Investing in a VUCA World

We were clearly surprised by Trump’s tweet last Sunday informing us that he was raising tariffs to 25% from 10% on the initial $250 billion of Chinese imports as well as implement tariffs on the remaining $300+ billion. However, we had an action plan ready to go if trade talks broke down and it helped us last week. We have continued to outperform the market averages.

We have long commented that we live in a VUCA world. This a climate characterized by volatility, uncertainty, complexity and ambiguity. Therefore, you must always be prepared for the unexpected. Trump’s optimism that a trade deal was in reach shifted a week ago Friday after he heard from lead trade negotiator Robert Lighthizer that the Chinese had backpedaled on key portions of previously agreed to trade deal. Clearly, he was annoyed and who could blame him as he was made to look foolish having just announced that a deal was in sight.

Negotiations began again Thursday in DC but ended without a deal being reached, so the hike in tariffs went into effect Friday morning. In addition, the Chinese were given an ultimatum to reach a deal over the next month or else the tariffs on the additional $300+ billions of goods will go into effect, too. The Chinese responded with its price to conclude a trade deal yesterday. The simple truth is that we do not know what will happen, so we must plan for the worst and hope for the best.

We agree with Trump that we should all compete on a level playing field without tariffs, government subsidies, unfair regulations and currency manipulations. Protecting IP and having equal access is of paramount importance, too. The U.S. has run massive trade deficits for years with our major trading partners running huge trade surpluses. It is time to level the playing field while protecting our IP. Fortunately, we have a strong domestic economy more than just offsetting our trade deficit. The U.S. trade deficit is approximately $600 billion reducing our GNP by approximately 3% (exports are 10% of GNP reduced by massive imports). And, we have become an exporter of energy after years of huge importing from the Middle East.

Our trade deficit with China, alone, was over $420 billion in 2018: imports of $539 billion offset by export of $120 billion. There is an enormous imbalance that needs to be addressed. And that does not even deal with the greatest problem which is stolen IP over the years. Companies, if they wanted access to China, had to agree to share IP or else. And many companies, nonetheless, have not been granted access to China. Clearly the playing field has not been unfair.   

While you may not agree with Trump’s tactics, it is a necessity for the U.S. to finally address unfair trade practices wherever they may exist including with our closest allies. Can you imagine the positive impact to our GNP if our trade deficit was reduced over time due to fair trade policies and a level playing field? And what is the downside dealing with trade imbalances/huge deficits now when our domestic economy is so strong? While prices may go up slightly near term due to the impact of tariffs, it is hard to imagine our trade deficit pressuring reported GNP. Will demand be hit by higher prices? Probably a little but most likely not as much as expected as the exporter as well as the importer absorb a slice of the tariffs while the supply chain is being moved. Herein lies a HUGE RISK to China. Already many companies have shifted production from China and that will grow exponentially over time without a trade deal. Just look at Under Armour as one example here. The company has lowered its production in China from 35% 6 months ago to less than 15% today and going down further fast. The key to our future success globally is for the U.S. to remain at the forefront of technological advancement which gives you some idea why our IP must be protected at all costs.

As you can imagine from our comments, we feel that China and our other key trading partners are at far more risk than the U.S. when/if trade conflicts escalate. What is our downside when we are already running huge trade deficits? Also, we really doubt whether there will be a surge in prices as global competition is more likely to escalate to maintain production and market share in home markets. The Chinese are keenly aware that production is moving offshore as supply chains are being shifted at an accelerating rate. China is also losing its cost advantage much like Japan did over 25 years ago. So, what will China do to hold onto market share? Cut prices in the face of tariffs sacrificing profits. China loses and prices don’t go up as many anticipate due to tariffs.

So why does Trump feel that this is the time to go to the mat on unfair trade policies? He sees domestic strength and foreign weakness. Is he right? Let’s look at the most recent data points:

  • The U.S. is in an enviable position compared to the rest of the world. Our economy just came off a surprisingly strong first quarter and it now appears that the second quarter is shaping up well to despite really bad weather in many parts of the country. We were particularly impressed that March wholesale sales rose 2.3 percent while actual inventories fell 0.1 percent therefore the inventory/sales ratio fell to 1.32 which should lead to higher production down the road as demand increases seasonally. We were equally pleased that both the CPI and PPI came in lower than projected and beneath the Fed projections testing the Fed’s view that low inflation is transitory.

