Midcourse Adjustments

It behooves you when living in a VUCA (volatile, uncertain, complex and ambiguous) environment to be open-minded and make midcourse adjustments while not altering your long-term view unless needed. You need to keep one eye on the present while planning two or three moves ahead, much like chess.

We want to reiterate that we do not believe that inflation will be a problem today or tomorrow. Global competitive forces, rapid changes in technology and the rise of disruptors will keep a lid on inflationary pressures especially in those countries with strong currencies like the US. Trump’s agenda of tax reform permitting full write-offs of capital spending, regulatory relief, and trade policy will lead to an acceleration in domestic productivity gains for years to come offsetting higher hourly wages. We recognize that trade tariffs will boost prices near term, but it will only be transitory as supply chains are shifted to non-tariff, low cost producing countries. Finally, energy independence is a big long-term plus, too. Did you know that we import less than 700,000 barrels per day from Saudi Arabia today down from a peak of 2 million per day and have a domestic oil stock pile of 680 million barrels as of July 1, 2018 to offset any supply disruptions?

The financial markets are preoccupied that the Fed will move too quickly and too far raising short-term rates fearing sustained inflation above 2%, effectively slowing the economy and possibly causing a recession. Every day we hear the market pundits tell us that they now expect the Fed to take the punchbowl away causing the next downturn by the end of 2019. We disagree but are humble and nimble enough to have made some midcourse adjustments to our portfolios over the last few weeks to ride the current wave shifting to stable above average growers like healthcare. We are still maintaining exposure to those companies that will benefit from sustained economic expansion well into 2020 which remains our base case. We have done this many time before. It is win/win approach as our portfolios will benefit and outperform no matter which scenario transpires.

We fully recognize that there are many events that could shift market psychology back to where it was before Powell’s speech a few weeks ago. We really think that he misspoke when he mentioned that rates were far from neutrality. Let’s state unequivocally that growth is good, especially if inflation stays controlled as is our base case. While all monetary bodies want to revert back toward normalization, their biggest fear remains deflation, so we continue to believe that all of them will stay one step behind permitting higher growth and acting only if/when inflationary pressures are clear cut and long lasting.

The US economy remains the engine of global growth. Growth is a good thing especially if it does not unleash inflationary pressures. We have not altered our view that third and fourth quarter real GNP growth will begin with a 3. We see no reason at this time to change our view that 2019 will be a very good year too with real growth exceeding 2.6%. Will growth decelerate as we move through the year? Absolutely as fiscal and monetary stimulus ebbs, but that is to be expected. Powell is smart enough to know that Fed policy must remain accommodative/supportive of continued growth as the alternative has far more risks. The Fed is likely to raise rates once more this year and no more than 2 times, if that, in 2019. We expect continued growth in 2020 too, which remains our base case.

Business and consumer confidence have been shaken overseas by trade concerns since exports are a far larger component of GNP in China, Europe and Japan. Have you noticed the weakness in industrial production in those regions? Just look at China’s third-quarter GNP report as it says it all. Third-world countries and markets have taken it in the chin too not only due to trade concerns but also by the strength in the dollar since so much debt is dollar denominated

Do you believe that Powell is oblivious to all of this? Even though monetary bodies say that they are focused only on their own economies, we believe that they all speak and work together. No country can remain an island unto itself without influencing the global economy. If our Fed truly slows our economy too much, the repercussions to overseas economies are enormous. Now do you see why deflation remains the number one fear globally. Powell gets it!

Growth is good and is a necessity especially if it does not unleash unbridled inflation.

The market’s biggest concern today is that the Fed believes that inflation will become the problem and that rates are far from neutrality to rein it in. After all that is what Powell said. The general belief is that the Fed will raise rates once more this year and four more times in 2019. If so, the economy will rapidly decelerate through 2019 and enter a recession in 2020. We disagree! We expect the economy to continue at a decelerating rate and that inflation will stay contained around 2%.

Trade remains at the forefront as a major potential problem too. Trump alerted Congress this week that his administration will enter trade talks with the ECB and Japan within 90 days per law. We remain confident that deals will be made along the lines of the ones made with Canada and Mexico. While we DO NOT expect a deal with China until those deals are completed, we would not be surprised if Trump and Xi pulled a rabbit out of the hat when they meet but that is not our base case. It is clearer each day that China needs a trade deal far more than the US. Corporations are moving as fast as humanly possible to shift their supply chains away from China. China 2025 is at risk!

Let’s wrap this up.

Will the Fed continue to raise rates such that it precipitates the next recession? Weakness has already appeared in autos and housing, the most interest rate sensitive parts of our economy; but that is to be expected. It is just as clear after listening to the most recent earnings conference calls, that the overall economy is doing better than fine. Unfortunately, the glass will remain half empty until we hear again from Powell and he clarifies his most recent statement. It would also help to see further gains in productivity which will calm investors’ fears too about potentially higher inflation.

We are focused on the upcoming elections too. Our base case remains that the Republicans keep the Senate but lose control of the House. While stalemate is not a bad thing, it is possible that a Democratic-controlled House makes noises about impeachment proceeding. While it won’t go far, it could rattle the financial markets.

The bottom line is that the US economy is doing just fine. We expect quarterly economic growth to decelerate but remain above long-term trends for the next 6 quarters. Listening to all of the earnings conference calls give us confidence that corporations are managing their businesses well; backlogs are still rising; there are some cost pressures which are manageable; and that earnings and cash flow will continue to increase above trend. We are still estimating S & P earnings near $155/share in 2018 and $170/share in 2019. Our stock market is undervalued with the 10-year Treasury hanging around 3.2%.

The real quandary facing the market is whether the Fed will take the punch bowl away and precipitate the next recession by 2020? As long as this question is at the forefront of investors’ concern we made midcourse adjustments over the last few weeks to our portfolio significantly increasing our exposures to pure growth companies with little or no economic sensitivity and reduced some of our exposure to the most economically sensitive areas of the market.

We want to make a comment about domestic aluminum and steel. The US has insufficient domestic capacity today even if aggregate demand plateaus. Steel imports due to tariffs could fall by over 10 million tons if we had the domestic capacity to handle it. That is why domestic producers are raising capital spending. There will not be domestic overcapacity in this and also in the domestic aluminum industry for many years to come as imports decline even if overall demand peaks. We own Alcoa and Nucor, best in class. Both stocks reported better than expected earnings and are ridiculously cheap but the market is not differentiating them from other cyclicals although their outlook won’t be hurt by a slowdown as their capacity utilization rise regardless. Both companies have announced stock buybacks out of their rising free cash flow. Patience will be rewarded over time but maybe not today.

Finally, we are optimistic that trade deals will be reached with the Eurozone and Japan. If and when that occurs, economic growth will reaccelerate in those regions. We are not concerned about Brexit and Italy as deals will be reached in our opinion as the downside, if not, could further destabilize the European markets. Expect the BOJ and ECB to remain overly accommodative as long as risks remain to the downside. China’s central bank will pull all the strings needed to stimulate their domestic economy further weakening their financial system which is a concern.

Our portfolios continue to own the largest and strongest US domiciled global banks; capital goods and industrials; technology at a fair price to growth; healthcare; cable and entertainment; domestic steel and aluminum; and special situations where internal developments will enhance shareholder value. We do not own bonds and are flat the dollar.

Remember to review all the facts; pause, reflect and consider mindset changes; see the need to adjust your asset mix and risk controls; do in-depth first hand research and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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