This Too Shall Pass

As investors, we take a multi-year view. While we do not want to minimize the devastation to life caused by the coronavirus nor its near term impact to the global economy, our role is to look over this valley, as this too shall pass, and take advantage of the inefficiencies created in all of the financial markets.


Global stock markets and commodity prices are falling while bond prices are soaring.  The dollar has regained its strength and safe haven status along with the Japanese yen. Opportunities are being created for the patient, long-term investor, but go slowly as uncertainty is the word of the day and markets hate uncertainty.


So far there are approximately 12,000 reported cases of coronavirus worldwide and nearly 260 deaths globally, all in China. If history is any guide, the rate of change in the number of people getting the virus and dying from it should begin to slow in a matter of weeks. The Chinese government is moving rapidly to contain the virus, corporations are shutting down their operations asking employees to stay at home, governments are restricting travel from and to China, and the best of the best in healthcare are working together to control, mitigate, and ultimately find a cure for the virus.


Let’s put the coronavirus in perspective.  The flu has infected over 19 million people while killing over 10,000 so far in the 2019-2020 flu season in the U.S alone. No one talks about it as a national disaster and a detriment to growth as we feel that we have it under control. Do we? The health authorities, when approving a vaccine each year for the flu season, rarely get it right. Does the flu epidemic alter the long growth potential of the U.S? No. Will the coronavirus alter the long-term growth potential of China? Not really! So why not look over the valley and take advantage of these near-term inefficiencies in the financial marketplaces? It is not easy for sure, but the best opportunities are created when others are uncertain and panic. We maintain a long-term view: buy when value exists and sell when fully valued.  We always challenge our core beliefs and remain open to change, if/when warranted. We fully recognize that we live in a VUCA (volatile, uncertain, complex, and ambiguous) environment but invest for long term gains rather than trade which is a losing strategy over time.


Our base case remains that the coronavirus and the flu will both be contained before the end of the first quarter, 2020. There is no doubt that near term global economic growth will be penalized big time as growth in China in the first quarter could easily be halved from previous expectations and multinational earnings will clearly be impacted too. But will that alter long-term prospects for both China and these corporations. Not at all!


Chinese monetary authorities mentioned yesterday that they will provide all the capital needed to deal with the economic blow from the coronavirus to support their financial markets. We fully expect the government to announce a massive additional fiscal stimulus plan to jump start the Chinese economy once the virus is contained.  In fact, all of the global monetary authorities will keep the money spigot wide open in 2020. Our Fed, which met this past week, confirmed its easy monetary policy not expecting the funds rate to increase until inflation reaches 2% for a sustained period which won’t happen anytime soon. On the other hand, Fed Chairman Powell did mention that the Fed may begin to wind down its $60 billion per month expansion in its balance sheet sometime this spring but that remains to be seen during these questionable times. The Fed will continue, no matter, to expand its balance sheet in the future but at reduced levels to maintain ample reserves in the system so the repo problem does not happen again.


Investment Conclusion


The engines for accelerating global growth are primed and ready to go once the world gets its arms around the coronavirus, trade deals kick in, and monetary stimulus is in effect, reducing the cost of capital for businesses and consumers alike.  Add to all of this, the benefits of major fiscal stimulus in China, Japan, and the U.S.  If anything, the virus may cause both monetary authorities and governments to do even more than is currently on their plates to re-ignite their economies.


We expect the global economy, as well as that of the U.S, to improve as we move through the year. For example, the U.S economy alone will be hit by around 0.5% annualized during the first two quarters of 2020 due to Boeing’s problems bringing the Max back online. We are hopeful that the FAA will approve it by mid-summer with production beginning even sooner but at much lower levels than existed in 2019. On the other hand, all of the trade deals finally concluded by the U.S. with China, Mexico, Canada, Japan and others will ramp up, too, as we move through the year, potentially adding well over 0.7% to annualized growth in the latter half of 2020. Net net, we would not be surprised to see first half GNP growth slightly less than 2% with the final two quarters running at 3% or above. In addition, as we wrote above, China’s growth will accelerate rapidly with added monetary and fiscal stimulus once the coronavirus is controlled such that their economy will recover and sustain growth at around 6% annualized once again as the year progresses.


