What to Expect in 2014 (And Beyond)

This outlook is being written a good 45 days later than when “What to Expect in 2013…” was written over a year ago. It is amazing how much can happen in that short time frame and can influence one’s view of the next year. If I let another 45 days pass I am sure there would be some things that would change. I believe the risks are to the upside on more positive news on the economy but at some point that news could affect Fed action.  Much of what could happen this coming year is influenced by what is going on in the energy sector. Middle East economies, of course, but also inflation, GDP growth, and geopolitical events will affect markets and the US economy specifically. These points will become clear as I spell out some of my expectations. Understand that these expectations follow the Byron Wien formula where I believe there is greater than a 50% chance they happen when the rest of the world may not agree. The “Expectations” are designed to stimulate thought. Some of them can relate directly to the securities markets, but some do not, and this year, a little whimsy. Hopefully, you can figure out which one that is. Let’s begin:

  1. After printing two 4% GDP quarters in 2013 and seeing a 1 percentage point drop in the unemployment rate, there is finally some recognition that, maybe, the Fed’s actions really did produce some stimulus. This could lead to self-sustaining growth in the US economy in 2014 with at least one more 4% print this year. Less noise from the crazies in Washington adds to business confidence and, ultimately, capital expenditures.
  2. Economic growth and job creation become more apparent with forecasts for a decline in the unemployment rate possibly approaching 6% before the end of the year. The Federal Reserve begins making noise about speeding up tapering and hints at reducing the time the Funds rate would remain anchored at its current level. This is in spite of limited evidence, at least early in the year, that the inflation rate is approaching the targeted 2% level. This ultimately has a dampening effect on the markets.
  3. We begin seeing some academic work and, of course, the pundits talking about an acceleration of the technological revolution making the case that low inflation or maybe even some signs of deflation are actually a good thing in this technologically driven environment. The low inflation picture is reinforced at the headline level by energy supplies expanding within the US, in the Middle East from Iraq and, ultimately, Iran. As other countries embrace fracking the potential for even more supply keeps downside pressure on energy prices.
  4. The negative elements on inflation, which are not sufficient to cause major concerns, come via erratic supply in soft commodities from continuation of drought in certain areas combined with weather abnormalities which, more and more, are blamed on climate change. As we get into the latter part of the year, the improving developed market economies combined with growth in Asia put some upward pressure on hard commodities. Investors must make the decision to invest in the extraction companies that have suffered from low prices or directly into the commodities themselves.
  5. The positive change in US trade balances from lower imports of energy combined with rising energy exports adds more than a percentage point to US GDP and reinforces the case for a strong dollar relative to almost every other currency except possibly the Chinese yuan. Asia shows growing signs of a currency war fueled by the impact of further weakening of the Japanese yen beginning to very seriously affect the export trade of its Asian competitors.  While this has a tendency to push up inflation rates in many of the Asian countries, the developed markets benefit from lower prices on many imported goods further softening their inflation rates.
  6. The impact of the currency wars raises questions about the stability of some of the emerging markets, particularly in Asia. There are also concerns about the pace of wage increases in these heretofore attractive locations for outsourcing. Manufacturing and some service corporations begin making different strategic decisions on the best places to locate manufacturing and processing centers.  The decisions are reinforced by a growing belief that technological advances will continue to allow capital to substitute for labor, or at least keep pressure on wages. More business activities find their way back into the developed countries of the world. China moves cautiously in the same direction, taking advantage of its own technological progress. It begins marketing itself as a technological leader as opposed to a low-cost labor market. This is not easy as China, at the same time, continues to push toward a more consumer-oriented society. Incomes have to rise and, politically, the population needs to be kept content. It will not be a smooth year for China.
  7. Coming elections in India point to a possible loss of leadership for the Congress party. Combined with continued economic difficulties and some strife associated with the potential leadership change, the country moves further down the path of being even less attractive for foreign direct investment. It loses another year to the relative growth of its Asian neighbors and finds itself participating in the currency wars as a possible way to salvage elements of growth.
  8. With the exception of Chile, Colombia, Mexico and Panama, the rest of Central and South America flounders. The US begins to pay more attention to its southern neighbors. Out of desperation, Argentina reaches a settlement on its outstanding debt and begins a focus on building its energy sector with some help from outside sources. A Menem-like regime change becomes a more likely political outcome.
  9. The changing energy picture outside the Middle East, combined with likely increased production out of Iraq and, ultimately, Iran, result in a change in the relative importance of Saudi Arabia and, to some extent, Israel. This could produce some positive movement in the Palestinian situation, and some changes in the relationships of Saudi Arabia with the rest of the Middle East and possibly Asia as the US becomes an even smaller market for its oil and an export competitor. On the other hand it raises the risk of some turmoil in the region as the power picture changes and attempts are made to preserve the old order in  a possibly military fashion.
  10. The fading newspaper industry surprises the street with its earnings in the early part of the year and benefits from contentious congressional races in the third and fourth quarters as well. The advertising related to Academy Award nominations and ultimately selections reaches new heights in print and social media. Studios advertise some small (but not cheap) movies to extremes to compete with some very high quality films and performances. We actually walked out of a couple of the most highly advertised ones. Aren’t two-page spreads a little extreme? Unfortunately, the correlation between the advertising and the nominations and awards becomes very direct leaving it up to the audiences to hopefully, make their own decisions after the fact. The quality and audience continue to rise for television productions and the associated delivery mechanisms for these performances leaving 3-D sequels and prequels to the movie industry. Can’t wait for “Inside Llewyn Davis Today–in IMax.”

