As global economy expands U.S. industrials should shine

The U.S. economy continues to slowly move ahead as we reach the end of the year. The estimated growth in GDP in the fourth quarter is for 2%, down from the 3% of the 3rd quarter.

We believe much of the higher 3rd quarter growth was due to a jump in higher business inventories as well as a large increase in military spending due to the end of their fiscal year. We do not believe these are likely to continue.

Although the fiscal cliff negotiations have come and gone with only a compromise on tax rates agreed to, the lack of spending cuts continues to be very unsettling for both businesses and consumers.

Fears are emerging that we will go through this again when the debt ceiling is reached in a couple months. Sequestration was only postponed for several months without any indication of what the eventual outcome will be with regards to the projected spending cuts.

There is also an emerging level of tension among developed countries devaluing their currencies. Most developed countries central banks are printing large amounts of currency in an attempt to keep their economies afloat and to aid in the increase of their exports.

However, there are signs of growth in the emerging markets around the world. A report released by the Brookings Institute shows that thirteen of the fastest growing metropolitan areas are in China. It also stated that three fourths of the fastest growing metro areas in the world are in Asia, Latin America, the Middle East, and Africa.

The consumption of the world’s GDP by emerging market nations has grown from 21% to 36%. Historically, emerging markets have grown in “fits and starts.” There now appears to be a sounder financial footing for many of these economies.

This has been helped by an accumulation of foreign currency reserves from their export of commodities and a manufacturing base driven by cheaper wages. This growth in foreign exchange reserves provides a greater cushion to support their currencies in times of crisis.

We believe this will eventually slow as these economies begin to transition to a more consumption driven economy from their current export driven economies. Their consumption continues to rise due to an expansion of their middle-class.

The number of households with annual income between $5,000 and $15,000 is growing rapidly, especially in China, India, and Indonesia. Most economists believe that an annual income of more than $5,000 in these developing countries is the tipping point for an expanding middle-class.

This wealth generates a need for consumer staples, consumer discretionary, and health care. This causes a greater investment in infrastructure. The need for infrastructure creates a greater need for manufacturing and materials companies.

As theses economies expand and they begin to consume more internally, this helps to protect them from the malaise in developed markets. A report released by the National Intelligence Council forecast that the growth in the global middle-class constitutes a tectonic shift. They believe billions of people will leave poverty and enter the middle class; for the first time, a majority of the world’s inhabitants will not live in poverty.

Amidst all the world economic trends, the U.S. economy has several areas of potential growth. The developing worlds need for materials, energy and technology will increase. We feel this will give an advantage to American companies who have a broad exposure to the products needed in emerging markets.

With the technological developments in the oil & gas industry, we believe American companies that use energy as a fuel or as raw materials will be more competitive against companies in high cost countries. The report released by the National Intelligence Council believes that China will overtake the United States as the leading economic power in the world by 2030.

However, they also state that because of the revolution in energy production in the U.S., we will remain a force in the world economy for some time to come.

Natural gas prices have rebounded somewhat from the lows of below $2 per million BTUs, but are still at insufficient levels to encourage more drilling for dry gas. Currently dry gas prices are in the $3.60 per million BTU range.

This price range is great for utilities, chemical companies, fertilizer manufacturers and manufacturing in general which use natural gas as a fuel or feedstock.

As a result, chemical companies are continuing to move production back to the U. S. from overseas which is causing plants in the Gulf Coast to expand capacity at a strong clip. The American Chemistry Council stated that as long as natural gas liquids are pouring out of wells, we will continue to have a decisive competitive advantage.

BSG&L has a long term investment horizon. We still believe industrials, including manufacturing and chemicals, are the place to be.  However, we are not adding to our positions until we see the market resolves some of its problems.

Until we see the outcome of the spending side of the fiscal cliff, the direction of the economy and markets is uncertain in 2013.  However, having said that, we like chemical companies, fertilizer manufacturers, small to mid cap E&P companies that are increasing reserves and production year over year and manufacturing companies.

Two E&P companies we like are Continental Resources (CLR) and EOG Resources (EOG).  In the MLP space, we like Enterprise Products (EPD) and Kinder Morgan Partners (KMP).

We believe they are less sensitive to commodity prices, since they transport, store, and process oil and natural gas without taking ownership.  Until the impasse in Washington is resolved, cash is king, in our opinion. These two MLP companies have nice dividends and have shown an ability to increase quarterly distributions for some time.

In the chemical industry, we like LyondellBasell (LBY), Huntsman Corporation (HUN) and Westlake Chemicals (WLK).  Their profit margins have shown a greater increase due to cheaper natural gas prices than some of the bigger chemical companies.

In our opinion, heavy equipment manufacturers like Caterpillar (CAT) and Deere & Company (DE) will be good investments over the next few years. As the world economy begins to expand again, we believe material producers like Cliffs Natural Resources (CLF), Freeport McMoran Copper & Gold (FCX) and the larger coal companies will once again move up in the investment placement arena.

Just to restate, I believe that the lack of an agreement on spending cuts at year end and the myriad of new regulations will be a damper on 2013 economic activity and therefore investment returns.

That is why we are emphasizing investments in companies we believe have good cash flow, good cash distributions and companies that operate in areas where they have a competitive advantage due to much lower energy costs and raw material input costs.

Gold last year was as volatile as the stock markets. I believe copper and oil will be the inflation hedges going forward. We prefer companies that generate good after tax returns. With interest rates at historic lows, even as dividend taxes go up, the after tax returns are higher than most investment grade debt.

Central Banks around the world have injected so much liquidity into their markets, that when it is finally put to work, we believe commodities will move up dramatically in price. BSG&L is a long term investor.

The investments discussed are held in client accounts as of January 7. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.

Any index comparisons provided in the blogs are for informational purposes only and should not be used as the basis for making an investment decision. There are significant differences between client accounts and the indices referenced including, but not limited to, risk profile, liquidity, volatility and asset composition. The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry, among other factors.

Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.