Nothing To Fear But Fear Itself

by: Bill Ehrman

FDRs sentiments from his 1933 inaugural speech reflect what I believe today regarding the Fed raising funds rate and Greece exiting the Euro. I recognize that there are many problems in the world that could impact the financial markets at any time ranging from politics everywhere, to the Shiite/Sunni conflict throughout the Middle East, Ukraine which represents Putin's intentions in Europe and elsewhere, and there is, of course, always the unforeseen. There is never clear sailing in financial waters but it is our responsibility to weigh the risks with the returns and to invest for the longer term rather than trade on each event.

Last week I discussed my core beliefs which included: monetary policy will remain easy virtually everywhere in the world; the supply of funds exceeds the economic demand for funds which is beneficial for financial assets; the dollar will be the currency of choice; the global economies will improve, albeit slowly; inflation and interest rates will remain surprisingly low due to globalization and an abundance of labor and commodities; government policies and lack of credibility hinder confidence at all levels impeding growth and needed investments; commodity prices will remain under pressure as long as supply outstrips demand and inventories rise; M&A activity will remain high as virtually all the deals are anti-dilutive in short order and additive longer term; speculation is mainly in real estate, art and private equity and finally, corporate profits will be surprisingly strong especially in those companies making strategic changes to enhance future returns and profit.

In last Thursday's blog titled "Reversal Of Fortunes" I remarked that the financial markets finally woke up and realized that the global economies were improving and that fears of deflation had evaporated, especially in the Eurozone. The ECB raised its inflation forecast for the Eurozone to 0.3% in 2015 while maintaining its forecast at 1.5% and 1.7% for 2016 and 2017, respectively. I mentioned, as I have before, that interest rates were ridiculously low and that the yield curve would steepen and that the one way trade in both interest rates and currencies was over. I added that traders would get caught and there would be a reversal of fortunes. Finally, invest in companies that would benefit from the global economic improvement and internal changes to improve profitability, cash flow and free cash flow with dividend yields over 2.5% and increasing over time.

Let's look at each region and discuss how last week's events support or challenge my core beliefs:

1. Friday's employment numbers was the key data point last week in the United States. Clearly there was a strong rebound in May from disappointing April numbers.

U.S employers added 280,000 jobs and the prior two months job gains were revised up by 32,000; the average hourly earnings were up 2.3% from the prior year; the labor force participation rate was 62.9%; the unemployment rate was reported at 5.5% and was actually 10.8% using broader measures; 6.7 million people working part-time and over 3 million new jobs created over the last twelve months.

2. Other economic statistics reported last week included: factory orders fell by 1.0% in April; the ISM index for national factory activity rose to 52.8 in May, the ISM's measure for new orders rose to 55.8 while the measure for production fell to 54.5; construction spending rose 2.2% in April; the trade gap fell 19% to $40.88 billion as imports dropped 3% while exports rose 1.0%; U.S productivity fell a disappointing 3.1% in the first quarter and then there is the consumer who remains over 67% of GNP: consumer spending was flat in April while personal income rose (a higher savings rate); consumer comfort fell to a 7 month low in May to 40.5 and consumer borrowing rose to $20.5 billion in April. These stats confirm an improving rate of growth in the second quarter but nothing to write home about. The IMF lowered its economic forecast for the U.S in 2015 to 2.0% from a previous forecast of 3.1% and urged the Fed to delay its rate liftoff until the first half of 2016.

3. Greece is really caught between a rock and a hard place as it can't satisfy the demands and previous agreements with the ECB and stand by its promises by the Tsipras government to the Greek people. You can have all the meetings to look good and play the game between all parties but you can't fit a square peg into a round hole. The Greek government even went so far as to defer its IMF payment owed this week by taking the unconventional approach of bundling all June obligations to months end.

Mario Draghi, President of the ECB, commented after the ECB meeting this week that he was pleased with the economic progress in the Eurozone to date and was committed to see the bond-buying program continue until its stated conclusion in the fall of 2016. He added that the markets should get used to a higher periods of volatility, which he added won't affect monetary policy decisions. Those comments spooked the global bond markets and rates rose around the world. The IMF raised its economic forecast for the Eurozone to 1.4% this year from 0.9% in 2014. Ironically, growth in the Eurozone has slowed most recently including in Germany.

4. The OECD lowered its growth forecast for China to 6.8% in 2015 from its previous forecast of 7.4% and lowered its forecast for Japan slightly to 0.7% in 2015 while maintaining its forecast for 2016 growth at 1.4%. The OECD also suggested that Japan implement spending cuts to meet its fiscal targets rather than boosting its retail sale tax as done previously. India joined the world monetary authorities by lowering its interest rates last week to stimulate growth as it lowered its 2015 forecast to 7.6% from a previous estimate of 7.8%. We believe that the true number is closer to 7.0% but still pretty good.

OPEC met this past week and maintained its production levels at 30 million barrels when it is actually producing at around 31.58 million barrels a day. Supply of oil is still exceeding demand, inventories continue to rise and the price of oil hovers around $60 per barrel. While it is clear that demand for energy will increase as the global economies improve, watch out for incremental supply from Iraq and Iran. Also, it is important to note that the EPA study on fracking supports the industry contention that drinking water is NOT impacted. Clearly this benefits potential oil production in the United States, as we get closer to energy independence and being an exporter of product on the world markets.

Our Take

We agree with the OECD that global growth will improve this year but at a rate of gain LESS than earlier projected including in the U.S.; the dollar will remain king for a host of reasons including a change in its energy dynamics; inflation and interest rates will stay subdued as growth will be subpar, globalization is a fact of life and both labor and commodities are plentiful keeping pressures on prices; and M&A activity will remain strong as the economics of a deal have never been better due to low interest rates.

Economists are unable to build into their models a change in confidence in the system and a desire to be more risk averse that exists at every level today from governments reducing their deficits to corporations matching capital spending to depreciation and finally to consumers who continue to increase their savings rate.

Don't fear that the Fed will begin to increase its funds rate sometimes in the not too distant future from a ridiculously low level, as overall monetary policy will remain unusually very easy for quite a long time. The other side is that the overall demand for funds will stay muted due to the new conservative bias that permeates society.

Rates for 10-year bonds in the Eurozone should NOT yield under 0.5% as the European economies begin to improve off the bottom and fears of deflation abate. And finally don't fear Greece exiting the Euro as the ECB and the financial system has had plenty of time and improved liquidity to prepare for that day. There will not be contagion; and financial stress, if any, will stay contained. The Euro may fall initially but then rally thereafter.

The financial markets are fine. There really is "nothing to fear but fear itself" at this juncture. Currencies and rates will normalize as speculators liquidate positions but the foundation for investing remains sound. Asset allocation is paramount as I remain negative on bonds and recommend stocks that will benefit from an improving global economy, are making strategic changes internally to enhance returns and are yielding over 2.5%. Bank stocks, benefiting from increased loan growth and a steepening yield curve, comprise 18% of our portfolio.

Control risk by maintaining ample liquidity at all times.

Invest Accordingly!