Investment Outlook 2018

As a kid in Massachusetts I always loved the water. This stemmed from the 2 weeks we spent each summer on Cape Cod near Falmouth. While I was growing up I was always very rambunctious and a pretty poor student. In 6th grade my dad bribed me saying if got all B’s on my report card he would buy me a sail boat which I could sail on nearby Lake Waban on the Wellesley College Campus.  This led to the quickest academic turn around my teachers had ever seen- all B’s and an A or two.

So off we went looking for a boat and came across a 7’ 11”  Dyer Dhow Midget which, it turns out,  is  the oldest  continuously made fiber glass  dingy first produced in 1949. After that, my summers were filled with sailing  all day on Lake  Waban.  Senior year in high school I landed a summer job with the YMCA on the  Chesapeake Bay teaching sailing at Camp Tekoha –  it was a sailor’s nirvana.

In recent years Karen and I have chartered bare boats in the  Virgin Islands and then in the Sea of Cortez  in Baja along with 1 and two week sailing vacations.

What, you might ask, does this have to do with investments?  Well, let me explain.  In sailing you can  sail with the wind or into the wind. To sail into the wind you have to tack  (zig zag back and forth to make your way to where you want to go).  Sailing into the wind is hard to do. It is  slow and difficult to discern whether you will get to where you want to go and  when.

If you are sailing with the wind (i.e. the wind is to your  back or stern) you are going the same direction as the wind. Sailing with a  tailwind, as they call it, is much easier, faster and the chances of getting  where you are going rise considerably.

In the paper which follows, I will develop what I believe  will be the investment tailwinds for the next several years. These are economic  themes which will direct and propel the economy and significantly influence the  speed and direction of the sailors (companies) in the race.

My investment approach for stocks is focused on buying  attractive companies at reasonable valuations in relationship to their growth  potential, financial strength, and outlook for dividend payments. This is a  bottom-up approach focused on individual companies. I am also mindful of major  themes or trends (tailwinds) which will influence the climate for a company or  industry either favorably or unfavorably.


I believe that each of these themes taken individually will persist for a number of years and will be significant in the influence they have on the economy and the investment markets.

  • Historically low interest rates – but with tightened availability of credit, will modify behavior of  governments, business, individuals and investors;
  • Natural Gas, a game changer -Increased availability of a reliable, lower cost source of natural gas  in the face of dependence on an unstable Middle  East and mounting concerns about the  environment  will drive change in  how we use energy.
  • Grown in the USA-The strength of our agricultural  position globally will become even more pronounced as investments are  made to increase production, yield and productivity.
  • Made, again, In the USA – Businesses, as they assess  their energy costs, labor costs, quality and supply chain management  issues, will find domestic production increasingly competitive.  Consequently, we will see businesses moving production back to the USA.
  • Emerging markets growth – the  emerging markets will continue to grow rapidly as they build  infra-structure, meet the needs of a growing middle class, and export
    goods to developed countries.

And, while these are seemingly disparate themes, upon further examination, a pattern starts to emerge. So as the sailor in me starts to set course for the next few years, I will focus stock investments on large U.S and global companies with strong balance sheets, innovative products and a global reach.  I feel these companies will prosper as they address the industrial, infra-structure and consumer demands of a global economy.

Most of these companies are U.S. based with significant operations overseas. As the U.S. economy strengthens they will find significant demand here in North America in: energy development, transportation, technology, agriculture, health care and more. They will also find strong demand in the emerging markets and to a lesser extent Europe.

I believe they will also encounter an increasingly hospitable manufacturing environment in the U.S. in terms of: energy costs; labor costs, productivity and flexibility; transportation; and reliability and availability of resources to run their business.  This will buoy employment in the U.S. over a period of years.

In addition there will be a tailwind for purely domestic mid-cap companies which support U.S. industry.  Specialty manufacturers, distributors like Fastenal a specialty parts company, transportation companies including truck manufacturers like Paccar, railways and more will find they have smoother sailing than in the past as the domestic tailwinds I anticipate gain strength.

