The global financial markets continued to march to new highs last week despite Trump's problems, his withdrawal from the Paris Accord and his stalled agenda in Congress.
What gives? The truth is that the top down global macroeconomic outlook continues to improve despite a conflicting jobs reports in the U.S. and bottoms-up corporate earnings continue to strengthen while interest rates hit new lows for the year. This just is not the formula for a market top, which I have been affirming week after week to the consternation of many traders. Nevertheless, I do recognize that a market correction could occur at any time but normally not when everyone is looking for one.
Let's look at the facts: Europe, including the U.K., is doing much better economically than anticipated just a few months ago. Japan too. China, despite all the concerns in the media, is exceeding its growth targets for the year. The emerging markets are surprisingly strong and the U.S. is chugging along at its 2+% rate. The bottom line is that global growth is exceeding expectations for the year.
On the other hand, corporations both here and abroad are raising their earnings forecasts after a 17% gain in the first quarter while maintaining tight controls over costs and spending. The last piece of the evaluation puzzle, which has been the big surprise for me, is interest rates. The U.S. 10-year treasury rate hit a new low for the year at 2.17% on Friday. How do you sell a market with these fundamentals?
The question that I ponder is why interest rates are so low today. It is neither a weak economy nor a strong dollar like last year, which resulted in huge capital inflows from abroad putting downward pressure on yields. Hence, it must be that inflationary expectations have been reduced, which, if so, is great news for the financial markets. I have long argued that globalization and the disruptors would put a lid on future inflation, which seems to be the real answer for why rates are so low now.
As you know, I have disagreed with the Fed that lower energy prices were just transitory. It's for real! Let me state the obvious. Low energy costs are good for the consumer and for business. It does not hurt that corporations continue to generate huge free cash flow and the individual savings rate is up above 5.2%.
The bottom line is that the global macroeconomic backdrop for owning equities both here and abroad remains favorable when looking at capital allocation. I still do not recommend owning bonds as the global economy accelerates which should lead to a steepening yield curve even though the monetary authorities will remain accommodative while staying one step behind.
Industrial commodity prices have corrected big time since the winter due mostly to China clamping down on excessive leverage and speculation. Demand for industrial commodities has actually risen during this period faster than production resulting in a decline in inventories, which is normally a positive for prices. Oil remains the exception as U.S. production increases have more than offset OPEC production declines and global inventories have continued to rise. U.S. energy independence remains an objective of the Trump administration, which was one of the reasons for his decision to exit the Paris Accord. I support energy independence.
Against the backdrop for a favorable environment for owning equities, it all comes down to industry and stock selection. We are living through a remarkable period of change and mindset shifts at virtually every level, which creates tremendous opportunity to profit on both the long and short sides of the market. We have discussed the impact of the disruptors on many industries focusing in on retail box stores. Disruptors now impact virtually every industry either directly or indirectly so you need to focus on management to see how they have responded and whether they remain at the forefront of change or not.
Last week I focused in on Huntsman Chemical (NYSE:HUN), Dow (DOW)/DuPont (DD) and the money-centered banks. I want to add a comment on the banks, which by the way got whipsawed last week, as many bank managements indicated that trading revenues weakened in the second quarter after unusually strong first quarter gains and then there was the weaker than expected employment data on Friday.
We do not own the banks as a trade but as an investment. We believe that changes in regulations and future stress tests will permit them to grow more rapidly, buy back more stock and increase dividends at an accelerating rate all beginning after the June stress test. Banks which once sold at a premium to tangible book are now selling at a discount to book and to the market multiple. That will change over time and we want to own them for that reason. We own AIG, too, which sells at a discount to real book and is buying back billions in stock.
I want to repeat something else I said last week which was there is nothing any longer in the market for Trump's pro-business and pro-growth agenda. The pendulum has swung all the way back from extreme optimism to extreme pessimism today. That creates a huge opportunity as I still expect Congress to pass a watered-down tax reform bill skewed to business tax reductions; a trillion-dollar infrastructure program which will be the focus this week in DC; more and more regulatory reforms while Ross and his team promote fair trade. By the way, I believe that Trump does support clean air and less pollution but wants a deal fairer to the United States just as he supports free but fair trade. Healthcare reform will not occur until the Democrats come to the table but that may not be until late 2018.
I have also been recommending the global industrial stocks like EMR, FTV, GE, HON, IR and UTX as longer-term investments that would benefit from global reflation. All of them except GE have significantly outperformed the market. I find GE particularly attractive today, as the market doubts whether management can achieve $2.00 in earnings in 2018, which always was at the top of its $1.90 to $2.00 range. This company led by Jeff Immelt has gone through a huge transformation, selling off most of its financial businesses, reinvesting in technology and its core businesses while returning tens of billion dollars to its shareholders. This company should sell at a multiple close to HON, which therefore offers us 30+% upside from here plus, a secure 3.4% current yield.
This really has been the teflon market rising to new heights despite the negative press every hour of every day including the negative bias of the pundits. We continue to recommend staying the course and investing for the longer term rather than attempting to trade the market. Buy only best in breed with superior managements who are at the forefront of change and will succeed longer term regardless of politics.
So remember to review all the facts; pause, reflect and consider mindset shifts; fully understand your capital allocation and risk controls; do independent research on each investable idea and…Invest Accordingly!