Executive Summary
1. There are attractive investment opportunities in 2015, but we expect more volatility. As we’ve said over the past several weeks, we see good momentum in economic fundamentals supporting corporate profit growth and stock price appreciation in 2015, especially in the U.S., and potentially in some other global markets. We think that some common fears are unwarranted — for example, global deflationary tendencies; stressed foreign debtors who have borrowed in U.S. Dollars; instability in Europe prompted by fresh troubles in Greece; financial stresses in Asia from excessive leverage and falling commodity prices; and stresses in the Chinese shadow banking sector. However, we recognize that these unwarranted fears can have very real effects on the market when traders’ anxiety reaches critical mass. We would regard market pullbacks on these fears as buying opportunities. Besides the U.S., we see the possibility for European stocks to perform well if the European Central Bank implements a QE program, which many expect in late January. Despite bearishness on base metals, we see limited downside, and think that some metals could surprise to the upside as world GDP accelerates in 2015. Gold continues base-building, but may come under selling pressure.
2. China’s coal use set to peak. In spite of developed-world alarm at China’s carbon emissions, pollution, and coal consumption, internal structural trends in China seem set to cause coal usage to peak by 2020 and then begin to decline. China’s shift from heavy industry to a consumer-led economy; government programs aimed at reducing energy intensity; the expansion of non-fossil electricity generation; and a determination to reduce pollution in the country’s more developed east — all are causing coal-use growth to slow and eventually decline.
3. Don’t fear the peanuts. Parents of school-age children are aware of the apparent explosion in peanut and other allergies among children that’s happened over the past fifteen years. Whatever the cause, there has been no simple solution, except the banning of peanuts, tree nuts, and other allergens from classrooms. Now a French company has introduced a transdermal patch to reduce peanut sensitivity, which has performed well in clinical trials. We take this as an indication that there are profitable innovations to be found in the medical industry even outside the pharmaceutical and biotech sectors.
4. Another trick up Abe’s sleeve. International investors have grown less enthusiastic about the reform potential of the Abe administration in Japan, with foreign inflows into the Japanese stock market drying up. We think the Japanese market may perform tolerably well in 2015 with ongoing QE from the Bank of Japan. We also note the plans announced to cut Japanese corporate taxes, which are currently the second-highest in the developed world. Even more interesting are proposals to give extra tax breaks to companies who raise employees’ wages at least 3 percent. Even if Abe doesn’t implement deep structural reforms, such tax cuts could have a positive effect on the Japanese economy, and the Japanese stock market.
5. 2015 — a “perfect storm” for cybersecurity? Relentless cybersecurity news has made this theme one of the hot investment topics for 2015. Unfortunately it is extremely difficult to translate into investment opportunity. We suggest concentration on individual names, and particularly those with the capacity to leverage the analysis of big, unstructured data to spot threats preemptively.
We Have Highlighted Attractive 2015 Investment Opportunities — But You Should Expect More Volatility
These past few weeks, we have been describing how we believe the U.S. market, and possibly Europe, India, and Japan, will be interesting in 2015. This week we will describe how the U.S. and world markets will be subject to some volatility in 2015, and how that volatility will lead to opportunities to add to positions and to extend profitable investments.
We expect U.S. and world GDP growth to be strong in 2015. We anticipate that the U.S. economy could grow at close to a 4-percent rate, and that world GDP growth will be about 3.8 percent (both before inflation). We anticipate that U.S. unemployment could be anchored in the 5 percent range by the end of 2015, and that U.S. corporate profits will grow at a rate of 8 to 10 percent for 2015.
All of this creates a U.S. stock market that is well-situated for more gains. Even though the market is near record highs today, strong U.S. GDP growth, strong U.S. corporate profit growth should drive stock prices higher. Accelerating and deepening this trend are positive consumer sentiment, increasing employment, increasing retail sales, decreased long term unemployment, increased corporate capital spending (more U.S. based plants factories and thus more U.S. employees), and increased small business confidence (small business has been the engine of job creation for decades). Last but not least, a stronger U.S. dollar continues to attract investment capital to U.S. investment markets.
Of course, there are risks. These risks are real inasmuch as they create fear and volatility.
