Global Uncertainty Trumps Lower Interest Rates

When will all the monetary authorities and governments realize that lower interest rates at this point won’t boost global growth? No one wants to borrow due to global uncertainty! The impact of lower interest rates is pushing investors further out on the risk curve. Is that their intention? Does that benefit the economy, consumers and business owners? While some interest costs will decline which is good for sure, consider also the negative impact on all the savers around the world like retirees. Would you buy a bond in Europe and Japan where interest rates moved further into negative territory last week? You are paying the lender for the privilege of owning their obligation. Maybe it’s time for all these governments to issue huge amounts of long-term debt to finance projects that will stimulate growth and raise employment. Hear us, Germany? Can you believe that our government is still selling mostly short-term paper to finance its obligations when long-term government bond yields are so low? How foolish!

It is time for Trump and his administration to realize that it is their actions–not Fed policy–that is holding back growth here and abroad. How can a business properly plan with such uncertainty about trade/policy? Just look at what Trump said last week. He announced 10% tariffs on $300+ billion of Chinese imports effective September 1st; continued to threaten 25% tariffs against European car imports and raised tariffs on Russia. By the way, he could turn around on a whim and not move forward on any of these additional tariffs as he did with the threatened tariffs on Mexico due to immigration issues on the border. 

Let us state unequivocally that our market is statistically undervalued today with earnings surprisingly up in the second quarter, 10-year treasury yields at 1.85% and bank capital/liquidity ratios at an all-time high. None of the preconditions for a market top are apparent. Yes, we were disappointed with the markets’ reaction to the Fed 25 basis point rate cut and an end to its balance sheet runoff announced last week as the yield curve did not steepen nor did the dollar fall. It is hard to fathom that 10-year bond yields ended the week at 1.85% here, -(0.50) % in Germany and -(0.10) % in Japan. Powell stated the obvious at the follow-up conference meeting that the U.S. economy is in fine shape, but the Fed is worried about global growth and escalating trade tensions. Clearly the December hike was a mistake. While we still believe that the Fed will cut rates by an additional 25 to 50 basis points by year-end, we doubt that it will help the manufacturing side of our economy unless there is some resolution/certainty on trade. 

The bottom line is that we continue to expect the U.S. economy to do reasonably well over the next 18 months bolstered by strong consumer spending and additional fiscal stimulus. While we do not like tariffs, as it is a tax on our consumer, it is important to put them into their proper context: GNP is approximately $22 trillion; consumer spending is the largest portion at approximately $14.3 trillion and the incremental tariffs may add up to $30 billion if all passed through to the consumer which is unlikely. By the way, the first 25% tariffs on $250 billions of Chinese exports did not really impact consumer spending nor inflation. Also, total tariffs, if enacted, would be less than half the boost in fiscal spending over the next two years and far less than the tax cut that went into effect last year. Could tariffs slow growth from what it otherwise could be…of course! Even though we continue to believe that the manufacturing sector of our economy will remain flattish, we are still forecasting growth over 2+% over the next 18 months especially with Trump doing everything in his power to bolster the economy and stock market as we move towards the election in 2020. 

Let’s take a look at the most recent data points which support or detract from our view that the U.S. economy is in good shape; growth in China continues to slow; and the outlook for the Eurozone remains poor. We also do not like the outlook for Japan, especially if trade tensions escalate globally.

1.) There was a tremendous number of data points reported in the U.S. last week that support our belief that economic growth will continue at a 2+% rate for the foreseeable future: the U.S. economy added 164,000 jobs in July; unemployment was only 3.7%, hourly wages rose at an annual rate of 3.1%, and U-6 fell to 7.0%. Revisions subtracted 41,000 jobs from the prior two months. The Conference Board reported that the Consumer Confidence Index rebounded in July to 135.7 from 124.3 in June. Consumers were more optimistic about present-day conditions, the future and their outlook for the labor market. Pending home sales beat expectations in June too as low mortgage rates finally kicked in. It was important to note that personal income rose 0.4% in June; disposable personal income also increased by 0.4% and personal consumption expenditure rose 0.3%. The all-important PCE which the Fed watches closely rose only 0.1% in June and is up 1.4% from the year earlier. We were pleased to see that new orders for manufactured durable goods increased 2.0% in June after two monthly declines while shipments increased 1.4% and non-defense new orders for capital goods increased by 4.8% in June. 

Unfortunately, the ISM Manufacturing Index fell to 51.2 in July from 52.7 in June supporting our contention that this sector is still weakening. Also, construction spending continues to weaken too and is down 2.1% compared to last year at this time. 

