Looking Into the Abyss or Over the Valley

The global financial markets are holding their breath waiting the outcomes of President Xi and Trump’s meeting this week in Buenos Aires on trade followed by the Fed decision on December 19th regarding rates. Uncertainty prevails such that market participants are taking risk off selling stocks and commodities while buying bonds and adding to cash reserves. We clearly remain in a VUCA environment: volatile, uncertainty, complex and ambiguous.

So, how are we to profit longer-term from this environment?

We find ourselves using tried and true theories we have learned over our 45+ years successfully managing money: game theory, George Soros’ (our former partner) theory of reflexivity, systems theory, and Graham and Dodd’s work on financial analysis a la Buffett. We always plan two or three moves down the board but are nimble in the moment as reality/perceptions change.

Our last several blogs have dealt with our views on the global economy, Fed policy, trade and where to invest. Let’s discuss each one briefly once again to provide a basis for how we have evolved/restructured our portfolios including raising a significant amount of cash over the last month. Our core beliefs act as our true north for investing. As facts and our general perceptions have shifted, we made mid-course adjustments to our portfolios recognizing that we live amidst volatility, uncertainty, complexity and ambiguity. We fully recognize that reality of the current environment may differ significantly from general perception.

Let us state unequivocally that the global economy is weakening (including the US) as evidenced by:

  1. A decline in business and consumer confidence
  2. Fears of escalating trade tensions/wars especially between the US and China
  3. Shifts in global supply chains causing near term disruptions along with temporarily higher prices
  4. A fight for global influence between the U.S and China disrupting relationships
  5. A super strong dollar siphoning in funds from abroad pressuring foreign rates
  6. The BOJ and ECB freezing while the Bank of China is aggressively easing raising China’s financial risk
  7. Falling commodity prices, especially oil
  8. Junk bond spreads widening
  9. Capital spending plans being deferred
  10. Fed policy looking in the rear-view mirror threatening higher rates resulting in a flattening and/or even inverted yield curve rather than looking in the windshield at slowing global growth and weakening inflationary pressures
  11. A split Congress resulting in grid lock at best
  12. Political instability in many regions
  13. Brexit final agreement

The truth is that it would not take much to turn this all around shifting the glass from half empty to half full. And it begins this week in Buenos Ares.

We remain hopeful that President Trump and Xi can agree to a trade ceasefire next week postponing additional tariffs. If so, the global financial markets would let out a sigh of relief and rally. We would also expect the dollar to weaken, commodity prices to rise and the yield curve to steepen. If no deal is reached, the financial markets would decline; the dollar would rise; bond yields and commodity prices would fall further at least until the Fed meeting in December. We would fully expect the Fed to hike rates once but then pause pending review of additional data points down the line mentioning that risks to the downside have increased. The financial markets could rally then but not all sectors as market participants still would be concerned about a global slowdown including here in the states.

Interestingly, we still expect the Fed to pause temporarily in December even if a ceasefire were reached with China as global growth and inflation, including here, are clearly slowing. The markets would be relieved by the Fed action but still take a wait-and-see attitude as perception of a slowdown may well outweigh reality until more data points are achieved. Notwithstanding, we would expect a market rally; the dollar would weaken; the yield curve would steepen and commodity prices to rise.

Fourth-quarter and 2019 real growth are now likely to fall below 3.0% until business and consumer confidence improves supported by more certainty over trade, political, financial and tax issues which we fully expect to happen next year. Trade deals with Japan, the Eurozone, Australia and India should be reached by mid 2019 followed by intense negotiations with China on all issues including IP. We would expect a trade deal with China before mid-2020, a Presidential election year.

How are we positioning our portfolio?

We continue to believe that stocks as an asset class are undervalued today utilizing financial analysis valuation a la Graham Dodd/Buffett. We DO NOT expect a recession nor a decline in earnings in 2019. Despite our longer-term optimistic view, we raised cash recognizing that near-term risks have risen; perception of the current/future economic situation is much weaker than what we believe reality will be; and fundamentals analysis/valuation can be over ridden by electronic, systematic trading which takes no prisoners. ETFs’ have grown tremendously as an asset class such that when investors sell them all stocks in that ETF come under pressure without any fundamental/valuation differentiation. Herein lies an tremendous opportunity for an investor with a one to three year time frame.

We have reduced our holding of banks and industrial commodities; added to healthcare, consumer non-durables, airlines, cable with content and special situations including some industrials like DWDP, FMC, HUN and UTX; own technology at a low valuation to growth; and domestic steel and aluminum benefiting from tariffs and we expect a domestic infrastructure bill; and raised our cash reserves meaningfully. We do not expect the yield curve to steepen unless there is a deal with China and the Fed pauses. The dollar would weaken then too. If no deal is reached and the Fed continues its path of higher rates, all bets are off. Financial assets as a class would weaken; the dollar would rise; and bond yields would fall along with commodity prices.

While we are hedging our bets currently, we believe that odds favor a ceasefire with China and the Fed pausing after raising rates in December. The glass would then shift to half full from half empty and perception/reality would close the current gap.

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

Invest Accordingly

Bill Ehrman
Paix et Prospérité LLC

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