What a Difference a Year Makes
The financial markets began last and this year with a bang. However, there are significant differences, both positive and negative, that lead us to believe that this year will end differently than last year.
A year ago, investor optimism was at an all-time high with expectations that the global economy would accelerate, earnings would increase to record levels, inflation would rise, albeit slowly, monetary authorities would remain accommodative but would begin to return to “normal” and threats of trade wars was just a whisper. It helped that the pro-business Republicans controlled both the White House and Congress, too. Everything looked great but we all know what happened in hindsight.
Today investors are pessimistic, maintaining record levels of cash as the global economy is rapidly slowing down, earnings are under pressure, inflation is declining, monetary authorities have little room to ease further, and tariffs are a fact of life. It does not help that the Republicans lost the House and the Progressive Wing on the Democratic party is out in full force aiming to win the Presidency in 2020. Other problems facing investors include the continued rise of populism in Europe and the potential of a hard Brexit. That’s plenty to worry about.
But markets have a way of rising on a wall of worry as is the case now. Why? We have been commenting over the last few weeks that the creation of money by all of the world monetary authorities, including now China, will exceed the use of capital in the global economy. This flow of excess capital finds its way into financial assets pushing up prices of stocks, bonds and commodities. We no longer fear that the Fed will tighten further in 2019 nor that the BOJ and ECB will begin tightening by year end. In fact, we believe that the Fed may ease sometime this year either by lowering the Fed Funds rate and/or pausing on unwinding its balance sheet. And then there is the Bank of China who is now doing whatever it can to supports its economy. Quite a reversal in global monetary policy in just six months.
Stock and bond prices/yields ended last year as if we were already in a recession. The market’s biggest concern, including ours, was that the Fed was on a path hiking rates that would push our economy into a possible recession by the second half of 2019. This view changed abruptly when the Fed basically did a 180 at its December meeting. Unfortunately, the Fed still chose to hike rates one more time and continued to project unwinding its balance sheet by $50 billion per month. Fortunately, the Fed also mentioned that it would pause on any future rate hikes which was a huge sigh of relief for the markets and that it also could pause on any further balance sheet unwinding if the data points so dictated. The Fed woke up and finally saw the light removing the biggest risk to the stock market in 2019. Since stocks were selling at recession prices, the markets have had a huge rally led by the economically sensitive sectors which has continued through Friday. We successfully shifted our portfolios by the beginning of 2019 and have outperformed the averages year to date.
Don’t underestimate the power of the monetary authorities to, at a minimum, stabilize the global economy preventing further weakness and rising deflationary pressures. You may have noticed the rise in industrial commodity prices, including oil, since year end.
Trade concerns are holding back the global economy, big time, as businesses just cannot plan not knowing what will the new rules of the game will be. Why move ahead on capital spending and hiring plans until you know where it would be best to build the next plant: China, Vietnam, Japan, Britain, Germany or the United States? And what if there is a hard Brexit? Can you see why the boardrooms are confused and basically plans are on hold? But here again, less spending means more cash build up, too, which benefits financial assets.
Change is in the air which could be a real boost to the global economy. What if deals are struck with China, Japan and the Eurozone? Sounds hard to believe but it is a necessity to stimulate the global economy. The markets are basically holding their breath waiting to see if Presidents’ Xi and Trump can reach a deal. We continue to expect the March deadline to be extended another 60 days and then some deal to be reached when both meet. Both leaders need a deal for economic and political reasons. It is important to remember that Trump measures his success by the level of the stock market and he realizes what will happen with or without a deal. And he wants to be re-elected badly next year. If our economy and financial markets are down, his chances would be bleak. Don’t ever forget that the President has a lot of power over the economy even if he can’t get any new legislation passed in Congress. Expect a strong economy by mid 2020. President Xi needs a deal, too, as his economy is much weaker than the numbers show and unemployment is rising.
Also, don’t underestimate the political pressures in Japan and the Eurozone to reach trade deals. Remember that the U.S. is the largest market for each of them. The U.S. holds the best hand dealing with everyone as trade is a much smaller percentage of our economy than almost any other major industrialized nation. It will be interesting to watch how Trump responds if European car imports are deemed a national security problem.
As trade deals are reached, the prospects for accelerating global growth will almost occur overnight. No one believes that 2020 global economic growth will accelerate. We like those odds.
It must be noted that European governments are being greatly influenced by the rise of populism in Italy and Spain. Pressure is mounting throughout Europe to increase domestic spending and cut taxes to stimulate domestic growth. To hell with the German controlled ECB! That is a huge change from last year. Clearly the chance of a hard Brexit is playing a major role here, too. Beside the ECB easing further by year end, we expect many country deficits to expand in 2020 as additional spending plans are passed along with tax cuts causing deficits to rise.
What a difference a year makes!
We expect additional global monetary ease, trade deals, and much more local spending in China, the Eurozone and Japan to stimulate growth.
We want to underline that this is a minority view. Virtually no one is forecasting accelerating growth in 2020. Since none of this is in the market, we are not paying for it. Put another way, the risks to the downside are unfathomable without more monetary ease, trade deals and local spending. And what happens politically if the global economy continues to weaken? The current leaders, excluding President Xi, are at risk with populism rising even more.
What are we doing now?
We believe that 2019 could unfold virtually the opposite of 2018. We expect global growth to continue to weaken slowly but then stabilize benefitting from additional monetary ease. We would expect eventual trade deals combined with hikes in domestic spending to accelerate growth as we move into 2020. Inflation will stay muted due to the impact of globalization, technological advancements and more disruptors. We disagree that operating margins have peaked for this cycle as more gains lie ahead as more is done with less year after year.
The bottom line is that the stock market is undervalued as we expect earnings to increase in both 2019 and 2020 with interest rates remaining surprisingly low due to muted inflationary pressures.
Our portfolios are concentrated in healthcare companies with accelerating unit growth benefitting from new products; capital goods and industrials with volume growth, margin expansion and strong cash generation; technology companies at a fair price to value; low cost industrial commodity companies generating huge excess cash flow; domestic steel and many special situations where management closes the gap between current price and underlying value. We are flat the dollar although we expect it to weaken over time and own no bonds as we expect the yield curve to steepen slightly as global growth accelerates later this year into 2020.
Remember to review all the facts; pause, reflect and consider mindset shifts; analyze your asset mix always with risk controls; do independent research and…
Paix et Prospérité LLC