The Gold Report: 2017 will be a year of change. In the early days of the Trump administration, what should investors be focusing on?
Joe McAlinden: The important thing investors have to keep in perspective is that this is a market that has had its own trends prior to the surprise election outcome. And while the election outcome has altered a number of aspects for the economy and the markets, there were fundamental forces in place prior to the election that we have to keep in mind.
First, this whole bull market environment that we've enjoyed so much since 2009 when the rally began is now almost eight years old. And bull markets on average don't last that long. So this is a very important point to keep in mind. Stocks have tripled, and you have to begin wondering how much longer it will go on.
An important variable is what's going on in the fixed income markets. Here we've had a multidecade bull market where rates have fallen to historic lows and hit a low point in July and started moving up, I point out again, prior to the election.
Meanwhile, we are in a very advanced bull market for stocks, but I believe it's being reenergized by the Trump win. We're in a stage of the business cycle now where interest rates are going to be a headwind. Historically, equities have been able to advance further in the face of rising rates, but at a more laborious pace. Sector selection is far more important.
Nonetheless, having said all of that, the reenergizing that we're seeing as a result of the Trump victory is important and probably will extend this aging bull market at least for another year.
I am very cautious, just to finish up on the big picture, on the outlook for bonds. I think they're going to continue to be under pressure, which means rates are rising. All asset prices tend to be based on the expected future stream of earnings discounted back to present value. And when the discount rate is rising, it is a considerable headwind. And that is what we're dealing with.
Now, on the election, we have seen a surprise with the loss of a candidate who was seen by many as providing an Obama third term. The policies would have been by and large similar.
However, with Donald Trump's election, we have a shift toward very pro-business, pro-growth policies. Irrespective of what anyone thinks of the person who is now running the White House, it is important to focus on policy if you're concerned about the investment outlook. The policies are clearly pro-growth, based on the various aspects of Trumponomics that we've seen from the administration so far. We're looking at tax cuts. We're looking at efforts to improve trade relationships and return jobs to America. We're looking at reduced regulation and an energy policy that is going to be very much pro energy independence.
All of this adds up to, as we look ahead, a higher gross domestic product (GDP) growth rate, which affects a lot of different industries and companies, but also probably even higher inflation than what was already baked in.
The stage has been set for higher inflation by the quintupling of the Federal Reserve's balance sheet over the last seven or eight years. But that hasn't really emerged because there's been a lot of slack in the economy, particularly on the manufacturing side. And so we've seen expectations of inflation in the bond market rise sharply. This is measured by taking the coupon rate on bonds and subtracting the Treasury Inflation Protected Securities rate. And here we see a very dramatic rise in inflation expectations, and I would say for good reason. I would also say that it's probably only the beginning. Indeed, the just-reported December CPI (Consumer Price Index) jumped to a 2.1% year-over-year change. Just fifteen months ago, the inflation rate was zero.
TGR: Let's turn to gold. What is your outlook on the metal?
JM: I turned positive on gold a year ago for the first time maybe in my professional career. The reason primarily is the huge increases that we have seen worldwide in the size of central bank balance sheets. We most typically look at the Fed because we think of gold as measured in dollar prices. But this phenomenon—quantitative easing, zero interest rates and a massive monetization of government and other debt by the world's central banks—is a global process. Simple logic would suggest that this is a form of currency debasement, which in time is going to lead to a rush into precious metals for investors to protect their money against loss of purchasing power.
So since that time when we turned bullish, gold has had a huge rally and now a huge setback, which gets to the shorter-term environment. Because we measure gold most commonly in dollars, that price is extremely sensitive to the fluctuations in the dollar in the foreign exchange markets.
This setback that we've had in gold prices in dollars has been a mirror reflection of the strength in the dollar, particularly the strength that has accelerated in the wake of the Trump election.
When the Fed raised rates by a quarter of a point in mid-December, the hike was widely expected and fully priced into the market. The more important issue was that the consensus of expectations of members of the Federal Open Market Committee was increased from the prior meeting from two hikes in 2017 to three hikes. In the foreign exchange markets, that was viewed very positively.
However, my research has shown that what matters over time are not the changes in what we should call nominal interest rates but, rather, real short-term interest rates or inflation-adjusted short-term interest rates. The reason I am positive on gold and why I want to be buying in this pullback that we've had in the last half-year or so is that the inflation-adjusted rates in the United States are actually going to be falling, not rising.
While the Fed will be raising rates and the market will be raising longer-term rates, I believe the inflation rate is going to move up faster than that. And so the calculation for real or inflation-adjusted interest rates is to take the actual or nominal rate and subtract the prevailing inflation rate. And if the prevailing inflation rate is going up more quickly than the federal funds rate, then real short-term rates are falling.
That is what I see happening over the next one to two years, which is why I think that at almost any time, gold is going to bottom out and start another big leg up, similar to the one that we had in the first half of 2016.
Now, possible reinforcement of that is a change that's reportedly coming in the area of Islamic finance where Muslims are going to have greater flexibility in terms of their ability to own gold. I'm not sure how that plays out, but it is certainly something not to be ignored. There are 1.6 billion people that practice the Islamic faith in the world, and I think in time this is going to be an important factor in the supply/demand picture. So far, it doesn't seem to have had much impact in the marketplace, and I think that's because this movement of the dollar is a much bigger issue in the short run.
TGR: Where do you see the price of gold going and how are you investing in gold?