So what does this all mean for the markets? I wish I knew. History says that the kind of equity market we had in the US in 2013 is usually followed by a decent year.  I don’t think it is that simple. We could see some re-allocation by institutions whose US equity portfolios have been pushed above their target percentages. At the same time, if we are beginning to return to a more normal relationship between earnings yields and fixed income yields, traditional debt doesn’t look that attractive. It may mean that markets outside the US are more attractive–maybe Europe and maybe some of the emerging markets if the currency is hedged out. There are some risk elements in the geopolitical situation. I think we will have to look harder for returns this year and the risks are high enough to look for some less correlated investments. I wouldn’t reduce my equity exposure, but I might change the mix.

We’ll have to see if another 45 days sets us up for totally different surprises. If nothing else I hope this has provided some food for thought.

I have some longer term expectations including a carryover from past years which, one of these days, will actually come to pass. I include these as additional repast for the brain. As has been the case since the millennium, the year will likely be more interesting than we anticipated.

  1. Contrary to normally quiet years during a transition of leadership, to some extent in reaction to some elements of an “Asian Spring” in the region, China takes further steps in response to a more activist populace upset with corruption, the environment, and some areas of economic stress. Externally, this includes significant acquisitions in other countries as well as the opening of manufacturing and service facilities where there is a receptive government. At home, R&D is accelerated, particularly in alternative energy, space and IT processing. Subsidies for hydrocarbons are reduced and an explicit carbon tax is put in place.
  2. As the US economy grows, corporations find qualified hires difficult to come by.  Enlightened corporations become educational institutions to provide skills and basic knowledge to a work force that has been idle and undereducated by the public systems. Corporations become much more vocal about creating paths to bring more immigrants into the US system, expanding visa programs and finding other mechanisms to add talented labor to the domestic pool. The tide shifts significantly on immigration issues. The skill match is aggravated by decisions on the part of some US corporations to bring business operations back into the States. Labor costs are rising elsewhere and the elements of control, rule of law, productivity, available feedstock and relative safety lead to better economics for manufacturing and service operations.
  3. Moore’s Law, driven primarily by Intel driving down the nanometer scale and introducing other innovations,  continues to march on. The use of Big Data becomes ubiquitous. This produces technological advances that enhance the opportunities in health care, manufacturing, extractive industries, media and services beyond even the imagination of some of the best speculative fiction writers. These advances, on balance, are positive but continue to raise concerns about the environment and quality of life and opportunity for those at the lower end of the economic and educational spectrum.
  4. Breakthroughs in stem cell research particularly led by work coming out of the New York Stem Cell Foundation change the nature of disease management and eradication and move general therapeutic advances away from animal models to direct testing on human cells. Targeted therapeutics driven by DNA analyses tied to narrower classes of patient recipients change the nature of drug and health delivery. It becomes apparent that the US FDA model is slowing the pace of US therapeutics development by the cost and time required to bring solutions to market. Much as financial services regulation was geared to the benefit of larger entities, it becomes clear that therapeutics development has been on the the same path. Change occurs in response to other countries moving more rapidly in bringing solutions to market.
  5. Away from continual ups and downs in financial assets as the world works its way through the hangover from the 2008-2012 financial crises, the general march of human progress is positive. I hope to be around to observe it. Maybe the breakthroughs suggested in the previous expectation will help that.

