From Headlines to Trendlines: 2014

THOMAS M. HAINLIN, CFA NATIONAL INVESTMENT STRATEGIST

For many investors, meeting basic financial needs like security and annual lifestyle expenses can engage their full investable resources. For other investors, wealth transcends the basic expenses of life. After primary needs are met excess wealth may be deployed to pursue other purposes. These may include personal interests such as affecting positive social change (through social impact investing or philanthropy) or pursuing personal or shared family interests (such as fine art, classic cars or other collectibles). Another purpose may be a longer-term goal of growing wealth through time and across generations. We refer to this investment objective as wealth expansion .

WEALTH EXPANSION

A wealth expansion portfolio allows investors who have excess wealth the opportunity to position a part of their overall investment portfolio today toward a vision or a view of the world of tomorrow. When immediate financial priorities are generally met with other, shorter-term investments, a wealth expansion portfolio can be treated as long-term, patient money, with less sensitivity to the potential volatility triggered by daily headlines and the unpredictability of shorter-term market cycles. For example, while patient money portfolios were probably impacted by shorter-term events and dislocations of the last decade (Argentina’s default, the events of September 11, 2001, the bursting of the dot-com bubble, the Lehman Brothers bankruptcy and resulting financial crisis, and the bursting of the housing bubble), they may have also taken advantage of the decade-long rise in the price of gold (up more than 400 percent), emerging markets equities (up nearly 350 percent in U.S. dollars), and oil (up nearly 250 percent). 1

A wealth expansion portfolio is focused on identifying how to capitalize on medium-term dislocations and opportunities, as well as on longer-term trends and themes. The world is constantly changing. Sometimes the change can be slow, inexorable and barely perceptible. Other times the change can be rapid and quite disruptive. For investors in a wealth expansion portfolio, the most important question becomes, Am I positioned to take advantage of the changes happening in the world around me, or is my portfolio going to be disrupted by the changes taking place?

THEME INVESTING

Theme investing involves the process of effectively identifying the catalysts or causes for long-term, transformative change. These changes can impact an individual business or an entire industry, and can even transform an individual country or the entire global economy. These catalysts may not be directly related to specific government policies, how fast or how slow the economy is growing, how many or how few jobs are being created, or whether inflation is around the corner or far out on the horizon. Rather, we believe the catalysts are more likely to be related to the effects of political, social, environmental, demographic or technological developments.

Investors with a wealth expansion portfolio should think about stepping away from the microscope and peering through the telescope. They should consider looking to the distant future for opportunities, and ask, Will the trends and themes of the past repeat themselves in the future, or will the future witness new regimes, new winners (and new losers)? In other words, Is my portfolio positioned for where the world has beenor where the world is going? Thus, for long-term, patient investors, we believe the focus should be less on today’s headlines and more on tomorrow’s trendlines .

THE MEGATRENDS OF THE LAST 25 YEARS

In Capitalism 4.0 , author Anatole Kaletsky identifies vast and irreversible changes that have transformed the world politically, economically and technologically and whose effects have reverberated across the capital markets. 4 These include:

The fall of the Berlin Wall in 1989, which symbolized the end of communism, opened up the so-called Second World (the Soviet Union, its allies and satellites), spread to areas such as India, Southern Africa and Turkey, and provided the major world powers with a peace dividend (substantially reduced defense spending) 5

The subsequent end (or pause?) of the Cold War between the Soviet Union and the United States, which opened up the so-called Third World, put an end to proxy wars, and led to political liberalization and economic development across Southeast Asia and Latin America

The opening of China, capped by China’s entry into the World Trade Organization (WTO) in 2001

Together, these developments led to a long-term (possibly permanent) shift in the world’s economies and capital markets. The closed economy of the First World (with a combined population of 800 million in 1989) became a global economy with billions of new workers, consumers, producers and savers. 6 Manufacturing industries moved from advanced economies to the developing world, helping to create over 525 million jobs worldwide since 2000. 7 Put into perspective, this equates to the addition of more than three times the size of the entire U.S. labor force to the global economy. 8

The combination of urbanization and rising employment in the developing world has led to rising standards of living and a commensurate rise out of poverty. In East and Southeast Asia, 350 million workers have risen above the poverty level (defined as earning $2 or less per day) since 2000, creating a new global consumer class. 9

In addition, lower tariffs, free-trade agreements and technological advances, such as containerized shipping, drove a sharp rise in global and intra-regional trade. In the three decades prior to 2000, total world merchandise trade grew by an average of $370 billion annually. Following China’s entry into the WTO in 2001, growth in world merchandise trade accelerated to average $1.4 trillion annually in the decade of the 2000s and to over $3 trillion so far in the decade of the 2010s. 10 Globalization led to the disaggregation of the manufacturing process based on the principles of specialization and comparative advantage, driving global productivity growth and wealth creation.

