Money Makes the World Go ‘Round
Monetary authorities, fearing deflation, have now committed to go all-in to stimulate economic growth. Our first rule of investing is to analyze whether more money is being created by the monetary authorities than is needed by the real economy. If so, the wind is to our back as the excess capital finds its way into financial assets. Risk on! If not, there is financial tightening and money moves out of risk assets. Risk off!
We had a water shed event last week when the Fed declared war against any further economic weakness, removed the word “patient” from their vocabulary, and stopped saying that low inflation was transitory. The Fed clearly is finally factoring in the global economy, the strength of the dollar and trade issues into its view. While we recognize that the U.S. economy remains in fine shape, we still believe that the Fed should cut rates in July regardless of what happens next week when Presidents Trump and Xi meet as inflation has remained well below the Fed target of 2% for too long. We believe that low inflation is NOT transitory due to global competitiveness, technology and the rapid rise of disruptors industry by industry.
All financial markets rose last week after the actions of the Fed, ECB, BOJ, Bank of England and Reserve Bank of Australia. Risk on! While we are fully cognizant of the magnitude of the rise in our market so far this year, we still find it undervalued for investors with a longer-term time horizon. We do not believe that the market multiple should be around 17 times prospective 2019 earnings with 10-year treasury bond yields so low. In fact, the market would be undervalued even if yields were closer to 3%. Look at the results of the most recent banks’ stress test. Even under the most draconian economic circumstances, all of the largest banks’ capital/liquidity ratios improved from the last stress test, remaining well above required levels. Clearly financial/systematic risk is down too. The combination of long-term interest rates 300-400 percent below historic levels and bank capital/liquidity ratios at all-time highs should translate into a market multiple well above the historic range of 15-20 times earnings. Right? But the market is selling at 17+ times prospective earnings. What are we missing or does change of this magnitude take time to be factored into valuations as investors look in the rearview mirror? The bottom line is that the market multiple should move higher over time if interest rates/inflation remain low and bank capital/liquidity ratios remain high. Our success over 45+ years has depended on correctly assessing change and investing accordingly. So far, so good!
We are fully cognizant that all markets could have a hiccup if Presidents Trump and Xi do not reach a ceasefire when they meet to discuss trade at the G-20 summit next week in Japan. But any correction will most likely be short-lived, at least here, as we would expect the Fed and all the other monetary bodies to begin easing almost immediately to offset any global economic impact. We continue to believe that the economic impact to the U.S. will be much less than generally believed as the added tariffs would be either eaten by the Chinese supplier and/or some of the production would be quickly shifted out of China to non-tariff regions. In the end, we still believe that a hike in tariffs will be deflationary as production leaves China to lower-cost, non-tariff countries. Dozens of companies have already moved or are in the process of leaving China. That is why we believe that China is at far most risk of higher tariffs than the United States.
Let’s take a look of the key data points from last week that support or detract from our view that the key monetary bodies are ready, willing and are about to begin another round of significant easing to stem further economic weakness along with fears of rising deflationary pressures:
1.) The Fed had a watershed moment last week as they decided to leave rates unchanged for now but are willing to begin cutting rates immediately if the economic environment does not improve soon. The Fed is no longer feeling patient and is focused on trade issues, a slowing economy both here and abroad, low inflation, the strength of the dollar and an inverted yield curve. It was interesting to hear that the Fed is no longer worried that low unemployment will unleash inflationary pressures. We expect at least one Fed rate reduction and possibly two between now and year end even if there is a trade deal. On the other hand, we don’t believe that the Fed will take any further action in 2020, a Presidential election year, unless the economy weakens materially.
The U.S. economy has continued to slow moderately as evidenced by HIS Markit Composite PMI of 50.6 in May, a 40- month low; the flash Services Business Activity Index of 50.7, also a 40-month low; the flash Manufacturing PMI at5 50.1, a 117-month low; the flash Manufacturing Output Index at 50.2, a 37-month low; leading indicators were flat in May suggesting slower growth ahead; housing starts declined in May 0.9% while home sales actually rose 2.5% due to lower mortgage rates as interest rates continued to decline.
