a year from almost 11 per cent as recently as 2013.
While many investors will be reluctant to invest in emerging markets there are still great opportunities here in North America. Slower growth and reduced trade will negatively impact companies that are global multinationals or are involved in selling high-tech machinery to China, a country that is pivoting away from export-led growth and toward consumption. Investors can insulate their portfolios from the potential weakness in global trade by focusing on more domestically-focused companies.
One company that I think will do particularly well with Donald Trump as the U.S. president is defence and aerospace manufacturing stock General Dynamics Corporation (NYSE—GD). General Dynamics is primarily a defence company and should benefit from an uptick in defence spending both in the United States and the company’s key export markets. Margins for the company are likely to expand owing to better cost control and export mix. In addition to its exposure to the defence industry, the company offers investors exposure to the aerospace business, principally via Gulfstream Aerospace. I have a ‘buy’ rating and a twelve-month price target of USD $175 per share for General Dynamics Corporation.
Another company that I really like is oil and gas pipeline stock Pembina Pipeline (TSX—PPL). The company boasts a very strong dividend yield of 4.6 per cent and a strong best-of-breed fee-for-service business model that delivers stable operating results. The company has a number of development projects that are slated to come to market over the next few years, which should help boost the share price and the dividend. Historically, Pembina has an outstanding track record of steady dividend increases. I have a ‘buy’ rating and a twelve-month price target of $45 per share on Pembina Pipeline.
Another name that I really like is bank stock KeyCorp (NYSE—KEY), a super-regional bank in the U.S. that provides a wide range of retail, commercial and investment banking products. This financial stock has a growing middle-market business and should be the beneficiary of a rising rate environment. I have a ‘buy’ rating and a twelve-month price target of $15 per share on KeyCorp.
Savvy investors looking to insulate themselves from some of the ill effects of declining global trade should consider bonds and sectors of the stock market that are domestically focused. While there will always be something to worry about in the world of investing, at least with straight-forward domestically-oriented companies that pay a dividend, you are being paid to wait for markets to normalize.
John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse.” He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or firstname.lastname@example.org.
This is an edited version of an article that was originally published for subscribers in the October 2016/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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