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BFI Infinity
January 8, 2017

Felix Zulauf's Perspective


Political developments have dominated the markets in recent months. Donald Trump’s victory in the US election, the French primaries, and the Italian referendum in Europe confirm the view that politics are becoming more important than economic facts. It remains to be seen how the uncertain year that lies ahead will unfold, with key elections scheduled in Europe, global changes heralded by the new US President and the world economy facing significant obstacles getting back on to a sustainable growth track.

The Trump Effect

Trump’s victory was yet another manifestation of the public’s discontent with the status quo and the widespread mistrust of the establishment. Nobody knows exactly where this Zeitgeist shift ultimately will lead to, but markets are betting on it to last longer, and are adapting quickly.

Although there are no specific details on the new administration’s policy agenda, markets prioritized hopes and perceptions over facts. As a result, the “Trump rally”, an early bet on fiscal stimulation, de-regulation, tax cuts and protected industries, already had a tremendous impact on the bond market. Even though little is known about the Trump administration’s plans of government spending and infrastructure programs, the vision presented during the campaign implied a sharp deficit increase. This, combined with the United States’ chronic current account deficits and a very low national savings rate, would force interest rates higher.

Finally, while Trump’s economic nationalism might be successful in forcing some US multinational corporations to adapt their supply chains by using more domestic resources, it will also have a significant impact on the country’s trading partners. This will most probably result in less imports by the US and more regional trade inside Asia and Europe; in other words, a reduction of globalization and an increase in regionalization and nationalism.

Europe Follows Suit

After the shockwaves of Brexit and the Trump victory, the outcome of the Italian referendum, an overwhelming rejection of Prime Minister Renzi’s constitutional reforms, also delivered a blow to the establishment, although it will most likely not lead to major changes regarding the Euro just yet. In France, outsider and known Margaret Thatcher fan, Francois Fillon, won the conservative party’s primary elections, with former president and establishment figure Sarkozy finishing third, a crushing defeat likely marking the end of his political career. In the upcoming general election, as the socialists are expected to be defeated (Hollande’s approval rate stands at 4%), Fillon will face Front National’s Marine Le Pen, who has promised to launch a referendum about France’s membership in the Eurozone and the EU.

In Germany, Angela Merkel will be running for Chancellor again in October 2017, even though her message and policies do not seem to resonate with the German public as they once did. Even if she wins due to the lack of viable challengers, she would most likely govern with a weak majority and a multi-party coalition. Her vision of Germany leading and further integrating Europe appears increasingly unrealistic as political changes and social shifts throughout the EU, when added to the country’s onerous history, are making it an unlikely unifier of nations.

Security and defense also present additional challenges for Europe, since the US’s role as the world’s policeman will likely be redefined under President Trump. With a weakened NATO, Europe will be forced to carry a much higher burden, which could eventually lead to a more integrated European military cooperation and see defense budgets sharply increased from their current low levels.

World Economy Outlook 2017: Another Slowdown Could Be in Sight

It is not clear what we can expect for the next 2-3 quarters. Widely-followed indicators like the PMI are still ticking upwards, while market- based indicators like sharply higher bond yields or a stronger US dollar are pointing in the other direction. The impact of Trump’s policies will likely be limited, as the multiplier effect of the promised tax cuts is relatively low. Uncertainty is also heightened by his trade policy and how it will practically unfold.

For Europe, an orderly breakup of the Eurozone and a decisive shift towards federalism seems to be the only viable way forward for an economically sustainable EU. Without such drastic changes, Europe must either follow the establishment’s vision of full integration (an unlikely scenario, since voters are firmly opposed to it), or see the Euro fragment through referenda and member state exits. With the USD rising, Trump ushering in global changes, and Germany’s unwillingness to become the engine of growth via strong domestic demand stimulation, the stress inside Europe will compound. In the year ahead, Europeans will be faced with important political decisions; decisions with the potential to deeply impact the economy and the future of the continent. The bottom line for Europe’s economy is that it will likely show signs of a slowdown over the next 2-3 quarters.

