Guild Investment Management, Executive Summary, Dec. 15, 2016

Executive Summary

1. The new strategy for productivity growth. When labor productivity rises faster than inflation, so do living standards. That’s why administrations of every political orientation seek to boost labor productivity. However, they pursue this goal with very different strategies. For the past eight years, the U.S. followed a strategy focused on government as the engine of employment and productivity growth through expanded programs, more stringent regulations, and higher taxes; now the country is shifting gears to a new strategy based on the incentivizing of the private sector through tax cuts and selective deregulation. No matter which strategy is judged by history to have been more successful, investors must simply adapt to the environment as it changes — and the new environment suggests that a very different set of winners and losers will emerge in the coming months and years. We believe the winners in the next year or two will include consumer companies that can benefit from a sharp increase in consumer confidence; companies whose earnings derive primarily from the U.S. and can benefit the most from corporate tax cuts; and those who will see a relaxation of regulations that had grown over the last eight years. Over a longer period, perhaps four years, benefits could accrue to companies that will benefit from a major infrastructure bill. We are concerned about businesses that get a lot of their earnings from sales to government, since the incoming administration has signaled a tough bargaining stance. Businesses which continue to shift operations overseas could also face headwinds from a domestically focused Trump “bully pulpit,” and we would avoid them.

2. Robots are not the enemy — as long as education keeps pace. Robots are not the enemy. Research shows that industries which are being “computerized” tend to experience higher-than-average employment growth. Growing employment and productivity still translate to cheaper goods and higher living standards, just as they did during the first industrial revolution in the 19th century. Both then and now, the key is to have a workforce that continues to be educated appropriately to work together with its new robotic companions. “High school” was the innovative paradigm in the first industrial revolution — and STEM (science, technology, engineering, and math) education will need to be for the current robotics revolution. Ultimately, automation is nothing to fear — it is a force to be welcomed.

3. Market summary. We remain bullish on the U.S. and Japan. We suggest buying on market corrections. In our opinion, bonds should be avoided as interest rates will rise.

For the U.S. Economy to Grow, Productivity Must Rise — But

The Obama administration aimed to increase U.S. labor productivity; and the incoming Trump administration has the same goal. Although the goal is the same, their prescriptions are different. Here is our list of industries to own and to avoid.

Economists generally agree that for a nation’s standard of living to improve, labor productivity must rise faster than inflation.

Such productivity growth creates jobs, increases economic growth, and improves the living standards of the poor — lifting their income and economic status. In turn, rising living standards grow the middle class, stabilize and enhance middle-class values, make the nation more stable, and ultimately set the stage for even greater growth.

In the U.S. and much of the developed world, historians, policymakers, and economists accept this productivity-centered model of economic growth and development. In the U.S. there have historically been two basic strategies to support growing labor productivity, and we will briefly outline them in this note.

We are not judging which of these basic strategies is more effective and which is less. We are observing that over the past eight years, we have had one political model, and for the next four years, we will have a different one.

We will have an opportunity over the next four years to judge which model works better on the basis of the results. In the meantime, investors will have to work with the model put in place by the incoming administration. Understanding how the proponents of each strategy see the world, and how each allocates government resources, will help us predict which industries and companies are going to be attractive for investment during the next four years.

Two Paths to Productivity Growth

First, we’ll describe the model employed by the Obama administration. Put simply, under this model, the government increases taxes on businesses, the wealthy, and the middle class, and offers subsidies to the poor. Government sees itself as the bulwark of employment and tries to create jobs by expanding government and government-related employment opportunities. Those who employ this strategy seek to use regulation to assure an even playing field for all economic participants.

The second model, on the other hand, is the one taking shape in the policy proposals and cabinet picks of the incoming Trump administration. In this model, entrepreneurship and private-sector employment are the preferred engines of job creation, with incentives to growth offered to business through lower taxes and less regulation.

(When Mr. Obama was elected President, we read both of his autobiographies. Now that Mr. Trump has been elected, we have read his The Art of the Deal and are starting another of his books. In both cases, we gained valuable insight into each man’s concerns and ideas.)

