Watch Interest Rates and the Dollar
The financial markets continued to advance last week as the prospects of U.S and China signing Phase I of a trade deal appear likely, surprising the naysayers. Also, the chances of a hard Brexit are diminishing and the Fed began buying its initial $60 billion/month of Treasuries pushing down the short end of the yield curve and weakening the dollar.
As discussed last week, the Monday morning quarterbacks doubted that Phase I of the trade deal would amount to hill of beans (bad pun) even if it were signed, which many doubted. We disagreed as we felt that Trump could not afford to escalate trade tensions going into elections next year as it would jeopardize the economy, the stock market and his chances of winning. Larry Kudlow gave a very convincing interview last Thursday that trade talks were going exceedingly well and that relations with China’s team had improved to the point where Phase I would be signed next month when both Presidents meet in Chile at the APEC Summit and that the next phase should be completed in a few months. While we recognize that Larry is always an optimist, we read yesterday that China’s Liu not only confirmed Kudlow’s comments but went even further discussing the progress on protecting IP and other areas of concern between the two countries.
The bottom line is that we are even more convinced today that the U.S and China will negotiate a series of trade deals over the next nine months; the December tariffs will not occur and there may be even some rollbacks of existing tariffs before election next year. While Trump clearly needs this to win election next year, China needs it to revitalize its economy and slow the exodus of manufacturers shifting their supply chains to other Far East countries.
While the ECB and UK Prime Minister Boris Johnson finally reached a deal on Brexit, the British parliament voted to delay Brexit until January 31, 2020. Johnson will propose a Withdrawal Agreement Bill next week to Parliament to force the issue now. The bottom line is that the chances of a hard Brexit have greatly diminished and with it another leg down in the Eurozone economy.
Finally, the Fed began its off-balance sheet expansion last Wednesday by buying $7.5 billion in Treasury bills to deal with changes in the economy and to add liquidity to the financial system. While the Fed continued to stress that buying $60 billion/month of Treasury bills is not another round of QE, it does have the same impact pushing down short term rates, steepening the yield curve and weakening the dollar.
While we were not surprised that the IMF reduced, once again, its growth forecast for 2019, now at 3.0%, the slowest growth in many years, we are getting increasingly confident that we are reaching an inflection point such that global growth may re-accelerate as we move through 2020 as we expect a reduction in trade conflicts combined with more fiscal stimulus next year. We even believe that Christine Lagarde will be successful when she becomes head of the ECB in convincing Germany to loosen its purse strings and permit other Eurozone countries to do the same. The combination of monetary ease, a reduction in trade conflicts, and broad fiscal stimulation is the right recipe for accelerating growth next year.
Watch interest rates and the dollar to confirm whether the pendulum has begun to swing in the other direction as we now believe.
While we remain optimistic that our markets have more room to run, we have made mild shifts in the composition of our portfolios as we have gained more confidence that global growth will be better than expected next year than currently anticipated. We now expect the yield curve to steepen; the dollar to fall, and industrial commodity prices to rise over the next year. Since we know that we are looking over the near term valley, our baby steps to get more economically sensitive in our portfolios includes adding to our financials, capital goods/industrials/machinery stocks and industrial commodity stocks while reducing our defensive holdings which are selling at the very top end of their historic valuations. Each of the companies that we own or are buying have great managements and are generating substantial free cash flow that is being used to close the gap between their current stock prices and their intrinsic value. Their dividend yields all exceed the 30-year treasury rate.
We fully recognize that global growth has continued to slow including in the U.S and China. Clearly, the U.S is best positioned at the moment as our economy is dominated by consumer trends and government spending as all of the other major industrialized economies, including China, are dominated by production which has clearly continued to weaken. Since we are risk-averse, we have continued to favor the U.S markets at this time but with more economic sensitivity than before. As the cards turn up supporting our view that the trade conflicts are easing and more fiscal stimulus will be introduced abroad, we fully anticipate adding more foreign exposure to our portfolios especially if the dollar weakens as we now expect.
Let’s take a look at the most recent data points that support/detract from our current view that the U.S economy will continue to expand at around 2% while growth overseas, including China, is still slowing which will be the reason that governments, especially Germany, capitulate and add fiscal stimulus on top of existing extreme monetary ease.