We believe these political, economic and technological megatrends of the last 25 years will continue to exert influence on economies and capital markets into the future. The global economy continues to become more open. Global trade continues to grow, particularly in trade among developing economies (often called the south-south trade). Myanmar is another example of a former pariah country beginning to enact political reforms in order to join the global economy.

THREE THEMES THAT DEFINED THE DECADE PAST

Within the 25-year megatrends, the last decade witnessed many trends that influenced and shaped the performance of global capital markets. Three events in particular, at the beginning of the decade, stand out:

United States Twin deficits and a declining dollar

In 2001, the United States had just enjoyed three consecutive years of budget surpluses. The Congressional Budget Office (CBO) estimated that if policies continued, the entire net debt of the U.S. Treasury would be eliminated by 2009. 11 Unfortunately, by 2002 anticipated future budget surpluses had already turned to deficit, and by 2010 the annual federal deficit had reached nearly $1.5 trillion. 12 Rather than being eliminated, marketable debt held by the public mushroomed to nearly $9 trillion by 2010. 13 Meanwhile, the trade deficit, which averaged $100 billion annually from 1984-1997, soared to over $700 billion annually from 2005-2008. 14 The decade of rising twin deficits (fiscal and trade) saw the real trade-weighted value of the U.S. dollar fall by nearly a quarter against other major currencies, while over the same period U.S. equities generated an annualized rate of return of just over 1 percent. 15

Europe One currency, many distortions

With the introduction of a common currency in the euro area, 17 countries shared a single exchange rate. Interest rates across the euro area converged toward the low rates of core nations, such as Germany. Lower interest rates in peripheral nations provided consumers in countries such as Ireland and Spain access to more affordable mortgages, leading to an overheated real estate market. Lower interest rates also allowed governments in France, Italy, Portugal and Greece to increase debt issuance and European banks and insurance companies proved to be eager and willing buyers for government debt. When world capital markets began assessing each of the 17 countries as separate and distinct borrowers rather than as a united Europe, a sovereign debt crisis ensued and European banks and insurance companies were caught in the crossfire. During the first decade of the new euro, European stocks generated an annualized rate of return of less than 1 percent (in local currency). 16

China Labor shock, infrastructure awe

The dominant trend of the last decade was the rapid urbanization and industrialization of China. China joined the WTO in 2001, bringing hundreds of millions of workers into the global labor force. Access to abundant and low-cost labor, combined with advantageous exchange rates (enforced by strict capital controls), provided a comparative advantage and facilitated a migration in manufacturing from developed economies to Asia. The combination of export profits and captured domestic savings (via low or negative real savings rates, so-called financial repression) financed an infrastructure boom, supporting the migration of hundreds of millions of workers from rural areas to the cities. This migration has been dubbed the largest peacetime movement of people in history. 17 Rapid urbanization fueled soaring consumption of commodities, particularly industrial metals. In 1995, China consumed less than 10 percent of the world’s nickel, copper and aluminum. By the end of 2010, China alone accounted for more than one-third of the world’s nickel and nearly 40 percent of the world’s copper and aluminum consumption. 18 The decade saw copper prices rise by more than four-fold, oil prices more than double, and broader emerging market equities generate a 15 percent annual rate of return (in local currency) for investors. 19

FIVE INVESTMENT THEMES FOR THE DECADE AHEAD

With the dramatic geopolitical and economic changes in the world, critical questions for long-term investors are: Will these three events that helped define the last decade continue to influence and impact the markets in the decade ahead or are we at an inflection point? Have these past trends run their course? What are the emerging trends that will define the decade ahead?

Within the context of the ongoing political, economic and technological megatrends described by Kaletsky and an examination of outcomes of the events of the past decade, we believe that we are indeed at an inflection point. We have identified a number of seismic shifts occurring around the world that are likely to lead to different outcomes for industries, for countries and for the global economy. We anticipate the impact of these changes will be reflected in the performance of the capital markets in the decade ahead. It is from this perspective that we derive a list of the following five themes that we believe have potential investable implications for long-term wealth expansion investors.

