Here Comes the Fed

The Fed is about to change course officially this week beginning with at least a 25-basis cut in the Funds rate. The last five times the Fed cut rates “outside of recessions – including 1984, 1987, 1989, 1995 and 1998 – the S&P 500 rose an average of 11% over the subsequent six months and 16% over the next year.” It is interesting to note that the U.S. markets hit new highs this past week although bond inflows continue to increase at a record annualized pace of $450 billion for the year while stock outflows are running at a record pace, too, of over $150 billion for the year. Guess Larry Fink had it right!

Here is one other stat that you might find interesting:  the 10-year bond yield compared to the stock market multiple is trading at a 70-year low. Maybe a 20 multiple is not too much to expect with 10-year bond yield well below 2.5% and bank capital/liquidity ratios at all-time highs. By the way, did you notice that Buffett increased his holdings of Bank of America to 10.4%? Yes, we own it!

We believe that the Fed should be bold at this meeting and cut rates by 50 basis points to jolt the foreign currency markets. Why you might ask? While our economy is doing just fine as evidenced by the better than expected second-quarter GNP report, dollar strength has siphoned money from abroad flattening/inverting our yield curve, penalized growth in those key markets and pushed up the cost up of dollar-denominated commodities overseas. Let us state categorically that if the U.S. was an island unto itself, the Fed really should not cut rates at all even with continued low inflation as our economy is bound to pick up momentum in the third quarter bolstered by continuing strong consumer demand, an end to inventory liquidation along with improved net export numbers both which penalized second-quarter numbers and continued strength in government spending. 

It is time to look over the valley and acknowledge that the Fed will be embarking on a major shift in monetary policy by cutting rates this week to go along with additional fiscal stimulus. We hope that you read the two-year budget agreement just agreed upon by Trump and the Democrats.  Unfortunately, both parties are not concerned about rising deficits going into an election year and agreed to increase aggregate domestic spending by several hundred billion dollars without any caps and real offsets. While we are totally against this agreement, it is clear that fiscal policy will remain highly simulative to domestic growth over the foreseeable future. While China could say the same thing but to a different degree, we remain worried that China’s growth will be hurt by a more rapid fall-off in production/exports than currently envisioned without a corresponding offset/ boost in domestic consumption.

It’s easy to understand why the IMF lowered its 2019 forecast once again. It now believes that global growth will be around 3.2% in 2019 penalized by a deceleration/uncertainty in global trade followed by a small rebound to 3.5% growth in 2020. It’s interesting to note that the IMF said that risks continue to be to the downside as fear of a hard Brexit is rising. The IMF did not change its forecast for U.S. growth in both years but lowered its growth targets for the Eurozone, China, Japan, and the Emerging Markets.  

Let’s review the data points for the week that support/detract from our view that there really is no place like home:

1.) The U.S. clearly is and will remain the engine for global growth for the foreseeable future. The vast number of data points/events of the week support our view that domestic GNP real growth will accelerate to more than 2% over the next few quarters supported by a change in Fed policy along with increased fiscal ease. Second-quarter real GNP exceeded forecasts (not ours) coming in with a 2.1% gain. The composition was not surprising to us too as consumer spending rebounded with a 4.3% gain; inventories subtracted $44.3 billion or 0.86% from GNP; net exports subtracted $34.7 billion or 0.65% from GNP; government spending rose a robust 5%; business investment fell 0.8% and core inflation rose at a slightly faster 1.8% rate which remains below the Fed 2.0% target.

Other key data points include: new orders for manufactured durable goods increased by 2.0% in June; durable good shipments rose 1.4%, unfilled orders fell 0.4%, inventories rose 0.3%, non-defense capital goods orders rose a surprisingly strong 4.8%; existing home sales fell 1.7% in June even though borrowing costs fell; the IHS Markit Composite PMI Output Index rose to 51.5 with the  services index increased to a 3-month high at 52.2 and the manufacturing index falling to 50.0. Clearly, the all-important consumer sector is thriving while the manufacturing sector is plotting along.

We remain optimistic that U.S. real growth will remain above 2% for the foreseeable future supported by the Fed lowering rates along with increased fiscal spending. We really doubt that Trump will do anything foolish like impose added tariffs on China and Europe until after elections fearing the damaging effect on the U.S. economy which is his main source of political strength as we enter 2020.

We are disappointed that both the Republicans and Democrats support broad antitrust reviews of our big, highly successful tech stocks. Technology is our strength. Is our consumer really being hurt by more services at lower, if any, cost to them? We are all for more privacy. More regulations would only impede competition and hurt our competitive standing in the world.

2.) All you have to do is listen in to earnings conference calls to glean that growth has slowed down dramatically in China… but maybe not for Starbucks though. We continue to believe that corporations are shifting their supply lines out of China as fast as humanly possible negatively impacting both the all-important production side of their economy as well as consumer demand. Don’t believe the rhetoric that China is easily offsetting falling U.S. exports as the facts belie the comments. China’s overall exports rose just 0.1% in the first six months with U.S. exports falling 8.1%. China cannot sustain 6% real growth with numbers like this.

We continue to believe that China real growth will continue to slow down without a real trade deal. Even though U.S. negotiators will begin face to face negotiations in China this week, we were surprised to hear Trump agree with us that a real deal will most likely NOT be reached until after elections. We expect China to agree to small deals along the way like increased agricultural purchases to hold off Trump from imposing tariffs on the additional $300 billion of Chinese exports to the U.S..

We continue to avoid investing in China at this time.

3.) President Mario Draghi of the ECB signaled that the “worse and worse” outlook warrants more ECB stimulus. Clearly, the European manufacturing sector is moving into recession already as evidenced by all the recent data out of Germany, heretofore the strongest economy in Europe. Someone has to explain to us why the ECB adding to its net asset purchases will boost inflation and growth! The ECB is swimming upstream and will be totally ineffective until the European governments wake up to the need for aggressive fiscal stimulus and regulatory reform. Do you hear us Germany? And then there is the growing threat of a hard Brexit by the end of October! Just listen to Johnson, the new British Prime Minister.

Invest in Europe? Not us, no matter how cheap it may appear.

4. ) The BOJ meets this week too. What more can they do at this point? Not much! The government really is hamstrung from increasing fiscal stimulus by its huge budget deficit to GNP. Invest in Japan? Not us!

We have not altered our investment position that there is no place like home. Listening to as many earnings conference calls as possible only strengthens our view that management can make all the difference in the world in whether a company/investment succeeds or not. We only own best in class with strong management, winning long term strategies to succeed in an ever-changing global competitive environment, improving financial performance at the margin, strong balance sheets, growing volume with pricing power, rising operating income, cash flow, and free cash flow.

Here comes the Fed!

While the pundits constantly are looking for a correction, you must take a longer view as an investor. Our market/economy will be supported by a change in Fed policy to lower rates along with a government increasing fiscal spending along with fewer regulations. We hope that the Fed is perceived as aggressive enough next week such that our yield curve steepens, the dollar falls and commodity prices rise. If so, all markets will lift as the outlook for global growth will improve too. Yes, the U.S. will be the tipping point if our Fed acts accordingly.

We favor investing in the U.S. until we see discernable policy changes abroad. 

Our portfolios own technology, global capital goods, and industrials, some financials, cable with content, low-cost commodity companies, some healthcare, housing-related and specific retailers, airlines, agricultural-related and many special situations. We are flat the dollar and own no bonds.

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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