Alarm Bells Are Ringing

Aggressive monetary ease may stem the global economic slowdown, while boosting the value of financial assets, but we really need widespread structural financial and regulatory reforms, as well as trade deals, to meaningfully re-accelerate global growth. We were not surprised to see the OECD last week cut its growth forecasts for 2019 and 2020 to 3.3% and 3.4%, respectively, with the majority of the cuts coming in the Eurozone. Inflation forecasts were lowered too.

We have not altered our view, one we had since January, that global growth would bottom out by mid-year and begin to accelerate as we move into and through 2020. The primary reasons for our optimism are:

  • All monetary bodies have now shifted to more accommodative stances which we had been anticipating.
  • Governments are increasing spending while decreasing taxes allowing budget deficits to widen.
  • Trade deals will be finalized and/or added tariffs will be put on hold.

Let’s take a look at what is occurring in the key economic reasons that warrant our view:

  • The United States has become the pivotal country impacting our view. There is no doubt any longer that the Fed will, at a minimum, pause hiking rates for all of this year and will most likely end unwinding its balance sheet within a month or two. We are not sure if the Fed will cut rates to halt dollar strength but it would be a smart move if done. The Fed’s primary objective has shifted to protecting the expansion rather than containing inflation.

    There were several economic numbers reported last week that need mention. The surge in the trade deficit in December to $59.8 billion and for the year to $621 billion had a lot to do with our domestic economic strength, weakness overseas and fear of added tariffs in January, 2019. No surprise that the trade war actually increased the deficit last year.

    The employment numbers reported on Friday were a shock to all, including us. Without going into great detail, we are convinced that the numbers were off-base. We are focusing instead on the ADP number which were reported Wednesday showing jobs rose by 183,000 in February, weekly unemployment claims remain near record lows and there are over 7.3 million job openings. We consider the December job report an outlier to reality and to be totally dismissed.

    It is clear that first quarter GNP will be the lowest point for the U.S. economy in 2019. Interest sensitive sectors like housing are already showing improvement with the recent drop in mortgage rates. There is no doubt in our minds that consumer spending will remain strong (just look at Costco, Target and Walmart numbers) as well as capital spending on technology which will boost future productivity.

    And finally, there are the heightened prospects of trade deals being concluded with China, Japan and hopefully the Eurozone this year.  2020 could surprise on the upside. Don’t forget that Trump will do everything in his power to boost the economy and stimulate the financial markets prior to the Presidential election in 2020. And the Democrats are running a huge risk moving too far to the left in our opinion.

    The U.S. stock market remains undervalued today as we expect S & P earnings to increase by at least 5% in 2019 with the 10-year treasury holding beneath 3.0%.
  • China’s National Conference last week was very revealing although not surprising to us. China lowered its economic growth target for the year to a range between 6% and 6.5% as expected. Premier Li Keqiang offered plans to stimulate the domestic economy through a combination of tax cuts and large spending projects. Trade was a major topic of discussion as it was clear that trade conflicts had severely hurt China’s economy. Ironically it was reported last week that China exports had fallen by nearly 20% in February from a year ago with exports dropping 26% to the U.S.. We are taking these numbers with a grain of salt too as exports were unusually high in November and December anticipating added tariffs in January. Weak imports were affected for the same reasons and do not reflect weakening domestic demand in China.

    We are confident here, too, that China’s economy will improve as we move through the year benefitting from the massive flood of added liquidity and tax cuts including a sharp reduction in the VAT. And what if there is a trade deal with the U.S. as we are anticipating? It is important to note that the Chinese government is trying to contain speculation in its financial markets by permitting a sale recommendation Friday on one of its most prominent insurance companies.
  • Japan’s economy rebounded 1.9% in the fourth quarter after declining 2.4% in the third quarter. Private consumption rose by only 0.4% as wage growth remains weak and net exports actually penalized growth by 0.3%. Japan’s Cabinet office just reported its latest composite of business conditions fell for the third straight month to its lowest level since June 2013. Japan desperately needs global trade conflicts to end. The BOJ cannot do more than it is already and it is equally difficult for the government to increase its deficit from these lofty levels. Japan’s economy will muddle along until global trade improves. We do expect Japan to reach a trade deal with the U.S. before the end of the summer which will improve the prospects of growth accelerating later in the year especially if China and the U.S. reach a deal too.
  • We remain negative as to the prospects of the Eurozone despite the shift in policy at the ECB last week. The ECB promised to maintain interest rates at current levels through year end and will offer banks a new round of loans not seen since 2016. We do not believe that the Eurozone can grow by even 1.1% in 2019 until the area can get its act together. Brexit, political problems in Italy and Spain, and most importantly its trade conflict with the U.S. are all putting a lid on Europe’s prospects. Germany must ease up on its neighbors permitting higher spending and lower taxes even if it means rising deficits. It is no surprise that  the region is in great need of structural reforms to better compete globally. Notwithstanding, we believe that all European governments recognize the downside risks including rising deflationary pressures and will work together to promote growth including a trade deal with the U.S..

Aggressive monetary ease has taken the risk of a near term recession off the board but it will not lead to accelerated economic growth until trade deals are reached. Businesses are keeping their hands in their pockets until they have some certainty over trade policy. We are confident that trade deals will lead to more capital spending and hiring. China, Europe and Japan are being hurt far more than the U.S. by trade issues and therefore have much more to gain once deals are reached.

We have been writing since last October that the risks to the downside were unfathomable and that it was about time for the powers to be to the right things. Trump has disrupted the status quo in so many ways. While we disagree with many things about him including his ways, we do agree with many of his objectives. Who can argue against no tariffs, no subsidies, no stolen IP and a level playing field? Who can argue that the U.S. bears all the research cost of drugs? Change is difficult and hiccups occur along the way but the end game may be worth the disruption.

Alarm bells are ringing around the world increases the odds that trade deals will be reached this year which will lead to an acceleration in global growth into and through 2020. It is important to note that no one believes this so we are not paying for it either. We believe that the U.S. markets are undervalued today even without trade deals. We are less sanguine on other markets unless trade deals are reached.

Our portfolios are more diversified than we can remember without one overriding theme. Each investment is led by great management with winning long-term strategies and the resources to see it happen. While we continue to hear about too much leverage in the system, it really is not corporate America whose balance sheets have never been better. We are concerned however by the buildup in government debt everywhere.

We own many drug companies who are benefitting from new product flow, rising margins and cash flow; industrials and capital goods companies with volume growth 1.5-2 times GNP, rising margins and huge free cash flow generation; technology  including semis at a fair price to growth generating huge free cash flow; cable companies with content like Comcast and Disney; housing related companies lie HD which will benefit from insufficient supply and low mortgage rates; low cost industrial commodity companies generating huge free cash flow; and many, many special situations where internal development will close the gap between current price and intrinsic value. We own no bonds as we expect the yield curve to steepen later in the year and we are flat the dollar even though we anticipated its near-term strength.

Review all the facts; pause, reflect and consider mindset shifts; look at your asset allocation with risk controls all the time; do independent research and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC


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