What A Difference A Day Makes

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by: Bill Ehrman

The financial markets did a 180 Friday after a sensational labor report followed by Fed Chairman Powell's opening comments prior to a panel discussion with two former Fed Presidents.

Powell clearly capitulated, emphasizing that the "Fed would be willing to adjust policy quickly and flexibly using all of its tools to support the economy (including its balance sheet) should that be appropriate to keep the expansion on track." The Fed will pause for now, unless data points dictate otherwise, from making any additional rate hikes in 2019, finally acknowledging that above-average gains in real growth and employment MAY NOT lead to inflation moving above its 2% threshold.

Can you imagine that we may have already reached normalization with a Fed Funds rate under 2.5%? Not only does it mean that the Phillips Curve is dead but also that the Fed is acknowledging the downward pressure on inflation due to global competition, disruptors and technology. Powell specifically mentioned that the Fed is closely watching weakness in our financial markets, the flattening in the yield curve, the impact of trade tariffs, falling consumer/business sentiment and weakness in foreign economies/financial markets, too. Without explicitly saying it, the Fed has shifted its view. They are more worried about downside risks to the economy than upside inflationary pressures.

The Fed is no longer our concern, after hearing Powell's comments, removing a key obstacle of the financial markets. In fact, the Fed may become our friend if it lowers rates sometime next year due to inflation running well below the Fed's 2% target level, which we anticipate will occur over the next three months at least.

We were also pleased to see that China lowered its bank reserve requirements by another 1% on Friday to support its economy. It is clear that China will pull out all stops to offset weakness in industrial production which is still the largest share of its economy unlike our economy where consumption dominates. The probability of a trade deal between the United States and China is clearly improving too, for obvious reasons. Trump needs a deal more than ever despite his rhetoric to the contrary as he will be running for President once again and can't win unless our economy is doing well. President Xi needs a deal too, as the unemployment rate will rise and wages will come under pressure if China's economy does not sustain real growth near 6%. Face-to-face trade talks between both countries begin Monday. We believe that it is highly likely that trade talks without added tariffs will be extended beyond the initial 90 days and the chance of reaching a real deal sometime this year is on the rise.

And, we believe that the dollar may have peaked on Friday with the shift in Fed policy removing tremendous pressure on overseas economies and commodity prices. No wonder the stock market rallied big time on Friday. The shorts got caught once again on the wrong foot looking in the rear-view mirror rather than anticipating Powell's next move. Fortunately, we did.

What a difference a day makes!

It remains clear that the global economy continues to weaken, including the United States and China. Just take a look at current yields around the world to get an idea of the growing fear of further global economic weakness and rising deflationary pressures: 2-year U.S. Treasury: 2.46% and 10-year U.S. Treasury bond: 2.67%; 2-year German bund: (0.06%), and 10-year bund: 0.2%; and 2-year Japanese bond: (0.19%) and 10-year Japanese bond: (0.05%). It doesn't take a genius to understand what bond rates are saying virtually everywhere. These interest rate differentials have led to a super strong dollar which has killed commodity prices along with many foreign economies. As we stated earlier, the shift in Fed policy may represent the high water mark for the dollar which will reduce pressure on foreign economies while raising industrial commodity prices.

Trade conflicts are now our number one concern as it is impacting all economies one way or another. Since exports are a small percentage of our economy, it impacts us less while penalizing those economies that rely on exports much more such as Germany, Japan, China and many emerging economies. A strong dollar/weak foreign currency which normally would have benefitted many foreign economies has not as global trade is essentially in a holding pattern after stuffing the pipeline anticipating higher tariffs in 2019. Just look at declining business sentiment virtually everywhere in the world which has put a lid on hiring and capital spending plans too. We would expect an acceleration in global growth once trade deals are reached which we still expect to occur later this year.

The U.S. economy continues to chug along, bolstered by strong consumer demand. It is hard to get too pessimistic about 2019 now that the Fed has shifted its policy and employment/wages continue to grow at above-average rates. We were pleasantly surprised that non-farm payrolls increased by 312,000 in December; hourly wages rose by 0.4% from November and 3.2% from a year ago; and that the labor participation rate rose too. These numbers bode well for solid consumer demand this year as over 2.3 million new jobs were created in 2018 along with higher hourly wages.

On the other hand, U.S. factory demand weakened more than expected in December with new orders especially weak. Trade remains a major concern across our economy and managements are taking a very conservative view towards 2019 holding back on future hiring and capital spending plans. We continue to believe that the U.S. economy will decelerate as we move through the year unless/if trade deals are reached. We want to underline that we do not see a recession nor declining corporate profits at this time, especially since the Fed is most likely out of the way. We continue to forecast real growth around 2% for the year with operating earnings up 4-7%. It is hard to forecast the yield curve steepening until the Fed cuts rates or trade deals are reached, which would lead to accelerating economic growth.

We still believe that global growth forecasts will be reduced to under 3% in 2019 unless trade deals are reached. Despite all the efforts by China's government to stimulate growth, it is highly unlikely that real growth will exceed 6% down from 6.5% in 2018. Prospects for the Eurozone and Japan are not bright at all. Clearly, the extent of monetary ease is ebbing which at the margin will penalize growth as rates can't get much lower than where they are already. And local deficits are on the rise which impedes further fiscal policy stimulation.

As we mentioned last week, it is up to the U.S. and China to lead the world out of its current economic quagmire. Clearly, the Fed finally saw the light and China is aggressively moving to stimulate its economy. Again, trade deals will be the key for an improvement in the global economies.

What do we do now?

As mentioned last week, we believe that the U.S. markets had gotten too cheap and we committed part of our cash reserves buying great companies at distressed/recession level multiples with strong balance sheets, positive earnings growth and cash flow, rising dividends currently yielding above 3% and large share buyback programs out of free cash flow in place.

We added more this week anticipating that the Fed would pause hiking rates in 2019 with the chance of lowering them too. Powell's comments were no surprise to us. His comments basically lower the risk of a pronounced economic downturn in 2019 and 2020, which was the major concern of market participants. We continue to believe that our market is undervalued with a multiple under 15 times projected 2019 earnings, with 10-year treasuries yielding less than 3% and bank liquidity still on the rise. The chance of any systematic risk is next to nil.

Notwithstanding, we will maintain above-average cash reserves as we are still in a VUCA environment. Volatility, uncertainty, complexity and ambiguity of general conditions remain at heightened levels. Our portfolios have broadened out slightly and include: healthcare, technology at a fair price to growth, industrials, industrial commodity companies, cable with content like Comcast (NASDAQ:CMCSA) and Disney (NYSE:DIS), consumer non-durables like P&G (NYSE:PG) and Pepsi (NYSE:PEP), domestic steel, and many special situations where internal movements will reveal much higher values than current prices.

We are neutral the dollar although we feel that it has peaked and own no bonds expecting the yield curve to steepen only after the Fed lowers rates or trade deals are reached. We recommend reducing real estate and private equity holding as their valuations are too high relative to financial markets.

It is time for our government to work together rather than tearing the nation apart. We find their actions troubling and irresponsible. Remember to review all the facts; pause, reflect and consider mindset shifts; look at your asset composition along with risk controls; do first hand research and… Invest Accordingly!