Download Outlook for Financial Markets

BMO Private Bank
MAY 2017
Outlook for Financial Markets
“A goal without a plan is just a wish.”
– Antoine de Saint-Exupéry
Summary
Economy
Saudi Arabia, the largest OPEC nation, is feeling
vulnerable; their economic advantage and
political leverage surrounding oil production is
quickly evaporating. After several failed policies
over the last three years, the Kingdom has
established Vision 2030, a program to diversify
its wealth beyond oil, including a planned initial
public offering of Saudi Aramco, the country’s
national energy company.
Kingdom redoubled their production targets, sending
production levels to new records, keeping the world
awash in crude. Oil prices cascaded. Between June
2014 and January 2016, the price of a barrel of oil
plunged from $114 to $29. As the world’s low-cost
producer, patrician policymakers wagered that the
Kingdom would be best positioned to survive a
contrived oil price collapse. Saudi finances suffered.
Its currency reserves plunged 28% to $536 billion, an
unsustainable pace that would have bankrupted the
Kingdom in five years. Saudi Arabia’s debt growth
outpaced its economic growth, prompting the rating
agencies to downgrade the Kingdom’s credit rating.
Riyadh responded with unprecedented fiscal reforms,
including an increase in excise taxes and visa fees, a
reduction in water and energy subsidies and a cutback
in public works projects.
Saudi Arabia’s production war in recent years
backfired. The country hoped that opening their
oil spigots would undermine other producers,
notably Iran and the United States, forcing them
to crimp supply. Iran, their political rival, suffering
under international sanctions at the time, ramped
up production once they were lifted. At the
same time, indomitable U.S. producers seized
on advances in horizontal drilling and fracking,
including the use of wireless seismological
testing. Breakeven production costs in the
U.S. declined steadily as a result (Exhibit #1).
Between 2007 and 2015, U.S. production nearly
doubled to over nine million barrels per day.
Saudi King Salman embarked on a worldwide
roadshow of sorts to raise global awareness of next
year’s Aramco offering. The deal, which is expected
to offer 5% of Saudi Aramco, is anticipated to be the
largest IPO in history. The Kingdom plans to use the
proceeds to diversify away from energy. Last year
Saudi Arabia invested $3.5 billion in Uber, a company
that represents a threat to future oil demand.
Faced with declining market share, the
Exhibit 1 » Falling Cost of U.S. Shale Production
Wellhead breakeven oil prices
$100
$60
$40
2016
2015
2014
2013
2016
2015
2014
2013
2016
2015
2014
2013
2016
2015
2014
2013
2016
2015
2014
$20
2013
Barrel of Oil Equivalent (BOE)
$80
$0
BAKKEN
North Dakota
EAGLE FORD
Texas
NIOBRARA
Colorado & Wyoming
PERMIAN DELAWARE
Texas
PERMIAN MIDLAND
Texas
Source: Reuters, NASWellCube, S.Culp, 29/11/2016
Saudi Arabia, the largest OPEC
nation, is feeling vulnerable;
their economic advantage and
political leverage surrounding oil
production is quickly evaporating.
Despite the seemingly divergent
Fed monetary policy, central
banks worldwide are slowly backing
away from their pedal-to-themetal monetary programs.
This year, despite Trump’s protectionist
presidency, flows into emerging
market funds are their strongest on
record, according to a recent Financial
Times report. Mexico is one of the
best-performing markets this year.
President Trump’s pledge to bring
America’s jobs back home may
carry an interesting side effect,
the rise of robotics. A U.S. corporate
tax rate cut, should it come to pass,
would reduce the cost of doing business
in the United States, but it would do
nothing to curtail labor costs, giving
U.S. employers increased incentive to
invest in labor-saving technology.
While Republicans are in the process
of regrouping, the future path of policy
is unclear. Their failed health care plan
represents a major setback that puts the
rest of the Trump agenda in jeopardy.
M AY 2017
Bond Market
President Trump has vowed to bring back all of
America’s manufacturing jobs lost to globalization
and outsourcing. That’s a big commitment.
Between 1979 and 2010, 8.3 million manufacturing
jobs disappeared, according to the Bureau of Labor
Statistics. While employers have added more than
900,000 jobs since the recovery, it still leaves us
about 7.2 million positions short.
Recent studies conclude that only 15% of
America’s manufacturing job losses were
attributable to outsourcing and global trade.
