The Election, Fed, Global Economies and Inflation

US elections took place last week. Republicans held on to the Senate while the Democrats took control of the House, as anticipated. The global markets rallied until Thursday when the markets reacted negatively after the Fed decision. The Fed, as expected, held rates steady but reiterated their intent to raise rates over the foreseeable future. They stated that the US economy was strong, unemployment was still improving and inflation was likely to rise above their 2% threshold. Friday’s PPI report reinforced investors’ perception that inflationary pressures were indeed building such that the Fed had all the justification needed to continue hiking rates. The Fed release, however, did mention that capital spending softened. There was no mention of weakness in housing and autos, two sectors most sensitive to rising rates. Markets here and abroad fell on Friday fearing several Fed rates hikes not only slowing growth but most likely precipitating the next recession by 2020. We disagree!

Friday’s PPI report along with global markets’ reaction was just another example of looking in the rear-view mirror rather than the windshield. There is weakness in all industrial commodity prices including oil and gold. Oil breached $60/barrel on Friday. In addition, unit labor costs are increasing around 1% after productivity gains. So, where’s the concern? The bottom line is that inflationary pressures are NOT accelerating but are in fact turning down as shown by the third-quarter GNP report with inflation falling to 1.6%.

Growth is weakening in Europe, Japan and China, so why expect demand for industrial commodities to rise?  Even the rate of growth is decelerating here. It is clear, therefore, that global demand for commodities is clearly slowing which explains the weakness in commodity prices even though capacity growth is minimal. Oil is a special story as it is clear that the US made a deal with Saudi Arabia to pump more and more oil to not only offset declining exports from Iran but also enough to weaken prices. The decline in oil prices, dollar dominated, will reduce inflationary pressures here and abroad. Will OPEC cut production sufficiently to boost prices? Yes, short term, but not over the long term as demand growth is in a downtrend with the emergence of electric cars, solar and windmills.

We are not concerned about the CPI too as global competitiveness; technological advancements and the rise of disruptors puts added pressure on consumer prices everywhere especially with aggregate demand slowing too. So, where’s the beef? Trade tariffs may cause a near-term burst in prices, but the longer-term implications will be muted by shifts in supply patterns. Have you noticed the Chinese government offering special incentives for companies to remain in China? Don’t believe the rhetoric from the Chinese government that all will be just fine. It won’t without a trade deal with the US.

Global economies and markets are more intertwined than ever before. Governments and businesses have broadened their horizons and think globally, so why not the Fed, too? Fed policy has a domino effect on all other monetary bodies and economies so shouldn’t the Fed take a more proactive view including global ramifications when setting policy? The Fed mandate right now is centered on domestic economic growth, employment and inflation just here. Clearly trade plays a role as it impacts GNP. The Fed is the only monetary body in the world tightening policy returning to “normalization.” Its policy has led to a super strong dollar draining money from around the world pushing global rates up even though growth in those regions is weak. In addition, many industrial commodities, especially oil, are dollar dominated, so a strong dollar pushes up inflation around the world. If the Fed continues on its path raising rates, it will not only slow our economy but also hurt foreign economies as the dollar would continue to strengthen siphoning money from around the world raising global rates pressuring their economies when the reverse is needed.

It is time for the Fed to look forwards, not in arrears, as deflation, rather than inflation, is the real risk facing the US and global economies. It is time for the Fed to broaden its mandate and consider the global impact of its decisions. Same can be said for all monetary bodies. Globalization and the domino effect of one to the other are facts of life today.

Where are we going?

The US economy is in great shape. Fourth-quarter growth will slow to around 3.0% as inventories are liquidated. We expect strong consumer demand offset by a larger trade deficit and only moderate growth in capital spending. We sense a real shift in business attitudes maintaining a conservative bias to capital spending which is unique at this stage in a business cycle. Money will be spent to strengthen global competitiveness while reducing overall costs. Corporations will continue to generate substantial free cash flow throughout the cycle to increase dividends and buybacks. M & A should accelerate next year too. Finally returns on equity and capital will increase which is positive for future stock valuations.

We still expect the Fed to hike rates in December but then to take a more measured approach going forward effectively stepping back from Powell’s comment that the Fed Funds rate is far from normal. The US economy will continue to grow above trend line in 2019 bolstered by strong consumer demand, higher government spending and a boost in capital spending as trade deals are made bringing more certainty and confidence to corporate boards.

Trade remains the key issue holding back the global economy. It is next to impossible for businesses to plan not knowing the impact of new trade deals. Even the deals reached with Mexico and Canada are at some risk if the Democratic-controlled House tries to make too many changes to the agreed upon deal. We remain confident, notwithstanding, that the US will reach trade deals with the Eurozone, England, and Japan over the next six months. We are hopeful that Trump and Xi will agree when they meet later this month to a short-term ceasefire while both sides try to hammer out a deal. As trade deals are reached and confirmed, we expect an acceleration region by region.

We are not looking for any breakthrough legislation out of DC for the next two years. There will possibly be an infrastructure deal, but it is hard seeing both parties agreeing to anything. Stalemate in DC is fine by us.

What are we doing?

The common thread running through our portfolio is that we invest only in best in breed. Superior management with winning long-term strategies is key to us. Each company has above average volume growth, pricing power, rising operating margins, net income, cash flow and free cash flow. Key areas of concentration remain the largest domestic banks; capital goods and industrials; technology at a fair price to growth; healthcare; cable; domestic steel and aluminum; transportation; retailers; and special situations where internal actions enhance shareholder value. We are flat the dollar despite our view that it is the currency of choice. We own no bonds as we still expect the yield curve to slightly steepen from these levels. Finally, we caution you to maintain excess reserves as systematic trading can disrupt the market anytime creating unusual values to be bought.

Patience is a necessity in today environment. Invest for the long-term as trading is a losing proposition.

Remember to review all the facts; pause, reflect and consider mindset shifts; always look at your asset mix with risk controls; do independent research and…

Invest Accordingly!

Bill Ehrman
Paix et Prosperite LLC

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