Thinking Out of the Box

As we discussed in last week’s blog “Race to the Bottom” traditional means of stimulating economic growth are no longer working and are, in fact, backfiring from their real intent.  Governments’ need to move away from reliance on any additional monetary stimulus, which clearly is not working, and begin huge fiscal stimulus programs financed with 50+ year bonds at little or no cost. If not, the risks to the downside, including deflation, will continue to rise. But change is in the air!

Look at what happened to all financial markets Friday after it was reported that Germany may be willing to run fiscal deficits during recessions.  That’s Germany, the most fiscally conservative country—not Greece—that we are talking about!  But, will the government actually pass a large pro-active anti-cyclical package? Well, Germany has indeed entered a recession so, let’s see if the government walks the walk. Time will tell, but if Germany passes one, expect all countries in the Eurozone to quickly follow suit with Germany’s blessing. Remember that deflation is everyone’s biggest fear, not inflation. We also believe that Christine Lagarde, who will shortly become head of the ECB, will support such stimulus programs. And we expect ECB’s Draghi last hurrah to end with a bang next month, his largest stimulus plan to date. Will it work? Doubtful! But change is happening.

China ‘s central bank announced reform yesterday. The bank will replace benchmark interest rates with Loan Prime rates based on world bank lending rates as a reference for pricing new loans. Policy makers are hoping to substantially cut borrowing costs and increase supply while increasing demand for funds. We expect the government to announce major new fiscal stimulus plans to bolster growth in the next few weeks too. If not, China’s growth will continue to decelerate, and unemployment would rise. But don’t fret as change is happening.

The U.S government is considering selling 50-100-year bonds. We discussed this very same topic last week and strongly believe that the U.S should not only refinance as much of its short/medium term debt as possible longer term to benefit from the huge decline in rates but also finance a much-needed infrastructure program this way. Change is happening here as well.

Look at the topic for discussion next week when the Fed governors meet at Jackson Hole for their annual symposium: “Challenges for Monetary Policy” in today’s global environment. How relevant is that? We expect to hear that the U.S economy is fine, but the Fed is worried that weakness overseas could find its way to our shores such that the Fed had to commence a midcourse correction. We really hope to hear what the Fed has in its toolbox, beside lowering rates, to steepen the yield curve which is of great concern to all. Let’s see if Powell and the Fed really have come up with creative tools to end the yield curve flattening/inversion. If so, that would be great which would help restore business/investor confidence. More change brewing.

We pride ourselves for positioning our portfolios to not only benefit from the current environment but also for looking over the valley to benefit as change happens.  Right now, our portfolios are highly defensive owning consumer no-durables, utilities, some retailers, cable with content, technology with little/no exposure to China, airlines, special situations and gold. We own no financials nor cyclicals. Even though change is happening, it does not occur overnight so great patience will be needed to let it all unfold. The rewards could be tremendous. As we mentioned last week, we are creating an options portfolio to benefit from the changes we see taking place with governments and monetary authorities finally thinking out of the box.

We were asked last week by one of the truly great investors of our time whether we felt that our market was fully valued at less than 17 times earnings with 10-year treasuries yielding around 1.5% and 30-year bond yields hovering around 2%. He was pulling our leg. He knew what our answer would be. Undervalued, but only for investors. We recognize that near term systematic trading can play havoc with the market and make anyone look foolish. Did you know that over half the S &P is yielding far in excess of the 30-year bond yield? And we expect dividends to rise over time. What would you rather own today as an asset class? Stocks, for sure. Our strength is to own the right stocks.

The U.S economy continues to be in far better shape than virtually every other major industrialized nation. Let’s take a look at the most recent data points that substantiate or detract from our view:

  • The U.S economy is tracking for 2+% growth in the third quarter led by continued strong consumer demand along with stimulative fiscal policy at all levels. Our industrial complex and farming remain stuck in the mud held back by our trade policy. Consumer sentiment has trailed off recently but is still a healthy 92.1; current economic conditions is 107.4 and the index of consumer expectations fell to 80.2. All of these numbers are good but apprehension over trade and jobs are rising. The services sector continues to roll along with second quarter revenues up 1.3% from the first quarter and up 5.4% from a year ago. We were pleased to see housing permits increase 8.4% from June levels while housing completions rose 7.2% as low mortgage rates finally appear to be kicking in. Retail sales continue strong as evidenced by Walmart’s numbers. We expect good numbers out of Target and Home Depot this week. The traditional department store unfortunately continues to suffer and lose market share. It should be noted that the U.S deficit already exceeds last year’s numbers as spending has increased by 8% while revenues rose only 3%. Highly stimulative.On the other hand, industrial output declined 0.2% in July and is down 1.5% since December. Capacity utilization has dropped to 75.4 percent, 3 percentage points below the long-term average. 