The overwhelming majority, or about 6.2
million jobs, was the result of technology and
automation. Over the last 30 years, technology
has transformed the production floor, as robots
have replaced humans. A typical Ford or General
Motors plant of today would be unrecognizable
to an overall-clad production worker of the
1970s. Now, thanks to innovations in artificial
intelligence, white collar jobs are increasingly
in jeopardy. Algorithms are supplanting human
judgment in finance and health care.
It can be argued that one algorithm, the Taylor
Rule, should replace the Federal Open Market
Committee, the group of governors within the
Federal Reserve who control monetary policy
by setting the overnight interest rate. Proposed
by John Taylor of Stanford in 1993, the Taylor
Rule arrives at an “ideal” federal funds rate. The
formula is designed to achieve price stability
and full employment by systematically reducing
uncertainty and increasing the credibility of future
actions by the Federal Reserve. The formula takes
into account actual inflation to target inflation
and potential GDP growth to current growth to
determine an optimal target rate.
Prior to the financial crisis, the fed funds rate
generally tracked the Taylor Rule. During the crisis,
however, the Taylor Rule plunged well below zero.
Since the recovery, Taylor’s algorithm argues for
a substantially higher overnight Fed target rate.
While the Federal Reserve’s overnight interest rate
is set to rise to 1% next week, Taylor’s rate, the
one designed to eliminate uncertainty surrounding
Fed policy, argues for 3.8%.
Furthering the debate, a Republican-controlled
House Committee recently approved a bill to
allow for a congressional audit of Federal Reserve
monetary policy. Republican lawmakers have
challenged the Fed’s independence for years,
arguing that our nation’s central bank is not
accountable. Whether or not the 12 Federal Open
Market Committee governors should be replaced
by a robot is subject to further debate. One thing
that’s clear; the Fed’s overnight target rate is too
low for current conditions.
Despite the seemingly divergent Fed monetary
policy, central banks worldwide are slowly backing
away from their pedal-to-the-metal monetary
programs. The Bank of England and the Bank of
Japan, which were aggressively easing policy as
recently as last summer, left their benchmark rates
unchanged at their most recent policy meetings.
One holdout appears to be the European Central
Outlook for Financial Markets • May 2017
Bank, headed by Mario Draghi, which recently
hinted at ending its aggressive stance, but
stopped short of overt action. The ECB stood pat
ahead of elections in the Netherlands, France
and Germany, where euroskeptic parties had
made inroads. Since then, the populists failed
to carry the Dutch election and Marine Le Pen’s
National Front appears to be losing momentum
in France. Nonetheless, the ECB has maintained
its €2.3 trillion bond-purchase program, known
as quantitative easing. The central bank has
signaled that it will continue to buy €60 billion
eurozone bonds each month through the end of
the year. It’s getting increasingly difficult to justify
such an aggressive stance, especially since the
eurozone is currently the fastest-growing major
economy in the developed world. Annual inflation
hit 2% last month, up from zero as recently as
June of last year. The region is hitting multi-year
highs in economic sentiment, business surveys
and employment. The ECB will likely tighten the
reins soon, but Mario Draghi & Company are
likely waiting for the French election result before
moving forward.
Equity Markets
Aggressively low interest rates, set substantially
below the rate of inflation, helped fuel a powerful
reflation rally. The S&P 500 has expanded 229%
since the bottom of the financial crisis. While most
measures suggest stocks are expensive, the one
perspective emboldening bulls is gauging stock
prices through the lens of bonds.
Meanwhile, the power that central banks
possess to propel markets is fading now that
global economic conditions are improving.
That’s because global equity markets aren’t
as dependent on central bank policies as they
once were. As recently as 2013, emerging
markets plunged in response to the “taper
tantrum,” when then-Fed-chairman Ben
Bernanke hinted at cutting back quantitative
easing. The move threatened to embolden the
dollar and divert foreign capital away from
liquidity-dependent emerging economies.
This year, despite Trump’s protectionist presidency,
flows into emerging market funds are their
strongest on record, according to a recent
Financial Times report. Mexico is one of the bestperforming markets this year. That’s because the
emerging world is no longer dependent on the
largesse of developed world capital. Emerging
market current account deficits have turned into
surpluses, as borrowing was reduced and their
currencies are relatively cheap. Some of the most
troubled economies, like Brazil and Russia, are on
the mend, while inflation in credit-heavy China is
welcome news.
