Responding to Change, Again!

The financial markets continued to rally big time last week as global tensions eased with the United States and China making meaningful conciliatory gestures.

 

Specifically, Trump postponed the imposition of 5% extra tariffs on Chinese goods by two weeks to mid-October so that China could celebrate its October 1National Day without a fresh escalation in tensions. China responded by making substantial agricultural purchases and delaying added tariffs on many U.S imports until mid-December. China also announced a huge list of U.S. imports that would be exempted from tariffs. In addition, there were comments from both sides that there could be a narrower deal now followed by subsequent deals down the line. Maybe both sides finally recognize the pitfalls to their economies if the trade conflict escalates out of control. Remember that Trump wants to get re-elected next year while China wants to succeed on  Made in China 2025.

None of this went unnoticed by the financial markets. Stocks continued to climb, bond prices fell as the yield curve steepened, the dollar fell, and industrial commodity prices rose while precious metals fell reflecting reduced global tensions. Underneath the hood, there was huge rotation in the stock market out of defensive names into more economically sensitive ones that were selling at recession level valuations. Fortunately, we began to shift the composition of our portfolios 10 days ago adding some financials, capital goods/industrials, and commodity companies while reducing some of our more defensive holding including gold stocks.

While it is impossible to be certain if there is an “all clear” at this point as we live in a VUCA (volatile, uncertain, complex, and ambiguous) environment, we must act and react accordingly as the cards turn up one way or another. And we hedge. We have made four major shifts in the composition of our portfolios over the last year dictated by events: the Fed over-tightening last October; the Fed capitulating in December; trade tensions ratcheting up big-time late spring; and now. Paix et Prospérité has outperformed the indices (especially the hedge fund index) over this period and over our career as we respond to change quickly. As our tag line states, we review all the facts; pause, reflect and consider mindset shifts; analyze our asset mix and risk controls; do independent fundamental research and invest accordingly.  Right now, the wind remains to our back as more liquidity is being provided by the monetary authorities than is needed in the real economy thus boosting the value of risk assets.

Remember that another round of global monetary ease has just begun: China cut the bank reserve ratio freeing up $126 billion of added bank liquidity; the ECB cut its target rate to minus 0.5% and reintroduced a program to buy more eurozone debt;  the BOJ may cut again next week or wait until its next meeting to see the effects of the proposed retail tax hike October 1 on its economy; and we expect the Fed to cut the funds rate by an additional 0.25 points on September 18.

Let’s review some of the key data points reported last week that support or detract from our view that the U.S markets remain undervalued and are preferred over other markets until there is more certainty on trade and/or major fiscal/ regulatory policy changes are actually passed in key overseas economies.

 

The United States

The majority of economic data reported last week supports that the U.S economy remains in great shape led by the consumer combined with huge fiscal stimulus. Just read some of the following stats which serve to underline the strength of the U.S consumer: the index of consumer sentiment rose to 92.0 in September, current economic conditions rose to 106.9 and the index of consumer expectations increased to 82.4. Wow! It was also just reported that August retail sales advanced more than expected rising 0.4% from the prior month, led by motor vehicles and on-line purchases, after an upward revised 0.8% increase in July. In the first week of September, initial unemployment claims fell to only 204,000, an indication of continued employment strength. The U.S. budget gap widened to more than $1 trillion dollars in the first eleven months of the fiscal year, up 19% from a year ago, as government spending rose 7% while receipts increased only 3%. Don’t forget that the most recent two-year budget deal will expand the deficit by several hundred billion providing additional stimulus to the domestic economy.

It was also reported that core CPI and PPI accelerated slightly in August with core CPI, excluding food and energy, up 2.4% from a year ago and core PPI, also excluding food and energy, up 2.3% from August 2018. Ironically, inflation expectations moved lower in August. Manufacturing data reported last week support continued weakness as inventories are rising faster than sales and capital spending remains constrained

Despite rising inflationary pressures and the recent steepening in the yield curve, we still expect the Fed to cut rates by an additional 0.25 point on September 18. If not for trade issues and real weakness overseas, we would vote against lowering rates further. After all, our economy is doing just fine. And we expect Trump to do whatever is necessary, including reaching some interim/partial trade deals and cutting taxes on the middle/lower classes, to boost the U.S economy and stock market in 2020 before the Presidential election.