A Brief Look at the World—China, the US, Europe and the Lake Forest Investment Society

I am heading out to Chicago for one of the triannual meetings of the Lake Forest Investment Society.  We have been meeting three times a year (yes, triannual can mean three times a year) for many years to talk about the economy and the markets, including providing some specific stocks for a “portfolio.” The best performing security for the period between meetings gets its touter a free lunch. The portfolio, an unaudited, equally weighted hodge-podge of names is actually up  427% vs. the S&P at 130% over the 16 years this group has been meeting.  The Society originated as a group of ex-Mitchell Hutchins employees and some of their favorite clients who wanted an excuse to share some provocative ideas on stocks, the economy, the world and life, eat high cholesterol meals, and maybe play a little golf. Some of the members and their origins have changed over the years, but the dialogue continues. The following are some thoughts I expect to share at the meeting:

China’s Role

This global deficit crisis won’t really be resolved until China enters the picture. China needs an export market to provide sufficient jobs while it tries to move to a consumer economy. It cannot find itself with a slow-growth economy if it wants to avoid political disruption, particularly at a time of leadership change. The developed world, both the US and Europe, needs to be showing some growth in order to be consumers of Chinese goods. With new leadership coming in 2012 there is an opportunity for China to provide some form of quantitative easing through the purchase of longer-dated securities or other mechanisms.  This could be combined with the purchase of real assets and intellectual property as well in both the US and Europe. Until we see some movement by China, the developed world markets will face continued uncertainty, as the resources available to resolve the European crises, specifically, are just not adequate. However, I doubt China will move until both Europe and the US take stronger steps on their own to develop long-term deficit solutions and near-term stimuli.

The US’s Role

Contrary to what has been a continual reduction in GDP forecasts and increasing odds of a double dip by the pundits, I think the US could show decent growth in the second half of this year—not enough to create a lot of jobs, but decent. This does assume that the Super Committee or some variation thereof comes out with a long-term deficit reduction program combined with some near-term stimulus, and Congress actually supports this effort. I think the odds are greater than 60% that they will. This doesn’t necessarily provide a boost for the second half of the year, but it clears the air for next year and eliminates some elements of uncertainty in the minds of business and investors. My guess is we could have one more horrendous scare, probably coming out of Europe, before the world comes to its senses and responds to what could be a real crisis otherwise. What needs to happen long term is a whole ‘nother post, but one could read Friedman’ and Mandelbaum’s new book, “That Used to be Us,” to get a sense of some of what has to happen.

Europe

What a mess. It does not appear that the mechanisms exist to deal with the Greek deficits without putting the European banking system and maybe some other financial entities at grave capital risk. Whatever does come out of Europe as a solution—and I think it will take the Chinese to at least have the appearance of a solution—growth will be slow, as the European banks will not be in a position to lend for some time.  This is an opportunity for the Chinese probably to the detriment of the US, if they choose to pursue it.  China bashing in the US will likely drive China closer to Europe. China can also be more specific in its actions by dealing with individual countries and companies as opposed to the Union.