One reason for more volatility is the recurring, periodic bouts of fear that deflation and recession will take hold in the developed world. Every year since 2009, there have been a significant number of market commentators and market participants who believe that the world will slip into deflation and recession and possibly depression… some saying it could happen by 2015. As we have been saying for five years, we are unequivocally in disagreement with this view.
Let us examine some of the other fears one by one and see how realistic they are.
1. Perceived inability of U.S. dollar borrowers to produce commodities to repay their loans.
In our opinion, this risk is not serious. Total loans to producers of oil and base metals are not enough to significantly impact the banks who have lent them money. In every economic cycle, some loans are not repaid, but most loans are repaid, and banks make money over an economic cycle with their lending activity. This is one such cycle — banks are making money on their lending activities.
As is typical in every economic cycle, unpaid loans or unrepaid bonds will make headlines, but this won’t be sufficient to damage the banking system or public confidence. Panicky traders may throw away stocks when this type of news appears. We will treat such occasions as a buying opportunity.
2. Instability in Europe
a. Economic instability in the areas of Greece, Portugal, France and Spain
b. Unwillingness of the Germans to allow government bond purchases by the European Central Bank (ECB).
c. Slowness of major European banks to repair their balance sheets and stop speculative bond and stock positioning.
Announcements of any of the above will have a short-term negative effect, and we will see the same kind of temporary panic and risk-off behavior that has been so prevalent for the last five years. Over the last five years, central banks have come to the rescue of these types of problems not only the European Central bank but central banks all over the world. History has repeatedly shown that these are not a long term problems and history further shows that buying in the face of such negative headlines and panicky action from traders has produced substantial profits.
3. Instability in Asia.
a. Banks that have made too many loans to highly-levered financial entities.
b. Banks that have made too many loans to commodity producers.
c. Banks that have borrowed too much money in U.S. dollars that need to be refinanced or repaid in 2015.
None of the above potential problem areas are especially large or troubling as a percentage of all bank loans in the region, and thus we do not see this as a long-term problem.
4. Perceived instability in China
China is a very large economy. Accordingly, China has problems, and China has many solutions. One problem is that too many speculative instruments have been issued by stock brokers and by insurance companies promising unrealistic returns to investors. Many of these instruments will fail. However, these products are external to the banking system; they are directly issued by brokers and insurance companies to the public. Some of these organizations will fail to repay the investors. This will be handled by direct infusions of government money into the companies in certain cases, and by loss of capital by investors in other cases. The sum total of losses will not be large enough to shake confidence in the Chinese economy. We anticipate that investor losses will discourage further investment by the public in these non-bank, non-insured products.
Chinese banks are not in real danger because Chinese banking is still a closed banking system. There is little foreign debt (in large quantities) and few foreign deposits. Recently, several anonymous and secret capital infusions have been made by the Peoples’ Bank of China into major Chinese banking institutions — and the government has trillions of U.S. dollars more to use in like manner if it is needed to avoid a banking panic.
Why We Like Europe If They Do QE in 2015
We are concerned that Europe has been slow to do the proper thing to bring the southern tier of nations in the community into responsible fiscal position. On the plus side, the Europeans are belatedly correcting the lack of capital in some European banks. The bright spot on the horizon is ECB’s President Mario Draghi, who may move forward with QE even if the Germans continue to hold out against such action.
Once the ECB begins its QE program (which we expect won’t occur until after its next meeting on January 22), there will be a rush to get into European stocks. European stocks are experiencing low valuations, and the larger companies are paying a very high dividend, approaching 4 percent. Until then, the world is waiting in anticipation to see what the ECB is willing to do. This is a scenario that could produce rapid and substantial gains for those investors who react quickly after the ECB finally takes action. Some will seek to act before the ECB does. This approach will be dangerous if the Germans, for domestic political reasons, are able to forestall the advent of QE in Europe.
What about Japan?
Japan remains an enigma. We discuss some positives below, but there are negatives that could stall Japan. In our opinion, Japan will rise in 2015, but its rise will be moderate, and money can be more profitably invested elsewhere.