 

China
We have not changed our view that China needs a trade deal more than the United States. We mentioned last week that exports, even in dollar terms despite the weak yuan, fell for the fourth consecutive month in August. Since the trade war began a year ago, China has cut taxes, lowered bank reserve requirements, weakened its currency and sharply increased fiscal stimulus especially on infrastructure projects. Notwithstanding all of these moves, their economy continues to slow, and companies are shifting their supply chains out of China as fast as humanly possible. None of this has gone unnoticed by the government and may explain some of their recent conciliatory moves on trade delaying some tariffs, removing some products from the tariff list including soybeans and pork and finally announcing major purchases of agricultural products.

We believe that the government wants to make a deal with Trump knowing full well that Trump needs a deal to get reelected and that the Democrats may even be more difficult to negotiate if elected than Trump. We would only consider investing in Chinese consumer companies at this time.

 

Eurozone/England

The ECB did exactly what was anticipated last week lowering its key interest rate and launching a program to buy additional bonds. Big deal if there is no demand for money. Industrial production has continued to decline, exports are weak and capital spending has slowed to a halt. We can only hope that Christine Lagarde, when she becomes head of the ECB in November, can convince the finance ministers to change their debt rules that currently limit spending. Draghi has tried but unsuccessfully.

We remain very pessimistic about the outlook for the Eurozone. We do not see added fiscal stimulus soon; we do not see needed regulatory reforms; we do not see trade deals with the U.S., and we see Brexit on the horizon. Why invest here?

 

Japan

Japan remains on the cusp of raising its retail sales tax to 10% on October 1.  Second-quarter growth slowed to 1.3%, weaker than anticipated, and the third quarter growth started on an even weaker note as machinery orders slowed dramatically. Here again, we do not see how it would help its economy if the BOJ cut rates further from a negative 0.1% rate and increased its debt buyback program. And how can the government increase fiscal stimulus with its current debt load to GNP? Japan is really stuck between a rock and hard place captive to global trade conflicts and the inability to raise domestic spending. Why invest here?

 

Conclusions

While we are hopeful that a trade ceasefire can be reached, there can be no certainty so we remain open-minded and are willing to change if events dictate. Clearly, there were some concessions made on both sides last week which were meaningful, but a real trade deal is anything than certain. We believe that both sides are trying to find a middle ground and will hopefully take baby steps to achieve a series of trade deals that encompass both the trade imbalance and IP.

What we know for sure is that all monetary bodies are extremely accommodative, creating more liquidity in the system than is needed by the real economy. Clearly, this helps all risk assets. The Fed is next on deck to cut rates this week. We continue to believe that our 10- and 30- year bond yields are too low viewed against the continued strength of our economy with inflationary pressures increasing somewhat. We were pleased to see that over $170 billion of corporate debt has been refinanced in just the last two weeks significantly reducing interest costs, lengthening terms, and boosting profits/cash flow. Finally, the U.S government is considering issuing 50+year bonds next year. Great news!

Despite the recent rise in the market over the last three weeks, we continue to believe that it is undervalued selling at slightly above 17 times prospective earnings with the 10- year treasury yielding 1.9% and the 30-year treasury yielding 2.3% with bank capital/liquidity ratios so high. Isn’t it amazing how quickly the pundits changed their view over the last few weeks? Fortunately, we began to shift the composition of our portfolios two weeks ago focusing on a change in tone from both China and the United States, continued dovish words out of all monetary bodies and finally comments heard on corporate conference calls.  The untold story is how well corporate America is performing despite a VUCA environment.

The bottom line is that the wind continues to our back for investing as we are able to find great companies with superior management, winning strategies, rising volume, profits, cash flow, and free cash flow selling well beneath intrinsic value. Here again, look at Buffett’s bond yield v.s earnings yield matrix. Pretty straight forward decision for investors.

We began shifting the composition a few weeks ago away from defensive stocks which were over-owned selling at historically high multiples to more economically sensitive stocks selling at recession multiples generating huge free cash flow with dividend yield well above even the 30-year Treasury bond. Many of these investments provide multiple ways to win like UTX mentioned last. We maintained our exposure to technology, cable with content, retail-like HD and TGT, telecommunications, airlines, and many special situations. We added banks, capital goods/industrials, industrial commodities, and machinery. We own no bonds and are flat the dollar.

 

We are looking forward to our inaugural “Investment Committee” webinar tomorrow, September 16 from 8:30 am – 9:15 am EST. We will begin the webinar with a review of the global investment environment and after our 15-minute presentation, we will open up the call for your questions.  You can join the webinar by typing the following in your browser: https://zoom.us/j/9179217852. To ensure a better experience you may wish to download the free Zoom software from the Zoom download center onto your computer for the best possible experience: https://zoom.us/download

 

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

 

Invest Accordingly!

Bill Ehrman

Paix et Prospérité LLC

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