Investment Theme #1 The U.S. energy revolution: a global game changer

Overview

In the last decade, lower labor costs were a comparative advantage that helped facilitate a shift in global manufacturing from developed economies to emerging ones. Today, we believe a combination of three forces may offset that shift:

Converging costs of production as workers in emerging economies demand higher wages and better workplace conditions, and rising middle class populations in emerging market countries demand a greater focus on environmental issues such as air and water pollution and food quality

The pursuit of divergent energy policies and investments by the world’s major industrial economies that led to differing outcomes: nuclear (Japan and France), wind (Germany, Spain and the United Kingdom), coal (China), and natural gas (United States)

Access to abundant and low-cost energy may offset the impact of cheaper labor and become the comparative advantage for manufacturing in the decade ahead. If so, U.S. industrial companies may be uniquely positioned to benefit from this shift.

In addition to technological advancements, rising domestic oil production in the United States has led to a decline in oil imports, while increased use of domestically produced natural gas to generate electricity allowed for greater exports of coal. If fiscal deficits are also reduced, a decline in the U.S. twin deficits (fiscal and trade) would mark a shift from the past trend and could conceivably lead to a stronger dollar in the decade ahead, making U.S. assets more attractive to both domestic and foreign investors.

Key points

The ongoing mega-trend of the last 25 years continuesglobalization and a manufacturing process ordered by specialization and comparative advantage. Three primary production factors go into finished goods and services: land (real estate), labor (workers) and capital (money and machines). Other secondary production factors include commodities such as oil, natural gas and industrial metals.

The last decade was marked by a global labor shock as China joined the WTO and access to abundant and low-cost labor became a comparative production advantage that helped facilitate a shift in global manufacturing from developed countries to emerging economies. Today, manufacturing costs in China are rising. In addition, social pressures are rising as China’s burgeoning middle class is demanding a greater focus on environmental issues such as addressing air and water pollution and food quality concerns.

Meanwhile, energy costs around the world have diverged due to different energy policies pursued by the world’s major industrial powers, United States, Europe and Japan:

After the oil supply shock in the 1970s, France and Japan made significant investments in nuclear energy. However, after the Fukushima Daiichi nuclear disaster of 2011, Japan announced that it would join Germany and other countries in shutting down its nuclear plants to pursue alternative energy sources. France announced a goal to reduce dependence on nuclear energy from 75 percent to 50 percent by 2025. 20

Major investments in renewable wind energy by Germany and Spain (also in Italy and the United Kingdom to a lesser degree) have not been supported by realized performance in wind farms. 21 Meanwhile, taxes on fossil fuels to subsidize renewable energy sources have resulted in significant increases in electricity costs for Germany, hurting export competitiveness. 22

The United States may be in a position to benefit from recent technological advancements in energy production, namely the combination of horizontal drilling and hydraulic fracturing techniques to access oil and natural gas from previously inaccessible shale rock formations.

Access to abundant and low-cost energy may ultimately provide U.S. industrial companies with a comparative advantage (a global energy shock) in global manufacturing in the decade ahead, more than offsetting comparatively higher labor costs. Lower natural gas prices help provide a benefit to U.S. companies in two ways: through primary consumption of natural gas (particularly in industries such as petrochemicals and fertilizer) and through the continued shift of electricity generation from coal to abundant and low-priced natural gas.

Two-thirds of U.S. industrial energy comes through direct or primary sources of energy such as coal, natural gas, petroleum and renewable energy, with natural gas being the largest single source. The remaining one-third of U.S. industrial energy comes indirectly from electricity. Natural gas, as a share of electrical power generation, has steadily risen from an average of 17 percent in the 1990s, 22 percent in the 2000s, and 32 percent so far in the 2010s. 23

An increase in consumption of domestically produced natural gas for electricity production means that the United States has excess coal that can be exported to other nations. In 2012, the United States exported a record 126 million short tons of coal. 24 In addition, the United States has reversed a 25-year trend of declining domestic oil production and rising oil imports. In 1985, the United States produced nearly three-quarters of the oil it required. By 1994, oil imports outpaced domestic production. By 2006, the United States imported two-thirds of its required oil. The application of new technologies has led to a dramatic increase in domestic oil production. North Dakota more than quadrupled its production from 2008-2013 and the state is now the country’s second largest oil producer (behind Texas), having passed both California and Alaska in 2012. 25

As a result, imports of oil have declined for the first time in 25 years and the United States is exporting refined gasoline for the first time in 50 years. 26 Falling oil imports, coupled with rising coal and refined gasoline exports have already led to a drop in the U.S. trade deficit (approximately one-half is due to oil imports). If this trend continues and the U.S. fiscal deficit also continues to fall, the dollar may strengthen in the decade ahead, making U.S. assets more attractive to domestic and foreign investors.

Finally, a diminishing reliance on imported oil may lead to a shift in U.S. strategic interests, with resulting geopolitical implications. The recent U.S. pivot to Asia may be seen in this light.