It's amazing how fast sentiment shifts. The pundits went from wildly bullish to pessimistic in a matter of days as they looked through the rear view mirror at a few stats that are most likely misleading and/or off the mark.
Seasonal adjustments as well as tax reform have played havoc with January stats and will continue with first quarter economic statistics. Change is in the air. 2018 is setting up as a sensational year economically both here and abroad. 2019, too!
Tax reform will certainly act as a shot in the arm for the U.S. economy with millions of people receiving one-time bonuses, which will mostly likely be spent boosting first and second quarter growth. Corporate earnings and cash flow boosted by lower tax rates and repatriation of foreign cash will kick in more and more as the year progresses and beyond. Will the economy expand by over 5% in first the quarter as the Atlanta Fed predicts? Not likely but it will be over 3% for sure with further above average gains for the rest of the year and 2019. Not too shabby!
Opportunity knocks for investors.
The employment data reported last week was solid with the U.S. economy adding over 200,000 jobs and the unemployment rate holding steady at 4.1%. However, the financial markets panicked Friday after seeing that average hourly earnings rose 0.3% from the prior month and are up 2.9% from a year ago. Bond yields jumped as fears of rising cost push inflation trickled through the marketplace.
However the average hourly earnings number was boosted by a decline in the workweek to 34.3 hours (bad weather) and tax reform bonuses. One-time bonuses are not permanent and should not be built into the longer-term corporate cost structure or inflationary expectations. It is not as if companies raised base pay 3%. So, don't worry. Global competition and the disruptors will keep a lid on future inflation.
Notwithstanding, hourly wages are set to rise in 2018, as corporations are more confident in future growth than at any time over the past few years. Wage hikes will be offset by higher operating rates and additional efficiencies. Managements are not that stupid. It does not hurt that tax reform will reduce their tax bill giving them more money to spend to further automate but it really is much more than that. It's all about Trump's pro-growth, pro-business agenda.
Real economic growth is accelerating everywhere. Competition for employees is clearly rising while slack in the workplace is declining as both domestic and foreign companies are expanding in the states rather than abroad. Consumers will have more money in their pockets to spend. This is a great problem for America to have. Thank you President Trump!
Will there be margin pressure as many fears as employment costs rise? Not likely! Unfortunately, historic measures of productivity just don't seem to work. The market got spooked last week when it was announced that productivity fell 0.2% in the fourth quarter (up 1.7% for the year) as unit labor costs rose 2%. It was interesting to note that manufacturing productivity actually rose 5.7% in the fourth quarter. It is almost impossible to measure productivity in the service sector. Benefits of tax reform and economic growth will more than offset any wage pressures. We still forecast S&P earnings will increase over 15% in 2018 and 10% in 2019. Nothing has changed.
Bond markets got clobbered last week with the yield curve steepening big time here and abroad due to concerns over an overheating U.S. economy, accelerating growth overseas, rising inflationary expectations due to wage pressure/poor productivity and finally the expanding financing needs of the U.S. government as tax reform is front loaded.
It does not help that the Fed is winding down its balance sheet. But the $3 trillion in repatriated cash and rising income will be a partial offset. It has to go somewhere. The 10-year treasury ended the week over 2.8%, the 10-year bund at 0.76% and the 10-year Japanese bond at 0.07%. The dollar strengthened throughout the week.
We have not altered our view that the Fed will raise rates at least 3 times this year, the yield curve will steepen and the 10-year Treasury bond will hit 3.25% by year-end. The bond markets have clearly been overly complacent up until last week. We still expect all monetary bodies to remain one step behind until inflation approaches 2% as fear of stepping on the brakes too soon impeding growth is of greater concern right now to all of them than rising inflation. Is last week's interest rate move enough to stop the stock market? No, as earnings growth will more than offset a decline in multiple as rates rise but not all markets or all stocks are alike.
Rising rates and steepening yield curves caused by accelerating global growth is good news. Remember everyone's concern about an inverted yield curve. That fear evaporated fast. We would get concerned if the 10-year Treasury approached 4% this year. For now opportunity knocks for investors.