We continue to expect second quarter GNP to grow around 2.25% led entirely by the consumer as industrial weakness persists. Consumer and business psychology should benefit from the apparent shift in Fed policy. Low interest rates are good for everyone but retirees who live on a fixed income.
We continue to expect Trump to do whatever he can to stimulate economic growth in 2020 to benefit his election run. And we expect the Fed to stay out of his way.
2.) China’s economy will clearly be tested if the trade conflict with the United States escalates. Notwithstanding, corporations are already reviewing their supply chains reducing their dependence on China. We fully expect the government to do all in its power to stimulate domestic demand, lower rates, and shift exports to other countries. Unfortunately, we doubt that exports to the U.S. can be fully offset by these moves. Even if Foxconn moves only half of Apple’s production out of China that will still add up to over 1 million job losses excluding the multiplier impact of the suppliers.
While we believe that Presidents Xi and Trump will reach a temporary ceasefire next week, we are less confident that an ultimate deal will be reached protecting IP. Just look at the U.S. action last week against 5 additional Chinese tech companies.
3.) Our outlook for the ECB remains poor at best. Solving trade conflicts will not be the panacea for what ills the ECB. The region better start making changes to its fiscal, financial and regulatory policies. Trade, too! You need not look any further than the massive problems in Italy, Spain and France. Governments in each of these countries are unable to enact needed changes to policies as Germany just won’t permit it.
While ECB Bank President Draghi promised fresh stimulus as soon as July, there really isn’t much left for them to do. How negative do rates need to go before they stimulate growth? It does not help that Trump is complaining that the ECB is using extraordinarily low rates to weaken the Euro penalizing U.S. exports to the region.
4.) The outlook for Japan has continued to weaken too: the flash Manufactures’ PMI fell to 49.5 in June; new orders declined at the fastest rate in 3 years; backlogs fell to the lowest level in 6 years and core consumer prices rose 0.8% in May, including much higher energy costs, from a year ago.
While the Bank of Japan is hinting at further easing moves, there are few bullets left in their gun to do anything more. The country’s extraordinarily high ratio of debt to GNP limits the government’s ability for additional fiscal stimulus. Clearly the proposed hike in retail taxes should be postponed.
There is no place like home. We are confident that the Fed will act soon to sustain our economic growth no matter what the circumstances may be. While we do NOT expect a trade deal in the foreseeable future with China, we do expect both leaders to kick the can down the road a little while longer. We fully recognize that Trump needs to do whatever he can to sustain the U.S. economy through elections in 2020 but he also must appeal to his constituency which likes his hard line on trade. It is clear that Trump’s chances would be hurt more by economic weakness than a relatively weak deal with China.
The bottom line is that all of the monetary authorities are willing to step up to the plate adding additional monetary stimulus to their economy trying to boost economic growth along with higher inflation. Far more capital will be provided by these measures than is needed by the real economy at this time which means that it will boost the value of financial assets. Risk on!
The Fed has the most room to lower rates to stimulate growth as the Federal funds rate is 2.25-2.50% compared to a comparable rate in the Eurozone at -0.4%; in Japan at -0.1%, in the United Kingdom at 0.75% and in Australia at 1.25%. In addition, the Fed can stop the run off of its balance sheet.
Fortunately, we were looking through the windshield over the valley and structured our portfolios anticipating all of these moves. In addition, we have moved our covered calls higher as the markets have risen maintaining additional upside with dividends while protecting the downside just in case Presidents Trump and Xi cannot reach a ceasefire on additional trade tariffs next week.
We will always own the best in breed companies that will thrive in any environment. The common thread amongst all of our holdings begin with superior management; winning long term strategic plans; technological leaders; rising volume, revenues, operating profit, cash flow; dividend yields above the 10-year treasury bonds and large stock buybacks.
We own healthcare companies, consumer companies, technology companies, some financials, low cost commodity companies; real estate related companies; cable with content; global industrials and capital goods companies; and many special situations.
We expect the yield curve to steepen and the dollar to fall as investors anticipate the next Fed moves lowering rates.
Remember to review all of the facts; pause, reflect and consider mindset shifts; always look at your asset mix with risk controls; do independent research and…
Paix et Prospérité LLC