Patience Will Be Rewarded

The global economic and financial landscape has rarely been better but the market pundits and media would rather you think differently. They focus on perceived negatives as they do not want to give Trump and his team any credit whatsoever for unleashing a pro-business, pro-American environment that has resonated worldwide. This change is a process with benefits that will be occurring over the next several years.

The U.S. government passed tax reform last year to be effective in 2018. The market appears disappointed that first-quarter growth will come in around 2.5% rather than closer to 3% as many had anticipated earlier. Let’s state the obvious:

  • First-quarter growth is historically the weakest of the year as government seasonal adjustments are off the mark
  • Individuals did not see any benefit in take home pay until the end of February
  • Corporations have not had time yet to adjust their actual spending and hiring plans for the year to reflect the new tax rules including repatriation of foreign cash
  • Benefits of regulatory reform and change in trade deals does not occur overnight

Patience will be rewarded!

We expect 3%+ growth for the next three quarters and in 2019 as the benefits of tax, regulatory and trade reform kick in. We find it amusing that the pundits are commenting that world growth has “crested” while none have altered their 3.9% growth forecasts for this year and next. Nothing wrong with that!

The banks got clobbered on Friday despite sensational first-quarter earnings from Citicorp and J.P Morgan. The reason for the weakness stated by the pundits was disappointing first-quarter loan growth. How ridiculous! JPM reported a 25% gain in earnings with a 15% ROE. Not too shabby for a stock selling at a 33% discount to the market! Managements were optimistic that loan growth would pick up sequentially as we move through the year as individuals/corporations begin utilizing the benefits of tax reform. Here again, the pundits are using the rear view mirror rather than looking through the windshield. Banks continue to be a major portion of our portfolios despite huge appreciation over the last three years. They are still selling at less than 12 times earnings despite increasing returns on capital, enlarged buybacks and significant increases in dividends all on the horizon. In fact, we added some on Friday.

Stop being short-term oriented, take advantage of foolish sell-offs and invest with a one to two-year time horizon. Real change is in the air. Managements are more focused on sustaining/increasing returns throughout economic cycles while continuing to strengthen their balance sheets, which should lead to multiple revaluations over time. Industrial commodity companies such as BHP and RIO are the best examples of more disciplined management practices. We added to both positions recently despite having doubles in both stocks since initially purchased 3 years ago. Both stocks sell at 10 times our 2018 earnings forecast yielding over 4%.

Again, patience will be rewarded!

If I were to tell you that the market would finish the year up 10% but there could possibly be a 10% correction along the way, would/should you hold off buying now? Well, that is the forecast of my former partner and now Vice Chairman of Blackstone, Byron Wien. I love Byron but no one is that good! The bottom line, even from Byron, is that the market is undervalued today. That we agree on!

World trade tensions eased last week after Chinese President Xi’s gave a major speech suggesting that China would reduce tariffs on autos and many other items as well as add further protection to intellectual property. While we have heard all of this before, there is reason to be optimistic that China and the U.S. will begin resolving their trade issues without the introduction of major tariffs. Trump, to his credit, added further pressure on China suggesting that the U.S. will enter negotiations to enter the Trans-Pacific Partnership (TPP). Finally, it is becoming increasingly clear that the United States, Mexico and Canada will resolve their trade differences and agree to an overhaul of NAFTA. Maybe Trump deserves some credit here as his administration has taken on trade abuses when former administrations just kicked the can down the road.

Trump is clearly taking a hardened stance toward Russia, too, as evidenced by his administration kicking out more diplomats for illegal actions here and abroad; implementing additional trade sanctions like on aluminum (did you notice the move in Alcoa last week?); and finally attacking Syria for illegally using chemical weapons against their own people. It was important that France and the UK joined us in a coalition against Syria. By the way, we thought that Nikki Haley did a great job at the UN on Saturday responding to the Russia.

So where do we stand today?

We continue to believe that the market is statistically undervalued as:

  • S & P earnings are likely to exceed $150 per share in 2018 and $165 per share in 2019
  • The yield curve will steepen as economic growth accelerates in the second quarter with the 10-year treasury likely to exceed 3.25% sometime this year and rise further in 2019; rising yields due to strengthening growth is a positive
  • Financials continue to strengthen their balance sheets reducing systematic risk
  • Monetary authorities will remain one step behind however the days of aggressive ease are behind us
  • Commodity prices will rise as demand outstrips supply so utilization rates increase
  • Inflation will stay contained around 2% due to the impacts of globalization; technology/disruptors; and an acceleration in productivity gains hold down unit labor costs
  • Capital spending takes off as corporations, both foreign and domestic, begin utilizing the benefits of tax and regulatory reform as well as new trade policies
  • The dollar will strengthen later in the year as risks of trade wars subside and the U.S. economy accelerates
  • M & A will remain strong
  • Volatility is here to stay as the market as excessive monetary ease is behind us and the market is overly sensitive to sound bites but investors should stay the course

Patience will be rewarded.

We continue to emphasize the financials; global industrial and capital goods companies; technology at a fair price to growth; industrial commodity companies including domestic aluminum and steel; and special situations where internal changes will lead to multiple revaluations over time.

Remember to review all the facts; pause, reflect and consider mindset shifts; always look at 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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