Let's take a quick look at our core beliefs to see if there are any changes that would alter our investment strategy:
- Global economic activity is clearly accelerating. German economic growth accelerated to a six year high despite a strong euro, China is humming along above 6.7% and Japan's economy led by exports is strong as well as the emerging market economies. Check!
- Inflationary pressures are muted but are clearly picking up as global growth accelerates. We do expect wage rates to rise finally but margin pressure will be limited as utilization rates rise and efficiencies increase. Notwithstanding global competition and the disruptors are powerful offsets to rising inflationary pressures. Rising inflation, albeit small, due to accelerating growth is good news.
And what if Amazon (NASDAQ:AMZN), JP Morgan (NYSE:JPM) and Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) find a way to curb health care inflation? It's going to come one way or another and the long-term benefits will be huge. Check!
Global interest rates remain remarkably low relative to inflation. We firmly believe that all monetary bodies will stay one step behind for fear of putting a lid on global economic growth and prosperity just as growth is taking off. We do not expect the BOJ and ECB to alter their policies further until 2019. Draghi will let his successor take that next step. Not him. And we expect Powell's Fed to go slow permitting the U.S economy to meaningfully accelerate. Trump would not have nominated him otherwise.We expect global yield curves will continue to steepen for the right reasons-growth and no longer fearing deflation. Check!
- We see no reason to alter our view that S&P earnings will exceed $150 per share in 2018 and $165 per share in 2019. Check!
- Capital spending plans have already begun to accelerate and will meaningfully contribute to economic growth in the second half of 2018 and beyond. Trump's infrastructure program is likely to pass in some form this year. Notwithstanding, his administration will move quickly on accelerating the regulatory process permitting infrastructure projects on the books to move forward this year. Check!
- M&A has already begun to accelerate as evidenced by the billions of dollars of deals announced last week. Expect a good portion of the $3 trillion repatriated to be used for M&A. Watch the industrial, healthcare, consumer and tech spaces in particular. A new round of consolidation is coming and the prices paid will put a bottom in the stock market. Check!
- Financial regulatory relief is a fact of life both here and abroad aiding the financial sector, which provides the fuel for the global economy. The Fed' action against Wells Fargo (NYSE:WFC) will benefit BAC, C and JPM in particular. Check!
- Industrial commodity prices will benefit longer term from growth in demand and rising utilization rates. We do expect Trump to announce further trade sanctions boosting U.S steel and aluminum prices. Energy prices should do just fine. Don't expect a return to $50 per barrel in the near term. And take a look at the lithium producers, as supply will be limited for the next few years. Electric cars have a great future. Check!
- Stock markets remain undervalued based on $150 in S & P earnings this year and a 3.25% 10 year treasury but not all markets, sectors or companies are alike. We remain short bonds. Check!
The rapid shift in sentiment creates an opportunity for investors with a one to two year time frame. The pundits have consistently been wrong, always looking in the rear view mirror and never looking through the windshield.
Let me say categorically that GROWTH IS GOOD!
I find it ironic that the market is concerned with a 3% or even 3.5% 10-year bond rates. We finally have a positively sloping yield for all the right reasons. The real fear always was an inverted yield curve. Do you really expect the monetary authorities to take the punch bowl away so soon when lack of growth and fears of deflation were their main concerns for years?
Opportunity knocks for investors with a one to two year time frame at least. Global growth is accelerating; inflationary pressures remain muted although increasing; real interest rates remain low and negative in many areas; monetary authorizes will remain one step behind for fear of slowing growth; and earnings are taking off.
We will take this opportunity to add to positions of favored stocks while maintaining excess liquidity. We continue to emphasize global industrials and capital goods companies; financials, especially money center banks, low cost industrial commodity companies; technology at a fair price and special situations. We only want to own the best of the best with great managements and strong financials.
Remember to review all the facts; pause, reflect and consider mindset shifts; analyze your asset composition and risk controls; do in-depth independent research and… Invest Accordingly!