We were going to title this week’s piece “what’s wrong with a strong economy (especially if inflationary pressures were contained)” until we read Berkshire Hathaway’s (NYSE:BRK.A) (NYSE:BRK.B) third quarter filing. Buffett purchased nearly $13 billion of equities bringing the total so far this year to a 4-year record of $24 billion. If Buffett found sufficient value in the third quarter, imagine what he bought in October using his huge excess liquidity with the markets falling by over 5% from September 30th levels.
Buffett has commented before that equities were his preferred asset class as the earnings yield far exceeded bond yields, private equity valuations and real estate. It was clear in Berkshire’s recent report how lower tax rates and changes in depreciation boosted after tax profits, cash flow and equity returns.
Corporate America not only continued to report outsized gains in profits, up over 20%, again in the third quarter but also meaningful improvements in cash flow, free cash flow and returns on equity. Corporations are not only raising dividends and increasing buybacks but also reinvesting in their businesses that will boost future profits. Clearly earnings comparisons will get tougher next year as the reduction in tax rates is a one-time event but capital investments, tight cost controls, technological advancements and stock buybacks are likely to result in another above average gain in corporate profits/share in 2019.
The stock market multiple at less than 16 times earnings is too low with the 10-year treasury yielding less than 3.2% and bank capital/liquidity ratios at new highs. Stop looking at historic multiples as long as the 10-year treasury remains well below historic ranges.
That brings us to what we wanted to discuss this week in the first place which is what’s wrong with a strong economy as long as inflationary pressures remain contained. We smiled when the pundits commented that this past week’s employment report may have been good for Main Street but it was bad for Wall Street. How ridiculous! As Kudlow says “economic growth is the path to prosperity.”
Nonfarm payrolls rose by 250,000 and the unemployment rate held at a 48 year low as more people entered the work force. Gosh, that is terrible. Not! The concern was that hourly wages rose 3.1% from a year earlier fueling inflationary concerns with further hikes coming in the Federal Funds rate. Don’t forget that productivity gains accelerated to 2.2% improvement in the third quarter which means that real wages are actually increasing by less than 1%. Also, third quarter inflation actually declined from the prior quarter to only a 1.6% gain, below the Fed 2% threshold.
We still expect the Fed to raise rates in December and 2 or less times in 2019 depending on the data points. We expect Powell to step back from his statement that the funds rate is far below normal and say that the Fed will adjust rates based on its current view of economic growth and inflation. We still believe that the biggest concern for the Fed is raising rates too fast, pushing the dollar higher further, impacting global money flows and slowing our economy too far for the one economy doing well in the world. Imagine the ramifications if we turn down too!
Deflation is a far bigger risk still than inflation. Have you monitored housing starts, auto sales, and industrial commodity prices? None of them reflect an overheating economy and runaway inflationary pressures. By the way, a widening trade deficit reflects a strong U.S economy and weakness overseas. Have you noticed persisting weakness in China, Europe and Japan. It is only logical to assume imports rising faster than exports regardless of a strong dollar.
The bottom line is that U.S. growth is not only good but a necessity with world economic growth slowing. Powell should pause after the December rate hike, watch the data points over the ensuring months and maintain an accommodative stance keeping real rates low as long as inflationary pressures remain contained.
Trade issues remain a major impediment to global growth. Business and consumer confidence have fallen as uncertainty has put major spending plans on hold. We remain confident that the U.S will reach deals with the ECB and Japan before China. We are hopeful that Trump and Xi will agree that trade negotiations be reopened between our countries but don’t expect a fast deal. If Trump postpones broadening tariffs and hiking rates, the markets will have a huge rally. Don’t go short going into their November meeting!
What are we doing?
Listening to corporate conference calls has instilled added confidence that an investor must look over the valley in a VUCA (volatility, uncertainty, complexity, ambiguity) environment. Systematic, electronic trading is the bane of fundamentalists as it takes no prisoners but if you maintain excess liquidity, like Buffett, you can pick up great investments at bargain prices maintaining a one to two-year time frame. We have built back positions in many of our core long term holdings after the conference calls as their futures are indeed bright.
We invest in companies with rising volume, operating margins, cash flow, free cash flow and returns on equity. It is a diverse list ranging including financials, industrials, capital goods companies, healthcare, cable, airlines, domestic steel and aluminum, technology at a fair price to growth and many special situations where internal changes will add significant value. We do expect the yield curve to steepen but by not too much from here. The dollar remains the currency of choice still.
The bottom line is that growth is a necessity so the Fed needs to tread lightly as the alternative is far worse. And we do not expect inflation to rear its ugly head. Like Buffett, we see great value in today’s market. Stay the course, keep excess liquidity at all times and invest for the long term as trading is a losing proposition.
Finally, we expect this week’s election to be a nonevent as the Democrats take control over the House and the Republicans keep control over the Senate. We only wish that all politicians could put country above party. Wishful thinking.
Remember to review all the facts; pause, reflect and consider mindset shifts; review your asset mix with risk controls; do independent research and… Invest Accordingly!