The reward of these tailwinds for the sailors in the race will be faster earnings growth, less turbulence in their journey, a more predictable outcome, and the ability to reward investors with an increasing stream of dividend income.

Emerging market investments will continue to have a tailwind but, not as they have for the past 10 years as their valuations are approaching those of developed countries.

And finally in fixed income, which has had a tailwind for the past 25 years, the seas will be a little rougher. Credit quality all over the globe has deteriorated and while rates will stay low by historical standards they have the potential to move up from their cyclical lows. The challenge for bond investors will be to eke out a decent yield without taking in water so to speak.

If you are a particularly curious sailor, below is more on each of the 5 tailwinds I foresee.

1-Historically low interest rates

A number of forces have converged that I believe will cause interest rates to remain low for 3-5 years into the future and maybe beyond. Rates will likely move up from their cyclical lows as the economy gains strength but stubborn secular forces will work together to keep a lid on interest rates.  Among the forces at work are: the de-leveraging of debt among consumers and governments both in the U.S and Europe, sluggish economic growth due to lingering problems from the severe recession of 2008-2009, the need on the part of many governments to cut spending to balance budgets, and excess capacity in a number of areas.

The chart below shows the relationship between 10 year U.S. Treasury yields and the dividends of S&P 500 over the last 55 years. It is apparent that with interest rates having dropped on a secular basis since their peak in 1981 that the gap between bond yields and stock dividend yields has narrowed dramatically.

The stock bond yield gap has narrowed dramatically

The party is over for bonds

This chart also shows that the party is over for bonds. We have just gone through a 30 year period where returns on bonds were a function of higher yields plus appreciation as declining rates drove bond prices up. I view this as a market top and in my view, this calls for a much more cautious approach toward fixed income both in terms of quality and maturity.

Low interest rates are good for some

Low interest rates are advantageous for companies and individuals who have strong balance sheets and can either lower their cost of borrowed funds or use prudent amounts of leverage to pursue opportunities which make economic sense.

And a challenge for others

On the other hand, low rates pose a problem for investors who have traditionally used fixed income investments to earn a decent income on their assets.

  • One obvious example of this is retired individuals who previously could invest retirement funds in C.D.’s, bonds, annuities and earn 5-8% when today they      can earn 2-3% at best.
  • The same problem exists for insurance companies, particularly life insurance companies, which use policyholder premiums to invest in assets to offset long-term liabilities such as annuity payments or life insurance reserves.
  • University endowments, which once planned on 7-8% returns from bonds and other investment are now having to scale back both expectations and spending.
  • Pension plans are also adversely affected – when the rate they can earn on investments declines, the size of their unfunded liability rises causing them to have to contribute more to fund their future liability.

Investors will turn more to dividends as a source of income

From an investment standpoint this means that the stocks of large financially strong companies paying dividends of 2-4%, with the ability to grow their dividend over time (in addition to growth of the stock value) are relatively more attractive for investors with a moderate risk tolerance. Of course this is not in lieu of fixed income investments but it is likely to lead to a greater allocation to income oriented equities.

2-Natural gas, a game changer

Natural gas is cheaper and much cleaner than coal or petroleum products and the U.S. supply and reserves have grown dramatically in the past few years. In fact, due to renewed exploration and new development techniques, production has reached levels not seen in 40 years. Companies like Exxon, Chesapeake Energy, Devon and other have made significant domestic investments.  Natural gas will be a game changer for many aspects of the U.S. economy and it will emerge visibly in the next 1-5 years.

We are back to 1970’s production levels

We have the second cheapest natural gas in the world

Globally natural gas tends to sell in regional markets because it is difficult to transport. As a result, prices vary all over the world from market to market. Aside from the Middle East, the U.S has the lowest prices for natural gas in the world.

And a superior distribution system

We also have an extensive network of 305,000 miles of pipelines to ship natural gas all over the country to electric utilities, manufacturers and large cities which distribute it to consumers. These pipelines are interesting investments. They are publicly traded master-limited partnerships which pay a hefty distribution (which is often tax sheltered) and as their volumes grown distributions have increased and they have appreciated.

