Markets charged higher again in the fourth quarter of 2017 continuing the pace of record highs in all the major stock market indices. One nuanced change in the 4th quarter is that many income-oriented investments also demonstrated positive performance as the fear of global recession subsided, at least for the moment, evidenced by the fact that the spread between yields on “high yield” investments (sometimes thought of as “junk bonds and securities”) and investment grade securities narrowed markedly. We have no idea how long this will last, but we thoroughly expect that the “pessimistic punditry” will find something to revive the negative drumbeat about the economy at some point in 2018, as it has almost like clockwork each year since the 2008-2009 financial crisis. We have begun to view such negativity favorably as it has been so completely wrong for so long. We worry that if it stopped, the economy really would weaken.
We believe the likelihood of an economic downturn anytime soon has been dramatically lessened given that the largest tax reform legislation in the United States in over 30 years was passed by Congress. While we prefer a more aggressive tax reform, particularly on the individual side, the impact that the reduction in corporate tax rates from 35% to 21% will have on economic activity cannot be underestimated, in our view. This has led us to revisit our long-held analysis of the “four pillars of economic health”: taxes, interest rates, inflation and global freedom. We believe these collectively cover the gamut of factors that affect economic health. Taking the time to ponder the state of each is helpful in developing a sound “big picture” view. Here is our view on each:
Pillar I: Taxes – As we stated, in the US the tax picture has just become much more favorable given the passing of new tax legislation. On the corporate side, regardless of the political nonsense surrounding the debate, lower corporate tax rates are a major stimulus to capital investment and ultimately economic activity. We come from the perspective that corporate tax rates should be 0%. That’s right, ZERO! Contrary to popular opinion, corporations are not “the Wealthy”, they are entities, behind which are employees, shareholders and customers (consumers), both wealthy and non-wealthy. Corporate taxes simply lessen employee pay and shareholder returns, and increase the prices customers pay for the product or service the corporate entity provides. We want corporations to have nothing to do with the tax code and simply grow, invest, pay people, and provide products/services to customers. We realize that in any political environment, such an approach is virtually impossible. In the current political environment, it is impossible. However, the new tax law makes it far more possible for corporate entities to do the things they should do, and on a much more competitive basis with other countries who have had lower tax rates than the US corporations for years. We could analyze tax policy for pages and pages, but suffice it to say, tax policy has moved in a very favorable direction.
Pillar II: Interest Rates – While closely related to inflation, it is important to understand that low interest rates are not necessarily always the best policy, either for curtailing inflation or for providing the best economic environment. In recent years, we have argued that interest rates are far too low and the Federal Reserve (the Fed) policy keeping short term rates so low was creating economic distortions. Over the last year or so, the Fed has finally begun the long overdue increase in interest rates. We are pleased to see this and only hope that they are not too late and so far behind the curve that it is impossible to avoid over-tightening (raising rates too high) at the worst time (when the economy does inevitably slow). Notwithstanding these concerns, interest rates are moving in the right direction and getting into balance with economic activity. We will consider this mildly favorable.
Pillar III: Inflation – It is notable that inflation has not been considered to be a problem in recent years. Even with a 2% inflation rate (which is essentially the Fed’s target), in 10 years the dollar will devalue by more than 20%! Make no mistake: it is an invention of the neo-Keynesian sect that has propagated the myth that such a result is ok! By all means, inflation, and its opposing twin, deflation, are equally devastating in the event of either occurrence. However, deflation is not the problem today, and is virtually impossible to experience for any extended period given that fiat currencies (currencies tied to nothing) are in use the world over. Nonetheless, it is safe to say we are not experiencing, nor do we anticipate, the type of hyperinflation that can be catastrophic. We consider inflation to be neutral.
Pillar IV: Global Freedom – This may be the most important of the pillars. It is the freedom of the human spirit that enables creativity, innovation, and human progress. For people to be truly free, their governments must allow for the basics of property rights, freedom of expression and, above all, the rule of law. Every year we review the Heritage Foundation’s “Index of Economic Freedom” which considers the state of freedom around the world, and has been doing so for the last twenty years. Fortunately, for the fifth straight year in 2017, the index suggested the world has become more “free”. As investors who seek out innovative companies in which to place our capital, it goes without saying that this is very encouraging. In listening to the daily broadcasts about the state of the world, one can often become discouraged. This sensationalism is missing the signs around the world that such a dire view is unwarranted. We encourage readers to check out the details of the study.
One negative in the study is that the United States has fallen further in ranking on the list. It is now 17th in the world. It is not even considered a “free” country, but only “mostly free”. This is due to the increased level of government control and regulation that has been enacted in the 21st Century in the United States. We have railed against this many times in recent years and believe that recent moves to reduce the level of regulation in the country will help to improve the standing of the United States in the index in the future. We view the Global Freedom pillar as favorable.
The net effect of our recent assessment of the four pillars and how they relate to the Investment Climate give us a high degree of confidence that much of the “crisis” mentality of the early 21st Century has run its course and investors should be rewarded even more than they have been for staying the course, particularly those invested in the innovative, high-potential growth companies. As always, we continue to seek out, invest in, and diligently monitor the progress of those companies on a daily basis for our investors.
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