    It was also reported that the trade deficit came in at $50 billion in March with the trade gap with China declining to a three year low of $28.3 billion. China still is nearly 60% of our trade deficit. Our trade deficit will be penalized for a while by the absence of Boeing Max 737 sales. Finally, job openings continued to grow and now stands at an amazing 7.49 million unfilled jobs. Opening increased in transportation, construction and real estate.

    While we still believe that our economy will chug along for the rest of the year into 2020, we remain concerned about the impact on consumer/business psychology if trade conflicts escalate. We must acknowledge that our Fed, unlike other monetary bodies, has ample room to lower rates need be to offset any domestic weakness or fear in the system. It is equally important to recognize how financially strong our banks are especially compared to overseas banks. And never forget that 2020 is an election year. Trump will do whatever he can to stimulate the economy and have a good stock market going into elections.

  • We clearly are more concerned about China’s growth prospects without a trade deal with the U.S.. There is little question that the Chinese government/monetary authorities have done as much as they could do to stimulate the economy in 2019: taxes have been lowered; domestic spending hiked; reserve requirements reduced and money has been flooded into the system. The government went so far as to buy stocks on Friday to boost their market to try and show the world that the new tariffs would not hurt. FALSE!

    While we won’t predict the magnitude of the impact of higher tariffs on China, it is clear that growth will be hit for a host of reasons as discussed earlier. And if the government lets the yuan fall to offset the impact of tariffs, it will eventually boomerang and hurt China’s financial system and economy. China is clearly between a rock and a hard place. While we can appreciate their desire to stand up to Trump, it is time to face reality by opening up its economy and ending huge subsidies while protecting everyone’s IP.

    By the way, China’s exports fell 2.7% in April while imports rose 3%. No matter what China says, its economy is at risk without a trade deal.

  • We remain pessimistic about the growth prospects of Europe without major fiscal, monetary, regulatory and trade reforms. And we see no way for any of that to occur with such differences between the members. The EU cut its economic forecasts for 2019 and 2020 to 1.2% and 1.5% respectively which we feel is still too optimistic.  There really is not much more the ECB can do to stimulate growth in the Eurozone. That says it all!

  • Japan’s future prospects rest sorely on trade deals being reached with the U.S. and with the U.S. and China. What more can the BOJ do too at this point? It appears that first quarter GNP actually fell by 0.2% as firms postponed capital spending and consumer demand fell as well. We don’t believe that Japan reaching a deal with the U.S. is enough to really stimulate Japan’s economy.

So, what are we doing now?

We quickly adjusted our portfolios last week considering that the probability of a trade deal being reached near term had diminished substantially which would lower our outlook for accelerating global growth into 2020. Could it still occur? Of course, but we learned a long time ago that it was better to be risk averse in unsettled times so that we have the liquidity to take advantage of market weakness. We sold stocks Monday that would be penalized by an escalating trade conflict with China raising cash above 17% of our assets.  In fact, we did some buying Friday morning as some stocks hit our buy points.

We agree with Lee Cooperman’s comments Friday on CNBC that the markets are fine longer term as the Fed is friendly, valuations are reasonable, and the chances of a recession are very low. We believe that the environment for risk assets is still favorable with an accommodative Fed; an expanding economy without inflationary pressures; a pro-business administration going into a national election next year; 10-year treasury yields hovering around 2.5%, bank liquidity and capital ratios at new highs; a strong dollar and rising earnings/cash flow. We do believe that long-term inflation will stay surprisingly low therefore the stock market multiple should be higher than 17 times earnings making the market still undervalued by 10% today. But we recognize that corrections can occur at any time especially in a VUCA environment.

We have adjusted our portfolios ever so slightly reducing our exposure to China while raising some cash. The overriding theme in our portfolios is owning companies with excellent managements; winning long-term business strategies in a globally competitive environment; rising volume, margins, earnings, cash flow/free cash flow and above market dividend yields.

Finally, we feel that each company sells well beneath its long-term intrinsic value.

Our holdings include pharmaceuticals with major new products; global industrial and capital goods companies; technology that enhances productivity and security; cable with content; housing related; U.S. based global financials selling beneath book; domestic steel; and many special situations. We remain flat the dollar and own no bonds as yields are just too low relative to even inflation at 1.5%.

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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