Vive La Sweet Spot

Quite a week! Powell all but assured a rate cut in July; the yield curve steepened; the dollar weakened; trade talks with China opened; commodity prices increased; and stock markets rose. Doesn’t it sound like our playbook the last few weeks? 

What more can the pundits say who have been so negative and quite frankly, wrong throughout this period now that the markets have reached new heights? Yes, we too, are concerned about the second-quarter earnings but that is looking in the rear-view mirror. Remember that the Fed was tightening throughout 2018 slowing growth down and is just beginning to ease which will stimulate growth down the road. And we also know that Trump will do whatever he can to boost the economy and stock market in 2020, a Presidential election year. 

Long live this Sweet Spot! Even though our markets hit new highs last week, we believe that there is much more room to run. Why? We have argued for many months that the stock market multiple should rise appreciably above 17 times earnings even if the 10-year treasury yield rose to 2.5% with bank capital/liquidity ratios at all-time highs. Why isn’t a 20-multiple reasonable? If you believe like us, that our economy will improve down the road as the Fed cuts rates causing the yield curve to steepen and the dollar to weaken, why not expect earnings growth to re-accelerate by the end of 2019 into 2020? The bottom line is that the market has much more room to run over the next year. Our strength is not only asset allocation, but also stock selection. We have been reducing our defensive holdings like healthcare and consumer nondurables over the last few weeks, adding to technology, financials, airlines, housing related, retailing and capital goods/industrials. Special situations continue to play a major role in our portfolios. We are much more stock specific (rather than sector specific) than ever before buying only best in breed with great managements combined with winning strategies and generating huge free cash flow. 

Let’s look at the key data points of last week that will either support or detract from our current view. We continue to emphasize investing in the U.S. as our economic outlook at the margin is much better than almost anywhere else and there is much less risk if trade negotiations break down: 

1.) The notes from Powell’s two days on Capitol Hill along with the June Fed left little question in investors’ minds that the Fed will cut rates beginning in July. Powell acknowledged that risks to the downside had risen as global growth has weakened appreciably, business investment had softened and inflation continues well beneath the Fed targets. He did emphasize that job growth remained strong and the U.S. economy was doing just fine. Clearly Powell/Fed are worried about the strength of the dollar and the inverted yield curve too. We continue to believe that the Fed will cut rates by 25 basis points in July and by another 25-50 basis points by year-end hoping to stay neutral in 2020, a Presidential election year. If so, the yield curve will clearly steepen even if long rates don’t rise much, the dollar will weaken, commodity prices will rise and the economy will accelerate slightly later in the year into 2020 making Trump very happy.

Some important data points worthy of mention from last week included: total consumer credit rose by $17.1 billion; wholesale inventories increased 0.4% while sales rose 0.1%  resulting in a slight increase of the inventory/sales ratio to 1.35; producer prices rose 0.2% in June, excluding food and energy after posting a 0.4% gain in April and May; core consumer prices, excluding food and energy, increased 0.3% in June and is up 2.1% from a year ago; the Fed preferred PCE index is up only 1.6% from a year ago; the Consumer Comfort index rose to 63.8 in June and jobless claims declined to a 12 week low of 209,000.

While economic growth has statistically slowed down from the first-quarter rate of gain, the all-important consumer spending sector has picked up buttressed by strong employment gains along with real wage increases. We continue to project real GNP growth around 2% for the rest of the year and slightly higher in 2020 as an easier Fed policy kicks in.

2.) Growth in China has continued to slow in June as evidenced by a decline in exports of 1.3% year on year while imports fell 7.3% from last year. China’s exports to the U.S. fell 8.1% to $199.4 billion during the first half of the year while imports from the U.S. fell an astonishing 29.9% to $58.9 billion. There was no increase in China’s June PPI from a year ago with consumer prices increased 8% from a year ago due to shortages of pork and fruit.

China needs a trade deal and fast as corporations are shifting their supply lines to other countries at an accelerating rate jeopardizing China’s growth initiative. It is interesting to note that the number of Chinese millionaires actually shrunk 5% in 2018 and even more so far this year. 

We expect the Chinese economy to continue to slow for the remainder of the year into 2020 unless a trade deal is finalized. The status quo is not enough to sustain growth above 6.4% despite huge government financial and fiscal support.

3.) Our outlook for the Eurozone remains bleak unless there is substantive fiscal, monetary and regulatory changes that benefits all countries in the region which unfortunately is not likely. While the ECB continues to promise further easing moves, what is left for them to do at this point? Will lower rates mean anything? Will buying more debt mean anything? NADA!

We see no growth in the Eurozone over the foreseeable future so why invest in this region which is cheap for a reason. By the way, France should not impose punitive taxes against our major tech companies as that is a battle France will lose.

4.) Our outlook for Japan remains cautious at best as exports remain very weak while core inflation continues to run around 0.5%, well beneath the BOJ’s long-standing objective of 2.0%. We continue to believe that the government should postpone any hike in retail taxes at a minimum and try to find some way to fund domestic programs to stimulate growth while minimizing the impact on the deficit. Japan is truly ham strung by its huge deficit to GNP along with limitations on the BOJ to do anything more to stimulate growth. Why invest in Japan now as it is cheap for a reason?

There is no place like home as the United States is really in a sweet spot with the Fed ready to embark on an easing program, the yield curve finally steepening and the dollar finally falling. While we are not concerned much about second quarter earnings as it is likely to be the low point for the year, we are closely watching closely the Democratic field for 2020 Presidential candidates. While it is too early to impact our investing today, we do have one eye on next year already just in case a far-left candidate begins to emerge as a real challenger to Trump/capitalism.

As you can glean from our earlier comments, our portfolios have continued to shift at the margin away from defensive stocks to those with more economic sensitivity selling at recession levels. While we expect to hear much out of politicians against drug pricing and large tech, we really don’t think much will be done to hurt them fundamentally. Notwithstanding, we have reduced our exposure to healthcare but not technology as that sector is key to our country’s long-term success so why kill the golden goose.

We strongly suggest that you listen to as many earnings calls as possible to see for yourself the differences in management, business plans and execution. Stick with the best in breed and you rarely can go wrong. 

Our portfolios which have continued to outperform are concentrated in global industrials/capital goods, technology, housing related, retail, airlines generating huge free cash flow, large domestic global financials, low cost commodity producers, and many special situations. We now expect the yield curve to steepen and the dollar to weaken.

Remember to 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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