Looking Towards 2019

2018 began with a bang with investors optimistic that synchronous global growth would accelerate; inflationary pressures would build, albeit slowly; monetary authorities would become less accommodative, including the Fed; interest rates would be rising with a steepening yield curve; the dollar would be strong; commodity prices would increase; corporate earnings would be sensational, especially in the US due to lower tax rates; and trade tariffs were just talk. It was a time to be risk on.

However, financial markets faltered as the year progressed as the environment shifted and risks rose: financial, economic and political.  

We are finishing the year with an outlook for 2019 that is almost totally opposite from the one we envisaged a year ago. For instance, fears are rising that there may be: a global synchronous slowdown including the US; deflationary fears are rising; the dollar would weaken; industrial commodity prices would weaken further moving below cash costs; monetary authorities, including the Fed, may have to do an about face loosening further including expanding their balance sheets once again; the yield curve would initially flatten and possibly invert before steepening once again; corporate margins and earnings would be declining by year end 2019; trade tariffs would be a fact of life, until not, pressuring business and consumer confidence; and political tensions would rise. Time to be risk off.

Yes, we live in a VUCA (volatile, uncertain, complex, and ambiguous) world. Change is everywhere and perception is not reality. It is our role to anticipate that future and invest accordingly.

As you know, we shifted our view months ago. We became more cautious reducing our equity exposure, significantly lowering our economic sensitivity and increasing the yield on our portfolios above the 10-year treasury rate. While we have outperformed the markets, we got hurt too. Why? Systematic trading takes no prisoners. We agree with our friend Leon Cooperman that the SEC should reinstate the uptick rule.

We continue to anticipate that weakening global growth along with market turmoil will cause the Fed to pause after a December rate hike saying that it will be data dependent regarding future policy changes. We would not expect any additional hikes in 2019 unless trade deals are actually reached with the Eurozone, Japan, Australia and India as well as progress on talks are made with China. If so, the outlook for resuming global growth would improve overnight. Remember that the Fed is tightening just by unwinding its balance sheet which is likely to continue unless the economic outlook for 2019 deteriorates further.

Monetary policy and trade are the pivotal issues facing the markets. It does not help that Brexit is still up in the air; there are problems in Italy, and our President and his administration are constantly on the defensive. Politics in DC are a clear headwind next year.

If trade deals are concluded and the Fed stays on pause, we would expect the global economic, financial and political landscape to improve dramatically as we move through the year. 2019 could end strong for all the right reasons. The truth is that stocks are inexpensive even at these levels, but may get even cheaper due to tax selling and a lack of clarity on what 2019 may bring. We do not expect today’s perception of 2019 to turn into reality if they make the correct moves. If not, we would expect a synchronous downtown later next year with the real threat of global deflation as we have discussed over the last few months. That is not our base case.

How do we navigate through these waters? First of all, we maintain a much higher than normal level of cash and liquidity. Second, we are not trading this market as you are apt to get whipsawed as the news bites change constantly. Third, we are buying companies with superior managements and balance sheets; winning long term strategies that include above average volume growth with pricing power, rising margins, operating income, cash flow, free cash flow and above average dividend yields along with large stock buybacks in place. Fourth, we are buying companies going through internal change to enhance shareholder value.

Patience is a necessity as well as maintaining a level head – never panicking. If Buffett found the third quarter an opportune time to invest billions, we can only imagine what he is doing today.

Remember that the US financial system as well as corporations and households are in great shape. There is no systematic risk lurking out there. Jobs continue to increase along with hourly wages. The US generated over 161,000 new jobs in October with hourly earnings increasing 3.2% over last year. Not bad at all.

We are confident that the Fed will go on hold after December removing one of the largest obstacles facing the financial markets. The fear of the unknown in this VUCA environment is weighing heavily over the marketplaces. But remember that adversity and fear create unusual opportunities for investors willing to look over the valley. 2019 is likely to turn out to be a pleasant surprise after a disappointing 2018.

Our portfolios are concentrated in healthcare; consumer nondurables; cable with content; technology selling at a reasonable multiple to growth; domestic steel; global industrials and capital goods; and many special situations. We are maintaining a high level of liquidity, own no bonds, and are dollar neutral. We suggest reducing real estate and inflated private equity holdings.

We continue to hope that our government can work together for the best interests of the country rather than self-interests. George Bush’s funeral was something to remember. He was a great man and patriot.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

 

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