“We’re Just Getting Started”

Gary Cohn, President Trump’s Head of the National Economic Council and former Vice Chairman of Goldman Sachs, stated those words after the February employment report was released on Friday. It wasn’t that just 235,000 jobs were created with wages rising 2.8% year over year; it was the composition of growth that mattered most as it was skewed to construction and manufacturing rather than services and retail. If “Make America Great Again’ and “America First” become even partial realities, then the path to profitable investing is clear.

Let’s begin by reiterating that global interest rates have bottomed as global growth and inflation are rising. Even Mario Draghi admitted Thursday after the ECB meeting that growth and inflation are both running above their forecasts. The ECB did not adjust either its rate levels or monthly purchases of debt. Clearly the ECB is willing to remain one step behind so the yield curves will continue to steepen. Interestingly, German rates have been held down as a safe heaven with elections soon in France and the Netherlands. The Eurozone remains until attack from within. Germany has been the clear winner of a weak Euro. Have you seen their most recent trade surplus? Will there be another Brexit?  I think so!

Next up is our Fed. It’s a virtual certainty that the Fed will raise rates next week but the devil will be in their commentary. Their conundrum is not knowing the specifics of Trump’s fiscal agenda. They are unwilling to speculate so the Fed will remain one step behind too. Expect our yield curve to continue to steepen at least out 10 years after which it may flatten so be careful.

While it is clear that we are living in an environment of rising interest rates, it is just as clear that earnings are increasing too even before any tax change that may take place as Trump wants. The key is to find companies with earnings growth in excess of the decline in market multiple, which is the reciprocal of forecasted interest rates plus some risk factor. I am currently forecasting the 10-year bond nearing 3.10% in a year plus a 2.25% risk factor as liquidity and capital ratios are high by historic standards. That all translates into an 18.5 multiple for the U.S. market.

When evaluating S & P earnings forecasts, you have to assign some probability to a tax cut effective this year or next. Personally I am not expecting passage of tax legislation until the fall of this year. Whether is will be retroactive for all of 2017 or not does not matter that much as long as it happens. I am building it into my forecast for 2018 to be safe with a statutory rate around 18% down from 28% today. The boost to S & P earnings would be approximately 14% from base levels. S & P earnings forecasts are close to $130 p/share over the next year WITHOUT the tax cut yielding a market target of $2400 which is basically where we are today.

So what’s up? First, we are not factoring in tax cuts nor the benefits to growth from added stimulus, a sharp boost in infrastructure spending, repatriation of foreign earnings and a shift in trade policy. Secondly we don’t buy the market, we buy stocks. Yesterday’s winners will be tomorrow’s losers and visa versa. We have been surprised that the market has basically lifted all boats since the Trump victory but that will change as his programs are passed so we can fully factor them into our earnings forecasts for the next several years. Remember that stock valuation is discounted cash flow of future earnings. Look through that windshield!

I want to comment on the decline of energy prices this past week. While OPEC and some non-OPEC members have stuck to their agreement to reduce production by approximately 2.0 million barrels/day, U.S. shale producers have ramped up quickly therefore inventory levels have not declined as expected so prices have fallen below $50/barrel. We always said that oil prices would be capped around $55/barrel, as U.S. shale production would start to become economic once again. But ramping up so fast has been a surprise to the markets. I hope that there is a lesson here for all commodity producers who have gone through a horrific down cycle… stay disciplined!!

I want to go back to Gary Cohn for a moment. He emphasized that meetings were held this week with major corporate executives on a massive infrastructure program approximating one trillion dollars that will be financed publicly and privately even with 50 or 100 year bonds. Both Democrats and Republicans support a huge infrastructure program so you should factor it into your equation for industry and company selection. Since “America First” is a key part of Trump’s agenda, emphasize domestic construction, capital goods and commodity companies, eg. steel, who benefit from this trend, when investing. If the company is a large domestic taxpayer too like Nucor Steel then that is even better.

Since we expect the yield curve to continue to steepen, financials should remain a major percentage of your portfolio. We have owned banks for a year now as win/win/win investments as earnings, book value and dividends were rising even without a steepening yield curve and would only get better in an environment such as this. Many of the major banks still sell at a discount to tangible book beneath a market multiple and remain in our portfolio today.

Corporations continue to change adjusting to a global competitive environment and the need to be the best in class. M & A activity will continue strong as the synergies and low cost of financing make deals good for both the buyer and the seller. Take a look at Dow/DuPont proposed merger to glean the rationale for merging and then separating into distinct separate businesses. Others will use that model too as the sum of the parts far exceed the whole. Huntsman is another case in point splitting into two public companies to create value similar to what Alcoa did splitting into two public entities too. The value of the combined entities rose over 30% since the split. We own them all.

The trade policy of the Trump administration will have far reaching impact on a number of industries. First off, dumping cases will be handled very quickly benefiting domestic producers such as in the steel and aluminum industries. “Buy American” will benefit them too. Secondly, there is likely to be some form of a border tax to pay for the individual and corporate tax reduction. While I am not sure of its final form, I will refrain from investing in industries that will be clear losers under that scenario. Retail comes to mind first. It does not help that Amazon has disrupted the box retailer forever.

Finally there will be clear winners and losers when the  “American Healthcare Reform Act “ replaces Obamacare. Some of the insurance companies stand to benefit from this program while hospitals stand to lose. Also, I would continue to avoid old pharma as drug prices will clearly be under close scrutiny of this administration.

The bottom line is that the reflation trend and trade are alive and well. Global growth along with inflation are picking up, which will benefit corporate earnings. Even China’s economy, which has investors concerned, will get a boost from acceleration in global growth. Notwithstanding opportunities abroad, we continue to emphasize investing in America, as the wind is to your back here for so many reasons all revolving around Trump and his policies. Again it is not if his agenda will be passed but when. Buy the reflation beneficiaries whose earnings growth are about to accelerate for several years to come and sell/short the past winners where earnings growth may not be enough to offset the multiple decline as interest rates rise. Active management should clearly outperform passive management over the next several years.

Remember to review all the facts; pause, reflect and consider mindset shifts; review your asset allocation and risk controls; do in-depth independent research and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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