    We were pleasantly surprised to see that non-farm business labor productivity increased 2.3% in the second quarter with unit labor costs up only 2.5% over the last year. Despite all the tariffs, the price index for U.S imports has fallen 1.8% over the last year. Interesting! However, overall CPI inflation has picked up modestly having increased by 0.3% for the second consecutive month.

    Trump postponed last week additional tariffs on over $100 billion of Chinese exports from September to December. It is clear that Trump is getting more concerned about the 2020 elections and wants/needs a strong economy and stock market to win. He also took the time to question three major bank CEOs learning first-hand how his trade policy is hurting corporate confidence impeding spending/hiring plans. We do not see how Trump could impose additional tariffs in December without hurting his election chances next year.

  • China’s July economic performance slowed dramatically from a year ago: industrial output rose only 4.8%; retail sales increased only 7.6%; and fixed asset investment slowed to growth of only 5.7%. These numbers are multi-year lows. Remember that China needs to sustain growth over 6% to keep their unemployment rate from rising. China is clearly suffering from the trade conflict as businesses’ shift their supply chains to other countries to avoid tariffs.Weakness in China’s bank lending in July also supports our view that China’s growth targets for the foreseeable future are suspect. Clearly, the bank moves yesterday are in response to weakening domestic growth/demand. We expect a major fiscal stimulus plan prior to October to bolster the economy. We expect growth to slow for the rest of the year but better performance in 2020 as all the stimulus kicks in.
  • Growth in the Eurozone slowed to only 0.2% in the second quarter. You only have to look at the move down in rates last week prior to Germany’s announcement that it may increase fiscal spending even if it caused a deficit. In our opinion, Germany and the rest of the Eurozone is already in a recession so the governments better move fast, or their economies will continue to deteriorate rapidly with rising deflationary risks. German economic sentiment fell to a negative 44.1 in August while the entire Eurozone economic sentiment declined to a negative 43.6. Whoa!We really don’t care what “big bazooka” Draghi and the ECB have planned for September. Time for the governments to step up to the plate with huge domestic stimulus programs. A hard Brexit in October is more likely than even which will only hurt growth all the more.
  • Japan is caught in the cross hairs of the trade conflict between the U.S and China. There is really very little that the BOJ can do to stimulate growth at this point. We are surprised that the government hasn’t already announced a delay in hiking the upcoming retail tax increase.

The prospects for Japan remain dim.

Governments/monetary authorities may be finally willing to think innovatively as traditional monetary means to stimulate economies are not working.  Just look at where current interest rates are globally and the sheer magnitude of government debt yielding negative rates. The race to the bottom has failed! It is time to stop pushing on a string and adopt major fiscal policies to stimulate growth. It is clear that there is a global movement finally afoot to adopt the right policies, but the risks remain high that governments move too slow adopting the needed stimulus plans.

Notwithstanding, we are for the first time, cautiously optimistic that the powers to be are finally panicking and will enact fiscal policies to stimulate growth, cause yield curves to finally steepen and end currency policies competitively devaluing one’s currency. However, we are not willing to shift our defensive view until we see more cards turn up supporting that view. 

Right now, there is no place like home. The U.S is clearly best positioned to sustain its growth rate over the foreseeable future as we have a strong consumer, a very stimulative fiscal policy and a monetary body with many arrows left in its quiver to support growth. Our market for an investor is tremendously undervalued for sure selling at 17 times earnings with yields so low and bank capital/liquidity ratios so high. There is NO financial stress as evidenced by spreads staying tight.

Our portfolios are concentrated in consumer non-durables, utilities, technology with limited/no exposure to China, retail including housing related like HD, healthcare with major new product flow, airlines,  gold, and many special situations. We own only best in class with superior managements, winning strategies, rising earnings, huge cash/free cash flow, dividend yields over the 10-year treasury bond yields and all selling well beneath intrinsic value. We own no financials, cyclicals and commodity stocks but we are working on an options strategy to shift more cyclical if the cards turn up right but with limited capital at risk. We continue to maintain above average cash reserves.

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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