Natural gas expanding role in electricity

Natural gas is currently the number two source fuel in the production of electricity in the U.S. with coal being number one1. Expert’s project that by 2035 natural gas will be number one and will double its energy share.

Our electric industry is globally competitive and will become even more so

As the graph below shows, the U.S. already has a very competitive electric energy industry. Lead times for change in the industry are quite long due to planning, licensing, and construction time. According to an Alliance Bernstein research paper, with the EPA emission requirements which go into effect in 2015, many utilities are converting old plants to modern, cleaner coal plants. Those that are able are shifting production to natural gas as soon as they can. Given the investments the industry is making to meet 2015 emission regulations, the savings from natural gas usage will be an offset to the capital investments the industry is making.  Natural gas will allow us to maintain our competitive electricity position and at the same time create a much cleaner environment.

Benefiting from the Air Toxics Rule will be competitive electricity generators whose nuclear natural gas or environmentally compliant coal-fired power plants are unaffected by the new regulations. They will maintain lower cost production and will enjoy materially higher power prices. Bernstein identified FirstEnergy (FE), Exelon (EXC), Constellation (CEG), Mirant (MIR), PPL (PPL), PSEG (PEG) and Allegheny (AYE) as some that fall into that category.

Natural gas will have huge implications for transportation

Another huge opportunity is for the use of natural gas in transportation including long-haul trucking, mid-sized vehicles like waste collection, delivery vehicles, and buses. The savings potential is attractive and the amount of greenhouse emissions are 23-30% lower than petroleum based fuels.  The technology for this is in place for all forms of vehicles using traditional combustion engines modified to burn compressed natural gas. The challenge in the U.S. has been a nationwide network of natural gas service stations and maintenance and repair providers. The first effort to build this capability was the T. Boone Pickens Company, Clean Energy Fuels Corp., which is fueling the largest share of regional mid-sized fleets in the U.S. and is well on its way to building a national distribution network for long-haul truckers nationwide. In the fall of 2011 Shell Oil, the U.S. subsidiary of Royal Dutch Petroleum, announced its joint venture to work with Westport Innovation, the global leader in natural gas engines, to build a North American network of service stations and maintenance services.

Transformation in natural gas

All of these factors are actively in motion. The surge in natural gas development is producing results at a significant level and growing;

  • Electric utilities are converting due to EPA regulations and the newfound supply;
  • More factories are taking advantage of the new low prices and availability;
  • New pipelines are being built and old ones reconfigured;
  • Engine manufacturers like Cummins, GM, Paccar, Ford, GM, Volvo and others are either in production or coming on-line;
  • Truck fleets are being converted;
  • A national network of fueling stations is being built; and
  • New technology to enable these changes is being implemented, refined and created

This is huge and it is transformative.

3-Grown in the USA

Demand for food is huge and growing

The world population is expected to increase from 6.9 billion in 2011 to over 9 billion in 2050. With more mouths to feed and an increasingly affluent emerging market consumer demanding a high protein diet, agriculture is facing both population growth and the expanding consumption of high protein diets.

Ability to expand supply is finite

On the supply side – climate change, a finite amount of cropland, and limits on existing production, make keeping up with rising demand increasingly challenging.

While agriculture is under 2% of our economy, the U.S. is the 3rd largest producer of agricultural products in the world (excluding the E.U.) as this information from the IMF as of 2010 shows:

Rank Country Output in billings of US$
World 3,585.829
1 China 599.582
European Union 293.080
2 India 284.524
3 United States 161.236
4 Brazil 142.141
5 Indonesia 108.130
6 Japan 76.424
7 Turkey 71.218
8 Nigeria 65.041
9 Russia 58.603
10 France 51.651

We are the strongest producer in the world

And as the graph below from the Economic Research Service shows, we are self-sufficient and a net exporter of agricultural products. The gray area is net exports since 1994.