China’s monetary and fiscal stimuli, launched in 2015, are still working their way through the system. Real estate prices have been pushed upwards again, and newly created credit has reached an extraordinary 40% of GDP within the last 12 months. China now appears to have changed its monetary policy from targeting credit growth to targeting interest rates. With interest rates at such low levels, the banking and shadow banking sector has exploded. And, as monetary growth is excessive, capital will flow out of the country and weaken the yuan. Consequently, pressure has mounted on other major Asian partners’ currencies, dragging EM currencies down as a whole and sending a clear signal to investors to avoid the EM complex on the long side.

Gold was one of the main casualties of the US election and it seems that the cycle is turning against the precious metal, with higher interest rates and a more conservative world. Although gold’s performance is not expected to significantly improve in the short- and mid-term, it remains a reliable investment option over the long-term.

Overall, it appears that large currency moves, increased uncertainty due to changes in US trade policy, and sharply rising bond yields may first lead to lower, not higher, global growth.

Felix Zulauf, founder of Zulauf Asset Management, has worked in the financial industry and asset management arena for almost 40 years. He was one of the first successful hedge fund managers in Switzerland, and he is well known for his excellent market timing and market-cycle predictions. He has also been a prominent member of the Barron’s Roundtable for almost 30 years. The Perspective is a summary of his thoughts conveyed to BFI in our regular meetings and discussions with Felix.

In the Limelight: The Trump Bandwagon - a note of cautionon spiraling enthusiasm

Expert predictions and dire warnings of markets tanking should Trump be elected have all been proven spectacularly wrong. The reaction we saw instead quickly came to be referred to as “the Trump rally,” with the S&P 500 bouncing back to record highs.

Stock market euphoria continued in the weeks following the election, sustained by the new President-elect’s cabinet picks and his confident twitter-delivered statements. As Figure 1 below shows, the markets have spoken: Investors have put their faith in Donald Trump and in his pledge to “make America great again”.

Instead of rushing in to join the celebrations, we want to make a case here for remaining temperate. We’ll consider the merits of a “wait and see” approach, of prioritizing facts over promises, and explore the reasoning behind a conservative and responsible wealth planning strategy. Tempting as it might be to jump on the bandwagon, it is important to remember that markets are a voting machine in the short term, but in the long term, they are a weighing machine.

From Theory to Practice: A Bumpy Ride

Many practical challenges lie ahead for Trump’s administration and his policy platform. For onething,Trumpcanexpectfierceoppositionfromthe Democrats, who will undoubtedly place obstacles in the way of his making the changes he promised on the campaign trail. Whether it comes to repealing Obamacare, building “the Wall”, infrastructure and defense spending, tax reform, renegotiating NAFTA, etc., all will require support from Congress. In theory, under the current Republican majority, he should have the votes. However, many of his proposals face opposition even from within his own party, which could present serious challenges to fulfilling his vision.

Nevertheless, even if the new administration does manage to overcome such obstacles, and Trump finds himself in the position to freely lead the country in the direction he envisioned, it might not necessarily be good news for investors or the economy in general.

Tax cuts: Small Details, Big Impact

Although the prospect of tax reform has been welcomed by the markets, Trump’s exact plan remains unclear. Steven Mnuchin, his nominee for the post of Secretary of Treasury, confirmed that the specifics of the new tax law will be clarified after negotiating and working together with Congress. It could therefore be premature for investors and business owners to factor in the campaign trail promises to their financial planning process.

Even if the new tax system is indeed enacted as described in Trump’s last relevant campaign speech, the middle class would indeed benefit, but only modestly, according to a recent analysis by the Tax Policy Center. By contrast to the campaign narrative, tax experts across the political spectrum agree that Trump’s tax plan would benefit the richest Americans the most. Warren Buffet’s Berkshire Hathaway, for example, stands to benefit from a $29 billion increase of its book value under the proposed tax cuts, according to Barclays.

Overall, Trump’s tax reform, as presented, would provide a major boost to corporate bottom lines and to the stock market. Nevertheless, it remains to be seen if, how, and by how much the individual investor would benefit.

The Cost of Bringing Jobs Back to the US

Trump has adopted a clear “carrot and stick” approach to persuading companies to reversing the trend of shipping jobs overseas, and to increasing their reliance on domestic resources instead.