The United States
The big debate here is whether the Fed will cut again at its next meeting, at the end of the month, or pause to see future data points that justify another rate cut. The Fed has cover either way, but it is our opinion that while the strength of the U.S economy really does not justify another cut at this time, the Fed will cut again due to global weakness, low inflation, and a super-strong dollar. Don’t forget that the Fed buying $60 billion/month of treasury bills is another source of monetary ease in addition to lowering the funds rate.
The consumer continues strong as evidenced by another strong Conference Board leading economic index of 111.9 in September; the coincident economic index at 105.6 and lagging index at 108.3. On the other hand, U.S factory output weakened in September impacted by the GM strike, sluggish global demand, and the trade war. These numbers may reverse if the GM employees ratify a deal accepted by their leadership and the U.S/China really reaches a full trade ceasefire. It may clearly be time to look over the valley!
We were particularly impressed by the largest bank earnings reported this past week. Both Jimmy Dimon of JPM and Brian Moynihan of BAC specifically mentioned that consumer spending remains particularly strong due to higher levels of employment, rising wages and above-average savings rates along with lower borrowings. Who knows better than them? Both mentioned weakness in business sentiment and spending, too. No surprise!
We are increasingly confident that Trump will do all in his power to stimulate the economy to foster higher stock prices as we move closer to elections next year. That will mean a ratcheting down of trade conflicts plus additional fiscal stimulus wherever possible. There really is no place better than home to invest today, especially with an accommodative Fed. Bet on more growth next year rather than less. In other words, don’t listen to the pundits.
The Chinese economy grew at only 6% (probably overstated) in the third quarter of 2019, the slowest rate of growth since the early 1990s. September data points show it all: factory output rose only 5.8%; retail sales growth slowed to 7.8%; business investment gained only 5.4% in the first nine months of the year and the jobless rate held at 5.2%. In addition, China exports fell 3.2% in September from a year ago while imports fell 8.5% during the same period. Finally, the PPI is falling while the CPI is increasing at its fastest pace in 6 years due to a surge in pork prices. Not good!
China clearly needs a trade deal that includes major purchases of agricultural products.
Economic growth has slowed to a virtual halt in the region while inflation has now fallen to a three-year low at 0.8% annualized in September despite all of the monetary stimuli. It finally appears that even Merkel’s own Christian Democratic policy is acknowledging the need for some fiscal stimulus. We will believe it when we see it, but we are growing increasingly confident that deflationary fears along with pressure from Christine Lagarde will lead to a breakthrough in Germany which will lead to added stimulus everywhere in Europe. Time will tell, but the pendulum is clearly beginning to swing the other way.
Japan is clearly stuck in a rut as it just raised retail sales taxes which is hitting consumer demand while exports remain weak. It is laughable that the big trade deal with the U.S will add only 0.8% to Japan’s GNP over the next 10-20 years. Japan needs growth elsewhere so that its exports can grow once again.
Let’s wrap this up.
Clearly we are back to the point that bad news is really good news as it is finally causing positive change to take place: the U.S and China have reached a real ceasefire on escalating trade tensions that may lead to a series of deals over the next 9 months; a hard Brexit seems to have been avoided; Germany seems to be capitulating on adding fiscal stimulus and our Fed has embarked on a new round of QE to replenish its balance sheet and lower short term rates which will weaken the dollar. Finally, Trump will do all in his power to bolster the U.S economy and stock market as he runs hard to win a second term.
The bottom line is that the pendulum is on the brink of moving in the other direction such that we may finally be talking about a resumption of global growth next year rather than further slowing. We have taken the first steps to shift our portfolio accordingly adding to global capital goods/industrial/machinery companies selling at recession valuations; adding some financials which will benefit from a steepening yield curve and some industrial commodity companies which will benefit from more growth and a falling dollar. We have maintained our technology exposure, including some semis; cable with content; healthcare only with major new products; airlines and many special situations.
Remember that the wind remains to our backs as long as we have an overly accommodative Fed and other monetary bodies creating more money than still needed by the real economy forcing investors out on the risk curve.
The weekly Investment Committee webinar will be held Monday morning October 21st, at 8:30 am Eastern Standard Time.
You can join the webinar by typing https://zoom.us/j/9179217852 into your browser.
Remember to review all the facts; pause, reflect and consider mindset shifts; analyze your asset mix with risk controls; do independent research which includes listening to company earnings calls and …
Paix et Prospérité LLC