Trade Tensions Dim Global Economic Outlook
Trump continues to surprise us by snatching defeat from the jaws of victory. We were so impressed when his administration a few weeks ago postponed any punitive action against Eurozone and Japanese car imports for up to 6 months and finalized the trade deal with Mexico and Canada to focus solely on trade negotiations with China. After all, how many battles can his administration fight at one time?
Unfortunately, that view changed with a tweet Thursday night when Trump threatened to impose tariffs beginning at 5% moving up to 25% on Mexican imports over the surge in migrants. Is he kidding!? Add that to the current 25% tariff on $250 billion of Chinese imports with the possibility going up to 25% tariff on the full $550 billion of Chinese imports by the end of June. The total tariffs could eventually be 25% on $900 billion of imports equal to $225 billion. We do not expect U.S. companies to absorb all or even some of the tariff. Hopefully overseas manufacturers lower prices somewhat to keep the business. Lower foreign currencies will help too. What we do expect is some part of the tariffs will be passed along in part or full in the form of higher prices to the consumer. Not good! But it is only a one-time event and lower prices will occur down the line when/if supply chains are moved.
Right now, companies don’t know where to shift their supply lines to avoid tariffs. They don’t what country, except the U.S., is safe from Trump’s tariffs. Did you see what happened to India yesterday? Not good!
We know many companies shifting production from China to avoid tariffs that have or are in the process of moving production to Mexico. Imagine their shock in reading Trump’s tweet. Really! How can a business plan for the future? Boardrooms around the world must be scratching their heads. Trump wants them all to build in America. Won’t happen! Companies will keep their hands mostly in their pockets until trade deals are reached bringing some certainty to planning supply chains. Until then, capital spending, hiring and economic growth will be penalized.
We must also consider retaliation by those countries singled out by Trump. We already know that China raised tariffs yesterday on $60 billion of U.S. imports. Additional actions will be forthcoming like on rare minerals. And then there is Fed Ex. We are quite confident that Mexico will not stand still and will most likely raise tariffs on at least some of the $265 billion of U.S. imports if Trump moves forward raising tariffs on Mexican imports.
Finally, we believe that Trump’s actions basically end any chance that Congress will pass the new USMCA. It appears that both Robert Lighthizer and Bob Mnuchin disagreed with Trump, but to no avail. Kudlow would have, too, but is out on medical leave. So, who did Trump get advice from? Not from those in the know. Clearly this was a political decision without full consideration of the economic consequences. Mexico, Canada and the U.S. need to be a seamless supply chain which is now in jeopardy.
But all of this could be reversed in a tweet! Same with the trade conflict with China. We think that cooler heads will prevail to avoid these all of these tariffs as the alternative is just too dire for all concerned. Don’t forget that Trump is a political animal first and foremost and he weighs his actions/success by the Dow Jones. Well, the markets have declined the most consecutive weeks in over 30 years since his turnabout on trade while long term bond rates have plummeted to lows not seen in years with a good part of the yield curve inverted signaling a major slowdown or even a recession ahead. We see a slowdown coming in the U.S. but not a recession.
Don’t forget that 2020 is an election year and Trump needs both a strong economy and higher stocks prices to win. He will focus on this political base. So will we! Could Trump be so smart to take the pain now so that 2020 will be a strong year going into elections? That is our current thinking. We now believe that economic stats for the remainder of 2019 will be weaker than we anticipated just weeks ago but remain confident that 2020 will be a better year. While we recognize that stocks are cheap, we may remain in purgatory a while longer waiting for the next tweet and/or resolution of all/some of these issues. We also expect the Fed to come into play by lowering rates at least once in 2019 and more next year if needed. The Fed has two mandates: employment and inflation. They succeeded on one but failed on the other. Inflation is just too low so the Fed must adjust rates down to take that into account. Hopefully the dollar will then weaken too which will be a bonus for all. The yield curve will steepen too.