Exports create jobs

Increased exports are particularly important as the U.S. economy slowly recovers from the recession.  Exports create jobs, especially in rural America.  Agriculture Secretary Tom Vilsack, indicated in a November 30, 2010 statement that “……each $1 billion in exports supports 8,000 jobs, meaning that agricultural exports alone in fiscal 2011 are expected to support more than 1 million U.S. jobs.”

Big investments are being made

Globally, agricultural production is limited by acreage and crop yield. With prices up, farmers and agri-businesses are investing heavily to increase production. Many companies in the agriculture industry are providing solutions to the world’s food crisis by helping farmers increase crop yields. For example, producers of potash, phosphates, and nitrogen are providing the needed ingredients to improve land fertility. In addition, makers of agriculture equipment like John Deere and AGCO are developing more efficient technologies, including GPS-enabled harvesting machines that make harvesting crops more efficient, while lessening the negative impact on soil.

While there are certain to be economic and natural forces that lead to swings in earnings for the agriculture sector, we believe it offers attractive long-term investment opportunities

4-Made (again) in the USA

“We are at an inflection point in manufacturing in terms of relative cost structures,” said Mark M. Zandi, chief economist for Moody’s Analytics. “Ten years ago, it was a no-brainer to locate in China, and now it isn’t so clear whether China is the low-cost place to produce.”

A confluence of forces is at work

A number of factors are aligning which will bring manufacturing back to the US:

  • For one, U.S. labor costs have not risen for a number of years as they have in other countries. China’s rate of wage inflation, for example, has been double digit. In the recent down-turn, U.S. workers and unions have been increasingly flexible in order to get back to work;
  • U.S. energy costs are some of the lowest in the world both in terms of electricity and natural gas. They are also the most reliable;
  • Shipping costs are rising. In the last four years, shipping costs have risen 71% because of higher oil prices, as well as, cutbacks in ships and containers, according to IHS Global Insight;
  • Quality control and supply chain management have become increasingly important. Experience has shown many companies, that having production offshore can lead to timing delays and quality problems. It also often adds to the time for innovation;

Manufacturing jobs are coming home

According to Forbes in their June 11, 2011 edition “… in the after glow of the Great Recession, something surprising is happening: U.S. manufacturing appears to be on the cusp of an awakening – if not a full rebirth. Companies like Illinois-based Caterpillar, the world’s largest maker of excavators and bulldozers, is shifting some of its excavator production from abroad to Texas. U.S. furniture maker Sauder is moving production back home from low-wage countries. According to the report by Accenture, some 61% of manufacturing executives surveyed by the consultancy said they were considering more closely matching supply location with demand location by re-shoring manufacturing and supply.”

In December 2011 USA Today wrote “A small but growing band of U.S. manufacturers — including giants such as General Electric, NCR, and Caterpillar — are turning the seemingly inexorable off shoring movement on its head, bringing some production to the U.S. from far-flung locations such as China. Others that were buying components overseas are switching to U.S. suppliers.

Ford Motor said Wednesday that it is bringing nearly 2,000 jobs to its U.S. plants by 2018 from suppliers, including those in Japan, Mexico and India.

Experts say the initiatives could moderate job losses that have dramatically shrunk the U.S. manufacturing industry. “I think we’re going to start to see a slowing of lost jobs, and we’ll see some jobs coming back,” says Simon Ellis, an analyst for IDC Manufacturing Insights. “At some point, it will balance out, and we’ll reach equilibrium.” ”

5-Emerging market growth

The case for emerging markets has been made for years. It continues to be valid and it continues to unfold. Developing countries will continue to grow more rapidly than the US and other developed countries.

All have large populations of relatively low paid, unskilled, and semi-skilled workers. Many have relatively undeveloped natural resources as well.  They are in an excellent position to manufacture products and components for export to developed countries.

Demand for infra-structure investments in the emerging markets will be high.

Consumers will demand more food, electricity, consumer discretionary items, medicines, etc.

Industries and companies are being built there and their attractiveness as investments continues to grow.  However, as the Vanguard graph below shows, the days of bargain basement prices found in the early 2000’s no longer exists and emerging market stocks are selling more in parity with developed countries.


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