Playing the Long Ball

The global financial markets are being held prisoner by rising trade tensions, primarily between the United States and China. While both countries feel, but to differing degrees, that they can weather a trade war, each is focusing on who will dominate the global economy over the next generation. And the key is technology! Herein lies the essence of the conflict.

The United States wants to alter the Chinese path, and the Chinese want to control their own destiny. No one can change the past where China insisted on IP transfer as a condition to enter their country, but the truth is that is not nearly as prevalent today as before.

Let’s state some simple truths: exports from China are less than 2.4% of U.S. GDP and less than 3.7% of China’s GDP while global trade is less than 3.6% of global GDP. Don’t worry about exports from the U.S. to China as it is too small to really matter. So, where’s the fuss? Even the pessimists forecast that an all-in trade war with China might reduce U.S. GDP by the most 0.6% over the course of a year once it begins while reducing China’s GDP by 1.2%? We think both numbers overstate what will actually occur as supply chains are redirected rapidly. We also believe that the forecasted inflationary impact of higher tariffs is overstated too. Just look at what inflation has been running here since the 10% tariff went into effect last fall: below the Fed targets!

If Trump implements 25% tariffs on the remaining $300 billion of Chinese exports to the U.S., it most likely won’t begin to impact our economy until sometime in the fall. And we expect that companies have already begun buying as much as possible already anticipating additional tariffs down the road. Expect both our trade deficit and inventory accumulation to swell during this period. S & P earnings could be hit, too, but here again, it is likely to be less than anticipated as only a portion of the higher tariffs is likely to be borne by the U.S. company itself. The super strong dollar may be a bigger penalty to corporate earnings than tariffs.  

Listen to Walmart’s and Cisco’s comments from their earnings call last week about the impact of higher tariffs on their businesses. Both managements are way ahead of the curve and don’t expect higher tariffs to penalize their businesses much, if at all. Of course, if managements kept their heads in the sand and did not plan accordingly, there definitely could be an earnings hit to their companies. As we have said every week, our first and most important decision regarding investments is the quality of management and their strategic planning to win regardless of the global competitive environment. There will be clear winners and losers from tariffs. Here is when active money management should excel!

We made several changes to our portfolios well over a week ago after Trump did a 180 on the prospects of an imminent trade deal after the Chinese reneged on the so-called agreement. He immediately imposed higher tariffs on the initial $200 billion of imports and threatened tariffs on the remaining $300 billion by June. Trade ceasefire had ended and war had begun. We acted quickly anticipating how the investors would react selling those companies most impacted by higher tariffs and lower world growth. We raised cash to 17% of our portfolios giving us the fire power to buy when others panicked. We subsequently added to our technology holdings and domestic companies with huge free cash flows not impacted by tariffs. The average dividend yield on our portfolios exceeds the 10-year treasury bond. We have continued to outperform the averages.

While we are definitely concerned about tariffs and the growing conflicts between our countries, we are keenly aware that there is action afoot to shift supply chains away from China to other countries in the region with low cost labor and no threat of tariffs. But it will take time. Raising tariffs is a one-time penalty to prices, inflation and growth. And not all of it will fall in 2019. In addition, we expect that the Fed will most likely lower rates to offset any negative impact to our economy acknowledging that the higher prices from tariffs are a one-time event likely to reverse in future quarters as supply chains are shifted and competition increased. For example, have you noticed that domestic steel prices which spiked after tariffs were enacted have fallen back beneath pre-tariff price levels? Pretty amazing!

Trump is playing the long ball dealing with unfair trade practices that have existed for decades and we are looking over the valley to the benefits to the U.S. economy from a more level playing field for global trade where IP is protected.

The key right now is the ability of our economy and also China’s to withstand an escalation in the trade conflict and higher tariffs. We continue to believe that the U.S. will be the winner with more to gain and far less to lose from an escalation in hostilities between our nations.

Before we go on and discuss the latest data points, it is so important that we acknowledge that Trump put off for up to 180 days any auto tariffs against the EU and Japan to avoid fighting on too many fronts at the same time and he also lifted steel and aluminum duties on Mexico and Canada so that the new NAFTA/USMCA could be move along in Congress and be passed. Finally, Trump threw down the gauntlet against China’s Huawei restricting its ability to access U.S technology. Smart move for many reasons!

