Sometimes, the anticipation of an event is far more troubling than when the event occurs. Waiting stinks and thinking too much raises calls forward all the fears possible in one's mind. Finally, when the day arrives and the event occurs, life gets brighter somehow and we can move forward once again.
Such a time is now and the event is the Fed finally raising its Fed Funds rate. Trust me that the global markets won't enter a tailspin nor the economies turn down. It is a sign of economic strength, not weakness. After all, rates should never have been this low anyway and it's time to return to normalization. And a 0.25% hike in rates might even flatten the yield curve initially. The global markets are stuck in a trading pattern until the Fed acts even though underlying fundamentals are improving. The U.S. stock market is undervalued and the bond market overpriced. Unfortunately, it appears that we have to first see that the sky doesn't fall down on all of us after the Fed finally lifts rates for the markets to really advance and reflect intrinsic value.
If I were to tell you that earnings would exceed expectations and interest rates would be lower than forecasted, would you have predicted a virtually flat stock market for the first seven months of the year? Well, that is what has happened so far in the United States. Second quarter earnings for over 70% of the S&P have exceeded forecasts while the 10-year bond yields have fallen beneath 2.20%. The market has bifurcated and paid up for high revenue growers like Amazon (NASDAQ:AMZN), Starbucks (NASDAQ:SBUX), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), and biotech stocks but not for industrials that have continued to grow revenues and profits despite economic headwinds.
It is hard for investors to think out of the box. What happens if I am correct and this economic cycle is extended for several more years due to a lack of excesses and an overall conservative bias at all levels: governments, corporations and individuals. We are used to the boom-bust cycles in the past and after three hikes in the federal funds rate, we normally would have expected the economy to stumble. Not today!
It appears that the general consensus is that a hike in the fed funds rate means that we are near the beginning of the end of the cycle, so it's time to be cautious and retrench. Boardrooms and individuals are playing so close to the vest, which in the end extends the cycle, but at lower rates of growth. That is really the best of all worlds… growth extended out over years, earnings and cash flow continue to increase for a multitude of reasons, lower interest rates than expected as inflationary pressures will be muted by low commodity prices and controlled labor costs and finally higher multiples for stock prices. Yes, I remain optimistic on the financial markets but not as a trade but as an investment. My core beliefs remain intact.
Let's take a brief look at events reported over the past week and put them into perspective as it impacts our investment outlook.
It is ironic to say that the United States' growth is standing out in the world when its second quarter GNP expanded only 2.3% after an upward revision in first quarter gains to 0.6% from a previously reported loss of 0.2%. In addition, GDP annual growth from 2012-2014 was lowered to only 2.0%, down 0.3% from prior numbers. Consumer spending continued to be the shining light in the second quarter and rose 2.9% compared to a 2.1% gain in the first quarter. It was worthwhile to note that the savings rate dipped to 4.8% in the quarter.
The Fed held its monthly meeting last week and maintained its overly easy monetary policy but also continued to remind us that a rate hike is in the future, but of course, it would be data dependent. Let's be frank here. The Fed is stuck between a rock and a hard place. It really wants to normalize rates but understands that problems still exist here and abroad. It's like threading the needle. The fed fears an even stronger dollar, weaker commodity prices and negative backlash by companies and consumers. But the labor market has almost achieved the Fed's target levels so it's time to put up, raise rates or lose credibility. A conundrum for sure. Let's be honest here. If our economy is expanding 2.0% with 1.5+% inflation, then the funds rate should NOT be 0. That simple.
The majority of economic reports last week were on the stronger side: the service sector PMI rose to 55.2 in July; the PMI Output index rose to 55.2 too; the Shiller index on home prices rose 4.4% over the last year; durable goods orders rose 3.4% in June while pending house sales fell. The U.S economy is doing just fine led by the consumer. Not too strong or too weak.
The Eurozone economic recovery seems to be picking up steam, albeit slowly. Bank lending and consumer sentiment has really improved boosted by aggressive easing by the ECB. Consumer spending is benefitting from lower commodity prices, especially energy. I have mentioned that the new deal with Greece was nothing more than kicking the can down the road. It is important to note that virtually all of the bail-out money is going back to the lenders to repay prior debts and to recapitalize the Greek banks rather than finding its way into the Greek economy. This drama is not over for sure.
Concern remains over China as the official purchasing managers index fell slightly to 50 in July. There are noises that the official band for the yuan may be widened as well as other policy moves to help boost exports. I continue to believe that the government has the will and resources to "ensure the continuity and stability of macro policy" to support and stimulate domestic growth.
A few comments on commodity prices. The problem is that production growth is outstripping demand growth. Finally, there are some rumbling of cuts in copper, aluminum and nickel production to help bring inventories back in balance. Oil prices have continued to decline, as there is a worldwide glut and cut in spending and exploration won't impact future production for many years. Tankers are full to the brim with oil and by-products looking for a home. I remain short the energy complex but have pared my shorts in copper and nickel producers. Remember that weak commodity prices is a big plus for the global economy as there are far more winners than losers. Ag prices have been weak too due to large supplies. All good for the consumer, inflation and interest rates.
Let's wrap this up. There really is nothing to fear other than fear itself. I see tremendous value in many industrial companies that have weathered the economic storm well and are still growing earnings and cash flow. Fortunately for me, the market is worried about the Fed. I am not. Again, there are no excesses out there and a general conservative bias that will remain for years. That is key!
I expect the economy to chug along at 2.0-2.5% for the next few years, inflation to remain controlled but the yield curve will steepen as we get further into the expansion, corporate profits will continue to surprise on the upside as managements are controlling costs and commodity costs are down, balance sheets will remain strong as capital spending will be equal to or less than cash flow and managements will continue to act as their own activists making the needed strategic changes to prosper in a slower growth world.
Listen to as many corporate conference calls as you can to gain true bottoms-up perspective of the economy both here and abroad. Think out of the box as we really have entered a period of sustained but low growth with rising profits. The stock market is 10 to 15% undervalued today and many stocks by far more. Take a look at Alcoa (NYSE:AA), Dow Chemical (DOW), Huntsman Chemical (NYSE:HUN), Nucor (NYSE:NUE) and Potash (POT) as examples of cheap industrials with strong futures. I am also still long the global infrastructure plays including GE (NYSE:GE) and Honeywell (NYSE:HON). It has been a strong 7 months for us with our funds up 16% net averaging 90% net long.
Change is in the air. As always, review the facts, reflect, keep an open mind, control risk at all times by maintaining ample liquidity and …