As we mentioned earlier, the Fed cut its funds rate by 0.25 basis points last Wednesday and also ended early its portfolio runoff. Unfortunately, we did not believe that Powell did a good job at the following press conference as he failed to fully explain the reasons for the mid-course adjustment and why two board members voted against the cut in rates. He never mentioned the yield curve nor the strength in the dollar as reasons for the shift in policy which we believe was a mistake. He did emphasize weakness overseas and trade conflicts as reasons for the cut.

Finally, the Senate approved the two-year spending bill which adds $200 billion to spending and suspends the debt ceiling until 2021. The annual deficit is unfortunately headed to $1 trillion which may boost the economy over the next two years but at what cost longer term?

2.) Growth in China continues to slow as evidenced by the most recent Calxin/Markit factory purchasing managers index remaining below 50 in July. The government will embark on additional monetary easing measures plus more fiscal spending to offset domestic weakness in production/exports/consumer spending especially with the 70th anniversary/celebration of the Communist Party rule on October 1st. It will be difficult for China to retaliate against any additional tariffs as there remains only $10 billion in U.S. exports to China not tariffed already. Also, China is fully aware of companies shifting their supply chains, so government officials have held many meetings recently with U.S. companies in China assuring them that the government won’t retaliate against them.

China needs to come to the table in good faith, stick to its commitments and end the trade conflict not using the upcoming election as a bargaining chip.

3.) The outlook for the Eurozone continues to deteriorate…just look at the fall in bonds yields further into negative territory last week. Growth in the Eurozone fell to 0.2% in the second quarter down from 0.4% in the first quarter even though the jobless rate fell to 7.5% in June, an eleven-year low. Inflation slowed to an eleven-month low in July at 1.1% year over year. Here too, we don’t believe that if the ECB takes additional easing measures in September that it will stimulate growth. It is time for Germany and all other nations in the region to embark on major fiscal stimulus packages along with major regulatory reform. Trade deals are a necessity too. It certainly does not help the outlook in the region that the odds of a hard Brexit are rising. We continue to avoid investing in this region for good reasons. 

4.) Nothing good to say about Japan other than its currency is doing better than most. We are waiting for the government to announce postponing its retail tax hike scheduled for October. Unfortunately, here too there is little left that the BOJ can do to stimulate growth. Uncertainty over trade and a huge budget deficit limits government options that could benefit the country. 
We continue to avoid Japan as well.

While we are not pleased that Trump announced additional tariffs against China effective September 1st, we fully understand his frustration that President Xi did not live up to the promises he made when they met in Japan. We believe that the U.S. is in far better shape than China and the other major industrial nations to weather the additional trade storm as trade is a much smaller percentage of our GNP: our banking system is strong; the fed has many arrows left in its quiver to stimulate;  our economy/consumer are in good shape; and our fiscal policy is highly stimulative. Our markets are undervalued using many different tools, but we like to use Buffett’s favorite one which compares earnings yield to bond yield. That differential has widened to the largest difference in many, many years.

It is amazing to see how fast the pundits shifted their view looking in the rear-view mirror rather than the windshield. Bullish to bearish overnight. They think like traders rather than investors. We view market dips as opportunities to invest/add to positions at better prices as long as we have not altered our investment stance.  Second-quarter earnings are beating estimates, companies are generating huge amounts of free cash increasing their dividends and buybacks. Did you know that the S & P 500 dividend yield now exceeds the 10-year treasury bond yield? And dividends are going up meaningfully this year. Would you rather own a company growing at 10% per year yielding well over the 10-year treasury and selling at less than 60% of the market multiple or a 10-year treasury yielding 1.85%? Think as an investor!

 U.S. stocks as an asset class are inexpensive for all the reasons stated earlier. We did not keep our head in the sand. We responded to the market’s reaction to the shift in Fed policy. We sold several financial and industrials/commodity companies having anticipated a steepening yield curve along with a weakening dollar which did not occur and added to consumer staples and healthcare stocks with 10+% growth rates and yields 50% plus higher than the 10- year treasury yield of 1.85%. We also added to the growth portion of our portfolio emphasizing technology companies that won’t be hurt if the global economy slows further. Remember that as interest rates go down, valuations go up! We maintained our exposure to cable with content, housing related retail, specialty retailing, agriculture and several special situations.  In addition, we are planning to write calls against several of our positions if the economics work. Net, net we raised our over-all cash reserves hoping to add to our investments on further market weakness.

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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