“Sustain the Expansion”

The Fed’s semiannual Monetary Report was released Friday and really offered all the ammunition the Fed needs to begin lowering rates this month. The Fed is concerned that uncertainty over trade has constrained business spending and caused a slowdown in manufacturing. The Fed cautioned that growth in many advanced economies has slowed too. Not surprisingly, the report mentioned that the American financial system was in excellent shape as evidenced by recent stress tests. The Fed report went on to discuss that inflation continues to run well below the Fed targets and that a certain amount of inflation is considered healthy. Finally, the report concluded that risks to the downside and financial stability have increased due to global issues including the risk of a hard Brexit, fiscal challenges abroad, high debt levels in China and the possibility of escalating trade conflicts. The Fed emphasized that it will act to “sustain the expansion.” 

The Fed has two mandates: maximizing sustainable employment and stabilizing inflation. While the Fed has exceeded its goal on lowering unemployment, it has failed to achieve its inflation objective of 2% for over 8 years now. We continue to believe that the Fed should begin lowering rates this month to not only sustain the expansion but to catch up to the yield curve which has inverted in several places flagging a huge warning sign about the economy to all of us and hopefully the Fed too. The Fed needs to begin lowering rates NOW to narrow the interest rate differential with foreign rates which would cause the yield curve to steepen, stop the dollar from rising, boost inflationary expectations and global growth. 

Clearly, we all let out a huge sigh of relief when Presidents’ Trump and Xi called a cessation of the escalation in the trade conflict between the U.S. and China, but we really need the Fed to begin lowering rates now to not only sustain the expansion here but to release global interest rate pressures, including flow of funds from abroad. The United States continues to suck capital in from all over the world as the interest rate differential has only continued to widen over the last six months. There is absolutely no demand for funds in Europe which is one reason for such ridiculously low rates, even negative. The Fed needs to stop the dollar from rising.

We expect the Fed to begin lowering rates in July. While we believe that they could lower rates by 50 basis points then, we expect the Fed to go slow lowering rates by 25 basis points with another cut a few months down the road. We would not be surprised to see the Federal Funds rate end the year at 1.75% at which point the Fed would pause from any additional rate cuts in 2020, a Presidential election year, unless the economy weakens meaningfully.  

Let’s look at the data points from last week that either support or detract from our view that the U.S. economy is doing just fine with inflation running well beneath the Fed target, weakness continuing overseas and the dollar continuing to be super strong:

1.) The United States economy has clearly weakened from its stronger than anticipated first quarter real growth: the trade deficit increased to $55.5 billion, the highest level in 2019, as exports rose 2% to $210.6  billion while increased 3.3% to $266.2 billion with the trade gap with China narrowing to $31.1 billion; auto sales continue to be weak running at around a 17 million pace; construction spending fell 0.8%; and the  supply side manufactures index slipped to 51.7 with the non-manufactures index increased to 56.9% from April’s read of 55.5. Clearly the service sector is continuing just fine as evidenced by their business activity index at 61.2; new orders at 58.6 and their employment index at 58.1.

The unemployment data reported Friday was surprisingly strong rising 224,000 jobs which led to a quick selloff in the financial markets fearing that the Fed may not cut rates in July. However, the data confirmed that inflation would remain weak as average hourly earnings rose only 0.2% from last month and was up 3.1% from a year ago missing estimate. If non-farm manufacturing productivity continues to improve at a rate greater than or even near 3% as in the first quarter, it means that there is no employment inflation whatsoever. Since labor is 60+% of cost of goods, it also means that there is little inflation in the system. Conclusion: the Fed should cut rates even with unemployment so low and the economy performing pretty well.

Trump picked two Fed nominees, Christopher Waller and Judy Shelton, who are likely to support lower rates and easier policies. We give even odds only that either/both of them make it through the Senate review.

We remain optimistic that U.S. economic growth will average greater than 2% for the rest of the year into 2020 led by consumer spending. It is very hard to see much of a slowdown with well over 2 million jobs created over the last year combined with meaningful real wage gains. We continue to believe that Trump will do all in his power to bolster economic growth at least through the Presidential elections, 2020. Finally, we doubt that he would do anything foolish on trade which could hurt the economy.

2,) Growth in China continued to weaken in June which is no surprise. In fact, the Caxin-Markit manufacturing purchasing managers’ index fell to a five-month low of 49.4 in June which means contraction. China is suffering from weakness in domestic consumer demand, manufacturing and exports. While we continue to expect the government to enhance both fiscal and monetary policies to bolster the domestic economy, the country needs more than a ceasefire on trade to really reaccelerate growth.

3.) Growth throughout the Eurozone continues to be disappointing especially in Germany which is normally the engine of Europe. German factory orders plunged 2.2% in May and were down 8.6% from a year ago. Huge declines were reported in export orders and investment which does not bode well for the rest of the year. Rates moved further into negative territory last week which says it all.

On the other hand, we were pleasantly surprised that EU leaders nominated Christine Lagarde to be the new head of the ECB. We believe that she is incredibly intelligent, understands the problems with a global perspective, and will engage on multiple front to boost Europe’s growth potential.

4.) Japan on Friday raised its assessment of the economy as the coincident index of business conditions for May rose 1.1 points to 103.2 and output actually rose 2.3% from the previous month. We believe that the threat of a higher consumption tax in October may be pushing buying intentions/manufacturing forward which may result in disappointing numbers later in the year.  Japan needs the U.S. and China to resolve their trade conflicts before we will see any sustainable growth.

Ah, there is no place like home! We continue to believe that the U.S. stock market is undervalued with the 10-year treasury bond yield hovering around 2%, bank capital/liquidity ratios are all time highs and a friendly Fed wanting to sustain the expansion. Why shouldn’t the market multiple be closer to 20 than 17? We remain confident that the Fed will begin cutting rates soon as inflation continues to run well beneath their 2% long standing target. The market will continue to anticipate the Fed moves therefore we would expect the dollar to begin to weaken and the yield curve to slowly begin to steepen. That does not mean that we expect much higher long rates as we still expect inflation to remain surprisingly weak for the foreseeable future.

We are entering earnings season and we strongly suggest that you listen to as many earnings’ calls as possible so that you can better differentiate between managements which is the key to long-term investment success. 

Our portfolios are concentrated in technology, global capital goods and industrials, housing related companies like HD, cable with content like DIS, large domestic global financials like BAC, low cost, free cash generating commodity companies, healthcare with new product flow, agriculture, and many special situations. We own no bonds but expect the yield curve to steepen over time nor are we fully long the dollar anymore. 

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

Invest Accordingly!

Bill Ehrman

Paix et Prospérité LLC

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