Low Inflation is Not Transitory

We expect the Fed to make a game-changing announcement within months that their long-held belief that low inflation is transitory has been wrong. Inflation has been running well beneath the Fed’s 2% target for well over 5 years now despite rising employment, a near record low level of unemployment and accelerating nominal wages. We have been commenting for years that low inflation is sustainable due to the competitive effects of globalization, rapid changes in technology, and the incredible birth of disruptors changing the status quo industry by industry. Unfortunately, the Fed has remained dogmatic, looking in the rear-view mirror, expecting the Philips curve to kick in. No way! They just did not get it nor could they see it. Change was everywhere.

Today all one has to do is look at some of the most successful IPOs so far this year: Beyond Meat, Zoom, Pinterest, Lyft and Uber to name a few. Look at CNBC’s 2019 list of 50 of the most important up and coming disruptors. It’s simply amazing and, fortunately for all of us, this is just beginning. Change is still in its infancy! Good for us but not for the established companies unless they invest in their own disruptor like PetSmart who owned Chewy that went public last week.

The implications for long-term investing are huge if low inflation is really here to stay. Just ask Warren Buffett who commented months ago that the stock market would be tremendously undervalued if long rates held beneath 3.2% which was the rate at that time. Well, long rates are hovering around 2.6% today and are even lower abroad. Buffett’s valuation matrix comparing earnings yield to bond yield has only widened favoring stocks over bonds.

We fully understand that our view is in a minority but we are truly looking over the valley as a long-term investor. Change does not come overnight nor is accepted early on but low inflation has been a fact of life for at least 10 years now. Inflation is up 19.5% over the last 10 years and is up only 7.8% over the last 5 years? And there has NOT been a recession during that period of time. Think about it!

Right now, the market is selling at less than 17 times expected earnings. The pundits feel that it fair as the multiple is at the higher end of the historical range but they fail to mention that the historical range for bond yields is 300-400 basis points higher than rates are today. Also, these experts fail to mention that bank capital/liquidity ratios are at or surpassing all-time highs which we use as a proxy for financial risk in the system.

The bottom line is we continue to believe that the market is undervalued for investors. We are cognizant of all the risks, especially escalating trade conflicts. But here, too, we have a slightly different view than the consensus. We already have 25% tariffs on $250 billion of Chinese exports but somehow inflation has not ticked up yet. Maybe part of the reason is the fall in the yuan. Maybe another reason is that manufacturers are eating some of the tariff attempting to keep the business? And finally, maybe the buyers/suppliers have shifted some capacity out of China. Foxconn commented that they have sufficient capacity to supply Apple outside of China to avoid any tariffs. Do you really think China is willing to risk losing 2+ million jobs? That is one of the reasons why we believe that China is at far greater risk if the trade conflicts escalates than the U.S..

Besides escalating trade conflicts, we are aware that many experts are projecting an economic slowdown and possibly even a recession in the U.S. within the next year. We disagree because the U.S. consumer, who is 67% of GNP, will continue to carry the day while the producing side of the economy remains sluggish. Government spending will remain strong too.

Let’s take a look at the most recent data points that either support our view—or not—that the U.S. economy will do just fine; China’s growth will slow but still be the highest of all industrialized countries; Europe is in trouble and Japan will stay stuck in the mud:

1.) Economic stats for the U.S. last week were a mixed bag although we raised to above 2% our forecast for 2nd quarter GNP as consumer demand has finally picked up. Retail sales increased a seasonally adjusted 0.5% in May while April sales were revised  up to a 0.3% increase from a 0.2% decline; industrial production rose 0.4% in May although factory activity fell to 52.1, the lowest reading in 2 years; job opening were a seasonally adjusted 7.4489 million jobs while the number of Americans seeking jobs actually fell to 5.8 million; U.S. business inventories actually rose 0.4% in May, excluding autos, while sales fell slightly; and, finally, small business optimism rose to a seven month high.

The key economic stats for the week were consumer prices rose only 0.1% in May and are up 1.8% year over year; the producer price index advanced 0.2% in May and are up 1.8% from a year ago, including energy; and finally, the all-important PCE is up 1.6% from a year ago. All of these numbers remain below the Fed targets and include tariffs on Chinese imports.

