Time to Believe

Who better has the pulse on what investors and businessmen are doing than Larry Fink, a longtime friend, who is head of Blackrock, the world’s largest money manager? We were heartened last week to hear Larry say on the company’s earnings call that investors are under-invested in equities; the U.S. was the best-positioned economy of the major industrialized nations; companies were moving their supply chain out of China as fast as possible putting downward pressure on their economy; and it was time to put risk on. We couldn’t have said it better! Matter of fact, we have been saying that for months now, positioned our portfolios accordingly, and, as you know, have continued to outperform the indices. 

Larry added that “fiscal policy does more for an economy than monetary policy since the general population does not own stocks and bonds, especially in Europe and Asia.” Even if you don’t like Trump, you must credit the strength of the U.S. economy to his tax and fiscal policies as well as his effort to significantly reduce regulations. Clearly, China embarked six months ago to significantly ease monetary conditions as well as add fiscal stimulus wherever it could. However, its all-important export machine has been hurt significantly by trade conflicts with the U.S.. China has to worry also that its Belt and Road initiative is stalling out as it forced countries to burden themselves with too much debt without enough benefit. How many times can we say that there is not much more that the ECB can do to ease monetary conditions and that the region needs significant fiscal and regulatory reform? Unfortunately Germany remains a roadblock against major change. And then there are the growing risks of a hard Brexit facing England and the Eurozone. Japan, too, is stuck between a rock and a hard place as the BOJ has done as much as possible to ease monetary conditions; but, unfortunately, the government is hamstrung from added fiscal stimulus with total debt to GNP already at unsustainable levels. And, the Emerging Markets are basically held captive to the success/failure of the major industrialized nations. 

Maybe it’s time to believe. 

Let’s look at the recent data points that support/refute that there is no place like home:

1.) The U.S. is well-positioned to sustain growth over 2% for the foreseeable future bolstered by strong consumer demand which is over 68% of GNP. Don’t forget that our economy has generated well over 2 million jobs over the last year and wages per hour have increased by over 3% with inflation below 2%. And if you think that house and auto sales are interest rate sensitive, then clearly the outlook here has to be pretty good with rates so low. Finally, if you believe in the wealth effect, then the rise in house values along with all financial assets over the last six months should be a positive omen for continued strong consumer spending growth. By the way, we added to retail recently expecting a pretty strong Christmas season. Why not?

Here are some of the key data points reported last week: index of consumer sentiment was up to 98.4; current economic conditions remained at a lofty 111.1; index of consumer expectations rose to 90.1; jobless claims remained very low at 216,000 last week; leading economic indicators were at 111.5 in June, a slight decline from very high levels; coincident indicators rose to 105.9; lagging indicators  were 107.7; housing starts, permits and completions fell slightly in June while homebuilder sentiment ticked up as shortages intensified; and industrial production was flat in June while retail sales rose strongly across the board.

The bottom line is that the U.S. economy continues to do just fine. Growth is likely to exceed 2+% for the foreseeable future with very low inflation. The surprise could be that corporate earnings will do better than what the pundits are currently forecasting. So far, so good with nearly 80% of all companies reporting beating forecasts. By the way, don’t paint over an industry with a single brush. Did you notice the difference in reports/forecasts between CSX and UNP? The major banks did pretty darn well too, even with a relatively flat yield curve.

The Beige Book and comments from Powell last week at a conference in Paris support our belief that the Fed will lower rates by 25 basis points when they meet July 30-31st. It was important to note that Powell mentioned in his speech abroad that the Fed must pay added attention in its own decisions to global developments, including monetary policies. How long ago did we begin saying that? He also drew attention to the inability of all monetary authorities to boost inflation to their target levels. We continue to expect the Fed to lower rates by at least an additional 25 basis points before year end as well as ending its bond runoff from its balance sheet early. Powell and the Fed do not want to be considered political, so expect them to go on policy hold in 2020 unless something dramatic changes either way.

2.) China clearly needs to accelerate its transition from production-led to consumer-led in order to sustain growth above 6%, but it will take time and won’t be helped by corporations moving away to diversify their supply lines. The simple truth is that China’s trade conflict with the U.S. may be a mixed blessing in the end if it forces the government to open up its borders faster for foreign companies and with less restrictions/ownership/control. The government/monetary authorities have to be concerned too that overall debt levels do not rise too high limiting fiscal policy moves to stimulate growth like what is now happening in Japan. 

China needs a trade deal more than they want to let on; but without one, China’s growth will continue under pressure. We do not expect a trade deal to be reached in earnest with China until after our 2020 Presidential elections. We will avoid investing in China for now.

3.) The outlook for the Eurozone continues to deteriorate. Germany must be willing to stimulate its domestic economy using some of the huge surpluses built up over the last decade. Did you know that German household disposable income and spending has declined over the last five years? Unfortunately, France and Italy’s debt levels have risen dramatically over the few years like Japan inhibiting additional fiscal spending policies. And finally, it appears that the chances of a hard Brexit are rising which would clearly put England in a recession and hit European GNP too. Why invest here?

4.) Japan’s all-important exports fell again in June while manufacturers’ confidence fell to a three-year low. It is hard to believe that the BOJ and government maintain an optimistic face on future prospects. We are watching closely if the government postpones its retail tax like scheduled to kick in soon. Notwithstanding, the prospects for Japan remain poor at best until/unless the U.S. and China reach a trade deal.

It’s time to believe!

We are confident that the U.S. economy will continue to roll along at least through elections next year. We are concerned about the Democrats moving further left and its potential negative impact on our economy and financial markets. Trump realizes that a strong U.S. economy and financial markets are his keys to winning the election next year, so we expect him to do whatever is needed to stimulate growth without making any blunders like escalating trade tensions. At the same time, we expect the Fed to lower rates by at least 50 basis points between now and year end which should bolster economic growth; lower the short end of the yield curve thereby steepening the curve in effect; lower the value of the dollar alleviating pressures abroad; and lead to higher commodity prices. 

The U.S. market remains undervalued today. Our economy is in good shape, earnings are fine, cash flow is strong and low inflation is a reality. Why shouldn’t the stock market multiple be 20 times with the 10-year treasury holding beneath 2.5% and bank capital/liquidity ratios at all-time highs? Isn’t it ironic that the markets are hitting highs and investors are underinvested with record levels of cash and bonds? The path of least resistance for our markets remains higher especially as the Fed commences lowering rates. The trend of Fed policy is your friend which is far more important to us than if the Fed lowers rates by 25 or 50 basis points in July. We also believe that foreign economies will benefit at the margin from lower rates here as the dollar weakens as flows from abroad lessen. 

We have made a few changes in our portfolios over the last few weeks. The major shift was when we lowered the defensive holdings including healthcare and consumer non-durables, and raised the economic sensitivity of our portfolios adding to global industrials/capital goods, technology, industrial commodities, agriculture, domestic steel, financials, specialty retailers and airlines. We continue to own some healthcare, housing related retailers, and many special situations. We own no bonds nor are we long the dollar any longer expecting the Fed to begin easing this month. 

Review all the facts; pause, reflect and consider mindset shifts; look at your asset mix with risk controls; do in-depth research and…

Invest Accordingly!

Bill Ehrman

Paix et Prospérité LLC

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