Fundamentals in the U.S. are not as compelling as
they once were, especially in a politically–difficult
environment for President Trump. Speaker Ryan’s
health care rewrite would have raised $1 trillion to
help fund Trump’s tax cuts. The likelihood of the
president’s campaign promises getting signed into
law has diminished. Despite three rate hikes over
the last 15 months, overnight rates have fallen
further behind inflation, leaving U.S. “real” rates
increasingly negative (Exhibit #2).
The Federal Reserve is dragging its feet until it
sees clear signs of inflation. Fed governors have
stated that their 2% inflation goal is a target,
not an upper limit. Yellen & Company are just as
comfortable with 3% inflation as 1% inflation. This
suggests that our nation’s central bank will remain
easy, as evidenced by falling real rates, implying
dollar weakness with equities more favorably
positioned than bonds and foreign markets
outpacing domestic markets.
Outlook
President Trump’s pledge to bring America’s
jobs back home may carry an interesting side
effect, the rise of robotics. A U.S. corporate tax
rate cut, should it come to pass, would reduce
the cost of doing business in the United States,
but it would do nothing to curtail labor costs,
giving U.S. employers increased incentive to
invest in labor-saving technology. Allowing
accelerated depreciation on capital investments,
as he’s proposed, would only serve to push
business leaders further toward robots. No doubt,
robots already comprise a growing segment
of the U.S. job market. When President Trump
Exhibit 2 » Easy Money: Fed Funds Rate versus Inflation
Source: Bloomberg; BMO Private Bank Strategy
2
M AY 20 17
convinced United Technologies to keep its
Carrier air conditioning plant in Indiana, rather
than relocating to Mexico, a move that would
have saved the company in labor costs, United
Technologies CEO, Greg Hayes responded with
a plan to invest in technology to make up the
cost differential. In other words, Carrier will
manufacture U.S. air conditioners with more robots
and fewer people.
Robotics help justify shifting capital investments to
the developed world, since the primary rationale
for outsourcing was labor cost reductions. Now, the
prospect of robotic production gives higher-cost
countries, like the U.S. and Germany, a competitive
edge, particularly since the bulk of their customers
are located nearby. Three-quarters of all robots
today are sold in five countries, according to the
International Federation of Robotics (IFR), China,
Korea, Japan, the U.S. and Germany. Four of these
are considered “developed.” The auto industry
accounts for the most robots currently in use,
followed by electronics and metal fabrication. With
roughly 1.8 million industrial robots in operation
today, sales of industrial robots are expected to
expand by 13% annually through 2019 to more
than 2.5 million (Exhibit #3), according to the IFR.
Robot installations will ineluctably increase as the
cost differential between technology and labor
widens. While the price of an industrial robot has
fallen from over $1 million to about $250,000,
wages and particularly health care costs continue
to outpace inflation. According to a recent Barron’s
report, a typical $250,000 robot, including training
and ongoing maintenance, pays for itself in
two years, representing more than $1 million of
incremental cash flow in seven to eight years.
Once the upfront costs are paid, medium-sized
robots cost their employers about 50 cents an hour
to operate, while large robots cost a dollar an hour.
We must be careful what we wish for. Robotics’
competitive advantage is continually changing
today’s jobs market dynamics. As the benefits of
technology improve productivity and the standard
of living for everyone, the costs, most notably job
losses, are not equally distributed. Today’s jobs
require more education and interpersonal skills
than positions of the past, in an effort to maintain
a leg up on an algorithmic alternative.
While policymakers must embrace technological
change, steps must also be taken to better
equip our workforce to meet the ongoing needs
and challenges of the private sector. College
enrollment is critical, especially since 87% of
American jobs are in the service sector. Highquality service jobs are knowledge jobs requiring
an education or specialized skills. While the
unemployment rate among college-educated
Millennials is just 2%, it’s 8% for their cohort
without a sheepskin.
Historically, vocational training was either
overlooked, or simply looked down upon.
Vocational skills, like plumbing, electrical
and carpentry, could equip a new generation
of laborers with income-earning potential.
Community colleges, labor unions and employers
3
Exhibit 3 » 2019: 2.6 Million Robots in Operation
Source: International Federation of Robotics
are positioned to deliver these skills today for
those jobs that to date have been impervious
to technological change. Coding is a valuable
skill of the technological age. Educators should
emphasize coding in high school as they did
typing in the 1960s. Coding would enable
workers to contribute to an evolving economy
without the need of a college degree.