Other Topics

In spite of what most of the Republican primary candidates say—Jon Huntsman excluded–climate change is happening. We have no coherent policies in place and what was previously there is slowly being dismantled in Congress and by the Administration. Fiscally, we don’t seem to believe we have the resources to tackle this issue now, in spite of the long-term job creation possibilities.  And, the fascination with “fracking” and what that could do for energy independence is in the forefront with massive resources from the energy industry devoted to selling the story. In the meantime the failure of an over-funded science project, Solyndra, has raised issues about government involvement in clean tech.  These are their own topics, which I will deal with separately in other posts. In the meantime, back to the LFIS meeting, I will have a hard time coming up with a good stock idea. My personal portfolio is in cash and private illiquid companies. My compatriots will have some very interesting ideas, particularly at this moment in the market. I am not so sure the public market is as cheap as many opportunities in the private market today, particularly away from some of the frenzy around social media and other Internet related companies. Maybe one more crack in the public markets will get it there if it is combined with some stimulus in response.  In the meantime, real private companies are having a hard time finding funds from the traditional venture capital sources. We appear to be going back to the original sources of capital for venture companies, rich families either in the form of family offices or direct.  They can name their prices.  We are back to the old maxim that one makes the most money on a good price going in vs. the price going out.

Reduce Oil Imports by 1/3? Can we do it all with fuel efficiency?

The short answer is maybe. It would require that vehicles being sold ten years from now would have to average 75 miles per gallon—not impossible, but  improbable–unless. It requires political will, higher and real CAFE (fuel efficiency) standards and continued technological improvements or a gasoline price that rises substantially. The latter two are the factors about which I have the most confidence.

I hate to do this, but we need to understand the numbers. Try and stick with me on this. These numbers are rough but get us into the ballpark.

We import 9 million barrels of oil a day, about half from OPEC by the way. So we need to get rid of 3 million barrels a day or 1.095 Billion barrels a year. Now, those barrels don’t just go into making gasoline, but let’s make the leap of having all that reduction come from gasoline.  Based on refining experience, each barrel of oil typically produces about 19  gallons of gasoline (there are 42 gallons in a barrel). If we are to get rid of 3 million barrels of oil per day that means we need to reduce gasoline consumption by about 46 Billion gallons (42 gallons per barrel x 1.095 Billion barrels);  that’s out of the 160 Billion gallons consumed each year by the 240 million vehicles on the road today. (Notice that I capitalize Billion. We are talking BIG numbers.)  Those vehicles, each traveling about 12,000 miles a year, are actually averaging about 18 miles per gallon. To think about it another way (inverted), each vehicle is consuming about 0.0556 gallon per mile or 0.00132 barrel per mile. Pretty exciting so far…

Over the next ten years at a scrappage rate of 5% a year we will replace half of those 240 million vehicles. That’s where the reduction in consumption has to come from.  Let’s calculate what the mileage improvement has to be to eliminate those 1.095 Billion barrels a year.   Currently the half of the fleet that will be scrapped, which is less efficient than the whole fleet, is likely consuming about 1.8 Billion barrels a year or 4.93 million barrels a day. We would need it to be consuming only 1.93 million barrels per day or 0.705 Billion barrels a year or 29.61 Billion gallons per year. If each vehicle in that half of the fleet is traveling 12,000 miles a year it would have to be averaging about 49 miles per gallon. You can do this calculation yourself by dividing the total mileage for the fleet (1.44 Trillion miles) by the gallons expected to be consumed (29.61 Billion).  To get that average for the 120 million vehicles assuming a linear increase in miles per gallon over that ten-year period, the vehicles bought in 2022 would have to be averaging 75 miles per gallon.  While the all-electrics are already getting over 100 miles per gallon equivalent and many of the hybrids over 50 mpg it is still a stretch to think that we will get the average on all vehicles sold in a year up to 75 miles per gallon in 10 years or about 50 miles per gallon in 5 years.  It is not impossible, but would require one hell of a change in the growth path for highly fuel-efficient vehicles, supported by significantly higher CAFE standards.  The problem is we are starting with only 40% of all vehicles being subject to the higher CAFÉ standards. We have a lot of light trucks and real trucks on the road.

We should strive for all 3 million barrels a day coming from fuel efficiency. As I said, political will, CAFE standards, and technology are required, and higher oil prices are a given unless we do this. And, by the way, every million barrels a day of gasoline we don’t use, reduces CO2 emissions by 148 megatons per year.

The Gulf Crisis–Beyond Petroleum–A Game Changer?