Base Metals – We Caution Investors To
Not Be Too Bearish In 2015
It is currently popular to be bearish on base metals; the prices of many are moving sideways, and some pessimists see this price action as a symptom of poor underlying demand due to slow world economic growth. We disagree. World GDP growth will be stronger in 2015 than in 2014. We expect world GDP growth of about 3.8 percent in 2015 before inflation, and we do not see any reason that world economic activity will collapse. Any price weakness in base metals is due to big increases in supply as a result of the rapid production increases of many metals in the last five years. Demand continues to rise steadily, and we anticipate that some base metals like copper could surprise investors with their demand and price strength before 2015 is completed.
As for gold, it continues to make a long-term bottom. The strong U.S. Dollar is a headwind for precious metals and other commodities. We think gold could experience another bout of selling pressure that could take it below $1,100 per ounce — but investors should remember that over the longer term, gold is, and has been for centuries, a good store of wealth.
China’s Coal Use Will Peak By 2020
Many westerners love to hate China. The reforms that launched China on a multi-decade growth trajectory have lifted hundreds of millions of Chinese out of poverty, but sometimes it seems that more media attention is focused on beleaguered Foxconn workers than on the longer arc of China’s development.
China’s consumption of coal, and its generation of pollution and atmospheric carbon, is another issue that can raise hackles in the U.S. and Europe. November’s carbon-emissions accord between the U.S. and China was a good example. Critics noted that the U.S. promised much more aggressive action than China — with the implication that China would keep burning disastrous amounts of coal for the foreseeable future, and render impotent the carbon-reduction plans of the developed nations.
Surprise — China Changes
The problem with this overly negative view is that it doesn’t take China’s dynamism into account. A historical perspective is often helpful. The U.S. endured harsh working conditions during its rapid industrialization more than a century ago, but the economic and social gains of that growth laid the foundations for a prosperous consumer society in the 20th century.
China will face its own challenges, but the arc of its development is shaping up to be broadly similar. An economy focused on the growth of heavy industry, and on the primary and secondary sectors (resource extraction and manufacturing) is gradually shifting its weight to the tertiary sector — business and consumer services. This shift will not be without crises — for example, the government may not be able to manage the deleveraging of the shadow banking sector without significant stresses. However, we believe it is important to maintain a view of the secular processes at work.
Coal Use Set to Peak
What’s true for the development of the Chinese economy will also be true for Chinese carbon emissions and coal consumption. While we see alarmed reports about Chinese pollution crossing the Pacific and affecting air quality in the western U.S. and Canada, we also understand that China’s coal burning will not keep growing forever. In fact, the rate of growth in China’s use of coal has already begun a drastic decline. From 2001 to 2011, China’s coal use grew 9.0 percent per year; in 2012, it dropped to a 6.9 percent growth rate; and in 2013, it grew 2.0 percent.
Many government, financial, and industry analysts (for example, Citigroup, the International Energy Agency, the Chinese National Coal Association) have estimated that the peak of China’s coal usage will occur between 2015 and 2020. We read a report published in November by the National Bureau of Asian Research, a geopolitical think-tank, that summarizes these views, and broadly concurs with them, suggesting peak usage in 2020 at 2.55 billion tce (tons of coal equivalent).
In short, the threat of Chinese coal use and carbon emissions is something that may ultimately be addressed most effectively by the development arc that’s already in place.
What’s Driving the Decline of Coal in China?
Three secular trends are slowing the growth of coal consumption.
First, as we mentioned above, China is shifting from the dominance of heavy industry to the rise of a more service- and consumer-focused economy. Growth is moderating from the blistering pace of the past decade and a half and settling into a more modest, but still robust, 7-percent range. Heavy industry consumes 70 percent of China’s electricity — so the rebalancing of the economy is slowly reducing the growth rate of electricity demand. That means less coal use.
Second, the government has set binding targets for reducing the energy intensity of GDP. It may not reach that target (a reduction of 16 percent in energy consumption per unit of GDP between 2010 and 2015) but it has come a significant part of the way (even allowing for the official statistics being not completely reliable). But the bottom line is that policies are in place to increase the macro state of China’s energy efficiency, and gains are being made.
