Peak Earnings!

Fear swept through the financial market last week that the bull market was close to ending. The story was that earnings were peaking; global growth was slowing while our interest rates were rising. Well, no, no and yes.

Reported first-quarter earnings have been nothing short of sensational. Well over 60% of all reporting companies have exceeded prior projections and have raised numbers for the year. However, concern swept through the markets after Caterpillar’s CFO said (on their first quarter conference call) that these results would represent the high water mark for the year. The market interpreted this to mean that the level of operating earnings had peaked. Not so. Projected annual operating earnings were raised at the same time by $2.00 per share to a range of $10.25 to $11.25 including $400 million of restructuring costs. We believe that the CFO meant that operating margins had peaked for the year, as higher costs would filter through the P& L over the next three quarters while price increases would lag. By the way, the company bought over $500 million in stock in the first quarter at higher prices utilizing a small portion of its free cash flow.

CAT is an example where management has maintained tight controls reducing costs while generating huge free cash flow throughout its operating cycle. We do not own CAT, as we do not like to own companies with declining incremental rates of return even though reported earnings may continue to grow.

Surprisingly, the market took down many companies last week that reported excellent results fearing it was their peak as well. We wholeheartedly disagree. Many of these companies have accelerating volume growth, improving margins and rising earnings, cash flow and free cash flow while selling at significant discounts to the market. We not only added to existing positions but invested in some new ones that had previously gotten away from us. We had an excellent week also significantly outperforming the market averages for the month and year to date. Our strength is sticking to our disciplines at all times taking emotion out of the decision-making process.

The real issue facing investors last week was whether world growth was slowing and had peaked for the cycle. And if so, did the monetary bodies have any ammunition left to stimulate growth once again? After all, the BOJ and ECB have never stopped their aggressive monetary ease policies still buying huge amounts of bonds monthly. Draghi admitted as much last week after the ECB maintained its easy policy also commenting that reaching its 2% inflation target may take longer than anticipated to achieve.

Kuroda, the head of the BOJ, said the same thing a week earlier commenting that aggressive ease may last at least another 4 years. On the other hand our Fed has clearly shifted gears and started a policy returning to normalization. The Fed meets this week and there is concern that the Fed may hike rates responding to high wage and inflationary pressures recently reported. We doubt that the Fed will raise rates this coming week, staying one step behind, as they fear the potential impact of potential tariffs on trade, growth and inflation. A strengthening dollar, as we anticipated, has been a by-product of divergent monetary policies and widening interest rate differentials. Huge foreign capital inflows have kept downward pressure on our interest rates despite significantly more supply of treasuries.

We continue to believe that global growth will average 3.9% this year and next with minimal inflationary pressures. Here again, we disagree with the pundits as expect that global growth will accelerate as we move forward after a normal winter slowdown. It is very difficult to envision that global economic growth has peaked after really large increases in employment, wages and capital spending virtually everywhere in the world over the last year.

Substantial capital spending increases should result in much higher productivity gains holding down unit labor costs. Granted that material costs, including energy, are rising but competitive pressures along with technological advances and the disruptors are holding down price increases. We only own companies that can raise prices increasing/maintaining operating margins, and we are avoiding/shorting companies where pricing pressures are apparent therefore operating margins are under pressure.

Change is everywhere, and there is a whole new host of winners and losers in the global environment. This will continue for foreseeable future. New multi-year investable trends are emerging but patience will be needed as they unfold.

Global trade concerns remain a primary concern of the markets and us too. Clearly there has been much progress made since Trump prioritized trade imbalances and IT theft to the top of his agenda. We see positive movement on renegotiating NAFTA and expect Canada and Mexico to remain exempt from steel and aluminum tariffs (for now) that go into effect May 1st. The ECB and Japan may be another story as tariffs may be instituted to show to them and the world that Trump means business. And then there is Russia and China. We still expect that we will negotiate something with China down the road as it clearly serves everyone’s best interests. North and South Korea signing major accords ending hostilities and pledging denuclearization on the peninsula last week really do mean something. Trump and Xi Jinping appear to have a close relationship that should ease trade concerns and lead to a negotiated settlement that will be mutually beneficial to both parties and for the world too. We expect Trump to maintain a very tough stance toward Russia for no other reason than it is good PR.

We want to briefly comment on defense stocks that got absolutely killed last week despite reporting excellent results. We just initiated some positions in best in class as defense spending is on the rise and these stocks are now selling at discounts to the market with improving fundamentals and returns. These companies are cash machines. You can’t buy these stocks when there are obvious conflicts occurring in the world as traders flock to them in times of trouble. Think as an investor, not as a trader!

Peak Earnings?

No way! In fact, we have raised our 2018 and 2019 S & P earnings to $155 and $170 per share, respectively. Global economic growth will accelerate as we move through the spring led by the US. We expect the Fed to raise rates at least two more times this year; the yield curve to steepen with the 10-year Treasury bond breaching 3.25% before year-end. The dollar will continue to strengthen as interest rate yield differentials widen, since European and Japanese growth will lag our growth so the ECB and BOJ will maintain their overly aggressive easing policies as our Fed tightens.

Our biggest concern remains global trade issues. There are no winners even in a trade skirmish but the US clearly has the most to gain running such huge trade deficits everywhere. We agree with Trump’s policy of reciprocal trade tariffs and expect some resolution down the road substantially better than what we have now with our major trading partners. Our IP must be protected, as that is our future. We cannot afford to lose our leadership in technology, research and development no matter how enticing entering the Chinese market is to our companies.

We see 10% upside for our market but not all markets, industries and companies are alike. While other markets may be statistically cheaper, our pro-growth administration has already passed tax reform; has relaxed regulations and has a trade policy that supports “Made in America” which all will contribute to above average economic and earnings growth here for several more years compared to other regions.

Our portfolio is structured to significantly outperform over time benefiting from the production side of the economy where there is pricing power versus the consumption side, which is overly price competitive. We are emphasizing financials; global industrial and capital goods companies; technology at a fair price to growth (did you see INTC and MSFT earnings reports!); industrial commodities including domestic steel and aluminum; and special situations, including defense, where internal change will lead to multiple revaluation over time. And we remain short bonds  everywhere of all durations.

Remember to review all the facts; pause, reflect and consider mindset shifts; analyze your asset allocation and risk controls; do extensive, first hand research and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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