Last week we predicted that the pause button had been hit on all global stock markets. Fears of the impending Fed meeting, upcoming Brexit vote, additional ECB buying across all debt instruments (exacerbating a plunge in negative rate in Europe) and the prospect of no additional easing by the BOJ would dominate investor psychology resulting in market participants worldwide continuing to take risk off, sell stocks and push all bond yields to record lows.
I recommended keeping your powder dry and positioning yourself to take advantage of liquidation by others and the lack of market liquidity as excessive fear would dominate the markets. Let me state a few simple facts: cash is at record levels; equity ownership is down; interest rates are incredibly low; the consumers here and abroad are in excellent financial shape; speculation and new issues are non-existent; M&A activity is high; and the U.S. economy along with corporate earnings are improving.
As you can guess, I am not as concerned about the markets, especially the U.S., and plan to add to my positions on further weakness.
Let's review the key events of last week and start looking forward rather than in the rear view mirror as most are doing.
First up is our Fed.
It was no surprise to us that the Fed reduced its economic growth forecast for 2016 to 2.0% and held off on raising rates. That means that the Fed, along with us, has growth averaging more than 2.0% over the next few quarters after a weak start for the year. Interestingly, the Fed raised slightly its inflation forecast for the year but it is still well beneath the Fed threshold of 2% and will remain so for the next several years.
Janet Yellen admitted that the Fed has been overly optimistic on economic growth and wrong about low inflation being transitory. Market pundits were concerned that the Fed had lost credibility although it had finally caught up to where the markets have been. Is that really bad?
We wrote three years ago that there would be lower highs and higher lows in economic activity and that low inflation was NOT transitory, as the Fed had said time and again. So, now the Fed agrees and has adjusted down its future trajectory for the Funds rate accordingly while maintaining economic growth of 2% over the next few years.
The bottom line is that the Fed is now out of the way which removes a major impediment to future economic growth, investor psychology and corporate planning. Also the Fed governors are finally talking from the same page as evidenced by a unanimous vote not to raise rates in June and six agreed that "one and done" as we had earlier predicted.
The fake out here is that the economy will continue to improve through year-end surprising the pundits and the financial markets.
Next up is the upcoming vote on the 23rd in Britain to possibly exit the Eurozone. Understand here that the fear is not really Britain exiting the Eurozone but the Eurozone breaking apart totally such that each country has to negotiate amongst each other and with its global trading partners.
If you ask a Brit if he is an Englishman or a European, what would he say? An Englishman. Herein lies the problem behind the concept of bringing all the countries in Europe basically under one set of rules with one currency. Unfortunately the rules don't go far enough nor do they really reflect the mood of each country and its people who must abide by them. Just ask the Swiss their opinion of the Eurozone and the Euro? I did this past week.
I realize that this is an overly simplistic explanation of my view on the Eurozone as there really is a lot more that I can say if you have interest. While the concept behind the Eurozone was sound in that it created one economic body to better trade amongst themselves and compete in the world, it never went far enough to incorporate regulatory, tax and other needed social rules to unify all these nations under one flag. The differences between each country and its people are huge and there needs to be accounting for that.
I believe that the financial stability in the global markets won't fall apart as many predict should Britain exit the Eurozone. But it will be the beginning of the end of the Eurozone benefiting strong countries like the U.S. and ironically hurting countries like Germany whose currency would return over time back to the Mark which would appreciate significantly once there is no Euro penalizing its export competitiveness.
Now let's go to the main culprit behind the move to risk off in all financial markets - negative rates. Whoever came up with and implemented the idea should be fired - and that includes the heads of the BOJ and ECB. Negative rates have negative connotations across the board: banks won't lend as they can't make money and consumers who need interest income to pay the bills will have to cut back on their spending. The United States, Europe and Japan are comprised of aging populations, so negative rates is a major impediment to growth. Then how about the banks and other financial institutions including insurance companies, who rely on interest income to support their regulatory requirements, spending, earnings and dividends!
There is no shortage of capital in the world. There is a shortage of demand. We keep looking toward the monetary authorities for the cure but that is the wrong place to look. The problem in the world is that the governments have for whatever reason not implemented pro-growth programs sorely needed. This would include regulatory, financial and tax changes. We need to create a better environment for business to hire and to spend on capital investment. Redistribution of wealth, increasing the minimum wage and more social programs at this time just misses the point and won't solve the problem. I am not calling for trickledown economics but sound policies for growth that won't change based on who is in power in D.C.
Have you seen the French people rebelling against work rule changes, which are so badly needed to compete globally? Don't they get it? Japan seems to get it but does not have the financial flexibility to follow through with pro-growth policies due to its large debt load. China and India are two huge countries that both seem to get it but it takes time for their policies to work, so be patient.
Look for changes both in the United States and Europe. You have to be blind not to see what has to be done. Watch both the national and local elections here and abroad to see if the establishment is replaced by new blood. See if Germany eases up on other countries permitting them to spend more rather than further reduce their budget deficits. Watch to see if the monetary authorities stop tightening capital requirements and loosen regulations on local banks so lending can increase to support growth. Policies here and abroad are too restrictive.
Unfortunately the emerging markets are held hostage to growth in other parts of the world and won't do well without it.
Growth in the world is stuck in a rut and won't really accelerate until there are mindset shifts from the top down to the consumer.
So where does all of this leave us?
We continue to favor investments in the U.S. as it offers the best value. Our economy is in decent shape and corporate earnings will surprise on the upside. I also look for acceleration in refinancing at both corporate and individual levels to benefit from the move down in rates. This will be a big positive as annual interest costs will go down and maturities extended. M&A activity will accelerate, too, in this low interest rate environment. Imagine financing a deal with 15-25 year money at less than 4% annual interest cost. I wrote a few years ago that Apple (NASDAQ:AAPL) led the way by raising debt money overseas at low rates guaranteed by its foreign balance sheet rather than repatriating the foreign retained earnings and paying a huge tax. Microsoft (NASDAQ:MSFT) is doing the same thing in financing its acquisition of LinkedIn (LNKD). More corporations will follow.
Bottom line is that the markets have gotten too pessimistic creating opportunities to profit as an investor. This is a market of stocks and change is everywhere. Again, the average yield on our portfolio is around 3% and we expect each company will grow its earnings, cash flow and dividend over the next few years. Each company has recognized the need to implement new strategic initiatives to sustain its growth and maintain competitive advantages in a sub-par growth world.
We continue to outperform all indices.
Finally, review the facts, take a step back and reflect while others are panicking, control your asset allocation, liquidity and risk at all times, do first hand independent research as opportunities both on the long and short side are everywhere and…