Third, China is rapidly expanding non-fossil fuel use. The marked expansion of hydro, wind, solar, and nuclear — with 128 GW of non-fossil generation capacity coming online in the past 3 years — is making coal less significant in the country’s power mix.
Stability Is the Goal
What is driving the Chinese government’s pursuit of these three goals? The answer, we believe, is fairly simple: the desire of the Chinese Communist Party to remain in power.
The Party knows that unsustainable growth could be a key cause of unrest and social instability. Particularly, the transition to a consumer-led economy will be necessary to absorb the labor force of China’s growing cities. One analyst notes that “the labor-absorbing capability per [unit of] GDP in tertiary industry is about 20 percent higher than in secondary industry.” In short, the growth of the service- and consumer-oriented economy will help allay the social stresses of the growth of China’s cities.
The Party also knows that the pollution of China’s major cities and industrial centers has gotten so bad that it too could become a genuine threat to the stability of Party rule. This is one reason why the government is shuttering old, dirty coal plants in the country’s more developed east, and building larger, more efficient coal plants in the relatively unpopulated west, to be linked by new transmission infrastructure. Making Beijing, Tianjin, Hebei, and Shandong more livable is a key goal for Xi Jinping’s government — for very practical reasons of self-preservation.
Investment implications: Declining growth in Chinese coal consumption points to the continued secular trend of China’s transition from a heavy-industry led economy to a consumer-led economy. It also points to the determination of the Chinese Communist Party to reinforce the stability of its rule with sustainable growth and with a reduction in the severe pollution of its most highly developed cities and regions. Eventually, Chinese consumer-oriented stocks will benefit; Chinese renewables, particularly solar, could also become attractive. As usual, we note that China remains in a cycle of monetary tightening and loosening as the government works to deleverage the shadow banking sector, and China traders should watch the monetary environment carefully.
Don’t Fear the Peanuts
Parents who have had school-aged children over the past 15 years have almost certainly noticed the rise of allergies. “Peanut-free” classrooms have become common as awareness of potentially life-threatening allergic reactions has grown. Between one in fifty and one in thirty children are estimated to have a life-threatening allergy — whether to peanuts, tree-nuts, milk, eggs, or some other food.
Anything Left to Eat in Kindergarten?
The incidence of such sensitivity seems to rise as a country becomes more developed, and no one knows why. One theory that has gained traction in the past several years is the “hygiene hypothesis,” which holds that the human immune system malfunctions when it develops in an environment that’s too clean. (Call this an unfortunate and unintended consequence of always washing your hands and not playing in the dirt enough.) That malfunctioning immune system mis-identifies molecules in peanuts or shellfish as harmful alien invaders, and dispatches immune cells to attack — which can cause tissues to swell, and, in the case of anaphylactic shock, airways to close.
Whatever the cause, there have been few options for prevention — just exposure restrictions and anxiety. Now a French company, DBV Technologies (Paris: DBV) has a promising treatment. They’ve developed a patch called “Viaskin” which children can wear and which introduces small amounts of an allergen transdermally — and critically, this method avoids severe reactions that can occur with prophylactic injections of allergens into the bloodstream. Initial trials have been hopeful, with half those treated able to tolerate 10 times the level of allergen exposure they could handle before the trial started. DBV’s product for peanut allergies recently completed Phase 2 development, the last stage before pivotal clinical trials. A patch for milk allergies is still in Phase 1.
We note this as an example of innovative medical technologies in an unexpected arena. Medical advancement doesn’t just occur in the pharmaceutical and biotechnology space.
Investment implications: Biotechs have been stellar performers during the past two years, and although biotech investing may become more difficult due to pricing pressures, there will still be strong performers to find. However, there may also be advancements outside the traditional world of small- and large-molecule research and development. We try to stay aware not just of pharma and biotech, but of other medical subsectors as well.
Another Arrow of Abenomics: Corporate Tax Cuts
Foreign inflows into the Japanese stock market have been drying up, as it has seemed more and more to investors that the reforms of Prime Minister Shinzo Abe come down to just one thing: massive QE from the Bank of Japan. The element of Abe’s program that virtually all analysts identified as the most crucial — structural reforms of the Japanese economy and the Japanese labor market — have not appeared. We and others have become skeptical that they ever will, and it seems that the Japanese stock market might perform tolerably in 2015 as long as the QE taps remain strongly open.