While we do NOT expect the Fed to lower rates next week at their meeting, we expect them to hint at a rate reduction in the near future especially if there is no trade deal forthcoming with China. Notwithstanding, we believe that the Fed should lower rates as inflation is too low. The Fed will lower rates even more than we currently envision if the economy does slow more than we expect but that is not our base case as the consumer is just too strong. Remember that Trump will do all in his power to boost the economy and stock market as we enter 2020 to bolster his re-election chances.

2.) China’s economy has continued to weaken: industrial production rose only 5.0% from a year ago while fixed investment increased only 5.6% in the first five months of the year. On the other hand, retail sales rose 8.6% in May supported by a longer May Day holiday. China’s imports actually fell 8.5% from a year ago signaling real domestic weakness. As expected, the government announced additional support for local governments and financial institutions to use “special bonds and other market-based financing methods to support key areas and major projects.”

If the trade conflict with the U.S. continues to escalate, we believe that China’s economy will suffer more than most currently expect. If there are tariffs on all $550 billion of Chinese exports, all of the suppliers will be hit, too, compounding the problem. China does not want to lose business to other regions as they will never get it back.

We still expect Presidents Trump and Xi to reach a ceasefire when they meet later this month. If not, China’s economy will suffer far more than here. By the way, China has just gotten a black eye from the protestors in Hong Kong winning a stay on extradition.

3.) Europe’s economy is in trouble. Look no further than the rising recession risks in Germany. All of the key indices of Germany’s economy have turned negative. German rates have moved further into negative territory too. It certainly does not help that Trump and Merkel are fighting over the proposed natural gas pipeline from Russia. Could Trump impose tariffs against German car exports as punishment? Yep!

We remain very negative about the Eurozone. Chances of a hard Brexit are rising too. And we really doubt that Europe will let U.S. agriculture in jeopardizing any chance of a trade deal.

4.) Japan will continue to stumble along hoping that the U.S. and China make a deal opening up global trade. While we continue to expect Japan and the U.S. to reach a trade deal before the end of the summer, it won’t unfortunately move the need for either economy.

There’s no place like home—or would you rather invest in China, Europe, Japan and/or the Emerging markets today? Not us, especially if the U.S. and China do not reach a ceasefire/trade deal. The bottom line is that the U.S. economy is doing just fine and we are on the cusp of the Fed lowering rates and stopping the bond run-off. What more can the Bank of China, BOJ and ECB do at this stage? Not much. The Fed is the only game in town and our markets will benefit.

In addition, we believe that the U.S. economy is in fine shape and has the least risk to escalating trade tensions globally. If/when the Fed lowers rates, which we expect in July unless there is a trade deal with China, the yield curve will steepen and the dollar weaken.  We would not be surprised to see traders anticipate both moves prior to the actual event.

We have structured a win/win portfolio owning only the strongest companies with the very best managements. We suggest that you listen to as many earnings calls as possible as you learn so much. For instance, we were on the Broadcom call last week. Broadcom is a great company but unfortunately has around 5% of its sales with Huawei which are now suspended due to Trump. What if Trump lifts that ban as part of a deal with China? Could happen. We do not own Broadcom; but we do have exposure to the semi area owning the technological leader, AMD, that will gain market shares for many years to come. We have written calls against the position too.

We have not changed our net exposure over the last week. Our portfolios continue to emphasize healthcare, consumer spending, technology, cable with content, housing related, some low-cost industrial commodity companies, capital goods and industrials and many special situations. The common thread throughout the portfolios is that we own best in breed with very strong financials, market dominant, rising earnings, positive free cash flow, dividend yields above the 30-year bond and large stock buybacks.  We have sold 2-3 month calls against a good portion of our portfolio affording us 8% upside, excluding dividends, and 9% downside protection. While we do not own bonds and are flat the dollar, we expect the yield curve to steepen and the dollar to fall when/if trade deals are reached and/or the Fed begins lowering rates.

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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