Friday, January 19, 2018

Think Strategically: 5 Issues & 5 Answers

By on December 27, 2017

Looking ahead to 2018, we believe the current U.S. economic growth rate may last longer than many experts believe; however, we may not see the same growth in the global markets that we experienced in 2017.

We see the Fed pressing slowly ahead with normalization, with markets sensitive to any early signs of other major central banks shifting policy gears. We believe investors will still be compensated for taking risks in 2018, but will be rewarded less.

Issue 1: Strong job growth and steady inflation indicate future rate hikes.

As the Federal Reserve raised rates a quarter percentage point earlier this month, no one was surprised, rather it was expected. In our view, the economic principles that drive the Fed have effectively met both in terms of labor growth and avoiding inflation and deflation by reaching price stability.

With the U.S. economy creating 228,000 new jobs in November, many are stating there may have been a shortage of skilled workers. This may decrease the pace of job growth in the new year as this level of growth is likely not sustainable for much longer.

We expect the Fed to raise rates three times next year, with the possibility of four hikes, but if there is any tangible downside change to growth, inflation, global growth or market instability, we should also expect its pace of policy normalization to slow considerably. However, it remains to be seen what impact the Incoming Fed chairman will have as he implements his views on Fed operations.

Issue 2: What does the geopolitical risk mean for global markets

Markets may seem calm, but geopolitical risks abound. From North Korea’s nuclear program to the recognition of Jerusalem as the capital of Israel, which may put additional pressure in the very stormy Middle East.

As President Trump drives his “Make America Great Again” slogan,  a hard U.S. approach on trade seems to threaten global free trade. We would not be surprised to see U.S. tensions with China over trade and security increasing. We see North American Free Trade Agreement (NAFTA) negotiations as a barometer for the new “Buy America, Hire American” policy.

Even though there is a possibility of a new NAFTA agreement happening during the second quarter of 2018, it may be hard to achieve, A tough U.S. stance could lead to a breakdown in talks. Any U.S. withdrawal from NAFTA would impact markets substantially and worsen trade frictions. With Mexico’s economy so closely linked with NAFTA, it could become the biggest loser.

A breakdown in NAFTA talks would be a troublesome sign for global trade.

Issue 3: Will market resiliency continue?

Financial markets have again proven resilient to geopolitical shocks in 2017. With robust growth, moderate inflation and ample liquidity, interest rates should slowly rise. Equities should make further gains in 2018. Upside surprises to inflation pose a main risk. With robust growth and bond yields seen as rising gradually, equities are expected to outperform bonds in 2018. Healthcare, telecoms, industrials and financials are our most favored equity sectors.

Corporate re-leveraging is likely to lead to some credit spread widening. BBB is our most favored credit rating for the segment.

Good earnings growth and an above-average valuation discount compared with developed world equities should continue to support emerging market equities and selected local currency bond markets.

With relatively high yields, but also cyclical sensitivity, real estate equities are favored in the eurozone. Our base case view of the world in 2018 is optimistic, as we expect a broad-based acceleration in growth. Unfortunately, it will not be a world without risks.

Issue 4: Millennials: Insights from next generation investors

Millennials are increasingly making their mark and shaping headlines. Quite soon they will become the dominant generation in the active working population worldwide. They are an increasing focus of politicians and executives, shaping trends as citizens, employees, consumers and investors.

Many millennial startups are being taken over by large corporations that aim to cater to the demographic and better understand it. One area is the electrification of vehicles, which is accelerating due to the millennial consumers, who demand cleaner-running vehicles. The year 2018 will be a turning point in shifting the economy for the millennial wave, as the next generation makes its mark on the world. 

Millennials are digital natives, and are truly global, interconnected and marked by the post-modern experience of uncertainty and a sense of collective responsibility. They have different views and approaches to life, work, collaboration, politics, banking and investing, and different expectations and priorities. 

Some top issues for millennials are affordable housing, education, vertical farming, blockchain developments, and artificial intelligence among others. We must all prepare for the world as seen by this generation.

Issue 5: Bankruptcy, Hurricane María and tax reform: What will happen to Puerto Rico?

Puerto Rico has been suffering economic contraction for more than a decade and even though the country has made several efforts to revamp the economy, these efforts have not worked.

Now, after two decades of fiscal imprudence, and excessive spending, as well as salary and benefit increases to all public employees without metrics to justify them, we are faced with the devastation of Hurricane María, which decimated the fragile infrastructure of Puerto Rico. Add to that the liquidity crisis and no access to capital markets. Puerto Rico has been and continues to face a crisis of a magnitude no other U.S. state or territory has ever faced.

A recurrent topic in the analysis of Puerto Rico’s economy has been its weak performance for the past three decades, during which our economy grew at a paltry 2% pace. A rate well below that of our peer group.

Joseph Schumpeter, the famous Austrian economist, used the term “creative destruction” to describe the market forces that promote constant innovation. We must accept these forces when our economic reality changes and readjust our focus toward new industries and initiatives that reactivate the economic engine.

Our infrastructure was in need of revamping even before the destruction wrought by María. We view this an opportune time to combine Schumpeter’s creative destruction with our current destruction and allow Puerto Rico to evolve, renew and rebuild a more resilient economy.

A recent study prepared by Estudios Tecnicos Inc. determines lost income and reconstruction costs to be between a low of $53 billion and a high of $67 billion. Most experts conclude that the figure Congress will grant Puerto Rico is closer to $20 billion. Congress also left town without being able to agree on an $81 billion hurricane and wildfire relief package, so working out differences on that will be high on the agenda in the new year. The higher the figure, the better Puerto Rico will fare.

Federal tax reform a game-changer

Puerto Rico had sought full exemption from new taxes, since it was being treated as a foreign jurisdiction when in reality it was a domestic one. In addition to the weak state of the economy, and right in the middle of the aftermath of two hurricanes, the tax bill treats affiliates of U.S. companies in Puerto Rico as if in a foreign country and imposed a 12.5 percent tax on intellectual property.

Final Word: What does 2018 mean for Puerto Rico

In 2018, more than any time in history, Puerto Rico needs to be creative with the tools it has. It is true that the approved tax reform poses a threat to our manufacturing base, that María brought us within view of the abyss, but we must march on, regroup and plan our next moves. Local opportunities may include:

  • Creative use of the Public Private Partnership model creating hundreds of new possibilities.
  • Decentralizing and downsizing the government to align it with our current reality.
  • Advance a Puerto Rican tax reform focused on economic growth and economic development.
  • Seek municipal reform to allow for the centralization of services, programs, events, activities, procurement and key services.
  • Create a government divestiture program to sell unneeded assets.
  • Eliminate obsolete government rules, regulations, programs and agencies.
  • Diversify and transform government monopolies and focus only on essential service operations and agencies.

As a final thought, a quote by British writer W. Somerset Maugham:

“We are not the same persons this year as last; nor are those we love. It is a happy chance if we,changing, continue to love a changed person.” 

We bid you all a happy and prosperous 2018.

–Francisco Rodríguez-Castro is president & CEO of Birling Capital. He has served in government, multinational and public corporations fro more than 25 years and has advised multiple entities in a diverse array of market segments. He has also participated in multiple mergers and acquisitions as well as in structuring transactions that combined surpass $10 billion.

 

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