Hope Springs Eternal
The global financial markets had a very strong week with expectations rising that the U.S. and China would reach a trade deal reigniting global growth. While all the comments from Trump and Xi support an optimistic view, we are not yet there and won’t be for another 4 weeks or so. Growth in the U.S. and China clearly bottomed in March but no so in the Eurozone, Emerging Markets and Japan. We continue to believe that investing in the United States and China are preferred since they will be the engine of global growth pulling along the other markets. We do recognize that the Eurozone, Emerging Markets and Japan have more upside/leverage if trade deals are reached but they also have much more risk if not.
Let’s take a look at the facts that support our view:
1.) The U.S. economy clearly improved in March as we expected. The most important stat of the week was the employment number reported on Friday. If you remember the last employment number was surprisingly weak raising concerns that the economy was slowing much faster than expected. We felt that the report was an outlier and expected stronger numbers in March which was exactly what happened. U.S. jobs grew by 196,000 in March, the unemployment rate remained at 3.8%, average hourly wages rose 3.2% from a year earlier and revisions added 14,000 more jobs to January and March.
Both the Manufacturers and non-manufacturers ISM indices for March were reported last week and showed improving growth. The ISM Manufacturers Index rose to 55.3, new orders were 57.4, production was 55.8, employment was 57.5 and prices were 54.3 while the non-manufacturers index was 56.6 with business activity at 57.4, new orders at 59 and employment at 55.9.
On the other hand, U.S. business equipment orders fell slightly after increasing 0.9% the month before and retail sales fell 0.2% in February after an upwards revised 0.7% gain the month before. Interestingly, March auto sales, however, rose to an annualized rate of 17.45 million vs 16.57 million in February. Lower interest rates may be favorably impacting auto sales, just like housing, which bodes well for strengthening consumer demand in upcoming quarters.
We have raised our forecasts once again, estimating first-quarter GNP around 2% with the full-year growth closer to 2.6%. Any trade deals reached this year won’t have much of an impact on our 2019 forecasts but clearly will bolster our 2020 forecasts and beyond. We see no reason for the Fed to alter their current view except if they remove the December rate hike recognizing that it was a mistake. Unless there are trade deals which would accelerate foreign growth, the Fed could be on hold for a long time.
There’s no place like home.
2.) Economic growth in China clearly picked up in March as we expected benefitting from all the monetary and fiscal stimulus pumped into the economy since December. The Caxin/Markit Manufacturers Purchasing Managers’ Index rose to 50.8 in March as new orders climbed to their highest level in four months. Employment levels at factories rose in March, too, which was the first expansion since 2013. In addition, China’s services activity expanded in March at the fastest pace in 14 months on new business growth. The index rose to 54.4 from 51.1 in February. China’s composite Output Index hit 52.9 in March, the highest level since last June.
We have raised our view of China’s growth in 2019 to 6.3% which does not include any benefit of a trade deal which will most likely begin to bolster growth by year end into 2020.
We like the Chinese market despite recognizing that a trade deal is a necessity for the country to sustain above average growth rates in 2020 and beyond.
3.) The outlook for the Eurozone remains bleak especially without trade deals. You need not look any further than accelerating weakness in Germany which is normally the growth engine for Europe to gain a full understanding of the problem facing the Eurozone. We believe that current forecast that Germany’s GNP will expand by 0.8% in 2019 (cut in half from the forecast 3 months ago) is still too high as new orders are down 8.4% from a year ago and exports are falling at an accelerating clip due primarily to weakness in autos. Core inflation has fallen to under 1.0% heightening fear of rising deflationary pressures. Can you now understand why German 10-year rates are hovering around the flat line? If Germany is the strongest economic country in Europe, then it does not take much of an imagination to understand what is happening elsewhere. Yes, trade deals would be a tremendous boost to Europe’s near-term prospects but the real problem why Europe is falling behind competitively globally goes much deeper. Europe needs fiscal, financial and regulatory reform to compete and it has to happen NOW or else!
By the way, we expect Brexit to be kicked down the road without a deal. Take time to understand why Brexit is happening in the first place and resolving it could just be the beginning of larger problems between members of the Eurozone. Can you imagine if a German is made head of the ECB which is widely believed?
The Eurozone has real problems which explains why its markets appear cheap.
4.) While Japan’s coincident index improved for the first time in four months in February, we are maintaining our negative view of future prospects for a number of reasons. Household spending is weakening as real wages are actually down 1.1% from a year ago. The average manufacturing PMI hit a two year low over the first quarter as nominal exports fell for the third consecutive month. Consumer confidence continues to fall which does not bode well for future consumer sales and machinery orders have now fallen for the third consecutive month. Japan is banking on building/spending plans for Tokyo 2020 Olympic Games to bolster growth but we doubt that it will be enough to offset consumer and export weakness. Remember that the BOJ really cannot do much more than it already is doing.
We remain pessimistic about the current prospects for Japan which desperately needs the U.S. to reach a trade deal first with China and then making a deal with the Japan.
Hope Springs Eternal!
While we fully understand strength in the U.S. and Chinese financial markets, we are dubious about the strength in Europe, Japan and also the Emerging markets unless trade deals are reached. Trade deals will lead to some acceleration in global growth for sure as businesses will be able to plan/spend/hire once again with some certainty based on new trade agreements but these deals will NOT be the long-term panacea for Europe, Japan and even the Emerging Markets unless there are major fiscal, monetary and regulatory reforms.
What are we doing now?
We have increased confidence as the economic/financial stats, monetary comments from Fed Members and companies support our view that the U.S. and Chinese economies bottomed out over the last month. We expect corporations to tell us on their upcoming first quarter earnings call that business got stronger month to month with March being the strongest month in the quarter and that there may be some upside to conservative 2019 earnings estimates made a few months ago. We will pay close attention to any changes in operating margin and cash flow assumptions for the year too.
The bottom line is that we believe that our economy will continue to expand over the foreseeable future. Remember Janet Yellen’s comment “economies just don’t die of old age.” The Fed is our friend as well as the administration as we look out over the next eighteen months. It also appears that Trump’s chances of winning in 2020 are rising as the Democrats keep shooting themselves in the foot.
Will there be trade deals that boost the global economy into 2020 and beyond? It appears more likely than ever in our opinion as Trump has regained the initiative after the Mueller Report vindicating him for the most part. Once trade deals are reached, don’t expect an instant boost to the global growth as it will take some time to implement but the financial markets will instantly reflect all of the benefits with many winners and some losers too.
Paix et Prospérité has continued to outperform the markets by staying one step ahead looking over the valley rather than in the rear-view mirror. We made two major adjustments to our portfolios over the last six months which served us well. First, we turned defensive last October when it was clear that the Fed was on the wrong path and then switched back to the offensive getting fully invested in December when it was clear that the Fed had capitulated. Our portfolio composition changed too.
Our portfolios currently include a few drug stocks only with significant new product flow accelerating growth prospects; global industrials and capital goods companies with volume growth 1.5X GNP and rising margins and free cash flow; technology at a fair price to growth including semis; a few financials selling at a discount to book with rising earnings, cash flow and dividends; housing related companies benefitting from low mortgage rates; domestic steel; and many special situations where managements is out to close the gap between the current stock price and intrinsic value. We are flat the dollar and own no bonds expecting the yield curve to steepen as growth in the U.S. and China accelerates.
Remember to review all the facts; pause, reflect and consider mindset shifts; look at your asset mix with risk controls; do internal research only and…
Paix et Prospérité LLC