Industries That Could Benefit From the New Policy Framework

We believe the following industries would be supported in the near term (the next year or two) by currently planned Trump administration policies.

1. Consumer companies that benefit from a more optimistic outlook for U.S. economic growth will be benefitted immediately. If people feel richer or more optimistic, they will spend on apparel and meals away from home. However, retailing is also making a shift from in-person to online and mobile, so be very careful to focus on strong e-retailers, or retailers whose products are inconvenient to evaluate online, such as many cosmetics.

2. Those which will benefit from a major cut in income taxes: namely, most companies who operate exclusively in the U.S. Those which have substantial foreign operations pay much of their non-U.S. tax in foreign countries where tax rates are closer to the global 20% average rather than the much higher 35% statutory U.S. rate. This group includes many businesses that are domestically focused, in manufacturing, minerals and materials, transportation, shipping, business services, energy and energy-related, retail, technology, medical services, banking and financial services, and business services.

3. Those which have endured increasingly intense regulation which will now moderate. This will take longer, but may happen within a year or two. Affected industries include banking, insurance, investment banking, mortgage insurance, mortgage finance, energy production, energy pipelines, and refiners.

Benefits would take longer — perhaps four years — to accrue to industries that will benefit from a major infrastructure bill: for example, industrial materials suppliers, construction companies, and construction equipment suppliers. These depend upon a longer procurement and implementation process. These will not see benefits in one or two years, but could by the time four years have passed.

Industries That Will Not Benefit From a Trump Presidency — We Suggest Avoiding Them

1. Those whose business have a large percentage of their sales to the U.S. government will find their profits pressed by the incoming administration’s avowed intent to get better deals. Mr. Trump has shown in his comments about pharma pricing and Boeing’s bill for the new Airforce One that he will demand the best price for goods bought by the U.S. government from private companies. He is very proud of his ability to negotiate low prices. He loves to negotiate, and he likes to feel that he and his organization got the best price. We expect him to work hard to create this psychology among U.S. procurement officials, and he will pressure them to lower the prices they pay for goods. Avoid companies where a large part of their revenues are derived from supplying the U.S. government. Their revenues may rise but their profits will be under pressure.

2. Those companies that continue to move operations overseas will struggle against the new administration’s agenda of keeping manufacturing in the U.S. The President-Elect’s “bully pulpit” approach makes free-market advocates very nervous. He argues that lower taxes and the implementation of activist trade practices will boost sales for U.S. manufacturers, even though U.S. labor costs are much higher than those abroad.

Investment implications: When labor productivity rises faster than inflation, so do living standards. That’s why U.S. administrations of every political orientation seek to boost labor productivity. However, they pursue this goal with very different strategies. For the past eight years, the U.S. followed a strategy focused on government as the engine of employment and productivity growth through expanded programs, more stringent regulations, and higher taxes; now the country is shifting gears to a new strategy based on the incentivizing of the private sector through tax cuts and selective deregulation. No matter which strategy is judged by history to have been more successful, investors must simply adapt to the environment as it changes — and the new environment suggests that a very different set of winners and losers will emerge in the coming months and years. We believe the winners in the next year or two will include consumer companies that can benefit from a sharp increase in consumer confidence; companies whose earnings derive primarily from the U.S. and can benefit the most from corporate tax cuts; and those who will see a relaxation of regulations that had grown over the last eight years. Over a longer period, perhaps four years, benefits could accrue to companies that will benefit from a major infrastructure bill. We are cautious of businesses that get a lot of their earnings from sales to government, since the incoming administration has signaled a tough bargaining stance. Businesses which continue to shift operations overseas could also face headwinds from a domestically focused Trump “bully pulpit,” and we would avoid them.
Automation May Not Be the Boogeyman

President-Elect Trump’s focus on offshoring as a source of American job losses has met one consistent response from the press: although offshoring was responsible for some of the lost jobs, automation was responsible for more. It’s not just Chinese workers who are taking the jobs — it’s robots. Amazon [NASDAQ: AMZN] is preparing to roll out high-tech brick-and-mortar locations without any check-out tellers.

