Still Playing the Long Ball

Quite a week! Trump left the G-7 meeting without signing off on the communiqué creating tensions with our long-term partners. Kim and Trump reached a deal on the denuclearization of the Korean Peninsula. The Fed increased the Fed Funds rate and presented a more hawkish view. The ECB and BOJ remained overly accommodative. And last, Trump announced $50 billion in trade tariffs against China who quickly retaliated in kind.

There is no better time than now to review all of these facts by, (you know the drill), pausing to reflect on the mindset shifts you see happening, doing your own research to be sure, and then consider what you think to be the proper asset allocation and risk controls for your portfolio.

While there were no real surprises last week from what we anticipated, all markets reacted violently on Friday to Trump announcing $50 billion in tariffs against China which was met with a quick response by the Chinese. There was a flight to safety with bond prices rising, stock prices falling and commodity prices declining along with the dollar.

Perceived adversity creates unusual opportunities to invest for those willing to look over what looks like a valley – but is really just the fertile ground for long-term investors to choose wisely.

Globalization is alive and thriving. Trade patterns, however, may shift; but that is not necessarily a bad thing. Trump is 100% right in his fight for open, fair and reciprocal trade tariffs while protecting our IP. He is playing the long ball, willing to take short-term pain for long-term gain. And there is no better time to do it. The US economy has the wind to its back benefiting from the huge tax cuts, deregulation and an America First policy. Second-quarter real GNP growth may exceed 4%!

Trump clearly believes that trade policies enacted decades ago to boost growth abroad are no longer valid today. He wants a level playing field. Why not? Even the WTO has lost its purpose and been rendered ineffective by its outmoded rules that are no longer appropriate. Trump refers to our manufacturing/producing goods deficit as the US runs a huge services surplus.

We believe that Trump is willing to walk the walk on trade unless all parties come to the table willing to move toward a level playing field. We are the only trading partner running huge deficits. Why? It is not just the Chinese willingness to purchase a $100 billion more in US goods but a long-lasting trade agreement that will create a level playing field and bring down our trade deficit meaningfully over time. He also wants to protect our IP, which is key to our future. Is it wrong that Trump wants nothing less than open, fair and reciprocal tariffs? And he wants similar agreements with all of our trading partners. He is playing the long ball. Nothing wrong with that.

Let’s discuss the near-term ramifications of trade skirmishes.

Clearly global growth will be penalized but not by as much as you may think. Countries will search for other sources and outlets for products. Do you think that China can easily replace all of its imports from the US? For instance, there is only so much soybeans harvested in the world. Do you believe that other producing countries run huge surpluses sufficient to supply China’s needs? Not so! Clearly there will be changes in trade patterns and near-term disruptions, but trade is essentially a zero sum game. Will countries be willing to cut off their noses to spite their faces for long? It is not just price that counts but assurances of supply too.

Trade wars benefit no one, so we believe that cooler heads will prevail in the end.

Clearly global growth will be hit to some degree depending on how broad trade skirmishes/wars actually becomes. We expect the smallest penalty to growth will fall on the US and the largest to China and Germany. Prices will increase too as the tariffs are passed along to manufacturers and to a lesser degree to consumers. Margins may suffer for those unable to pass along the cost increase costs. These one time increases in costs/prices will be considered transitory by all monetary bodies, so longer-term policies won’t change although they could be pushed out. For instance, our Fed may hold off on future rate hikes until the full impact of trade skirmishes/wars and higher tariffs are better seen and understood.

If monetary tightening is delayed, the global expansion will be extended well into and maybe beyond 2020 albeit at a lower rate as changes in trade patterns are enacted. Here again the United States will be the relative winner, as changes in trade patterns will not penalize our over all growth as our trade deficit is likely to fall. We expect domestic and foreign corporations will continue to step up domestic capital spending anticipating changes in future trade agreements. Corporate tax reductions and reduced regulations are other incentives to build here.

What are the longer-term implications of changes in trade patterns?

The United States and China are clear-cut long-term winners as we have said time and again. Major changes are in the air in both countries as the United States supports growth in its domestic manufacturing base and China emphasizes domestic consumption and technology as it downplays low cost manufacturing. Trump’s pro-business, pro-growth, America-First strategy has been a game changer, while President Xi Jinping’s 20-year plan for China says it all. Our European, Japanese and North American partners are one step behind in need of financial and regulatory reforms to better compete and grow in today’s globally competitive environment with changing trade patterns. Emerging markets may suffer too.

Where do we stand today?

We do not expect the trade skirmishes to lead to trade wars, as cooler heads should prevail. It may be easier to reach an accommodation with China and Japan than with the ECB and our NAFTA partners, but it will come even with them over time. It does not hurt that the US is the largest economy in the world with the lowest tariffs and least government subsidies, and it is rapidly becoming energy independent.

The United States economy is hitting on all cylinders. Both businesses and consumers are thriving as evidenced by accelerating growth in consumption and capital spending. Second-quarter earnings gains are likely to equal the 20+% gain as seen in the first quarter.

Let’s take an example. Nucor’s revised second-quarter forecast is that earnings are likely to exceed $2.10 per share vs. $1.00 last year with strong gains expected for the remainder of the year. The company has great management; is a huge cash generator; has 45 years of higher dividends and will likely pay a huge extra dividend early next year. Did I mention that Nucor is a steel company? It sells at less than 8.5 times 2018 projected earnings, and is a huge beneficiary of America First. Its best years are ahead.

Our portfolios are structured to benefit from longer-term trends in place. We play the long ball with one eye always focused on near-term events. We realize that there are times to reduce our exposure and hedge. We always maintain excess liquidity to take advantage on inefficiencies created in the marketplace. The pundits continue to stay one step behind and shifted over night recommending defensive stocks. We disagree as most of these companies have slowing volume and no pricing power so their operating margins will continue to fall over time.

We continue to emphasize the large financials who will benefit from loan growth, tight cost controls, increased market volatility, further dividend hikes and increased buybacks which should be announced shortly after the latest stress test results are reported; capital goods, industrials, and technology companies who will benefit from global growth and increased capital spending; industrial commodity companies as production growth outstrips capacity additions leading to higher prices over time (management remains very disciplined generating huge free cash flow); domestic steel and aluminum benefiting from America First; and special situations where internal changes unlock value not reflected in current stock prices. We remain short bonds and long the dollar.

Review all the facts; pause, reflect and consider mindset shifts; always look at your asset composition and risk controls; do extensive first hand research and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

Leave a Reply

Your email address will not be published. Required fields are marked *