Now let’s review the key data points that support our contention that the U.S. and Chinese economies will continue to chug along while weakness will persist in the Eurozone and Japan:

  • We expect the consumer to be the driving force behind continued above average growth in the U.S. for the remainder of the year into 2020. Who could argue against the over 2 million new jobs created over the last year; over 7 million job opening remain; the acceleration in both nominal and real wage gains; lower inflation and much lower interest rates? No wonder that consumer sentiment jumped to a 15-year high of 102.4 in May with the biggest gain in the expectations index.

    While we were disappointed that retail sales, especially autos, and industrial output declined slightly in April (weather was a big factor), housing starts rose 5.7% and permits increased 0.6%. The April small business optimism index increased to 103.5 in April, stronger than anticipated.

    We continue to believe that second quarter GNP will be around 2% penalized by a larger trade deficit and lower inventories. We see an acceleration in the second half benefitting from Fed actions since December and lower interest rates feeding through the economy. We continue to expect Trump to pull out all stops in 2020 such that growth will be better than 2019. Could there be an infrastructure bill? We need one, and it’s about time one passed Congress.
  • We commented last week that China’s growth slowed slightly from the first quarter rate as we moved through April: industrial production rose 5.4% from a year ago while retail sales increased 7.2%. Both gains were less than recorded in March. Capital investments still increased a healthy 6.1%.

    China raised tariffs on $60 billion of U.S. goods after the U.S. raised tariffs to 25% on $200 billion of Chinese exports.  It will be interesting to see what China can do once/if the U.S. raises tariffs on the additional $300 billion of Chinese exports without shooting itself in the foot.

    We are confident that China will introduce a host of measures to further stimulate growth if needed to maintain growth above 6.3% for the year. China is at risk as corporations, even based in China, move production to other countries to avoid the tariffs. While we are confident in the future of China, we believe that change needs to take place which may be hard, if not impossible, for them to swallow.
  • We remain very cautious/negative on the future prospects of the Eurozone and Japan without the U.S. and China clearing the air and making a trade deal. We are far more confident that the U.S. and Japan can reach a trade deal than the U.S. and the Eurozone. Japan is likely to open up to U.S. agriculture products just like they did removing restrictions on U.S. beef while it will be very hard for the Eurozone to do the same.

Let’s wrap this up.

We believe that we are entering a transition period that if and when a trade war between the U.S. and China ramps up with tariffs on every item shipped between our nations. We are hopeful that President’s Trump and Xi can bridge the gap between our negotiators and make a deal when they meet at the G-20 meeting in Japan on June 28-29. Until then, we expect the rhetoric to be turned up creating added anxiety in the financial markets.

We expect Trump to play the long ball insisting on a move level trade playing field as it helps him with his political base as he enters the 2020 Presidential race. It is interesting to note that many Democrats support his efforts on trade, and it appears that many more corporate leaders are leaning that way too after resisting any sort of trade conflict wanting to sustain the status quo instead.

It is our role to look over the valley factoring in all the near-term risks too. No one wants to see a trade war but no one believes that the status quo is acceptable longer term too. Clearly the U.S. and China are fighting over global economic dominance and neither wants to give in to the other. Technology is at the forefront of this battle and herein lies the major issue between our countries.

We believe that near-term global growth will suffer as the supply lines are shifted from China elsewhere. We are less concerned about any blip in inflation as it will reverse in rather short order. On the other hand, we expect all monetary bodies to open the faucets more and more providing the necessary fuel to keep the global economy expanding. The U.S. and China are in the best relative position compared to the rest of the world.

We prefer investing in the U.S. as we believe that long term inflation will remain muted such that our stock market multiple is too low at even 18 times earnings. The Fed/pundits have it wrong that low inflation is transitory! We expect corporate earnings to be more resilient to trade conflicts than generally perceived as corporations are just better managed utilizing technology to reduce costs and boost profitability.

Our portfolios continue to have a common thread: we own companies with superior managements; winning long term global strategies; rising volumes/revenues/margins/operating income/ cash flow/dividends and buybacks. Each stock is selling well beneath long term intrinsic value.

Our portfolios consist of healthcare companies; capital goods and industrials; cable with content; technology that enhances security and productivity; low-cost industrial commodity companies generating huge free cash flow with very high yields; U.S. domiciled financials selling well beneath tangible book and many special situations. We are flat the dollar and own no bonds.

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

Invest Accordingly!

Bill Ehrman

Paix et Prospérité LLC

 

 

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