The new wave of robot angst has prompted several analysts to bring attention to the work of Boston University scholar James Bessen. Dr Bessen published an analysis last year, in which he shows that as industries incorporate greater computerization into their tasks, the result is not the loss of jobs. On the contrary, the more computerization happens in an industry, the more job growth that industry experiences.

This is a common observation about the industrialization of the 19th century. For example, during the 19th century, 98% of the labor needed to weave a yard of cloth was automated. Yet the number of weaving jobs increased. Expanding production and consumption of goods meant that despite the fears of guildsmen in the early part of the century, new jobs were created which employed the vast new urban populations — and provided them with much higher wages and living standards.

The theoreticians of a robot apocalypse think that this time is different. This time, the robots will be so much more capable that they will simply replace us, and there will be no virtuous cycle of cheaper consumer goods, increasing production and wages, and rising living standards.

But Dr Bessen’s research suggests otherwise. An empirical examination of individual industries shows that as computers are incorporated, job growth for humans changes and accelerates. He notes bank tellers as an example. In the time since the introduction of ATMs, growth in bank teller jobs has been greater than job growth in the economy as a whole. Savings from ATMs allowed banks to open more branches — and tellers’ roles expanded to include more high-touch interaction with consumers.

A similar process has happened in the legal profession. Computer programs increasingly perform the “discovery” tasks that paralegals used to do — scanning vast document troves to determine what is relevant to a case. Yet as those programs have gained ground, paralegal employment has also risen faster than general employment. It turns out that “computerization” is not a danger to job security — it actually improves it.

The pattern that held throughout the 19th century is still holding now — and we believe, will likely hold long into the future. As automation proceeds, goods will become cheaper, disposable income will rise, and that disposable income will be used to express demand for services that only humans can provide. Fundamentally, we believe there will always be such services.

Education Is the Key

Here’s the catch, though: employment in “computerizing” industries rises — and that employment requires workers who are trained to work with their new computer companions.

As the “first industrial revolution” rolled on in the 19th century, raising wages and living standards, society responded by creating a new institution to educate workers to work with machines: “high school.” The answer for the new industrial revolution of automation is not to resist, but to welcome — and to make sure that STEM education keeps pace, so that our workforce can reap the benefits of higher productivity, higher wages, and higher living standards. This is another reason we are encouraged by the growth of massive open online courses, nano-degrees, and other innovative tools for learning.

And as an aside, we would love to see more robots being manufactured right here in the U.S.

Investment implications: Robots are not the enemy. Research shows that industries which are being “computerized” tend to experience higher-than-average employment growth. Growing employment and productivity still translate to cheaper goods and higher living standards, just as they did during the first industrial revolution in the 19th century. Both then and now, the key is to have a workforce that continues to be educated appropriately to work together with its new robotic companions. “High school” was the innovative paradigm in the first industrial revolution — and STEM (science, technology, engineering, and math) education will need to be for the current robotics revolution. Ultimately, automation is nothing to fear — it is a force to be welcomed.

Market Summary

1. We remain long-term bullish on the prospects for U.S. stocks although we suggest waiting for small corrections to buy. We do not mean corrections of 10%; it is our view that corrections of 2–3% may create buying opportunities.

2. We believe that Japanese stocks can be bought, but that the currency should be hedged. Several ETFs exist to buy the Japanese market with the currency hedged.

3. Our view continues to be that bonds, both U.S. and foreign, should be avoided. Interest rates will rise.

4. We have not forgotten about gold. A strong U.S. dollar is pressuring gold and silver; when dollar strength abates, gold and silver can rise.

Thanks for listening; we welcome your calls and questions.

Tim Shirata
Executive Vice President
Guild Investment Management, Inc.

12400 Wilshire Blvd. Suite 1080
Los Angeles, CA 90025
Tel: (310) 826-8600 Fax: (310)826-8611
email: tshirata@guildinvestment.com
http://www.guildinvestment.com