The Demise Of The U.S. Economy And Equity Markets Are Greatly Exaggerated

by: Bill Ehrman

demise They used to say that if the United States sneezed, the world caught a cold. It now appears that the sentiment has shifted to if China sneezes, it brings down the rest of the industrialized world. I don't think so.

Yes, China has a long-term plan to shift its emphasis from production/exports to domestic consumption and yes, it will take time and patience to succeed with plenty of bumps and stumbles along the way. But China has the will and capital to make it work, hiccups and all. President Xi Jinping is walking a tightrope of sustaining growth in excess of 6% while ridding the ills of prior years like excess spending, excess pollution, excess debt, poor oversight and poor long-term planning. We seem to forget that China still is a teenager amongst other major industrialized nations. It is still growing up, testing, making mistakes, going back to the drawing board and advancing once again. Are we any different?

Let's put China in perspective: it accounts for approximately 7% of all U.S. exports which represents less than 1% of U.S. GNP; it represents less than 5% of all U.S. multinationals' revenues and less than 2% of net income; it is less than 1% of U.S. banking assets; it accounts for less than 10% of all global imports which is about equal to that of the United States; it has external debt equal to only 9% of its GDP while owning $6 trillion of foreign assets including over $3.3 trillion in foreign reserves growing by $55-60 billion per month (trade surplus). In fact, China's foreign assets exceed liabilities by approximately $2.4 trillion. Remember, too, that China is a far more important trading partner to Japan and the Eurozone where exports account for 20-45% of GDP.

Frankly, I am tired of hearing from the pundits about why they believe the markets declined - after the fact. Not only is it not productive, it is looking in the rear view mirror, which is neither their job nor ours! It is our role to proactively research and reflect on the facts and carefully allocate assets while controlling risk - at all times. Only then can we invest accordingly.

We entered the year 93% net long with many internal hedges and remain strong to our core beliefs. Yes, we made slight adjustments last week. Absolutely! But we take this pause with our investor lenses on, not our trader lenses - unless, of course, we have altered our core beliefs meaningfully. Each investment, long and short, stands on its own two legs and each day it is re-evaluated. We never stand still. We are in motion at all times with an eye towards limiting mistakes and risk, as that is the key to positively compounding returns. Dividends play a large role in our portfolio, too. Our current yield exceeds 3.2%, which substantially beats cash alternatives and even the 10-year bond yield, with financially strong companies all generating large free cash flow after capital spending and debt repayment. And we expect these dividends to grow next year.

Before I go further, I made a mathematical error in last week's blog, which I corrected regarding my forecast for the S&P in 2016. S&P earnings are estimated at around $120 per share in 2016, the multiple should be approximately 18 derived using a 10-year bond rising to 2.75% by year-end and a 2.75 risk factor translating into a target price of approximately $2160 vs. $1922 currently. It is important to remember materials and energy comprise close to 15% of S&P earnings and have declined dramatically over the last year with further weakness expected in 2016. Therefore, if you strip these two sectors out, you would see that underlying earnings growth is much stronger than generally perceived despite dollar headwinds. You need to look under the hood to see what really happening.

I am forecasting U.S. economic growth for the year between 2-2.5% with inflation remaining less than 1.5%. Slow but steady growth led by the consumer without inflationary pressures is a core belief. Another core belief is that low inflation is NOT transitory, as the Fed has previously said but now many Fed members doubt. Read last Wednesday's Fed minutes! Most pundits are calling for the end of this economic cycle but it won't come anytime soon as employment gains (did you see Friday's report?) are too strong boosting consumer income, low energy prices continue to boost consumer disposable income and/or savings, and government spending will add to growth in 2016 rather than restrict it as it did in past years. Don't forget that consumer spending is approximately 68% of GDP. And Federal Government spending is another 22.5% of GDP. Both items will have wind to their backs this year supporting growth.

Let's do a quick review of economic data by region reported last week before we return to the theme of this piece, which is that the demise of the U.S. economy and stock market is greatly exaggerated.

I will begin with the United States, as it remains my main area of investing although the media is focusing more on China:

Clearly, the jobs report took center stage, as it should arrest any fears of an imminent economic slowdown as many fear. Just read these stats and draw your own conclusion: U.S. employers added 292,000 jobs in December, October and November jobs report was revised up 50,000, employment growth averaged 221,000 jobs per month in 2015, the unemployment rate was unchanged at 5.0%, the labor participation rate rose to 62.6%, wages were flat at $25.24 per average hourly earnings and rose 2.5% over the last year, the average workweek remained at 34.5 and hiring gains were broad based. Certainly, an unusually warm December contributed to the gain but overall, the numbers, including prior months' revisions were strong.

