Hope Springs Eternal
Global tensions ratcheted down this past week which led to rallies in all financial markets, a slightly steeper yield curve, a decline in the dollar, and higher commodity prices except precious metals.
Specifically, Hong Kong’s government backed down on the extradition bill with Chinese approval; Chinaannounced that high level trade talks with the U.S. would be held in October after lower level meetings this month; and Brexit appears delayed until after the end of October. China’s central bank also cut the reserve ratio to the lowest level since 2007 releasing $126 billion of added liquidity. Expect the BOJ, ECB and our Fed to announce additional monetary ease this month, too.
While all of this is clearly positive at the margin, the global economy needs trade deals finalized, significant fiscal stimulus and regulatory reforms to really turn around. Right now, the U.S economy is chugging along at a 2% growth rate; China is slowing to a 6% growth rate which may still be overstated; the Eurozone may already be in a recession; and Japan will slow more in the late fall into 2020 once we know if the retail tax hike goes into effect or not. You can only imagine what is happening in the emerging markets. The bottom line is global growth continues to slow and only major trade deals, huge fiscal stimulus packages, and regulatory reforms will save the day.
We have not altered our view that the U.S market is undervalued. We remain amazed that our interest rates are so low as our economy is doing just fine. However, growth has clearly slowed from earlier quarters. We believe that our long bond would be yielding closer to 3% today if not for the flood of money coming in from abroad reaching for any positive returns. The huge flow of funds from abroad also helps explain the strong dollar, lower industrial commodity prices, and higher precious metal prices. The U.S is siphoning money needed abroad hurting overseas growth. And then there is all of this dollar dominated debt, a time bomb, to consider too.
Let’s look at the key data points of the week that support or detract from our view that there really is no place like home. While hope may spring eternal, we remain doubtful that a full trade deal can be reached nor will major fiscal stimulus packages be passed overseas near-term therefore global growth will remain stuck in a rut for a while longer. Notwithstanding, we continue to make minor shifts in our portfolio adding companies with really outstanding managements even with a more cyclical bent.
The United States
The U.S consumer and huge fiscal stimulus, a combined 90% of GNP, remain the driving forces behind continued 2+% growth in our economy. Just look at some of the most recent data points that support our stance: the non-manufacturing sector grew for the 115thconsecutive month in August with the NMI index increasing 2.7 percentage points to 56.4%, the business activity index at 61.5%, the new orders index at 60.3% and the employment index at 53.1%. The U.S employment picture remains bright too although job growth slowed to 130,000 in August including 25,000 temporary government employees. The unemployment rate held at 3.7%. We were pleased to see an acceleration in hourly wage gains, up 3.2% from a year ago. Higher wages are being offset by continued improvement in worker productivity which rose a strong 2.3% in the second quarter. Weakness in job creation, as expected, are centered in the manufacturing and retail areas. The household survey, on the other hand, revealed nearly 500,000 new jobs were created.
Trump moved ahead September 1, as promised, implementing 15% tariffs on an additional $111 billion of Chinese imports. We do not expect the impact to be as punitive on our consumer as generally perceived due to changes in currencies, shifts in the supply chains and push back by the U.S buyers. By example, Target is insisting that its suppliers eat all of the tariff increases.
The manufacturing sector continues to weaken as evidenced by the ISM Supply PMI falling to 49.1 in August. New orders dropped to a seven-year low while the production index fell back to levels achieved nearly 4 years ago.
Finally, the Beige Book came out last Wednesday reporting modest economic growth in August; moderate hikes in wages; and continued weakness in inflationary pressures. The report highlighted weakness in trade, the negative impact of tariffs, poor business sentiment and the lack of business investment. Chairman Powell basically confirmed (in Zurich on Friday) that the Fed will cut rates by another quarter point in September to support continued economic growth.
The bottom line is that the U.S will continue to expand well into 2020 with minimal inflationary pressures. U.S corporations announced/issued over $65 billion of new debt last week with longer terms at ridiculously low interest rates refinancing higher cost debt while adding to cash. This is just the beginning. We also expect the consumer to join in refinancing mortgage debt at lower interest rates, too, therefore boosting disposable personal income.
