“Prepare for A Future Downturn”

Rather than a thoughtful discussion on ways to sustain the current renaissance of global economic growth, the leader of the IMF, Christine Lagarde, and leader of the World Bank, President Jim Yong Kim, plan to focus the next meeting of finance ministers and central bankers from 189 countries next week in DC on preparing for the next downturn. Reforms are needed to extend growth and mitigate against downturns rather than preparing how to respond when the next downturn occurs. They just don’t get it!

Barron’s lead article this weekend was titled “Melt Up Before The Storm” reflecting the continued skepticism by the pundits about the very foundation for the strong stock market performance. The experts clearly remain stuck in the past rather looking over the rainbow toward the future. They fail to recognize the positive implications of massive fundamental change everywhere.

Are you aware that the Fed is forecasting a high for the Federal Funds rate this cycle at 2.75% in a few years? Yep, a high! What does that say about their forecast for future inflationary pressures? Virtually all monetary bodies, including our Fed, fail to fully comprehend the massive impact of technology/disruptors and globalization that are putting downward pressures on all pricing.

Let me ask if you understand why global interest rates are so low, especially at this point in an economic cycle? The markets get it even if the monetary authorities do not! If bank liquidity and capital ratios are rising too, what does all this mean for the stock market multiple not only on next year’s earnings but also out 2 to 3 years? Why can’t the market sell at 24 times earnings with a 2.5% 10-year treasury and rising bank liquidity? And what if tax reform cuts corporate taxes by 10 to 15%, which increases S & P earnings to $150+ per share in a few short years. Now do you get why the market is performing so well? The market has a funny way of not letting people in who have failed to recognize the obvious which has been staring them in the face for so long and who unfortunately continue to use the past to guide them rather than looking forward.

Since starting in 2013, Paix et Prospérité has had an exceptional few years correctly understanding the global political, economic and financial dynamics and inter-relationships. We have been tested at times and have had to make minor adjustments along the way but the key was sticking to our disciplines, successfully recognizing the longer-term trends, controlling risk and staying the course. That’s what George Soros taught me 30 years ago when I was CIO of the Quantum Fund. He was a great mentor, and I appreciate the 8 years that I was there before I started out on my own.

Let’s take a look at what was reported last week and whether it supports or detracts from our current view that non-inflationary growth is accelerating along with corporate profits while interest rates remain low by any historical measure at this point in an economic cycle:

  1. Clearly some U.S. economic statistics are being influenced by the two hurricanes but the undertone is one of accelerating strength along with rising optimism that a tax reform bill will be passed over the next few months cutting corporate taxes, offering a tax holiday to repatriate overseas cash and a middle class tax cut: wholesale sales rose 1.7% in August and are up 7.2% year over year while August inventories rose only 0.9% month to month and 4.5% year over year which means that the inventory to sales ratio has declined setting the foundation for an acceleration in sales ahead; employment declined by 33,000 jobs in September greatly influenced by the hurricanes but the unemployment rate actually declined to 4.2% while the participation rate rose to 62.1% and hourly earnings increased 12 cents or are up 2.9% year over year which was greatly influenced by the storms most penalizing low wage earners; durable good orders increased 1.7% and shipments rose 0.3%; the trade deficit declined in August to $42.5 billion heavily influenced by the storms hurting the ports; the Merkit services index stood at a strong 55.3 while the price front showed some acceleration and the PMI Output Index fell to 54.8 – most likely influenced by the storms; auto sales accelerated to over a 17-million annual rate, the strongest level for the year, most likely benefiting from the storms as over 500,000 cars need to be replaced; the CNBC economic survey revealed consumer optimism at a 10-year high which bodes well for a strong holiday season and was fully reflected in the National Retail Federation increasing their forecast to near 4% growth this year and finally the ISM Manufacturers Index rose to 60.8, the employment index rose to 60.3, new orders rose to 64.6 and the production index rose to 62.2.
  2. The Republican-controlled House passed a $4.1 trillion budget last week, which was the first step toward tax reform as it leads next to a legislative process called reconciliation during which tax reform will take place and can pass the Senate by a simple majority. While we fully expect changes in the bill to occur, the odds of passage over the next six months continue to rise which the financial markets have clearly noticed. Secondly, the Treasury issued a report Friday revealing guidelines for loosening financial regulations to “encourage” growth in the capital markets to boost the economy. And finally, it is clear by statements of Fed members this week that the Fed will remain one step behind until inflation accelerates and after the benefits of any tax reform are seen if they are stimulating the economy.
  3. Eurozone economic growth accelerated at the end of the third quarter as indicated by a final Eurozone composite output index of 56.7 and a business services activity index of 55.8, both up from the prior period. The ECB held meetings last week to discuss how to scale down its huge bond buying program while trying to understand the recent strength in the Euro and corresponding weakness in inflation. We expect the dollar to continue to strengthen as we said a few weeks ago as the odds of passage of Trump’s pro-growth, pro-business agenda improves which will go a long way to assist the ECB to curtail some of its aggressive easing policies.
  4. Japan’s business confidence is at a 10-year high, which Prime Minister Abe is using to his benefit having called a snap election for October 22nd to increase his majority over the government to further his party’s economic agenda.
  5. China’s Central Bank announced targeted easing to boost small business loans without aggravating high corporate debt. Listen closely to what is said and comes out of the 19th National Congress of the Communist Party beginning October 18th and then the meeting between President Trump and President Xi Jinping in November. Don’t expect any trade moves by the Trump administration until after those meetings, if at all, as we expect negotiations between the leaders to resolve many of the issues. Also do not expect trouble with North Korea to escalate during this period, as it would embarrass the leader of China, which just won’t occur.
  6. The World Bank raised its growth forecasts for developing East Asia and Pacific for this year and next to 6.2% and 6.1% respectively while raising the spectra of trade protection penalizing these numbers.
  7. OPEC and Russia are clearly working to extend their production cuts well into 2018. Clearly the first-time visit of Saudi King Salman to Moscow to meet with President Putin says it all.

Let’s wrap this up.

While the majority of the pundits/hedge remain out of sync with the financial markets hoping for a correction to increase their exposure, the markets just won’t let them in. It is hard to imagine a better environment for investing as global growth is accelerating but not inflation; interest rates are staying low although the yield curve continues to steepen; earnings growth is accelerating; the probability of passage of tax reform and other parts of Trump’s pro-growth, pro-business agenda is rising; and Trump will be meeting with the head of China next month which should be a lid, at least temporarily, on an escalation of tensions with North Korea. I look for many positive developments from their face-to-face meetings that clearly are not discounted in the markets.

We continue to emphasize in our portfolios the large money center banks that will benefit from loan growth accelerating and a steepening yield curve; U.S. domiciled multinational industrials that will benefit from accelerating volume, tight cost controls and substantial gains in profits, cash flow and free cash flow; technology at a fair price to growth like Cisco, Microsoft and Oracle; the financially strongest and lowest cost industrial commodity stocks including domestic steel and aluminum including Alcoa and Nucor; and special situations like Dow-DuPont, Huntsman, FMC and Praxair.

One word of caution as we enter earnings season. There will be many anomalies as the hurricane will penalize many companies’ third-quarter earnings reports so look through that windshield rather than at the rear-view mirror and take advantage of any negative market reactions which are not deserved.

So remember to review all the facts; pause, reflect and consider mindset shifts; always look at your asset composition and risk controls; do in-depth independent research and …

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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