“US Offshore Drilling is a Good Thing” A few weeks ago, shortly after President Obama announced an expansion of offshore drilling rights, that was the working title of a post I was contemplating for this blog. The premise was that it would take many years before we weaned ourselves from our use of oil, and production of additional domestic oil and gas  would have some impact on overall prices, increase natural gas usage (reduce CO2 emissions), reduce our dependence on foreign energy sources and have a positive impact on our trade balances. While I was fiddling around with this post and enjoying some late season fishing in Argentina instead of writing, along came the  “Black Swan” Gulf disaster.

The disaster is ongoing as it will be for many years to come. Much has been written and will continue to be on the environmental, human, political and economic consequences of this Inevitable Accident, which is the way it should be referred to.  I have my own somewhat disconnected observations, which I will share. trying to see what, if any, good may come out of an event that some are calling a “game changer.” I expect disagreement and dialogue and hope we get some. I hope none of what I have to say approaches the idiocy of one of our Senators who is willing ro repeat again and again that the Gulf incident is not an environmental disaster. Let’s get to some of the observations.

This disaster was inevitable—the Inevitable Accident.  In the continuing search for and production of carbon-based energy sources we keep stepping up the risk, whether that is in a coal mine in Virginia or China, a shale deposit in Pennsylvania, a tanker on the ocean, a LNG terminal or deep wells offshore  anywhere.  The technology becomes more complex, the measure of risk more difficult, and the cost of mitigating risk too high at today’s prices for carbon to be fully recognized and absorbed.  Maybe this disaster was a good thing. I hesitate to say that because of the loss of life and livelihood for those directly impacted. However, the response to it may prevent other similar or worse disasters. Although, most likely, it will simply delay the next more devastating disaster as the risk-taking outpaces the rule-making in the effort to meet the insatiable demand for energy worldwide.  One example of risk-taking outpacing rule-making is the talk of raising the liability cap from $75 million to $10 Billion.  Odds are this “incident” should cost BP well north of $30 Billion. In today’s dollars Exxon-Valdez cost Exxon about $10 Billion. If a major oil company sees its financial risk as “only” $10 Billion, there are lots of risks one can take that have an expected value substantially higher than that.

Whatever the US does in terms of limiting off-shore or on-shore drilling or raising the cost via rules and regulations, it will likely have limited impact on drilling elsewhere. In fact costs may be lower elsewhere as the supply of rigs available rises. Brazil has some heavy duty drilling ahead of it. Its costs will go down. Whatever steps are taken will also likely benefit the bigger companies relative to smaller participants. OPEC must be jumping for joy as well.

I still wonder why we didn’t bring to bear immediately the best engineering and scientific minds in this country, or the world for that matter, to get in front of this disaster. The attitude seemed to be one of “this is BP’s problem.” There was much more time spent on establishing who was at fault than responding to the problem. Certainly, it made it more difficult for BP to shift responsibility technically and financially. But, this had the makings from the beginning of a potential major human and ecological disaster if things did not go well. When a casual suggestion late in the process from our Secretary of Energy provides a solution to a specific problem (gamma rays to analyze the stuck valve) one can just imagine what might have been in a much more organized effort to bring brainpower to the problem. It doesn’t give one much confidence that our response to the next disaster will be any better.

Maybe this increases the odds of further action by the US on climate change legislation and an increase in incentives for alternative energy sources. There are powerful forces opposed to that with several senators as their mouthpieces, but, maybe this is a game changer. I don’t yet see the outrage though. A few people boycotting buying fuel at a BP service station, which only hurts the owners of the station—not BP—but not much more directed anger. A lot of “isn’t it too bad,” as people drive their gasoline guzzlers to and fro, but no real outrage. Why aren’t consumers demanding that the auto companies (the US government in some instances) substantially increase mileage standards and come up with alternative fuel systems?  The boycott should be against new car purchases unless the mpg rating is at least at China’s standard, 35 miles per gallon on its way to 55 or 60 mpg. As I have pointed out before, once we get the fleet to that level we stop buying oil from other countries except Canada and Mexico—and at some point that should end as well.

One could go on with other observations, but the above are some major ones.  The level of outrage needs to rise nationwide, not just in the areas affected, as does the level of responsive and responsible action. Let’s not waste this crisis.  Let’s not wait for the next Inevitable Accident.