It's Always Something

Bill Ehrman profile picture
Bill Ehrman

A successful investor is a born cynic worrying more about downside risks than upside potential. Investing has only gotten more complicated over the years as we consider the intricacies of globalization and shifts in the political winds. We have been living in a VUCA (volatile, uncertain, complex, and ambiguous) environment for years now.

While it is clear that monetary policy around the globe has shifted to more ease over the last few months, many other issues remain before we can say "all clear." Yet, we still see upside potential for the financial markets over the next year as monetary policy has wind to our backs rather than in our faces which was our primary concern going into the fourth quarter of 2018. This is a time when those with a deep understanding of the inter-relationships of the geo- political and financial markets will shine as not all markets, asset classes, companies and stocks will perform.

Before discussing what still worries us, we want to comment on current monetary policy and the current state of the global economy.

The Fed met this past week explaining why there has been such an abrupt change to a more accommodative policy. While the Fed remains relatively optimistic about the U.S economy, it is concerned about a sharp slowdown in growth abroad, the inability of inflation to pick up despite the sharp rise in employment/decline in the unemployment rate, Brexit and finally trade issues. Basically, risks are more skewed to the downside than to the upside at his moment such that the Fed does not want to be blamed for precipitating a recession anytime soon.

While the Fed/Powell commented that it prefers to use the funds rate to adjust policy, it acknowledged that it would be willing to adjust its balance sheet, too. It is clear that the Fed is out of the way unless data points suggest otherwise. We do not expect the yield curve to steepen unless the Fed cuts its current funds rate or trade deals are reached that stimulate global growth.

Global monetary policy for the foreseeable future has become more accommodative as China has opened up the spigots and we longer fear the ECB and Fed becoming more restrictive this year. One word of caution is that German central bank President Jens Weidman wants the ECB to move ahead with its interest rate normalization. We disagree wholeheartedly.

Finally, the BOJ will maintain its overly accommodative stance as Japan's economic growth and inflation remain well below forecasts. Inflation in the Eurozone and Japan will be pushed down further benefitting from the EU-Japan trade deal that took effect on February 1st . The bottom line is that the creation of capital by the key global monetary bodies will exceed the need for capital which benefits the value of financial assets.

We continue to be surprised by the resiliency of the U.S economy. While there have been some delays in government economic releases due to the shutdown, here are a few recent stats: construction spending rose 0.8% in November; January consumer confidence came in stronger than anticipated at 91.2; ISM manufacturing index topped estimates at 56.6 with strength in new orders/production and weakness in prices; and finally, U.S payrolls rose a whopping 304,000 jobs after some downward revisions while wage gains weakened slightly.

Hiring and wages support our contention that the U.S. economy will continue to do just fine, thank you. The 2018 payroll gain was an incredible 2.67 million jobs which will buttress economic growth/spending in 2019. Earnings reports for the fourth quarter, 2018 have been just fine as well as earnings and cash flow forecasts for 2019 too.

On the other hand, growth in the Eurozone weakened in 2018 to its slowest pace in 4 years and prospects for 2019 look even worse due to the ramifications of weakness in exports. Growth in China was at a three-decade low in 2018 and will slow further in 2019 despite all of the monetary and fiscal ease. The seasonally adjusted PMI feel to 52.3 primarily due to weakness in exports. Japan's economy may have rebounded a little bit after falling 2.5% in the third quarter but prospects here remain weak too due to declining exports. The overriding impediment to an acceleration in global growth revolves around trade.

While comments out of DC surrounding the China-U.S. trade talks were promising, it became apparent that we won't really know the outcome until after President's Xi and Trump sit down preferably before the 90-day deadline expires in March. We still believe that Xi and Trump will extend the negotiating period another 90 days without any additional tariffs. The key issues remain protecting IP and China 2025. It is equally clear that trade talks with the ECB and Japan are taking the back seat to China and won't be negotiated in earnest for another few months.

We are more optimistic of concluding a deal with Japan than with the ECB although both really need a deal badly to stabilize/stimulate their economies.

Besides being concerned about global growth and trade, we are worried about the strength of the far left here as well as changes in political winds abroad. Unfortunately, it appears that the political center is losing control to the fringes on the left and right. Besides here, just look at Germany, Italy, Spain and Venezuela to name just a few countries experiencing political shifts.

We are also concerned about the buildup in U.S. government debt. What will happen to the deficit once the economy slows; will other borrowers be crowded out of the debt market; and what happens when/if short rates rise? None of this is good, but we do not see a problem occurring for many more years!

Another potential concern is whether profit margins can continue to improve. We believe so for a host of reasons beginning and ending with management. If you listen to earnings conference calls, you, too, can easily discern the winners and losers. Herein is why we believe that active management will outperform passive managers.

Have we shifted our current investment outlook?

Nope! We have gotten much more optimistic about the financial markets after the ECB and Fed capitulated along with the Bank of China opening up its monetary spigots too. When we look at the financial markets, we first analyze whether the global supply of capital exceeds or falls short of the demand for money. If it exceeds it, financial assets tend to do well and if not, financial assets are hurt. So, we believe today that the financial winds are to our back. We also believe that excessive monetary ease will stabilize global growth reducing the risk of further economic slowing and deflation.

Secondly, we believe that the prospects of trade deals being reached this year has risen as the alternative is unfathomable for countries more dependent on exports than the U.S like the Eurozone, China and Japan. While we are concerned about rising political risks and Brexit, we believe that multiples have already been ratcheted down below fair value enough to reflect these concerns.

The bottom line is that the financial markets remain sufficiently undervalued today with S&P earnings likely to exceed $172 per share in 2019 and with the 10-year treasury holding beneath 3%. We do not expect the yield curve to steepen unless the Fed cuts rates or trade deals are reached which would lead to an acceleration in global growth. But not all regions, asset classes or companies will perform. Herein lies our strength. We correctly made two major shifts in the composition/individual stock selection in our portfolios over the last four months.

We moved defensive in October when we felt that the Fed was in our face and reversed our position in December moving back to economically sensitive stocks selling at recession valuations when we saw the Fed shift its policy to remain accommodative as was needed as we predicted months ago.

We are fully invested today as the market is undervalued, cash levels/investor pessimism are high and professionals are praying for a pull back to commit cash reserves. Our portfolios are concentrated in healthcare companies benefitting from new products/volume growth; industrial and capital goods companies; technology at a fair price to growth; industrial commodity companies; domestic steel; cable with content; and many special situations where internal developments will unlock added value. We believe that the dollar has peaked and own no bonds as we expect the yield curve to steepen later in the year after the Fed lowers rates or trade deals are reached.

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

This article was written by

Bill Ehrman profile picture
Managing partner of Paix et Prosperite LLC, educator, mentor and consultant.  Former Senior partner and CIO at EGS Partners, Soros Fund Mgt and Century Capital Associates. Experience over 50 years  successfully managing money, investment banking, consulting and mentoring. He incorporates a top down global economic, financial and political view with bottoms up independent research industry by industry and company by company.

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