Path of Least Resistance is Up

While the preponderance of political news remains challenging, stock markets recovered last week rising on that proverbial wall of worry. A strengthening global economy, rising earnings, and incredibly low bond yields is a pretty good recipe for strong stock markets. Can you believe that U.S. equity funds posted the longest streak of outflows since 2004? Markets top when there is excessive exuberance and bottoms occur when pessimism is at its highest, as who is left to sell? The pundits keep getting it wrong as the path of least resistance remains up, not down as they say day after day! But not all stocks will rise.

Each week we review the global economic, financial, and political landscape, challenge our core beliefs, focus more on what could go wrong than right, review our asset allocation and holdings and make changes where appropriate. Ours is a dynamic process and the hardest thing to do is stand still when so many “smart” people (the pundits) disagree.  Our strength is “looking over the valley,” anticipating change. We look through the windshield when most are looking through their rear-view mirrors. Paix et Prospérité continues to significantly beat all averages and especially the hedge fund index by many multiples. Managing money is a chess game. While you are cognizant of the next move, you are planning many moves ahead to win. That is and has always been our strength over our successful 40-year career managing money.

The big fear last week was what the heads of the Fed, ECB and BOJ would say at Jackson Hole. In the end, there was no talk of tightening whatsoever in any of their speeches and follow up Q&A. In fact, both Draghi and Kuroda discussed the need for continued excessive accommodation. The common theme from all was the need for vigilance when it comes to financial regulatory policy changes and bank capital ratios. Draghi defended the merits of globalization and his fear of protectionism. It remains clear to us that the Fed, ECB and BOJ will remain one step behind in changing from an accommodative policy stance to any real tightening as inflation nears 2%. Jackson Hole was a non-event in the end.

Let’s take a look at the economic data reported around the globe last week:

  1. The majority of data reported in the U.S. was strong: the PMI composite hit a 27-month high; the services PMI rose to 56.9; consumer comfort hit a 17-year high at 52.8; durable orders, excluding transportation, grew 0.5% while new orders rose 0.4% in July; and the Atlanta Fed forecasted 3.4% annualized growth in the third quarter. Housing sales weakened in July to the lowest level in the year primarily due to a lack of inventory.We have spent a lot of time over the last two years discussing the impact of disruptors on inflation and how businesses must adapt/adjust to even survive. Amazon announced that it would significantly cut prices at Whole Foods this coming week after the deal closes Monday. Billions of dollars came off the stock prices of the food retailers including Walmart and Costco. Low inflation is not transitory as monetary authorities believe!
  2. Economic activity continued strong in the Eurozone: the PMI for manufacturers rose to a multi-month high of 57.4 while PMI for services dipped slightly to still strong 54.9. It is important to note that the composite PMI price index remains weak. Third-quarter growth continues strong despite the rise in the euro, which only has just begun to impact exports. Remember that a strong euro puts downward pressure on inflation too. Nevertheless, Germany raised its growth forecast for the year to 2.3% from its previous forecast of 1.9% benefitting from strong global growth and domestic consumption.
  3. Japan’s economic activity continues to surprise on the upside: the manufactures’ PMI rose to a multi-month high of 52.8 while the preliminary gauge of manufacturing output increased to 53.1. Growth in output, new orders and employment are improving across the board such that there are rumbling that the government should consider raising the sales tax again to finally tackle the country’s large debt load.
  4. Continued strength in the prices of key industrial commodities is a testimony that China is finally grappling with over capacity, zombie operations and high pollution. Ironically this is all occurring while the government is raising capital requirements to reduce speculation, tightened capital controls, and increased short-term interest rates. The LME inventory of copper is at a multi-year low. We remain confident that China will exceed its 6.5% growth target for the year.

As predicted last week, Trump and his administration have turned their attention to tax reform and a massive infrastructure program. Cohn, Mnuchin, Ryan and McConnell were all out there talking about both programs and Trump is starting a speaking tour promoting the merits of both next week. I continue to expect a reduction in the corporate rate around 20-22%, a tax holiday for repatriation of foreign earnings; a reduction in individual tax rates with little, if any, benefit for the wealthy and a reduction in the capital gains rate but with a longer holding period. How could the Democrats really fight against any of this, as it is the right policies move for America? And we all know how desperately we need to rebuild our infrastructure.

Let’s wrap up.

The market pundits and most investors are again caught on the wrong foot. How can you argue against the positive fundamental backdrop: the global economy is expanding, earnings growth is accelerating and interest rates remain incredibly low for this stage in the economic cycle. It appears that the monetary authorities are on hold and will remain one step behind until inflation begins to rise to near the 2% level which won’t happen for the foreseeable future. Fears over North Korea and a Trump administration are already in the market so there can be only positive surprises. What happens to the market if it appears that tax reform and an infrastructure program will actually pass? S & P earnings will get an immediate 15% hike and free cash flow will benefit too. All good for the company and investor. While I can’t predict the magnitude of the boost to economic growth from these programs, I can assure you that it will be positive.

So who are the real beneficiaries? We continue to emphasize the financials (large banks), multinational industrials, low cost industrial commodity companies including domestic steel and aluminum; technology at a fair price; and special situations like Dow which will close with its merger with DuPont this week and Huntsman who spun off its commodity business and will merge with Clariant, a Swiss specialty chemical company this year. Also take a look at Praxair as its proposed merger with Linde is a home run too. Don’t forget that a weak dollar will help U.S. multinational companies’ translation of foreign earnings after years of being penalized by the reverse. Avoid/short those industries/companies that are most vulnerable to the disruptors like the box retailers. And be patient as all of this unfolds, as it does not happen overnight.

So remember to review all the facts; pause, reflect and consider mindset shifts; analyze your asset composition and risk controls; do independent fundamental research and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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