We have continued to adjust our portfolios to reflect our new forecast: economic growth around 1.3% in the second quarter followed by 2% for the rest of the year as consumer spending remains relatively strong. S & P 500 EPS will likely expand by only 4% in 2019 to $167/share but accelerate to a 6% gain in 2020 to $177/share. While we always expected our rates to be pushed lower than forecasted due to huge capital flows from abroad, we had to adjust down our view of interest rates even more to incorporate weaker than anticipated global growth and inflation. Who would have forecasted German and Japanese rates remaining below 0 for so long putting immense downward pressure on our rates?
Let’s take a look at recent economic stats that support our current view that the global economy is weaker than earlier anticipated:
1.) We have lowered our view of U.S. economic growth as the spring recovery has just not materialized as we had anticipated: home price growth continues to slow and is now up less than 3.7% year over year as housing continues to weaken despite lower mortgage rates; household spending rose only 0.3% in April from March despite a 0.5% increase in pretax earnings from wages, salaries and investments; the April PCE rose 0.3% in April and is up only 1.5% from a year ago; first quarter GNP growth was lowered to 3.1% and showed signs of slowing growth In capital spending and manufacturing ahead; the wettest winter/spring will hurt the agriculture sector big time; and factories are on track for their weakest showing in 2019 since 2016 as demand for business equipment and commodities weakens here and abroad.
On the other hand, consumer confidence rose to an incredible 134.1 in May and is now close to an 18-year high. Consumer demand has picked up from weak first quarter numbers and is likely to remain relatively strong for the remainder of the year into 2020. It does not hurt that employment continues to increase above trend, hourly wages are rising, inflation and interest rates are low and over 7 million jobs need still to be filled. Remember that consumer spending is over 60% of our GDP. And our fiscal policy is additive to growth too.
Our economy is still in the best shape compared to the rest of the world. Our rates are being pulled down due primarily to arbitrage from abroad. We believe that our short rates are too high and our long rates are slightly too low. Our yield curve should steepen once the Fed finally lowers the funds rate. Our inverted yield curve is NOT indicating an impending recession as many believe.
Who will be the major beneficiary of any trade deals at the margin and who has less to lose without them? The USA! So, we are investing in America. Not China, Europe, the Emerging Markets or Japan.
2.) As expected, May economic results weakened in China: the official manufacturing PMI fell beneath 50 to 49.4 despite all the stimulus introduced by the government since December. Chinese leaders have eased credit, reduced taxes and ramped up infrastructure spending but the May slowdown accelerated in industrial production, fixed asset investment and exports. No matter what the government says, domestic demand cannot offset near term weakness in exports and companies leaving China to produce elsewhere. China needs to sustain growth neat 6% to fund all of its domestic needs so the country has a real problem no matter what face they put on.
3.) All you have to do is look at the interest rates in Europe and Japan to get an indication of how well/badly their economies are doing. We remain very pessimistic about the Eurozone due to a whole host of factors beginning with their inability to enact fiscal, monetary, regulatory and trade reforms to make the region globally competitive. No Brexit hurts too!
4.) Japan is just too reliant on global trade so the country badly needs the U.S. and China to make a deal. It really won’t make enough difference to Japan’s economy to make a deal with the U.S. alone which remains very likely before the end of the summer.
Global bonds yields hit multi year lows last week says it all: the global economy is weakening.
What are we doing?
We have continued to take risk off since Trump did a 180 weeks ago. We have significantly raised our cash levels, reduced our foreign exposure and lowered our economic sensitivity. In addition, we have sold calls against our core positions offering us 7% upside and 8% downside protection over the next four months. This move added to our cash reserves while we will also collect future dividends from these stocks.
All of the companies that we own have superior management; winning business strategies in a globally competitive environment; strong new product flows with pricing power; rising operating margins/operating income/net income/cash flow and free cash flow. In addition, the average dividend yield on our portfolio exceeds the 10-year treasury and each company is buying in a lot of stock out of free cash flow.
Our main exposure remains in healthcare; technology; capital goods and industrials; housing related; some financials and many special situations. We own no bonds nor are we long the dollar although we expect the dollar to remain strong until the Fed lowers rates and/or trade deals are reached.
Paix et Prospérité continues to not only outperform the averages, we are in position to take advantage of any further weakness should it occur.
Remember to review all the facts; pause, reflect and consider mindset shifts; look at your asset mix with risk controls; do independent research and…
Paix et Prospérité LLC