I felt that the Fed minutes from the December meeting were worthwhile as it showed a more divided Fed than generally assumed in deciding to boost rates. As you remember from prior pieces, the Fed has two main mandates besides maintaining economic stability: unemployment and inflation. While unemployment has reached its target of 5% this past year, inflation has now run below its goal of 2% for the last three years. Even the Fed does not forecast inflation hitting its 2% target until 2018 and now many members are questioning whether low inflation is indeed transitory and what the implications may be on future Fed policy. Additional concerns remain on a strong dollar and weakness overseas. I doubt whether the Fed will raise rates more than twice this year, which is below its own targets.

Other economic data points supported our core belief to emphasize consumption rather than production: holiday retail sales rose a surprisingly strong 7.9% in 2015 says MasterCard, consumer confidence and comfort rose to a 12-week high with consumer confidence in their personal finances rising to 56.2, the ISM Non-manufacturers index fell to 55.3, the trade gap narrowed to $43.4 billion in November as exports fell 0.9% while imports fell an even greater 1.7% to their lowest level since November 2011, the Atlanta Fed lowered its 4th quarter GNP estimate to 0.7%, the ISM manufacturers index fell to 48.2 in December but new orders rose to 49.2, construction spending fell 0.4% in November, and wholesale inventories fell 0.3%.

I have discussed week after week that change is everywhere and unless you take heed, you will fall behind and fail… in business, in personal life and also in politics. There is a reason that Trump, Cruz and Sanders are doing so well in the polls. Americans, including myself, are fed up with DC, the lack of leadership both in domestic and foreign policy and we want CHANGE. Look for it, as the status quo doesn't work. Just look at Saudi Arabia getting closer to Russia as one example of our fall in stature overseas. Things must change!

Let's turn to China, which seems to be in everyone's headlights. Can you imagine the challenge that President Xi Jinping and his administration face in taking the air out of the hot air balloon and keeping it flying at the same time? Clearly, they recognize the need to change and has set a course to shift the emphasis away from production to consumption; reduce leverage at all levels, reduce speculation; improve the quality of the environment; grow employment and incomes and to bring the country into the top echelon of global economic powers on equal footings.

Not an easy task for sure and it will take time with many mistakes along the way. The country is using the same bag of tricks that Japan, the Eurozone and we used which includes monetary ease, lower interest rates, let its currency fall to enhance global competitiveness, reduce leverage, improve capital ratios, close inefficient plants and boost domestic confidence. Naturally, there will be mistakes along the way and pain felt by many but I am confident in the future of China. I expect that China's growth was approximately 6.75% in 2015 and won't fall much below 6.0% in 2016. Still something to admire but many will doubt the integrity of the numbers. Expect the manufacturers' index to remain weak while the services index continues to climb to new highs. At least China recognizes the need to change to survive/thrive in the years ahead. Something others should follow!

The Eurozone finished the year on a relatively strong note as the Purchasers Managers Index rose to 53.2, bank lending is accelerating; the Euro is holding near 109 to the dollar and the ECB remains ready to increase QE as needed. Inflation is running well below 0.9%, excluding food and energy, which is well below the ECB's 2.0% target. If global trade weakens and if China lets the yuan devalue much more, the ECB could suffer more than most, as exports are a large share of most country's GDP, 40% in Germany alone. The large influx of immigrants from the Middle East and Africa may tax many budgets and impede near-term growth too.

What more can I say about energy prices and industrial commodity prices? You don't need me to remind you that both continue to weaken as supply continues to outstrip demand in most cases. It is important to remember that demand continues to grow across the board, but unfortunately, supply has grown more rapidly; inventories continue to build and traders/speculators who are leveraged are forced to liquidate. In addition, many producers are more concerned about gross revenues rather than profits just to support debt expense therefore are trying to increase production while prices are falling. Many will go out of business for sure. As you know, I have a different view of future energy prices and future industrial commodity prices. Time will tell, so be careful. We are in the late innings here. Change must take place. Even Saudi Arabia is considering bringing Aramco public. Interesting!

It is nice to be able to sit back and look at last week as an opportunity to take advantage of other investors' fears. The underpinning of the U.S. economy is just fine but certainly could be better. The major problem is that fear rather than optimism reigns supreme. A company would rather miss a sale, build one less plant, add one less new employee at this point in time as the board and management are running zero sum budgets, planning for little growth. The consumer is using the decline in energy costs and lower interest rates to spend a little but save a lot and lower debt. And the government, which has reduced its deficit dramatically over the last few years, has finally altered course, as spending is needed in healthcare, defense and infrastructure. The simple truth is the government is really a major part of the problem. Its paralysis has led to an antiquated tax system, too much regulation and not enough incentives for investment and growth. Change is needed in DC and it is needed now!

The bottom line is that we see no reason to alter our current asset allocation and investment exposure. We are 93% net long, internally hedged with a portfolio yielding over 3.2% in financially strong companies making the needed strategic changes to grow both the top and bottom lines, improve margins and increase free cash flow used to enhance shareholder returns one way or another.

Review your core beliefs: gather the facts, review your asset allocation, maintain ample liquidity at all times, control risk and… Invest Accordingly!

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