The Next 18 Months

No one doubts that Trump’s economic agenda, especially the tax cuts, will be a shot of adrenalin for our economy near term. However most of the pundits/skeptics feel that the afterglow will dissipate rapidly as we move into 2019 and beyond.

We disagree! The pundits/skeptics look at each piece of news emphasizing only the negatives without giving sufficient credit for the positives; and then conclude with a negative bias of the future without considering the alternatives.

A successful investor needs to review all of the facts, then pause to reflect and consider any mindset shifts, analyze the asset mix with risk controls and do independent research. You need patience to let events unfold, as change does not occur overnight.

Our strength is our ability to gather and synthesize all economic, financial and political events occurring around the globe; put them all in their proper perspective; find emerging trends and THEN, invest accordingly.

Let’s take a look at the major events of the week reviewing their implications for the future.

Trade

We anticipated that Trump’s meeting last week with European Commission President Junker on trade would be a telling event. It concluded positively with both sides agreeing to work towards a significant reduction in tariffs and subsidies creating open and fair trade between both regions. While the devil will be in the details, the mere fact that both agreed to move in this direction suspending any additional tariffs was a huge positive.

It also appears that the US is working rapidly on a trade deal with Mexico, which will be followed by one with Canada.

Finally, it was announced that foreign auto-producing nations were going to meet soon to discuss reducing trade tariffs across the board to create a more open and fair trading environment. The US was excluded from this meeting.

All of this sounds promising, doesn’t it? Maybe Trump deserves some credit here, but not so if you listen to the pundits/skeptics. We disagree, as the discussions are all moving in the right direction for open and fair trade with reciprocal tariffs. Don’t expect a miracle overnight, but watch the cards as they turn up. So far, so good!

It would be best,too, if we had a universal front dealing with China on trade and intellectual property. We do expect the US to take the lead here. Have you noticed how Germany has responded to China’s attempt to make acquisitions in its country? And how the ECB is moving to reduce dumping from China? Look at their immigration policy too. Not so different than us, but the media doesn’t broadcast any of that. Why?

The US economy

Second-quarter results reported Friday were excellent. Real growth came in at 4.1% with the Fed preferred inflation index falling to 2%. Consumer demand and capital spending were robust boosted by Trump’s tax policy. Inventories actually fell, reducing growth, but were offset by a huge increase in exports anticipating future trade tariffs, which reduced our overall trade deficit. It is important to note that real final sales rose by a robust 3.9% and after tax income rose a strong 2.6%.

Here again, the pundits/skeptics point to the probability of slowing growth for the remainder of the year as well as for 2019. We agree but draw a different conclusion. It would be great if real growth averages 3% or better for the rest of the year and for 2019 too. Don’t forget that jobs continue to grow by nearly 200,000 per month having added over 3 million new jobs since Trump’s election. It is not surprising that hourly earnings is improving too albeit at a slow rate. Therefore, we see no reason that consumption will not meaningfully add to growth. Then there is capital spending. We continue to expect a multi-year acceleration in capital spending due to corporate tax changes, especially for depreciation; reduced regulations and changes in trade patterns. Finally, we know that government spending will continue to increase. Add everything together, and it is easy to conclude that overall growth will remain relatively robust.

How will the Fed respond? We expect gradual increases of the Federal Funds rate over the next two years as the Fed moves toward normalization but not enough to cause an inverted yield curve. We do expect the yield curve to steepen unless trade fears escalate causing a flight to safety here and abroad.

Corporate profits remain strong growing at a 20+% clip this year as operating margins are rising while tax rates are declining. S & P earnings are likely to exceed $158 per share in 2018 increasing to over $170 per share in 2019. Cash flow and free cash flow are likely to increase strongly too despite higher capital spending, dividends and stock buybacks.

The ECB, Eurozone, BOJ and Japan

It is clear that both monetary bodies want to begin paths towards policy normalizations but remain on hold for at least another year. Economic growth and inflation were weaker than expected in the first half of the year as both currencies strengthened significantly penalizing exports. However growth in employment and somewhat high hourly earnings bolstered consumer spending. We expect growth in both regions to improve over the next 18 months unless trade disputes widen from current levels.

China

The government is taking a hard line on talks with the United States anticipating that Trump will buckle, as US elections grow closer. It is clear that the government has eased its monetary policy and has enacted programs to stimulate consumer, capital and infrastructure spending to spur economic growth for the remainder of the year into 2019. We see no reason to change our forecast for 6.5+% growth in 2018 and slightly less in the next year.

Facebook and the FANG stocks

Facebook was the stock of the week announcing strong second-quarter earnings but warning that operating margins will shrink significantly in future years. One of our rules is to look to invest in companies with rising margins and sell/short those with peaking/declining margins. Facebook and the other FANG stocks were priced for perfection so any bubble busting will/has resulted in a significant decline in those specific stocks. But on the other hand, investors looked elsewhere and bought banks, industrials and even healthcare stocks last week, which have all become value stocks.

Paix et Prospérité had an outstanding week and widened its outperformance to the market averages.

So where do we stand now?

The global economy will continue to do well although growth may not hit 3.9% this year and next. But don’t frown, as global growth above 3% is still quite good. Inflationary pressures will remain muted as long as trade tensions don’t rise much and trade skirmishes don’t turn into trade wars. We are hopeful that Trump will reach deals with the ECB, Mexico. Canada and Japan over the next few months. However, a deal with China may be stickier. We hope that Trump shifts tactics and brings alone our allies in dealing with China since we all face the same issues with them including IP.

We want to emphasize that corporations/managements are acting quite differently this cycle operating close to the vest controlling costs, divesting underperforming assets, spinning off businesses undervalued in the market place and continuing to generate tremendous free cash flow used in good part to enhance shareholder value. You must listen to the earnings calls to hear it all for yourself. Look through the windshield rather than the rear view mirror. Change is everywhere creating tremendous opportunities to profitably invest. But patience is needed as none of this occurs overnight.

We continue to emphasize the financials, capital goods and industrials, technology at a fair price to growth, industrial commodity companies as managements remain very disciplined, and some healthcare and many special situations where managements are making significant internal changes to create added shareholder value. We continue to expect the yield curve to steepen and expect near-term weakness in the dollar as trade tensions ease.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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