Let’s Make a Deal

My comments last week that Trump apparently had learned from his past mistakes on healthcare reform and has decided to reach out and work with the Democrats on DACA, tax reform and his infrastructure programs were controversial to say the least but now appear on the mark. Smart move by Trump as it looked too difficult to pass anything through Congress with lines drawn in the sand between both parties. The truth is that the Democrats have no agenda and need to latch on and be part of any agenda that will help Americans, especially the middle class, while the ultra right conservative Republicans have nowhere else to go really unless they want to go into the 2018 election as the real obstructionists to “Make America Great Again”. The financial markets were not blind to this shift in DC as stocks rose and bonds fell for the week. We will discuss later the longer term implications of passage of these bills on the economy and financial markets but you can guess that our conclusion will be another leg up for the stock market, a stronger dollar and lower bond prices but not all stocks will not participate equally.

Paix et Prospérité had another outstanding week outperforming all indices. It was interesting to listen to the pundits speaking at the “Delivering Alpha Conference.” You had government officials discussing tax reform and market professionals discussing the financial markets and their own book. Most of the investment professionals felt that the markets were too rich but here again, it was based on the historical range of market multiples. By that measure they would be correct but that is looking through the rear view mirror. Our success is looking through the windshield and over the valley. We see market multiples rising above historic ranges as interest rates and inflation are much lower than the norm at this stage in an economic cycle while the risk factor has declined too as bank capital and liquidity ratios are well above historic norms. If the “real” corporate tax rate declines to say 20%, which we still see as most likely case, now from a “real” rate close to 28% today, S & P earnings are boosted 11% overnight with improvements to cash flow and free cash flow too. Then there is the prospect of a tax holiday on repatriation of foreign cash. That number is close to $3.5 trillion today and growing. Pretty powerful stuff and enough to fuel another leg up for sure. None of this really factored into the markets yet.

Let’s take a look of events around the world and whether they support or detract from our current investment thesis:

1.) Economic statistics reported in the U.S. were a mixed bag last week as the negative effects of Hurricane Harvey were beginning to be felt with Irma’s impact on the horizon for September: U.S. consumer comfort fell to 51.9, a five-week low as both the buying climate and gauge of views of the economy were impacted by the hurricane; the PPI for August rose 0.2%, core by 0.1%, boosted by higher fuel prices also impacted by the hurricane; the CPI rose 0.4% in August but only 0.2% excluding food and energy; industrial output was also impacted by the hurricanes and fell 0.9% in August; retail sales fell 0.2% in August but rose 0.2% excluding autos; job opening climbed to a record 6.17 million in July while hiring increased and layoffs fell in the month; consumer sentiment fell to 95.3 in September impacted by both hurricanes; and finally the Atlanta Fed lowered its third-quarter GNP growth estimate to 2.2% with further decreases expected as the full impact of Irma is reflected in the forecasts too. On the other hand, U.S. income levels rose to a record in 2016 led by above average gains for black and Hispanic families. There was also a decline in the poverty rate to 12.7% from 13.5% a year previous.

We expect third-quarter GNP, impacted by both hurricanes, to come in close to or slightly below 2%. We do anticipate a slight improvement in fourth-quarter growth but still penalized by both hurricanes. But then we expect the rebuilding process to add to growth next year and beyond. In addition, we must start thinking about the positive impact on our economy as parts of Trump’s agenda are passed. Positive for sure!

2.) We expect growth in the Eurozone to be penalized for the rest of the year by the strength in the euro hurting exports. However, consumer demand will benefit from the surprising strength in wages, which rose a strong 2% in the second quarter over the prior year boosting the wage gain forecast in 2017 to 1.5%, 2% in 2018 and 2.3% in 2019. Industrial production was up 0.1% for July and 3.2% year over year slightly below earlier forecasts. The ECB has a major policy dilemma this fall as growth remains well above target levels but inflation is well beneath them while the Euro remains super strong putting further downward pressure on inflation. We expect Draghi to fool the markets and stay one step behind maintaining an overly easy policy until inflationary pressures begin rising to the 2% level. The key may be whether Trump can pass his pro growth agenda, which will boost the dollar relative to the euro and yen, which will make Draghi’s job easier. Finally, it appears that Merkel will win the election in Germany quite easily. A non-event.

By the way, Brexit has finally bitten the British economy. The BOE’s real conundrum is growth falling while inflationary pressures are rising. Will the BOE raise rates soon? Most likely, further exacerbating their problems.

3.) China is in fine shape as it transitions its economic growth away from production/exports to domestic consumption. Wages are rising, growth is strong and consumer/household sentiment is at a two-decade high. GDP rose 6.9% in the first half of 2017 with per capita disposable income rising 7.3%. Exports are growing, imports more, and factory output rose 6.0% in August while investment increased 7.8%. Some found those numbers disappointing but what other country would not die for them. Watch closely as to what is said at the Community Party Congress meeting on October 18th! We look for very positive comments on the country’s long term growth plans which will include cutting back on pollution, reducing zombie industries, increasing regulatory reform and higher bank standards. Expect a huge decrease in domestic steel production/capacity over the next five years and aluminum too. Long-term growth is expected to exceed 6% for the foreseeable future. Don’t cry for China!

Let’s wrap this up!

The big surprise has been Trump reaching across the aisle to the Democratic leadership in both the Senate and House and the willing acceptance back by the Democrats to participate with him in immigration reform, tax relief and a huge infrastructure rebuilding program made even more important/relevant by the hundreds of billions in damage caused by hurricanes Harvey and Irma. Now is time again to look through the windshield as to the positive impact of these policy changes and rebuilding Texas and Florida will have on U.S. domestic growth next year beyond the near-term disruptions caused by both hurricanes.

The path of least resistance for stocks remains up to the chagrin of all the pundits out there who continue to look through the rear-view mirror; the yield curve will steepen as the Fed remains on hold assessing the impact of the hurricanes on growth; the dollar will strengthen as it appears that Trump’s pro-growth agenda has a real chance of passage now and industrial commodity prices will continue to increase as demand continues to surprise on the upside while production growth is more limited by a lack of capital spending over the last few years along with production cutbacks in China beginning this fall.

We continue to concentrate our portfolios on the strongest money center banks; the U.S. domiciled global multinational industrial companies; technology at a fair price; special one off situations where internal change will lead to multiple revaluation over time and low cost industrial commodity companies including domestic steel and aluminum who will benefit from major cutbacks in Chinese capacity over the next few years. Have you noticed the performance of Dow/DuPont since the merger closed August 31st? More to come! Our portfolio is full of these types of investments providing us multiple ways to win.

Review the facts, pause, reflect, consider mindset shifts, adjust your capital allocation and risk controls as needed, do independent fundamental research and …

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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