JM: I think that gold bullion has the potential to rise above $2,000 ($2K) an ounce over the next three-to-five years. But the miners are likely to move in a greater percentage gain simply because of operating leverage in their businesses. It's the same fundamental forces that operate in any of these extractive industries, whether it's energy or silver or copper or gold. So the earnings swing, if gold prices move from their recent level to north of $2K, is going to be multiples in percentage terms of what you're going to see in the actual price of the bullion.
I lean toward exchange-traded funds (ETFs) that capture a basket of gold equities because that avoids the idiosyncratic risk of any single issue. Obviously, some of these companies may have more risk than others, and you can avoid that by just getting involved in a basket.
TGR: Is there anything else that you want to say on the macro investing level?
JM: I would like to touch on one other issue that will add to the upward pressure on GDP growth rates, which I think is very important in the economic outlook—demographics. Since about the late 1970s or so there has been a pick-up in the birth rate in the U.S., and all of those new human beings—the Millennials—are coming of age now. There is enormous potential impact from the Millennials on some important parts of the economy.
Everyone has talked about how the Millennials are living in mom and dad's basement and they're never going to come out and it's a big sociological phenomenon. I don't see it that way. I think it's pure economics. The young people have had a very difficult time finding jobs in a slow-growing economy. Now, the Trump administration promises to double the growth rate of GDP, but we are already seeing, as we run out of other workers with the unemployment rate under 5%, the Millennials begin to experience higher job growth than the rest of the population. Throughout this whole expansion, Millennial job growth has lagged behind the population as a whole, and now in the past year it's begun to grow faster. We're simply running out of middle-aged and older workers.
A key variable that, together with the maturing of the Millennial demographic cohort, we're beginning to see is tremendous demand on apartment and starter home availability. Demand is basically eating up supply. I think this is a phenomenon that's going to continue over the next several years. Everything that's in any way related to the housing business, whether it's builders, appliance companies, do-it-yourself retail, home furnishings, is going to be a very fertile field for investors to look for great ideas over the next several years, driven by this surge that I believe is about to happen in household formation by the Millennials.
TGR: Do you have other ideas for investing in the Trump era?
JM: For the last several years, the corporate side of the economy has not been pulling its weight. Growth has come from the consumer and with a lot of help from housing, particularly recently. Corporate capital spending has actually been in a severe recession, driven heavily by the downturn in energy spending. But it's been very bearish for capital spending overall in the U.S. Corporations have been very reluctant to spend money on capital expenses. That's not a normal business cycle phenomenon.
Some aspects of the tax cuts that are being proposed have the potential to stimulate a capital spending boom. The general reduction in taxes for individuals is important because a lot of small businesses are pass-through corporations and the tax rates for the owners are the same as the tax rate of their business. Where you have regular corporation structures, the new administration is planning to reduce the marginal tax rate dramatically. We have one of the higher rates in the world, and they want to bring it down sharply.
In addition, there are two things that are very important here. One is the plan to have a special reduced rate for corporations that bring back money that's been stashed overseas. That could mean a flood of capital coming into the country. But there are going to be strings attached to it so that it can't just be stashed under the mattress. It needs to be spent in some productive way.
One other thing being discussed in the Trump administration is a complete write-off of new capital investment in the year in which it's deployed. Normally when companies spend money for capital investment, it goes onto their balance sheet and gets written off over a period of years, depending on its expected useful life. The new administration is talking about a write-off of 100% of the investment in the first year.
If it goes through, it would pull forward a lot of future demand for capital investment into the period immediately following passage of the new legislation. There's the potential here in the next year or two for a shocking pick-up in capital spending in the U.S., which is going to have a very broad impact.
When you put that together with other steps that we're seeing this administration take or threaten to take, it leads me to be bullish on the following sectors of the market. There are 10 big Standard & Poor's sectors. The two that would be most affected by this are the industrial materials and the industrials. They each have their own ETFs as well. On a more narrow level, I think that an industry that's been out of favor for a long time although it's had a pretty decent rally since the election is the steel industry. One other is the oil services category, which should benefit from all of the foregoing—plus the Trump plan to open up public land to drilling and exploration. These are some ideas that are direct fallout from the administration's tax plans. They could be some of the best ways to play what's happening with the new administration.
The last one I want to mention is financial services, which has been struggling with high regulation that increased in the wake of the financial meltdown in 2008–2009, a flattish yield curve and very little loan growth. Now, looking forward, everything we've just talked about adds up to a steepening yield curve, less regulation and an acceleration in loan growth driven by higher GDP. So I think that the financial services sector, which has been rallying in the wake of the election, has a long way to go and is going to be one of the primary beneficiaries of the new administration over the next several years.
TGR: Thank you, Joe, for your insights.
Joe McAlinden has over 50 years of investment experience. He is the founder of McAlinden Research Partners and its parent company, Catalpa Capital Advisors. Previously, McAlinden spent more than 12 years with Morgan Stanley Investment Management, first as chief investment officer and then as chief global strategist, where he articulated the firm's investment policy and outlook. He received a bachelor's degree cum laude in economics from Rutgers University and holds the Chartered Financial Analyst designation. McAlinden has served on the board of the New York Society of Security Analysts.
Disclosure:
1) Patrice Fusillo conducted this interview for Streetwise Reports LLC and provides services to Streetwise Reports as an employee.
2) Joe McAlinden: I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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