The “carrot” he offered was reduced tax rates so that companies can avoid having to pass the extra costs down to their customers. We saw this strategy cross over from theory into practice in the successful Carrier deal, as Trump persuaded the company tokeep 1,100 jobs scheduled to move to Mexico at its Indiana facility.

Although the deal was used as evidence that Trump’s promises will be kept, many critics have raised doubts about the economic soundness of the move. By indirectly subsidizing these 1,100 jobs through tax breaks, the new administration is distorting market dynamics. The deal uses taxpayer money to support the increased cost of producing an air conditioner in Indiana instead of Mexico, and thus, even if it is not added to the price tag, the consumer still pays the extra cost.

Despite all the unintended consequences of the “carrot” element of the job repatriation plan might involve, the “stick” has drawn even harsher criticism. Trump has directly threatened companies that will not “comply” with a 35% tariff: “Please be forewarned prior to making a very expensive mistake” tweeted the President-elect, sending a stern message to companies should they choose to reject his invitation to bring jobs back to the US.

Not even his supposed allies, the Republicans in Congress, could stomach this solution of selective tariffs on imports from specific companies. House Majority Leader Kevin McCarthy has made it clear that he will not back this plan, as did Republican Senator Ben Sasse, who argued that the policy would effectively impose a 35% tax on American consumers.

Trade War Fears

Trump has recently stated that the US should look at trade “almost as a war”, to the dismay of many of his critics who have repeatedly expressed concerns that the President-elect’s tough talk on trade could trigger a trade war with another country. Also, his repeated threats to impose tariffs on Chinese goods, along with his unexpected call with Taiwan’s leader (a provocative move from China’s perspective), have done nothing to ease fears of trade tensions ahead.

Indeed, as can be seen in Figure 2, the US has lost more than 5 million manufacturing jobs since 2000, partly because of increased automation and partly because of corporations choosing to ship jobs to lower-wage countries such as Mexico, India, Pakistan and China.

However, the aggressive policies that Trump has proposed could easily backfire. Any tariffs, whether they are imposed on a single company or on an entire industry or country, could easily escalate and culminate into a trade impasse: a lose-lose situation for all parties involved, with consumers ultimately paying the price. China, Trump’s favorite campaign target, has made it abundantly clear that it would retaliate against unilaterally imposed tariffs (possible “counterstrikes” include devaluation of the Yuan, introducing new rules that make it harder for American companies to get their profits out of the country and canceling orders from US manufacturers, e.g. Boeing).

Hoping for the Best, Preparing for the Worst

The future of the US economy, and its impact on the rest of the world, is in a state of flux. Too many open questions and little clarity over the actual plans and the practicalities of the Trump administration’s policy direction make it impossible to accurately predict the net effect of his presidency. Of particular concern is the fact that Trump’s recipe to “Make America Great Again”, as presented during his campaign speeches, relies heavily on government spending, infrastructure projects and rebuilding the country’s “depleted military”, as Trump himself put it. This, combined with the promised tax cuts, translate into a sharply increased deficit.

The new President-elect will be taking over a federal government that has been on a “debt binge” ever since the financial meltdown of 2008: Federal debt has climbed from 35% of GDP in 2007 to 74% at the end of 2015. Many experts already predict that Trump’s plans and policies would take US debt to record levels. As veteran investor Bill Gross pointed out, investors “must consider the negatives of Trump’s anti-globalization ideas,” while he also warned that the Trump presidency would only add to the ”long-term global debt crisis.”

Whether the new administration’s plan will benefit individual investors remains to be seen. For the time being, all we know for sure is that Trump has a bumpy transitional phase ahead of him, and so do the markets, when the rally corrects, and enthusiasm subsides. Nobody can tell where the economy will stand when the dust settles. Even if Trump can ultimately successfully steer the US economy on a solid growth track, the process will most likely be protracted by bureaucracy and political opposition, and the market will take time to adjust to the “new normal,” whatever that might practically look like at the time.