However, we noted a piece of news recently that made us think “Abenomics” might not be a one-trick pony after all.
In 2012, Abe created a new cabinet post, the Minister of State for Economic Revitalization, and filled the post with Akira Amari, a veteran of Abe’s previous administration. After the recent election win that secured Mr Abe’s mandate for up to four more years, Mr Amari announced another strategy to help Japan out of its “low-flationary” slump: lower corporate taxes.
Amari said in a recent press conference that 2015 might see a 2.5 percent drop in corporate taxes. At 35 percent, Japan’s corporate tax rate is the second highest among the G7 economies, and Mr Amari wants to see it below 30 percent within the next few years.
Further — and most interesting to us — the government is floating a proposal to extend additional tax breaks to companies that increase their wages next year by 3 percent or more. Such a program could go some way to putting teeth in Mr Abe’s haranguing of Japanese businesses to raise wages, and by putting more money in workers’ pockets, could help stimulate inflation more directly. And unlike many potential reforms, this one is not likely to alienate vested interests in Mr Abe’s base.
We may doubt that Japanese rice farmers will ever face competition from China, or that Japan with enthusiastically open its doors to foreign workers. But Abenomics may have enough tricks up its sleeve nevertheless to keep the Japanese stock market attractive in 2015.
Investment implications: Japan has begun to disappoint some foreign investors, but we think that ongoing QE and potential new creative programs from the Abe administration could continue to boost Japanese stocks in 2015. As usual, we caution investors to hedge their exposure to the Yen, which should be pushed down versus the dollar by any stimulative government or central bank measures.
Will 2015 Be the “Perfect Storm” Year for Cyber-Security?
The humiliating hack of Sony brought a close to a year in which the cybersecurity news stream was relentless. Home Depot, Ebay, Target, JP Morgan Chase, Staples — and these were just the major, headline-grabbing hacks.
If the Sony hack was indeed perpetrated by the Democratic Republic of North Korea (DPRK), as the Obama administration alleges, that would represent a significant and dangerous escalation. The arrival of state and quasi-state actors raises threats to a new level. As we commented in our last piece on cybersecurity several months ago, the approach taken by traditional consumer-level antivirus — reactive rather than proactive, with detection systems isolated within particular domains of risk — is increasingly seen as fundamentally inadequate. What will replace it?
We believe that next generation cybersecurity will rely fundamentally on big data analytics. They key is the capacity for a security regime to gather unstructured data from across all parts of a network, and use those data to identify vulnerabilities and anticipate attacks before they occur. In addition, such data streams can help identify ongoing intrusions that have already occurred and gone undetected, a reality that administrators are beginning to learn is far more common than previously thought.
Big data analytics will allow a synoptic view of data points from across a network to be developed and interpreted much faster than has been possible until now.
Our contacts in the industry have pointed out that the most critical cybersecurity work is done within large firms — in short, off-the-shelf solutions provided by dedicated cybersecurity companies are, to some extent, a stopgap measure, while in-house tailored solutions are preferable. This makes the space difficult for investors to approach as a theme, which is frustrating, because the theme is an attractive one. The new HACK ETF (NYSE: HACK) provides exposure to a wide variety of software, hardware, cloud, and network companies in the space. However, these are volatile stocks, and this is one area where investors may be better served doing diligent homework and picking individual companies. If one were to buy HACK, we would suggest waiting for a substantial decline from its current price before buying. We will focus on companies that straddle the big data and cybersecurity universes, particularly those with unique strengths and solutions. Investors will need patience and tolerance of volatility to profit in this environment.
Investment implications: The crescendo of cybersecurity news suggests that 2015 may be a year where cybersecurity draws a lot of attention and a lot of investment dollars. We will make specific stock recommendations throughout 2015. As we continue our research in this area, we are emphasizing diligent research on individual companies, concentrating on those which employ proprietary big data analytics in the deployment of security solutions.
Thanks for listening. We welcome your calls and questions.
