Risk Back On

What a difference a few weeks makes in our view of the economic landscape and outlook for the financial markets! While we still believe that the U.S. economy will slow this year, we no longer believe that there is any chance of a recession for at least 18 to 24 months. It is clear that the Fed has capitulated and that Trump is pushing for trade deals to save his Presidency and give him a chance to run again in 2020. It’s fascinating to have a President who measures his performance by that of the stock market. Notwithstanding, our markets remain undervalued today due in part to Trump.

We listened closely to all the Fed governors that spoke this past week, including Chairman Powell, and read carefully the Fed minutes from the December meeting. Maybe we have a Powell “put” just like the Yellen “put”? It is clear that the Fed is focusing on much more than just declining unemployment. The Fed is closely watching the financial markets, the yield curve, high yield spreads, weakness abroad, the threat of increased trade conflicts, business sentiment, and finally, inflation. After reading the Fed minutes, we were surprised that they decided to hike the funds rate in December. The question remaining is whether the Fed just pauses for the rest of the year or lowers rates as “normal” is below what they had earlier thought? There is a possibility, however, that the Fed could hike once again, but that would happen only if trade deals are reached, which would be good for the global economy and all financial markets.

The bottom line is that the Fed is no longer an obstacle for the financial markets. The dollar fell, commodity prices rose and stocks went up last week as the Fed is out of the way. The question remaining is whether this is just a rally in a bear market or the beginning of the next leg up in a secular bull market. We believe the latter.

We continued to put cash back to work in the markets increasing our net exposure back to more “normal” levels. It is important to note that we made some structural changes in the composition of our holdings much like what we did back in October when we took risk off and went defensive raising a lot of cash, too. This time we reversed our prior position adding more economically sensitive stocks selling at recession valuations and sold some of our defensive holding that had performed well as a safe haven for investors fearing a recession. We just followed our disciplines, sticking to our core beliefs. However, when we had to make some changes, as you will in a VUCA (volatile, uncertain, complex and ambiguous) environment, we adjusted our portfolios accordingly.

Risk back on!

We want to discuss a long-term theme that we have mentioned many times over the last few years and how it will impact investing over the longer term.

We have written that inflation would stay surprisingly low pressured by the competitive forces of globalization, swift technological changes and the rise of disruptors sector by sector. The Fed minutes mention that Fed members may have finally woken up to the fact that low inflation may be here to stay and that rising employment/low unemployment may not mean rising inflationary pressures. Hence, the Fed maybe should not have raised rates in December and may have already reached normalized levels. 

Think about what it means for stock and bond prices if secular inflation stays contained around or under 2% as it is running virtually everywhere in the world. Did you know that inflation is even beneath 2% in China vs, a forecast of over 3% and much lower than that in Japan and the ECB despite all of the QE? We are many years into a global economic upturn and still inflationary pressures are muted. Wow, think about that!

The truth is that U.S. stock multiples are way too low today. Historic multiples have ranged between 15- and 22-times earnings but that compares to competitive interest rates at 5% and higher. And the 10-year treasury is well beneath 3% today while financial risk is low as bank capital and liquidity ratios are near all-time highs. Stock earnings yield, a Buffet favorite, is well above bond yields. Hence stocks are statistically cheap on a longer-term basis.

But, of course, it is not as simple as that. It bears repeating that we are in living in a VUCA environment. It is highly volatile, uncertain, complex and ambiguous. We will not have an “all clear” until trade deals are reached with the China, the ECB and Japan. We also need some finality on Brexit.

Global growth is decelerating rapidly as uncertainty prevails regarding trade. The U.S. is best in breed as exports are much smaller percentage of GDP than virtually any other major industrialized country. Just look at recent economic statistics out of China, Japan and Germany to get an idea how much trade skirmishes and the mere threat of trade wars have impacted growth. Business sentiment and spending are falling fast. We need, they need more, trade deals to reinvigorate global growth.

What is our current economic and stock market view?

While we have gotten over the obstacle of the Fed causing a recession in 2019/2020, we still believe that the U.S. economy will slow sequentially as we move through the year and that real growth will come in close to 2.0% for 2019. The government shutdown does not help either although we believe that the psychological effect of a dysfunctional government means more than the economic effect of less growth. We can’t wait to vote all the bums out in 2 years.

We believe that that the surprise in 2019 will be that overall corporate profits do better than expected much like GM’s forecast. There are, however, many industries where promotional pricing will penalize profitability like retailing and airlines but not all are the same. The bottom line is that we are still forecasting 6+% earnings growth for the S&P 500 this year. We expect active managers’ performance to stand out this year as there will be clear winners and losers in corporate America.

The difference between 2019 being a good year and an excellent year clearly rests on whether trade deals are reached. We remain optimistic that deals will be struck with the ECB and Japan as the alternative is just unthinkable. It is likely that China and the U.S. will extend their 90-day deadline for another 90 days but we are confident that a deal will be reached sometime this year as both President Xi and Trump need it for political reasons.

If trade deals are reached in 2019, we would expect an acceleration in global growth in 2020. No one, for obvious reasons, is forecasting that at this time. But if we are not paying for it and if valuations are still at very depressed levels, looking over the valley can be very profitable for those willing to invest for the longer term.

We clearly have become more optimistic on both the U.S. economy and our stock market now that the Fed is out of the way. Our portfolios have broadened out significantly to now include some depressed economically sensitive stocks while we have reduced exposure to the some of the defensive stocks.

Our portfolios include healthcare, industrial and capital goods companies, housing related retailers, technology at a fair price to growth including some semis, domestic steel and many special situations where internal actions will create significant added shareholder value. Since we live in uncertain times, we are only buying best in breed with the strongest managements, winning strategies, great financials with yields above the 10-year treasury along with significant share buybacks out of free cash flow. We continue to expect the dollar to fall and the yields to remain where they are until either the Fed cuts rates or trade deals are reached.

We suggest listening to as many earnings conference calls as possible to get a better feel about the current and future economic environment and to hear first-hand what sets companies apart from each other.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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