Just the acceleration of these two economies alone would be sufficient to boost global growth as we move through the year, but we also expect the emerging markets, Japan, Australia, India and others to move into gear as the year progresses. By the way, India’s government just slashed taxes and increased fiscal spending to boost growth back above 5% in 2020 from beneath 4% last year. You can see why we remain optimistic that global growth will end the year on a high note, after a sluggish start, which is not the consensus at this time, which we like.


After having reduced our economically sensitive stocks over the last few weeks as discussed in previous blogs, we are looking to add them back over the next few weeks as they are beginning to be priced, once again, at recession valuations. Each of the companies that we would buy have strong managements with winning strategic long term plans, have exceptionally strong free cash flow after investing in their businesses, have dividend yields well over 3% and growing and are buying back tons of stock out of free cash flow reducing the count by over 3% per year. Energy is not part of this group.


Before we conclude this blog, we must discuss two areas of uncertainty that has existed in the marketplace over the last few months. First, it now is evident that the Senate will vote next week to exonerate Trump. The impeachment proceeding will finally come to an end. Second, Brexit is a done deal as of Friday night at 11:00 PM. The transition phase will last for a year with Britain as a nonvoting member of the Eurozone but be able to trade freely within the EU. If the two sides cannot reach a deal on their future relationship by December 31st, business will be conducted on World Trade Organization terms and border checks will be imposed where now none exist. We would not be surprised to see Trump and Johnson make a major trade deal between them before either one makes one with the Eurozone.


In conclusion, we believe that the major issues facing investors today are transitory and that growth will resume as we move through the year. We are also factoring in that all of the monetary authorities are unusually accommodative providing far more capital to the system than is needed by the real economy thus finding its way into risk assets just like last year. And you know how the financial markets reacted last year!  Remember that most all interest rates have retreated to near all-time lows, spreads remain tight and major bank capital/liquidity ratios are at all time highs. Clearly the stock market multiple should exceed 20 times projected earnings.


But the major difference today than last year is that we are on the cusp of accelerating global growth with all the stars aligned once the coronavirus is controlled. This too shall pass. This has happened time and again when epidemics spread in parts of the world. Now is the time to average into stocks when uncertainty is high, valuations are low, dividend yields exceed the 10-year treasury yield, and few are optimistic about the future. We expect to look back in a few months after the virus is controlled and ask why we did not do even more buying as others panicked. We recognize that the Chinese markets could have a blood bath when they reopen next week but we expect the government to do all in its power to mitigate the decline. We will continue to average into those stocks that we want to own long term as prices weaken.


Our major area of emphasis remain technology, including the semis. Look at Microsoft’s numbers. It is our second largest position. We also own some financials who are earning more each year, generating tremendous free cash flow, pay large and growing dividends and are shrinking their capitalizations big time. This has all been done with a relatively flat yield curve. Can you imagine their earnings once the yield curve normalizes?


Global capital goods and industrials remain a major focus, too, as their volumes and earnings grow despite sluggish global growth. They are generating over 100% free cash flow per year that is in the billions being used to enhance shareholder returns. Also, we own the low-cost industrial commodity companies that are also generating billions of free cash flow with large well supported dividend yields over 5% and large buybacks in place. We expect shortages in copper in 2021.  Housing related retailers is another area that we favor as there is a shortage of low cost housing in this country. Finally, we own many special situations where their intrinsic value is at least 50% greater than current valuations. Each one has exceptionally strong balance sheets with huge free cash flow, too and yield over 3%. We own no bonds and are flat the dollar.


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Remember to review all the facts; pause, reflect and consider mindset shifts; turn off the pundits/experts; look at your asset mix with risk controls; listen to as many earnings call as possible; do independent research and …


Invest Accordingly!


Bill Ehrman

Paix et Prospérité LLC


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