King Dollar

To paraphrase Larry Kudlow, Director of Trump’s National Economic Council, “A strong dollar connotes a strong economy”. Unfortunately, cracks in the global economy are appearing.

Our Fed has begun a path toward normalization pushing up the Federal Funds rate as domestic growth has accelerated with strong gains expected for the rest of the year and 2019, too. On the other hand, short rates overseas remain absurdly low despite capital outflows due to economic weakness and persistent low inflation. The net result has been outsized weakness in the Chinese Yuan, the Russian ruble, the Turkish lira and, to lesser degrees, the European euro and Japanese yen.

While a strong dollar has positive ramifications for the US, up to a point, it has many negative implications for foreigners, whether it be governments, corporations or individuals, who own dollar denominated debt, as it raises the cost to carry while penalizing cash flow and increasing inflationary pressures. Don’t forget that oil is paid in dollars hurting the consumer and foreign corporate operating margins. Not good.

Trade concerns as well as existing trade tariffs are disrupting global growth as corporations are shifting trade flows while postponing some capital spending and hiring until there is more clarity on potential trade deals. While many pundits dismissed Trump’s claim that the US has nothing to lose and the most to gain by changes in trade flows, he appears to be right. If the financial markets are supposed to be predictors of future events, just look at the US markets and compare its performance to almost any other market.  For instance, look at the decline in Chinese markets.

The Chinese government continues to claim that Trump’s actions will not hurt its economy. If that was true, then why did the government reverse its monetary policy adding billions of new liquidity, lowered lending guidelines and eased capital rules? The government can only do so much to limit capital outflows and stabilize its falling currencies. Billions have been spent so far without much success as the Yuan continues to fall.

Russia and Turkey are separate stories but with similar problems. Clearly both governments and financial bodies will next raise rates sharply to curb capital outflows; but here again, it won’t stop currency flights to safety. Higher rates will only hurt growth putting both countries further behind the eight ball. There are really no good alternatives as both countries are burdened with excessive debt and weak financial systems. Russia, at least, has oil, but production but is running near full out already. And Turkey provides bases for our Air Force which presents a whole set of political issues for our government. Clearly Europe is at greater financial risk to problems in Russia and Turkey than the United States.

All of these countries, including the ECB and Japan, rely on exports for economic growth much more than the US. For example, Germany’s economy is sputtering as its export engine is slowing rapidly. Would you be building new capacity in Germany right now or wait until there was more clarity on trade deals and possible tariffs? What if talks between the US and Europe fail? Growth in domestic consumption can only go so far in offsetting lower exports in these countries. The ECB needs a deal—and fast! So does everyone else. So don’t believe the bluster coming out of foreign governments that they can withstand trade skirmishes. It hurts them all.

As we look over the valley, we are confident that trade deals will be reached as all understand both the benefits and downside if not enacted. Don’t believe that anyone can be an island unto itself and immune to trade conflicts. Notwithstanding, the US is best positioned to maintain reasonable growth as Trump’s pro-growth agenda offsets higher tariffs and shifts in trade flows. Unfortunately change is not easy especially if you are the beneficiary of antiquated trade rules and an ineffective WTO. It s clear that trade flows will shift, tariffs and subsides will come down, IP will be better protected, new winners and losers will emerge, and global trade and economic growth will re-accelerate after new trade deals are reached.

While we see continued economic slowdown abroad for the rest of the year, we do not foresee anything near a recession. After all, monetary policy remains overly accommodative including in China; employment and wages continue to grow bolstering consumer spending; and governments are increasing their expenditures. Remember that trade is a zero sum game. For example, there are only so many soybeans harvested in a season and Brazil is unable to fully offset US shipments. If Brazil diverts exports to China, then the US will fill that gap elsewhere. Bottom line is that the US will find markets for all of its soybeans. The real question is at what price.

As we said earlier, corporations are already shifting their trade patterns to reduce/eliminate expected tariffs. China is a clear loser and the government knows it. Do you really expect China to penalize Apple products when Apple employs thousands of Chinese? Same could be said for many other US companies like Starbucks. Don’t believe the bravado that you may hear from the Chinese government and media.

While we expect a slowdown in foreign growth for the remainder of the year, the US will stand out with economic growth averaging 3% for the next six months. We do expect positive movement on trade deals to continue starting with Mexico followed by deals with Canada and Japan. After elections, we would expect the US to announce deals with the Eurozone and finally China.

The bottom line is that global economic growth will accelerate as we move through 2019 into 2020. We realize that this is a minority view. We hedge our bets by only owning the strongest companies with excellent managements; win/win strategies to grow regardless of the global competitive landscape; excellent financials with huge positive cash flow which is first invested in the businesses to further improve their competitive positions then used to enhance shareholder value; and finally selling at a reasonable price to growth. We expect US corporations to buyback over $1 trillion in stock this year followed by another near record amount next year. At the same time we expect dividend growth to be over 8% each year.

We continue to emphasize large US banks that will continue to gain global market share; global industrials and capital goods companies as new plants are built, especially domestically, as trade flows shift and operating costs are reduced to improve their competitive position; technology at a fair price to growth; industrial commodity companies including domestic steel and aluminum as their capital spending is restrained resulting in higher utilization rates and prices in 2019 and much higher free cash flow than normal for this stage in an economic cycle; some healthcare and consumer stocks as a hedge against a second half 2018 slowdown and, finally, many special situations where internal changes will create substantial added shareholder value. We remain long the dollar and short long-term bonds expecting the yield curve to steepen over the next eighteen months.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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