It’s Darkest Before Dawn

It’s amusing to us to listen to the pundits/experts shifting their views almost daily staying one step behind the markets.

Forbes wrote an article about us on August 14, 1995 titled “Looking Beyond the Valley” in which we discussed our methodology to successfully invest which has been influenced over the years by partnering with great global investors such as George Soros. We always say that a successful investor must look through the windshield and “beyond the valley” rather than in the rear-view mirror. Our strength is a thorough understanding of global dynamics: political, economic, monetary, trade and regulatory and all of the inter/intra relationships amongst them. We are fundamentalists at heart always looking for that inflection point recognizing that the past is not necessarily prologue for the future.

Change is occurring everywhere which offers great opportunities to profit for the patient investor. Real change cannot occur unless the problems are recognized and action plans are enacted to right the ship. In fact, that was the topic of last week’s blog. Interestingly, over 90% of the 50,000 investors who read the piece felt that the future was bleak and that we have already, or will soon, enter a recession and bear market. Essentially, many do not agree with our positive longer-term view that the global economy will improve later in the year through 2020. Investor pessimism and cash levels remains high. Markets climb walls of worry and peak when exuberance is too high. By the way, the financial markets had a great week as both stock prices rose and bond yields fell.

You might be curious why both can occur simultaneously. It remains our contention that the global creation of capital is far in excess of the global needs for capital since the global economy is soft. This excess capital is finding its way into financial assets, namely stocks and bonds, which explains why both are rising. The logical question is whether this is creating a bubble or not.

We believe we are nearing an inflection point for global growth. We expect global growth to accelerate in future quarters benefitting from aggressive monetary ease coupled with a ton of fiscal stimulus like in China. And, in the U.S., too. None of this occurs overnight as there are lags between changes in policy, actual implementation and seen impacts. Finally, we remain optimistic that trade deals will be reached which will be a real boost for global growth bringing a sharp improvement in business confidence that will lead to increased hiring and spending. Right now, we are in a goldilocks environment…. growth has bottomed out, no inflation and ridiculously low interest rates. What’s not to like?

We are therefore not surprised that the global economic stats remain weak. Let’s review what is occurring by region:

1.) Economic stats in the U.S. remain weak: U.S. factory production fell for a second month in a row in February. We continue to believe that the threat of higher tariffs in January and the government shutdown as well as a very harsh winter along with poor seasonal adjustments are all putting downward pressure on recent economic statistics. There was a sharp rebound in retail sales in January off of what we believe was poor data reported for December which even revised lower to a 1.6% drop from the previous month. We don’t hold much credence in these numbers, too, as the key retailers continue to report really strong sales. Yes, autos are weak but not by that much to more than offset strong store and online retail sales.

Inflation data continues to be very tame as we had anticipated months ago when we constantly criticized the Fed for not putting more weight in their decisions to inflation remaining well below their 2% threshold despite falling unemployment. We are not saying that inflation is dead, but we do believe that the confluence of global competition, technology and the rise of disruptors will continue to put downside pressure on inflation keeping it under control. It appears that the Fed finally agrees with our view as it has said as such recently. Their primary objective is to promote sustainable economic growth. Thank heaven!

We continue to believe that the Fed will remain on pause for the rest of the year and will end unwinding its balance sheet in a few months further easing its policy. If there is no trade deal, we would expect the Fed to cut rates within a month or two. Don’t forget that the U.S. will continue to run a huge budget deficit which is stimulative for sure.

And what if there are trade deals as we expect?

2.) China’s Congress ended its annual meeting with Premier Li Keqiang pledging government support of over $300 billion including lower fees, tax cuts and massive infrastructure spending. The VAT will be cut meaningfully for all manufacturers too. All of this is in addition to the huge increase in monetary stimulus including reductions in capital ratios which just had been increased a year ago.

All of this stimulus is in reaction to the sharp deceleration in growth as we had predicted. In fact, industrial output fell to a 17-year low in the first two months of the year. We understand that output numbers may have been overstated in November/December of the last year due to trade concerns making comparisons this year difficult. Unemployment rose to 5.35 in February from 4.9% in December.

Growth in China will improve sequentially benefitting from all of this stimulus but the truth is that China needs a trade deal fast as manufacturers are moving production off shore at an increasing rate which will impede China’s future in a big way if not curtailed.

3.) The ECB has reached out to local governments asking them to “step up their game” as there is not much more that the ECB can do at this point. Economic growth remains anemic and inflation is weak. The OECD has said that the region would be best served by coordinated action involving fiscal support and structural reforms. Unless Europe addresses its structural issues, its future will continue to deteriorate. Sounds just like what we have been saying for well over a year now.

It won’t be easy for Europe to resolve its trade issues with any of its trading partners, including the U.S. and China, as each country has different needs and preferences. Europe is really between a rock and a hard place as change does not come easy. By the way, we expect Brexit to be kicked down the road for another few months.

4.) The Bank of Japan lowered its view of its economy on Friday penalized by weakness in exports and production. No surprise! Japan needs an acceleration in global growth to boost its economy so trade deals are the keys to its success. We now expect Prime Minister Abe to delay a sales tax increase to 10% from 8% which was to take effect in October. Japan’s central bank and the government have their hands tied doing much more to stimulate the domestic economy. It’s all about trade.

Looking beyond the valley reveals that it is clear that China and the United States hold the keys to an acceleration in global growth later this year into 2020. We remain optimistic that global growth has not only stabilized at these levels but will improve in the spring as the full impact of all the additional monetary and fiscal easing finds its way through their economies. Then there are the prospects of trade deals.

We remain hopeful that China and the U.S. will reach a deal over the next few months. Even with a deal, we do not expect all existing tariffs to be removed right away until both sides become convinced that the deal is working. A deal with Japan seems likely to follow the one with China and then there is Europe. It won’t be easy reaching a deal with the Eurozone as there are too many players and one deal is not likely to satisfy all. Notwithstanding, Europe needs a deal and fast. So, time will tell.

The bottom line is that we expect China and the U.S. will be the engines driving global growth. Emerging markets, Europe and Japan will be the byproduct beneficiaries which is why we believe that 2020 will be a much better year economically than 2019. And if the responses to last week’s blog were representative of most investors, there is nothing in the market for an acceleration in growth therefore we are not paying for it today. We like these odds as we hold companies today that will do well without faster growth but would absolutely benefit from stronger growth too.

Our portfolios include drug companies with new product flows; global industrial and capital goods companies with volume growth 1.5+ GNP with rising margins and cash flow; technology at a fair price to growth including semis; low cost industrial commodity companies generating huge free cash flow; cable with content like Comcast and Disney; housing related; domestic steel and many, many special situations where internal actions will close the gap between current and intrinsic price. We are flat the dollar and own no bonds whatsoever.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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