Global Rates Are Finally Rising

It is ironic that the financial markets are suddenly concerned with rising rates and steepening yield curves when the biggest fear all along has been flattening or inverting yield curves, negative rates and declining economy.

Let us state unequivocally that growth with a low inflation is the real recipe for higher equity values. The global monetary authorities have thrown billions upon billions of dollars to first, stabilize, and then, stimulate global economies fearing deflation most of all. Maybe it’s time for everyone to declare victory, shift toward normalization, promote sustainable growth with low inflation and move forward.

Trade issues have been the key impediment to global growth this year. We have argued that growth overseas will re-accelerate as trade deals are reached. Consumer and business confidence will then increase rapidly followed by a sharp acceleration in consumer spending, corporate investment and growth. It has become clear that the US strategy was and still is to negotiate deals with Mexico and Canada first since our economies are closely aligned and interconnected. US will next work to close deals with Japan and Europe using similar terms to those struck with Mexico and Canada as their template.

The Trump team will leave negotiating with China for last, isolating them as much as possible, to enhance our negotiating position at their expense. Don’t believe that China can be an island unto itself and still grow over 6% without a trade deal. Also, don’t believe that the Chinese populace is 100% behind its government. Maybe the older generation is but not the millennials.  The US is focused on a level playing field, no government subsidies and protecting our IP. Who can disagree? And it appears that we will have our trading partners negotiating with us here too. Could Trump be that smart or lucky? The benefits of all these trade deals will accrue for us for years to come. Why not give Trump some credit?

The US economy continues to hum along. Third-quarter real GNP is likely to exceed 3.2% supported by strong consumer demand despite weakness in autos and housing. The trade deficit has continued to expand penalized by existing and impending tariffs as well as strong domestic demand. It was no surprise that the employment data reported Friday was almost perfect: non-farm payrolls rose 134,000 despite being penalized by about 50,000 jobs due to the hurricane; revisions added 87,000 jobs to payrolls over the previous two months; the unemployment rate fell to a 48-year low at 3.7%; average hourly earnings rose 0.3% or at an annualized rate of 2.8%, lower than the previous month; and the participation rate held at 62.7 percent. Pretty darn good!

Amazon surprised us all by raising the minimum wage for its employees to $15.00 while eliminating bonuses and stock awards for hourly workers. We expect all retailers (and other industries like restaurants) to follow suit which will initially put pressure on their operating margins.

Fourth-quarter real GNP is likely to exceed 3%.

Fed Chairman Powell cautioned the marketplace that rates were far from normalized but that the Fed will only increase rates gradually closely monitoring all economic data. We believe that the Fed is wise enough to know that the benefits of fiscal stimulus will ebb as we move into 2019 so it is needs to go slow, monitor the data closely and remain accommodative. We believe that the Fed will raise rates in December and only twice next year staying one step behind. We expect growth to moderate over the next eighteen months but NOT turn down. And we expect inflationary pressures to stay contained due to offsets from global competitiveness, technology, disruptors and rising productivity. It is too early to forecast 2020 as we need to see if trade frictions continue to ebb and whether the Fed remains flexible and accommodative. We are willing to bet that Powell and the Fed will remain one step behind fearing a downturn over more rapid growth. If so, 2020 growth might surprise on the upside.

China is pulling out all stops to boost its economy, The Bank of China just announced its fourth cut in reserve ratios to boost lending at the expense of fiscal discipline which was the cornerstone of their policy just a year ago. We continue to expect substantial increases in infrastructure spending along with further cuts in taxes to boost consumer spending. Nevertheless, we expect growth in China to rapidly de-accelerate with gains falling below 6% over the next year. Don’t believe government rhetoric that China can withstand a lengthy trade war. China 2025 is in trouble and the government knows it. We expect the yuan to remain under pressure too despite efforts by the government to intervene.

Europe’s economy will stay stuck in the mud without a trade deal. The ECB will remain extremely accommodative for the foreseeable future putting a lid on short term rates as long-term rates finally increase reflecting inflationary pressures from a weak Euro, higher energy prices and weak productivity. Italy has promised to contain its future deficit closer to 2.0% but don’t believe it. Europe badly needs a trade deal to boost business and consumer confidence. Watch for one before year end.

We are hopeful that Japan and the US will reach a trade deal in short order. Prime Minister Abe has three more years to continue reforming Japan’s economy which makes us hopeful that Japan’s best days are ahead. We recently turned more positive on investing in Japan.

Let’s wrap this up.

The financial markets have finally gotten what they wished for… a steepening yield curve both here and abroad. The 10-year treasury has risen to 3.22%; the 10 year German bund to 0.57% and the 10 year Japan bond to 0.25% last week. Do you really find these levels high? It is clear that all monetary authorities are moving toward normalization in one form or another while still remaining accommodative and one step behind. Real rates remain negative in most parts of the industrialized world. Again, all monetary bodies are more focused on potential economic weakness rather than faster growth. Inflation is NOT a problem for all the reasons stated earlier. Oil is the only industrial commodity moving up due to the US embargo against Iranian oil. Economic growth is the path to prosperity.

As we said, the financial markets were taken aback by the fast rise in rates and steepening yield curves last week. While we still anticipate further steepening yield curves, it will be slow and not impact the real economy for the foreseeable future. We believe, like Buffett, that stocks are the asset class of choice by a country mile. Stocks can continue to increase as earnings growth will more than offset higher interest rates. The US remains the market of choice for a host of reasons. We continue to forecast S & P earnings over $160/share in 2018 and $175/share in 2019. Interest rates are still incredibly low and accommodative as long as inflation stays contained as we expect and the Fed remains one step behind. The equity risk factor has gone down too as bank capital ratios and liquidity continues to rise to historical highs.

Don’t get caught up in all the daily noise of the day and market volatility. Interest rates have risen for the right reason… growth. Inflation is not and won’t be a problem so don’t fret. And corporate profits and cash flow will continue to increase at above average rates offsetting the punitive impact of higher rates on the market multiple. Since the 10-year treasury even at 3.75%, which is our 12-month forecast, is still well below the 20-year historic range, therefore it is logical to assume that the market multiple will be above the 20-year historic range of 16-22 times earnings. Our 12-month market objective for the S&P 500 is around 3150, up 10% from current levels plus dividends. Our stocks should significantly outperform the averages as we have done for our entire career.

We continue to emphasize the largest US domiciled banks, capital goods and industrials, technology at a fair price to growth with the government not in their face, healthcare, cable, domestic steel/aluminum and special situations where internal development will add value.

Finally, Judge Kavanaugh was appointed to the Supreme Court after a horrific public battle which showed our political system at its worst. It is time for both parties to work together putting our country first. Judge Kavanaugh will move the court further to the right which is positive for financial assets.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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