Therefore, now is the time for planning ahead, to protect one’s assets against the uncertainty of the year, or even years, ahead. A responsible, conservative wealth planning and investment strategy, based on geographic diversification, would dictate that preparations are made and key steps are taken during the “good times”. By the time the winds have changed, and the excitement has soured, it is usually too late.

Cybersecurity: An industry coming of age

In a time when real, applicable innovation and solid growth are thin on the ground, and many initially promising sectors and companies have proven to be “one-hit wonders”, it is becoming increasingly difficult to find real success stories and identify truegrowth potential. The cybersecurity sector, however, one of the few true winners of a tumultuous 2016, appears to be on a solid growth track, holding great promise for the years ahead.

Today, concepts like “big data”, the “cloud” and the “Internet of Things” have become part of everyday life in the entire developed world. However, all the advantages of our increased connectivity, deeply embedded in business, society and even politics, have come at the expense of privacy and security. Governments, corporations, as well as individual consumers, have all come to appreciate the corresponding risks, leading to a sharp spike in cybersecurity investments.

Cybercrime Booming

Several widely publicized cyberattacks have made headlines in recent years. Data breaches, intercepts, espionage and even sabotage have become part of the news cycle and although the targets were diverse, the fallout was always severe and costly.

Back in 2013, after the Associated Press Twitter account was compromised by Syrian hackers, posting a false claim of an attack on the White House, the S&P 500 plunged by 1%, briefly wiping out $136 billion in value. A year later, eBay fell victim to hackers who managed to steal personal records of 233 million users, with usernames, passwords, phone numbers and physical addresses compromised.

According to IT Governance research, in 2015 a total of 300 million records were leaked and over $1 billion stolen. That includes the widely-covered Ashley Madison attack, in which hackers released the emails and physical addresses for 37 million users, as well as the hack of the personal email of CIA Director, John Brennan. In the same year, another cyberattack on Anthem, one of the largest health insurers in the US, resulted in 80 million customer records breached, including extremely sensitive information: names, social security numbers, addresses, employment information and income data.

As for 2016, it was the year of politics in cybercrime, with WikiLeaks releasing sensitive documents stolen from Hillary Clinton’s campaign and the DNC, and the recent US intelligence agencies’ accusations against Russia’s having manipulated the election. A number of central and commercial banks around the world were also targeted by hackers in 2016. The Federal Reserve confirmed multiple attempts to penetrate its security system, including four attempts it labeled as ”espionage.” Also, an attack on Bangladesh’s central bank yielded $101 million, Ecuador’s Banco del Austro was hit for $12 million and hackers also stole 2 billion rubles (more than $31m) from the Russian Central Bank. Finally, a gigantic Yahoo hack recently made headlines as well: the company revealed that 1 billion user accounts were compromised starting in 2013, in the biggest data breach in history.

The most worrying attacks, however, are arguably the ones that have not made it to the front pages. The ransomware epidemic has been quietly on the rise, with victims ranging from individuals and businesses to universities, hospitals, state and local governments and law enforcement agencies. Such attacks, using a malicious code that encrypts, or locks, valuable digital files and demands a ransom to release them, can have a disastrous impact: loss of sensitive or proprietary information, operationaldisruption, financial losses, and severe damage to an organization’s reputation. According to Symantec, the US is the country most affected by ransomware, with 28 percent of global infections, while Canada, Australia, the UK and Germany also make it to the top 10.

Consistently Growing Demand

In 2015, the British insurer Lloyd’s estimated ybercrime was costing businesses worldwide $400 billion annually, while Juniper Research later predicted an increase to $2.1 trillion globally by 2019 - a four-fold jump from the estimated cost of breaches in 2015. The average cost of a data breach was $4 million in 2016, according to the Ponemon Institute, or $158 for each compromised record. The exact figures varied considerably by region, as shown in Figure 3 below. Also, the World Economic Forum warned that a significant portion of cybercrime goes undetected, especially industrial espionage. Factoring in these “dark figures” would push the cost estimates much higher.

