Stay Focused On the Longer Term

Despite excellent domestic economic conditions, a hike in projected future S&P 500 earnings reaching $180 per share by 2020, and unusually low interest rates with accommodative monetary policies, the US stock market continued to take it on the chin last week. Investors fear trade wars with negative short-term ramifications despite longer-term benefits to the US.

By the way, our trading partners’ markets are acting far worse! Have you noticed the decline in the Chinese and German stock markets? Maybe this dichotomy is occurring because trade is a smaller percentage of our GNP, our economy is strong, we are running huge trade deficits with everyone and have less to lose, and our economic risks near term of a trade war are less than theirs. Don’t believe the rhetoric that it will hurt us more than them and that they have more bullets than us if tariffs are increased. Simply put, the US is the most self-sufficient economy in the world growing more energy independent by the day. Can’t say the same for the Eurozone countries, our NAFTA partners, Japan and China.

We are certainly not happy by the escalation in trade rhetoric between countries. The United States economy is on the cusp of great things. Trump’s pro-business, pro-growth agenda has unleashed corporate America after years of stagnation. Business confidence has risen to all-time heights; second-quarter growth may exceed 4%; corporate profits are still accelerating; employment growth is great and capital spending is starting to accelerate. So why is Trump doing this now? It is easy to argue that now is the best time, as this never could be attempted if our economy was weak. We are in total agreement with Trump that we need a level playing field for trade and that we must protect our Intellectual Property. You can argue that he could have gone about this in a different way but the truth is that the WTO does not work and our trading partners have no motivation to change as they currently have an unfair advantage over of our country granted 50 years ago when the policy was right at the time. What is wrong with equal reciprocal tariffs and no subsidies? We did not see one other G-7 member agree with Trump on this. We understand that change takes time, but let’s put a good faith deposit down today and commit to move in that direction with measureable goals.

We remain more optimistic that we can make a deal with China and Japan near term than with our European allies, Canada and Mexico. Politics are getting in the way of negotiation as no one wants to appear weak. Trump needs to soften his rhetoric and stop trying to bully our trading partners into submission. We need to create a win/win solution for fair and open trade. All tariffs must come down, trade restrictions lifted and regulations reduced. If we begin to move in that direction, global trade will actually pick up helping everyone.

Trump was able to do an about face on North Korea so it is plausible that that he also can shift his approach dealing with our trading partners without changing his ultimate goal.

After all, Trump has a huge ego and is focused on how he will be remembered in the history books. Remember that he also measures his performances by that of the financial markets so guess what his end game is? Higher stock prices! So do you really believe that he wants protracted trade skirmishes that mushroom out of control? Not so!

We are watching business and consumer confidence measures very closely to see if major shifts occur over trade fears that may impact near-term economic growth. Listening to second-quarter earnings conference calls for a clue of future expectations will be very important.

Clearly domestic growth accelerated meaningfully in the second quarter as we had expected and may now exceed 4%. Earnings growth may have accelerated too from the 18% or so gain reported in the first quarter. The surprise is that the yield curve has not steepened as the Fed increased the funds rate by 50 basis points so far this year and the economy has been so strong. We attribute the flattening in the yield curve to fears of a trade war and huge buying from abroad as the interest rate differential widened. Yes, the dollar strengthened meaningfully during this period as we had expected.

Focus on the long ball.

It is clear that trade patterns will shift over time. The US is the prime destination location for that next plant whether you are a domestic or foreign company. It does not hurt that Trump has significantly reduced taxes and regulations. Growth in domestic capital spending remains one of our core beliefs and themes. Could it be pushed out due to trade skirmishes? Not so for the company playing the long ball as a new plant, buying equipment and hiring a skilled work force does not happen over night.

Even if trade skirmishes pop up, the net impact on global growth will be minor as we expect shifts in trade patterns minimizing the net loss. While growth in Europe slowed appreciably over the last five months hurt by the strong Euro, that is about to turn, and we expect a better second-half performance in the Eurozone. Same improvement should happen in Japan as the yen has weakened from higher levels reached earlier in the year. We remain very optimistic on China and India too but are less sanguine on the emerging markets.

Finally the US is apt to report 3+% real growth for the year. Even if tariffs lead to a bump in inflation here, we expect the Fed to consider it a one-time event, transitory and not change its policy.

Have we changed our investment outlook?

We continue to focus our investments on the longer term while keeping one (maybe both) eyes on near-term events. We would not be surprised to see some tariffs enacted before all parties finally agree to come to the table. Trump is not bluffing and is playing to his core constituency. His ratings amongst all Republicans has only gone up which we are sure has not gone unnoticed by others.

Our portfolio is comprised of:

  1. US-based global banks who are well positioned to increase market share from foreign competition, who will benefit from accelerating loan growth and a steepening yield curve as the US economy continues to improve, who will benefit from more deregulation and will be permitted next week by the regulators to significantly increase their dividends and buybacks.
  2. Industrial and capital goods companies who will benefit from global growth and acceleration in capital spending. Expect to see much M & A in this space.
  3. Technology companies selling at a fair price to growth. Here again, tech spending is increasing at ever increasing rates everywhere.
  4. Industrial commodity companies including domestic steel and aluminum. We expect managements to remain disciplined increasing free cash flow for the foreseeable future, hiking dividends and increasing share buybacks.
  5. Special situations are an important part of our portfolio and reflect companies making huge internal and external shifts in the composition of their earnings by buying, selling or spinning off divisions to create added value for shareholders.

We are always making small adjustments to our portfolio as the market presents us with unusual opportunities to profitably invest. We remain short bonds and long the dollar.

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

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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