Adversity Creates Opportunity

by: Bill Ehrman

If you don't have a global perspective and understand the inter-relationship between all the economic, financial and political variables, then you will continue to trade recklessly, lose at every turn, and miss a great opportunity to profit when others are caught on the wrong foot and panicking.

By almost any standards, this was an amazing week with a Fed meeting, 4th quarter GNP being reported; the BOJ going negative on rates and several trial balloons about cutting back oil production.

I stated repeatedly during December that the Fed should hold off on raising rates as fourth quarter economic activity was disappointing, corporations and individuals were playing close to the vest, and there was no inflation. While I recognized that the jobs data continued strong, Fed credibility was at risk and there was a need to make that first step towards normalization, December was NOT the time to hike rates. The domestic economy was just not strong enough; psychology was negative and the dollar too strong.

January has ended and you don't need me to list what has transpired. Unfortunately, the Fed is stuck right now between a rock and a hard place as they will appear foolish doing an about face so soon after they moved on rates but, that is what they should do, and let the economy get on stronger footing before starting to hike once again.

The Fed did not change rates at this meeting and stated that it is "closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation." What else could they say at this juncture? Bottom line, the Fed is on hold and fears of several additional hikes this year is out the window. Yay!

Economic data for 4th quarter GNP came out after the Fed meeting and it was no surprise to us that GNP rose only 0.7% over the prior quarter. In fact, the numbers reinforced several of our core beliefs. We stated last week that the benefit of lower energy prices could be seen in higher consumer spending, a higher savings rate and improved corporate margins, excluding energy and materials. Well, consumer spending rose 2.2% in the quarter including lower gasoline sales and an unusually mild fall; disposable household income rose 3.25% in the quarter after taxes and inflation and saving rose to nearly $749 billion, up almost $40 billion in just one quarter.

Don't forget that over 800,000 jobs were created in the quarter, too. On the other hand, businesses cut back on inventory building and capital investment but operating margins improved if you strip out the energy and materials sectors. And finally the strong dollar penalized exports. By the way, excluding inventories and trade, the economy grew by 1.6% in the fourth quarter.

Most economists have revised their forecast for growth this year between 2-2.5%. We have been there for quite some time and see no reason to adjust it. Inflation will remain below 1.5%, the 10-year bond will remain below 2.5%, S&P earnings can still exceed $120 per share. And fair value for the market is still above 2,000. But not all stocks are equal!

The Bank of Japan took the markets by surprise Friday morning and introduced negative interest rates for the first time; clearly in an effort to boost the economy and head off deflationary forces. The yen immediately fell by over 2% vs. the dollar and the Japanese stock market shot up. The ripple effect could be seen throughout all global financial markets led by a strengthening dollar, one of our core beliefs.

By the way, the BOJ move makes a Fed decision to hold or even reduce rates easier to make to stem the rise in the dollar boosted by the huge capital flows from abroad into the states. Clearly, global interest rates were pushed down by the BOJ move. We now have negative rates in Japan and in Europe, something that I never thought that I would see short of a major recession or worse. Negative rates are meant to encourage banks to lend. My concern here is competitive devaluation as that is a zero sum game.

Before I go on, I want to make a comment about the dollar. I continue to hear from economists and pundits that a strong dollar is bad. I totally disagree for a host of reasons beginning with it meaning that our economy is stronger than others; it also means that our financial house is sounder than others; and while it means less exports, it also means less inflation and huge capital flows from abroad, suppressing our interest rates which helps everyone.

Finally, rumors of oil production cuts took place near the end of last week which supported an increase in price at one point to over $35 per barrel. Clearly the oil producing nations need higher prices to support their spending plans as their foreign currency reserves are rapidly depleting. It's equally clear that no one wants to take that first step but all will join in if, any when, someone takes the lead and means it.

Personally, I doubt that any agreement, if reached, will last as cheating is in their DNA. But, I would not want to be short energy at this point as the risks now are 50/50 that something may be announced and there will be a tremendous short squeeze. Do you know anyone long oil beside the producers? Are higher or lower oil prices better for the global economies and inflationary expectations? The answer is a crystal clear…lower prices but in an orderly way.

So why did the global markets spike on Friday? There are many parts to the answer but I feel the most important one is that the BOJ moves put the Fed on hold maybe for the year. Secondly, it appears that there is finally a move afoot by the oil producers to stem the rapid fall in prices.

Finally, the global economy is not as bad as many are saying. The U.S will grow 2-2.5%, the Eurozone by 1-1.5%; China by 6-6.5% although the government numbers are slightly higher; Japan by 1-1.5% and India by 7%. All we need is some optimism for these numbers to improve.

Pessimism and conservatism unfortunately are everywhere. Corporations are running a tight ship as we discussed last week. I would suggest that you read the transcript from Honeywell's (NYSE:HON) fourth quarter conference call as I consider Chief Executive Dave Cote one of the best leaders in corporate America. He is planning for a tough operating environment with slow global growth so he is planning conservatively.

He added that volume, margins, earnings, cash flow and free cash flow would all increase in 2016 despite all of these headwinds. Earnings have grown double digit for the last several years and the stock still sells at a market discount. Yes, we own Honeywell! Most every management has a similar outlook for 2016 and is budgeting/spending accordingly. Market tops don't occur when negativity is so high and reality is so far from perception. Things just aren't so bad out there and yes, we can do better.

Before I wrap up, I want to make one comment on industrial commodity prices. The "doomsday scenario" feared for by many executives in the field has occurred as prices have dropped to multi-year lows and are now well beneath cash costs of production. But unlike oil producers, mining and material companies have drastically cut production, cut spending and are reducing costs.

The big change has occurred this past week that even China is finally cutting back production. State-sanctioned cuts in steel could lead to 400,00 job losses; yes, that is right, and a further 150-million-ton reduction in capacity. China will cut back aluminum production, too. The bottom line is that we have reached the tipping point and I increased my exposure to industrial commodity companies who are financially strong and low cost producers. Read Potash's (NYSE:POT) fourth quarter earnings transcript.

If you haven't already, read the last few blogs I have written as each one remains on the mark. Unless you have strong core beliefs and understand global inter relationships and the dynamics of the vast economic, financial and political variables, it is impossible to manage money today.

We have nearly 40 years experience successfully managing money in all sorts of environment as we combine that top down global perspective with bottoms up in depth research. We have a truly systematic approach that includes risk controls. We have those core beliefs that guide us to profitably invest during periods of confusion and panic by others.

So, remember to gather and review the facts, step back and take a long pause, consider your asset allocation and risk controls, maintain excess liquidity at all times, do independent fundamental research and…

Invest Accordingly!

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