Hitting On All Cylinders

When the head of Target says that this is the best consumer-spending environment that he has seen in his career, take notice. We knew that Trump’s tax plan would significantly benefit corporate America but were less sanguine on its impact on the consumer. In fact, many pundits expected little or no impact on families earning less than $75,000. Not true—as evidenced by Target, Walmart and other retailers most recent results.

The US economy is hitting on all cylinders as demonstrated by a huge increase in capital spending; acceleration in consumer spending; a 16-year high in the savings rate; rising productivity; and record corporate profits, cash flow and free cash flow. It’s pretty easy therefore to understand why the US financial markets climbed to all-time highs last week despite all the political turmoil and trade headwinds. The same is not true overseas.

Stop listening to the pundits who blow hot or cold depending on the day. Paix et Prospérité prides itself on stepping out of the daily fray, analyzing the global financial, economic and political data, and then looking over the valley to invest for the longer term.

Some days are harder than others as the market can make you look foolish at times but not over the longer term if your analysis is correct. We have maintained a positive bias to the financial markets outperforming all indices since returning to managing money in 2013. We have also stayed long the dollar and short Treasury bills and bonds over that time frame too.

The financial markets got whipsawed last week but ended on a high note after Fed Chairman Powell’s speech at Jackson Hole on Friday. He confirmed that the Fed will stay one step behind; will maintain gradual rate hikes as the facts dictate; and that we have entered a new paradigm on inflation. The Philips curve is dead which we have argued for years. It’s no surprise that Powell’s biggest concern is trade. The Fed will raise rates in September and possibly again in December depending on the data points. But remember that the real funds rate remains negative and is not restrictive. And don’t worry if the yield continues to flatten as it has little to do with an overly restrictive Fed. It all has to do with huge capital inflows from abroad reaching for yield as the interest rate differential widened.

Let’s get more specific:

1.) US retail sales increased about 6% in July year over year despite weak auto sales while the savings rate rose to around 7%. Consumers have socked away an additional $1 trillion dollars this year alone. It is very unusual to see both numbers go up at the same time. Consumers’ net worth is at all-time highs, which bolsters our thesis that consumer sales will remain strong for the foreseeable future. Expect a great Christmas!

Total durable goods orders have risen 8.6% thru July compared to last year. Orders for non-defense capital goods, ex-aircraft, grew 1.4% in June, the largest increase this year. And remember that productivity growth is improving holding down unit labor cost and inflationary expectations.

Second-quarter S&P 500 earnings exceeded estimates such that we have raised our 2018 estimate to $160/share. We expect further growth in earnings next year to $173+/share.

Fed Chairman Powell commented at Jackson Hole that gradual rate increases remain appropriate as inflation is still low and he is not worried about the economy overheating. The Fed will stay one step behind until inflationary expectations increase significantly which we don’t foresee as rising productivity will keep real wage costs under control. The 10-year Treasury bond rate ended the week under 2.85%. We believe that the 10-year Treasury bonds won’t breach 3.25% until mid-2019.

2.) Trade talks continued last week. While there was no apparent breakthrough with China, the US is inching closer to a deal with Mexico. We were pleased to hear that American, European and Japanese trade negotiators were discussing ways to work together presenting a unified front dealing with China on trade and IP. Removing China from the WTO is under discussion. We agree.

The US and China introduced a second round of tariffs last week. We still don’t expect trade negotiations to pick up steam until after the November elections.

3.) China’s government along with the People’s Bank of China is pulling out all stops to bolster its slowing economy and Yuan. Past policies to reduce lending and raise capital ratios have been totally thrown out of the window. Local governments are being pushed to significantly increase infrastructure spending also and tax cuts are under consideration as well. Second half economic growth will actually fall beneath 6.4% if correctly reported. China is clearly worried about growth if trade conflicts escalate much more.

The government will be forced to open up its country or corporations will keep relocating facilities outside China. Protecting IP is receiving more attention also, so we do expect some significant policy changes moving forward or China 2025 will be at risk.

Trump has cancelled Secretary of State Pompeo’s trip to North Korea putting more pressure on China to act here too.

4.) Eurozone PMI moved up just slightly in August to 54.4. Second half growth is projected at less than 0.5% despite firm consumer sales. The one bright light remains rising employment and wage gains offsetting continued weakness in exports and durable orders.

We are monitoring closely who will be appointed the next head of the ECB. If Germany gets it way, expect more restrictive policies moving forward to the detriment of Southern Europe further benefiting the stronger northern nations.

Turkey is the fifth largest export market for the Eurozone so clearly there is some added risk due to Turkey’s current turmoil. And then there are potential problems with Italy down the road.

Let’s wrap this up:

Trump’s pro-growth, pro-business agenda has thrust the US economy ahead while weakness has appeared abroad. The Fed has been able to begin its path toward normalization while the ECB and BOJ remain with overly aggressive easing policies. Powell clearly stated last week that the Fed would remain one step behind alleviating the market’s concern that the Fed will move rapidly stopping out our economy prematurely. We continue to expect 3% growth for the remainder of the year and only slightly less in 2019. We see no reason to forecast a recession over the next 24 months, as the preconditions are just not present like real interest rates turning positive.

We continue to expect the US to reach a trade deal with Mexico, which will be followed by Canada. Deals will be reached over the next six months with the Eurozone and Japan focusing on reducing tariffs and subsidies across the board. As deals are reached, we expect economic activity to improve in those markets.

Finally, we expect the US and its allies to reach a deal with China further opening its markets and finally protecting IP. If no deal is reached with China, China has the most to lose, as exports are still a significant portion of GNP.  The government will do everything it can to support increased employment and wages to bolster consumer demand as well as capital spending but we doubt that will be enough to fully offset export weakness. The government must be concerned that capital inflows will dry up and global manufacturers will move elsewhere too. So don’t believe the government’s bravado that all is well. China is at risk if there is no deal. The bottom line is that we expect a deal with China, too, over the next 9 months, which will be a win/win for all.

What are we doing now?

Paix et Prospérité continues to emphasize:

  1. Large US global financial institutions who will benefit from loan growth domestically and abroad increasing market share, as well as from a steepening yield curve.
  2. Global capital goods and industrials who will benefit from changes in technology and a desire to reduce costs improving competitive position.
  3. Technology companies selling at a fair price to growth.
  4. Low cost industrial commodity companies selling high-grade ores and generating huge free cash flow. Domestic steel and aluminum companies are included too.
  5. Healthcare and consumer nondurable companies with strong unit growth and free cash flow.
  6. Special situations where internal change will create significant added shareholder value.

We remain short bonds and have covered our long dollar position.

Finally, the passing of John McCain saddens us. We deeply respected him and wished that we had more politicians like him who put country ahead of party.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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