It’s not just the cost of cybercrime that is set to explode in the coming years, but it is also the nature and the targets of the attacks that are evolving. “Cyberwarfare has crossed from the digital world into our physical realm, and there is a very real potential that cybercrime will lead to the loss of human life. A breach of our power grids, of our dams, or air traffic control mechanisms, could have catastrophic effects that are felt far beyond the financial and reputational impacts of a corporate attack,” warned Robert Herjavec, CEO of Herjavec Group, a global information security firm. Over the next years, expanding technology could indeed provide new targets and fertile hacking ground for cybercriminals. Companies and consumers are increasingly investing in Internet of Things technologies, in which billions of connected devices communicate with each other via the cloud. Also, per a recently published report by Scalar Market Research, the wearable tech market (“smart” watches, glasses, etc.), valued at $29.92 billion in 2016, is set to reach $71.23 billion, while Spanish telecom provider Telefonica predicts that by 2020, 90% of cars will be online, compared with just 2% in 2012.

This increased connectivity translates into increased cybercrime risk, but also into increased demand for cybersecurity products and services. And the industry’s market is not limited to the developed world either, as technology’s reach steadily expands all over the globe. Microsoft predicts that by 2020, four billion people will be online, doubling the current internet users, while 50 billion connected devices will be in use and data volumes will be 50 times greater than today.

Economy-Defying Growth

The emergence of this online frontier and the global escalation in cybercrime and cyberwarfare have contributed to the rapid growth of the cybersecurity industry; it has remained resilient to global economic challenges, resisting the resulting slowdown suffered by other sectors. A new report by Markets and Markets estimates the global cyber security marketwillgrowfrom$122.45billionin2016to $202.36 billion by 2021, at a CAGR of 10.6%.

Another argument for optimism can be derived from employment figures. There are over one million cybersecurity job openings, with more than 209,000 unfilled cybersecurity jobs in the US alone, up 74% over the past five years, according to data from the Bureau of Labor Statistics.

So far, North America holds the largest share of the cybersecurity market, followed by Europe and Israel, a leader in specialist military and intelligence technologies. However, emerging economies, such as China, India and South-East Asian countries are catching up. For example, India’s Data Security Council predicts the domestic market will grow to $35 billion by 2025, from about $4 billion today.

Investment risks and opportunities

While the cybersecurity sector will have great growth potential for the years to come, it is important to remember the lessons learned from the Dotcom era, from the Silicon Valley hype, and from the “flavor of the week” phenomenon which plagues start-ups and venture capitalists alike. Betting on the industry might be a winning strategy, but it can be challenging to identify individual winners.

Much like the rest of the tech industry, promising start-ups abound. New ideas and products are being pitched every day, attracting early investors andgarnering support, only to “fizz out” and disappoint before their “disruptive” and “revolutionary” concepts even make it to market. Even established leaders like IBM Security, Symantec, Cisco, Kaspersky Lab, and Palo Alto Networks are also likely to face fierce competition in the coming years, as the industry grows and attracts more talent, investments, and entrepreneurship from all over the world.

Therefore, a diversified portfolio comprised of a balanced mix of cybersecurity stocks would be a sound strategy to benefit from the sector’s growth,while offsetting the aforementioned risks. Our own approach at BFI is optimistic, yet cautious.

Although we strongly believe in the growth potential of the cybersecurity industry, we continue to closely monitor developments, trends and performances within the sector, in order to be able to make educated decisions and offer fact-based, actionable advice to our clients.

Legal Disclaimer

This report was prepared and published by BFI Wealth Management (International) Ltd., a Swiss wealth management company registered under the U.S. Investment Advisors Act of 1940 with the U.S. Securities and Exchange Commission (SEC) as an investment advisor.

This publication may not be reproduced or circulated without the prior written consent by BFI Wealth Management, who expressly prohibits the distribution and transfer of this document to third parties for any reason. BFI Wealth Management shall not be liable for claims or lawsuits from any third parties arising from the use or distribution of this document. This publication is for distribution only under such circumstances as may be permitted by applicable law. This publication was prepared for information purposes only and should not be construed as an offer, a solicitation or a recommendation to buy, sell or engage in any venture, investment or financial product. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. Although every care has been taken in the preparation of the information included, BFI Wealth Management does not guarantee and cannot be held responsible for the accuracy of any statistic, statement or representation made. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results.

All information and opinions indicated are subject to change without notice.

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