Social policies are needed to address those
Americans displaced by the rising tide of
technology. Even though our nation was built
on start-ups and risk-taking, entrepreneurship
is a dying culture in modern America, largely
due to the increased dominance of the largest
companies. Business dynamism is at roughly
half the level it was 30 years ago. Shifting
health care benefits to a portable, workerbased system rather than employer-based
could encourage individuals to strike out on
their own as independent consultants. Think
“gig” economy, or budding entrepreneurs.
Since technological progress benefits business
owners (capital) rather than workers (labor),
policies need to be considered to balance that
distribution. Bill Gates recently suggested a
robot tax, with the proceeds used to redistribute
income to those displaced by technology. Other
strategies would be to expand the earned income
tax credit to reward lower-income workers.
Perhaps the endgame is a universal basic income
(UBI) in which the government pays a basic
wage to all Americans, although it is argued
that a UBI would discourage work altogether.
Technology holds the promise of improved living
standards for our nation from the top down.
Our leaders must be willing to recognize and
address its on-the-ground consequences.
Financial Market Strategy
The Trump trade is at risk. Since the election,
investors have celebrated Trump’s surprise victory,
which promised tax cuts, regulatory rollbacks and
an infrastructure upgrade. U.S. small cap stocks
have rallied more than 15% since the election
on the prospect of business-friendly policies. The
financial sector is nearly 20% higher than where it
stood on November 8th.
The failure of “repeal and replace” of Obamacare
exemplifies how divergent political views
are, even within the Republican Party.
Investment markets have soured in response,
with financials and telecom bearing most
of the brunt of investor disappointment.
While Republicans are in the process of
regrouping, the future path of policy is unclear.
Their failed health care plan represents a
major setback that puts the rest of the Trump
agenda in jeopardy. Even though the health
care defeat accelerates the tax proposal, the
$1 trillion House Speaker Ryan had hoped to
raise by repealing Obamacare and replacing
it with their own plan is not to be. That’s a
trillion dollars that can’t be used to offset
lower personal and corporate tax revenue.
Congressional Republicans introduced a border
adjustment tax, a proposal that taxes imports
and credits exports, as another way to raise
nearly a trillion in incremental revenue, since
imports exceed exports. But given its uneven
application, with aerospace companies potentially
walking away with tax credits and retailers
like Walmart getting caught holding the bag,
passing such abstruse legislation would be
too complicated for Congress in its current
state. This means that the likelihood of acrossthe-board tax cuts and massive infrastructure
projects, without a tangible way of offsetting
them, becomes nearly insurmountable.
This doesn’t mean the president will simply sit on
his hands. Much of Mr. Trump’s regulatory reform
will likely take place, since its implementation
doesn’t require Congress’s cooperation. The
good news is the global economic recovery
continues and an overly cautious Fed will remain
accommodative. That should pave the way for
modest gains in domestic equities and more
substantial gains abroad.
Jack A. Ablin, CFA
Chief Investment Officer, BMO Private Bank
Outlook for Financial Markets • May 2017
Jack A. Ablin, CFA
Executive Vice President and Chief Investment Officer, BMO Private Bank
As Head of Macro Strategy, Jack chairs the Asset Allocation, Mutual Fund Re-Optimization and Harriscreen
Stock Selection Committees and is responsible for establishing investment policy and strategy within
BMO Private Bank throughout the U.S. He joined the organization in 2001 and has three decades of experience
in money management.
Jack earned a bachelor’s degree from Vassar College in New York, where he graduated with honors with an
A.B. in Mathematics and Computer Science. A member of the Beta Gamma Sigma International Honor Society,
Jack received an M.B.A. with honors and graduated cum laude from Boston University in Massachusetts.
He holds the Chartered Financial Analyst designation and is a member of the CFA Society of Chicago.
• Author of Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace, published in July 2009
by F.T. Press; Wall Street Journal’s best-seller list, 2009
• Frequent contributor to CNBC, Bloomberg, The Wall Street Journal and Barron’s
• Served as a Professor of Finance at Boston University, Graduate School of Management
• Spent five years as a Money and Markets correspondent for WTLV, the NBC affiliate in Jacksonville, Florida
• Named one of the Top 100 Wealth Advisors in North America by Citywealth magazine, in 2006, 2010 — 2016
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Written: April 2, 2017