China
China’s actions calling DC last week to hold trade talks, permitting Hong Kong to withdraw the extradition bill, and sharply cutting bank reserve requirements said more to us about their concern that China 2025 is in danger than any economic statistic or comment in the media. Also, it was interesting to hear that China held back on implementing most of its new tariffs until December. While we were surprised that the Caixin/Markit factory PMI rose to 50.4 in August, our checks, as well as new orders, show that manufacturing weakness is accelerating as corporations’ race to shift their supply chains away from China. Just listen to any U.S company conference call, like Lululemon and RH, and you will get our drift.
China’s economy will continue to slow despite freeing up more bank liquidity. Corporations there, as elsewhere, will keep their hands in their pockets until there is real certainty on trade. Unfortunately, their consumer cannot carry the day offsetting manufacturing weakness.
Germany/Eurozone
If Germany has entered a recession, can the rest of the Eurozone be far behind? Germany’s export dependent manufacturing sector remained in contraction in August with a reading of 43.5, yep 43.5, on the HIS Markit PMI. Industrial output is declining and layoffs are accelerating in Germany. Why hasn’t their government taken up any fiscal stimulus program? That’s just incredible.
We do expect ECB President Draghi to introduce another round of monetary stimulus on September 12thbut doubt that it will move the needle stimulating growth in the Eurozone. After all, it’s not the cost or availability of money keeping individuals and corporations from borrowing. It is the lack of demand for money.
The Eurozone, including Britain, are being held captive by a lack of trade deals between the U.S and China, a trade deal with the U.S and an impending Brexit. Negative rates throughout the Eurozone says it all. Can Christine Lagarde save the day? Doubt it unless she can get governments to loosen their purse strings. Listen up Germany!
Japan
We continue to get mixed signals out of Japan influenced by the still anticipated hike to a 10% sales tax in October from 8% currently. Quite frankly, we remain focused on continued weakness in manufacturing activity and export orders. BOJ’s Governor Kuroda discussed that further short-term rate cuts, lowering the target for long term rates, stepping up asset purchases and accelerating expansion of the monetary base are all tools in his arsenal. When will these governors ever learn? It’s not the cost of money but the lack of demand that is pushing rates down.
We continue to avoid Japan.
While hope springs eternal, nothing has changed from an economic perspective in the last week. Yes, China has made some concessions/overtures which we like but it all could be face- saving in front of the Chinese National Day celebrated on October 1. This year is the 70thanniversary for the founding of the People’s Republic of China. Yes, we are cynical, but for good reason.
We still believe that we could get a watered-down trade deal before elections as it may serve everyone’s best interests. President Xi has to stabilize the Chinese economy before too many companies commit or leave China and Trump needs to win an election. Either way, we continue to believe that the U.S consumer will stay strong; technology spending is a necessity for so many reasons; and great managements will always find a way to win regardless of the landscape.
We continue to favor investing in the U.S. at this time. Our market remains undervalued especially with longer term interest rates pushed down so far due to inordinately large capital inflows from abroad. Clearly our stock market is not being priced off of a 10-year treasury yield around 1.5% and a 30-year treasury around 2.0%. If so, our market multiple would be much higher especially with our bank capital/liquidity ratios so high. Have you noticed that junk bond spreads have narrowed too indicating no financial and/or systematic risk in the system?
We made some minor adjustments last week to our portfolios after China/Hong Kong capitulated on the extradition bill; China called to re-open trade talks in October; and Brexit appeared delayed. We reduced our gold exposure; lowered our utility exposure slightly; added some cyclicality with more than one way to win like UTX; and lowed our cash reserves.
Our portfolios continue emphasize consumer non-durable companies; technology; retail like TGT and HD; cable with content; healthcare; telecommunications; utilities; airlines; some industrials with a twist; and many special situations. We own no bonds and are flat the dollar.
We would like to invite you to our weekly “investment committee” webinar just as we led at each firm where we were CIO/Partner, like at Century Capital Associates, the Quantum Fund and EGS Associates. The weekly webinar will begin Monday September 16 at 8:30 AM -9:15 AM. We will send out information how to join the webinar and we hope you will find it helpful in your own investment process.
Remember to review all the facts; pause, reflect and consider mindset shifts; look at your asset mix with risk controls; do independent research and …
Invest Accordingly!
Bill Ehrman
Paix et Prospérité LLC