Geopolitical Concerns Dominate Markets

The world is a dangerous place. Therefore, we all want to believe that cooler minds will prevail to avoid the unthinkable. It raises a question though: Is there a way to protect oneself from a major nuclear conflict? Buying 10% gold, as Ray Dalio of Bridgewater Associates suggests, might be an option, but frankly, what will that do for you if the worst really occurs?

I remember the fear in the marketplace before the U.S. invaded Iraq back in 2003 to free the country from Sadam Hussein. Do you know what happened on that day? The market shot up like a rocket. I am not saying for a second that this is not a very dangerous and difficult situation. However, I believe that we should still continue to stay invested but only in the highest quality companies selling at a discount to the market that will thrive for many years to come despite what may or may not happen.

Do you think that Warren Buffett will sell? Don’t think so. He is probably hoping to use a good portion of his $100 billion excess cash if the market gets hit hard. But will it? I just don’t know, so I continue to prune the stocks that have had major up moves; add to some that have been recently been hit hard due to the market turbulence; find some new investments at attractive entry points; and maintain a dividend yield on my portfolio that easily exceeds the 10-year treasury rate while maintaining excess liquidity at all times.

Let’s review the major economic events of the week:

  1. Virtually all of the economic news out of the U.S. was on the positive side last week: the July PPI fell 0.1% in July and is up less than 2% year over year; job opening rose to a multi-year high of 6.2 million at the end of June; the consumer comfort index increased to a 16-year high in July; nonfarm business productivity increased at 0.9% annualized rate while unit labor costs rose only 0.6%; output rose at a 3.4% pace, the fastest gain in two years; corporate America is achieving the highest profits and sales gains in 13 years; and finally the CPI rose only 0.1% in July and is up less than 1.8% year over year. Not too shabby.
  2. China reported a 7.2% gain in exports in July while imports rose 11.9%. It was important to note that exports to the U.S. grew only 8.5% from a year ago, well below former double-digit gains. All in all, China’s trade surplus swelled to $46.74 billion and foreign reserves are again expanding. Even though China continues to tighten bank lending, the country is on target to achieving economic growth of approximately 6.9% this year. Consumer inflation rose surprisingly slow, up only 1.4% from a year earlier. Low inflation truly is a global phenomenon.
  3. Economic news out of the Eurozone continues to be quite favorable. German industrial output fell 1.1% in June from May but rose 1.8% from the previous quarter. German exports also fell in the month after 5 straight monthly gains. Could the strengthening Euro be impacting Germany? Maybe! Strengthening the Euro will also put added downward pressure on inflation, which I am certain that the ECB is closely watching.
  4. OPEC increased its global demand forecast for 2017 and 2018 by about 100,000 barrels per day as consumption has strengthened along with global growth forecasts. We still believe that oil is range bound between $45 to $55 per barrel for the foreseeable future, which is really good for global growth.
  5. Industrial commodity prices strengthened for much of the week until geopolitical concerns hit the markets. Glencore, like Rio Tinto, reported excellent first half results and gave optimistic forecasts for demand and pricing going out into 2018. Any sharp acceleration in cap ex will be the tip that the up cycle is near its end.

The bottom line is the global economy is in great shape. The monetary authorities face a conundrum as growth is exceeding their estimates while inflation is not. I believe that all monetary authorities including our Fed are now on hold for the rest of the year especially with rising geopolitical risks.

The financial markets acted as one would expect last week with rising tensions between North Korea and the U.S.: stock markets fell while bond prices rose and yields declined. Clearly there was a flight to safety. The VIX had a huge two-day move indicating the sharp rise in fear. It remains our opinion that China holds the key to reducing tensions between North Korea and the United States, as North Korea’s economy is almost entirely dependent on China. Don’t expect trade tensions to escalate between China and the U.S. during this period although we will continue to make noises like starting a IT trade probe next week. I don’t think China will fall for Trump’s carrot and stick tactics unless there is real movement behind it. Trump has let down the steel industry so far. Time to walk the walk.

I have discussed the huge impact that the “disruptors” have had on many markets. Box retail results last week was a reminder that if you don’t change and adapt to the new environment that you will continue to fall behind and eventually go out of business.

Another interesting story about a major disruptor, Netflix, occurred last week. Streaming has had a huge impact on the entertainment industry for sure. Disney, owner and developer of a huge amount of content announced that it would go it alone and develop its own streaming network for its Disney and Pixar initially. Remember that they also own Lucas Films, Marvell, ABC, and ESPN. It was the right decision and will take time to unfold. The pot of gold at the end will be well worth it for them. Both Disney and Netflix stock got hit on the announcement. I started a Disney position at the end of last week as the stock sells now at less than 15 times earnings with a bright future indeed. Remember that content is king in the entertainment business and Disney has it all including great management.

So where does all of this leave us? A little more cautious for sure but not frozen by any means. Volatility and fear create opportunities for those who maintain liquidity and stick to their time-tested disciplines. The global economy is on solid footing; interest rates are unusually low and corporate profits are rising faster than expected. Statistically the markets are still undervalued. We will continue to upgrade our portfolio but not increase our net long exposure in the process. While we did buy DIS, we sold elsewhere to fund the purchase. This is a time to do intense research as fear and panic create once in a lifetime opportunities for investors.

In closing, ask yourself how many of the pundits/experts are bullish? None! Markets rise on a wall of worry and fall when optimism is everywhere.

So remember to review all the facts; step back, pause and consider mindset shifts; analyze your asset composition and risk controls; do in-depth independent research and …

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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