Time To Pause

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by: Bill Ehrman

The financial markets fear an overzealous Fed looking in the rearview mirror rather than the front windshield. The Fed's mission is to promote noninflationary growth. Maybe it is time for them to declare victory and acknowledge that the U.S economy is expanding above trend with inflation remaining below their 2% bogey. Did you happen to notice that inflation actually slowed in the third quarter GNP report last week? Core inflation whether measured with and without food and energy actually slowed to an annualized rate of 1.6% in the third quarter despite real GNP growth way above trend at 3.5%.

Global competition, rapid changes in technology and the rise of disruptors have all kept a lid on inflationary pressures despite an acceleration in real growth to over 3% year to date; a near record low in the unemployment rate and a sharp increase in input costs this year, especially oil. By the way, corporate profits are still strong. Don't look at the reported revenue line as a sign of potential weakness as it is being penalized by a strong dollar. Volume growth and back logs, better indicators of overall strength, continued to improve sequentially.

So where is the concern?

Powell stated a few weeks ago that the Fed rate was still far from neutral. And we hear most governors cautioning us that the economy is strong therefore inflationary pressures must build. And if so, the Fed mandate beside unemployment is to keep a lid on inflation. Let us state once again that growth is not only good, especially if it is non-inflationary, but also is a necessity as the alternative has more dire consequences.

It is already evident that the interest rate sensitive sectors of our economy, namely autos and housing, have rolled over. Businesses are not stupid too and can read the tea leaves if the Fed were to continue hiking rates. Did you happen to notice the weakness in capital spending in the third quarter? Uncertainty over trade policy certainly does not help either? And then there is the stock market. How can the Fed be blind to that too? It doesn't take a genius to get why the market is weak. Growth may be good today but what about tomorrow if the Fed really raises rates 4 more times over the next year. The market is predicting a recession by the end of next year. We disagree. It's is time to pause after December.

Do you think the Fed is also oblivious to what is happening overseas? Growth has slowed in Europe, Japan, China and the emerging markets. The rise in our rates has led to a super strong dollar causing outflows abroad pressuring their rates. Trade issues has been a double whammy too pressuring their economies. Have you noticed accelerating weakness in Germany recently, normally the engine of European growth, and in China too? Export orders in China dropped the most in two years recently and prospects look bleak.

Wake up Fed before it is too late and you precipitate a real slow down here and something even worse overseas. By the way, have you ever seen a Fed thread the needle raising rates without causing an eventual recession? Who cares if it is shallow or not. Risks remain more to the downside if the Fed raises rates too much rather than to the upside if they pause after December. We are not saying that rates should not move up over time as our economy improves further but the combination of the Fed unwinding their balance sheet while consistently raising the funds rate may be too much to handle in a fragile global economy with geopolitical and trade issues.

Time to look over the valley.

The U.S economy is in great shape. Don't believe all the naysayers/pundits who blow with the wind looking in the rear-view mirror. Do we expect growth to slow from above trend rate of 3.5%? Absolutely but we still forecast growth above trend for the foreseeable future without unleashing inflation above 2.0% for any sustained period. Truth is that there are no threats of systemic risk; financial institutions have record high capital ratios and excess liquidity; the supply of capital globally exceeds the demand for capital; the consumer is strong maintaining a high savings rate; corporations are earnings record profits generating huge free cash flow; real interest rates are low while inflation remains below 2%.

So where's the beef? Don't markets climb walls of worry? The problem right now is that computer driven technical trading has taken over fundamental valuation. Program trading is indiscriminate and takes no prisoners. Haven't you noticed the market hitting air pockets day after day scaring the heck out of investors? The market is selling as if we were entering a recession next year with S&P earnings flat or lower in 2019 compared to 2018. We disagree wholeheartedly even if the Fed raised rates in December and twice next year. Would the economy slow down to under 3% growth? Absolutely but there is nothing wrong with that as corporate profits/cash flow would continue to increase which is our base line forecast. We are monitoring consumer and business confidence both here and abroad for signs of sudden change that could impact the global economies. We need trade deals as that would be a game changer overnight. And we do expect them with the ECB and Japan within the next four months.

Adversity creates opportunity if you invest looking over the valley rather than into the abyss. Stocks are selling at valuations as if we were already in a recession. The market multiple has fallen to under 16 times projected earnings with the 10-year treasury yielding under 3.2%. It was interesting to note that the huge increase in inventories in the third quarter did not translate into a burst in loan growth at banks. Corporations are flush with capital which will only build as profits continue to grow and inventories are worked off in the ensuing quarters.

So what are we doing?

We were not oblivious to the shift in investor psychology? Our blog last week was all about making midcourse changes. We significantly reduced our economic exposure while increasing our exposure to stable growers with dividend yields above the 10-year treasury and growing.

The shift did provide some protection but not as much as we anticipated as program trading took no prisoners. Herein lies the opportunity for investors with a longer-term view rather than day traders. We even sold many of the banks expecting the yield curve to flatten out as inflationary expectations came down fearing a recession while the Fed continued to hike the short end of the curve.

If the market continues to pummel stocks indiscriminately, we have a shopping list ready to go as value is everywhere. When we can add great companies with superior management with winning strategies and strong financials selling at less than 10 times earnings, we won't blink. Buffett is probably doing the same thing. Fortunately, we reduced our net exposure a few weeks ago to give us the liquidity to move on a dime.

Watch for Powell to dial back his statement about "far from neutral" and also look for trade deals. Either announcements will be immediate game changers and the pundits will do a 180 overnight.

Remember to review all the facts; pause, reflect and consider mindset shifts; constantly look at your asset mix controlling risk; do independent research and… Invest Accordingly!