The Past May Not Be Prologue For The Future

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by: Bill Ehrman
Summary

The past is most probably not an indicator of the change to come. It is unpredictable.

Nothing showed it more than the market reaction on Friday when the yield curve inverted stoking fears of an upcoming recession. Stock markets fell as bond yields plummeted.

While inverted yield curves have been precursors of recessions many times in the past, we do not think that indicator will be reliable this time, at least not for the United States.

We have been saying for some time now that we are living in a VUCA environment categorized by volatility, uncertainty, chaos and ambiguity. The past is most probably not an indicator of the change to come. It is unpredictable. Nothing showed it more than the market reaction on Friday when the yield curve inverted stoking fears of an upcoming recession. Stock markets fell as bond yields plummeted. While inverted yield curves have been precursors of recessions many times in the past, we do not think that indicator will be reliable this time, at least not for the United States.

Let us restate that we remain concerned about the economic environment in Europe and, to a lesser degree, Japan but not the prospects for continued growth in the United States and China. In fact, we believe that the economies of the United States and China are bottoming out such that growth will accelerate for the remainder of 2019 into 2020 especially if trade deals are reached which are highly probable. The slowdown in Europe and Japan won't really impact the current outlook in the U.S and China all that much. One of the conclusions of last week's blog was that the U.S and China will be the engines of future global growth which is a necessity if growth is to improve in the Eurozone, Japan and also the Emerging Markets.

Where would you rather invest?

Clearly Europe is falling behind competitively and desperately needs trade, financial, tax and regulatory reforms. However, we do not see how the EU can effectively negotiate trade deals and set financial, tax/regulatory reforms that serves each member self-interests. Why do you think Brexit is occurring in the first place? Just look at the internal debates in France, Greece, Italy and Spain as other examples at the heart of the Eurozone's problems.

There is a battle in Europe between the "have" and "have not" nations. And it won't end soon unless Germany relents, especially now, and let countries increase spending, cut taxes and increase deficits to boost their local economies. Ironically, Germany has its own problems as exemplified by its March PMI which fell to 44.7 due to sharp declines in new orders, lower work backlogs and firings. The manufacturing PMI fell to a low not seen since the financial crisis. The all-important German car market is being hurt by weakening exports clearly impacted by global trade conflicts. The French PMI was no better falling to 48.7 in March with the manufacturers PMI below 50, too, penalized especially by weakness in exports.

Japan has somewhat better prospects than Europe as the government fully recognizes the problems and is doing all that it can to bolster growth but is constrained by its huge total debt to GNP. Broad weakness is evident by the March PMI remaining below 50 with real weakness in orders especially for exports. While we expect the government to postpone a hike in the retail tax rate in the fall, that won't do anything to stimulate growth. Japan is in a box, badly needing the end of trade conflicts.

No surprise, therefore, that 10-year German and Japanese bond yields are hovering around zero having dropped beneath that barrier on Friday. Understand that there is not much more that the ECB and BOJ can do to stimulate growth at this point as monetary policies are as easy as they can be so there needs to be either major financial, tax and regulatory reforms or trade deals to rescue their economies.

Our financial markets reacted according to script on Friday looking in their rear-view mirror when 10-year U.S Treasury bond yields fell beneath the 2-year treasury bond. (If you were a foreign investor, wouldn't you be buying our debt with both hands, pushing our yields down but still well above their levels?) Inversion has been a reliable precursor to a recession but we do not think so this time. Here is why.

First of all, the Fed has made a complete about turn since October becoming more concerned about an economic slowdown than virtually anything else. The only surprise to us in last week's Fed decision was that the Fed expects to raise rates maybe only once in 2020. That's right-2020! We had expected the Fed to be on hold hiking the funds rate for the rest of the year and for the portfolio runoff to end in 4 months or so. We were not far off the mark.

Even though the Fed may not have reached their upside target funds rate, the current rate is high enough such that they can reduce rates just as much as they raised them if needed to bolster our economy. Europe and Japan cannot say that. There are tremendous benefits to our economy as rates go down beginning with business and consumer debt refinancing at lower interest rates therefore reducing annual costs boosting income.

If we were so worried that higher rates would choke off the economy then why don't we think that lower rates could boost growth? It will! Yes, savers may earn less on their balances but only if/when the Fed lowers the funds rate. Housing, an interest sensitive sector of our economy has already begun to strengthen and we expect a strong spring selling season.

Second, the U.S economy has added over 2 million jobs over the last year at higher hourly wage rates and there are over 7 million job opening waiting to be filled. We are confident that consumer spending which is over 63% of our GNP will remain strong.

Third, the U.S will continue to benefit from Trump's tax reform program enacted over a year ago. While we question whether the total package was fiscally responsible due to the large upfront deficits, it is without a doubt highly stimulative for the next few years. And we expect corporations to boost capital spending, especially for technology, due to the immediate write-off which will lead to higher productivity gains in future years. A huge plus for holding down future inflation while boosting profits.

Finally, there is regulatory relief which will continue to boost growth over the foreseeable future. We are therefore confident that the U.S economy will continue to perform above average for the remainder of the year and may even do better once/if trade deals are reached.

We recognize that our trade balance will remain a drag on reported GNP but the primary reason is our domestic strength and weakness overseas. We continue to believe that the U.S economy will expand by over 2.4% in 2019 with the first quarter being the weakest. Next year could be even better once/if trade deals are reached. We also expect Trump do everything in his power to boost the economy prior to the Presidential election.

The other engine of global growth remains China. China is truly the economic wonder of the world sustaining growth well over 6% for a decade. Just the law of compounding should reduce its growth rate to around 6% in 2019. What country wouldn't want that? The Chinese government reacted swiftly to slowing growth over the last six months but reducing financial capital ratios, flooding the system with liquidity, major infrastructure programs and sharp reductions in taxes for both businesses and individuals. We remain confident that China's economy will accelerate for the rest of the year and will do even better if/when trade deals are reached.

The bottom line is that the two engines of global growth are doing quite well, thank you, so fears of any imminent downturn, let alone a recession in the U.S due to the recent inverted yield curve are greatly exaggerated. The yield curve inverted due to explosive demand for our debt from abroad where rates are nonexistent. Past experiences from an inverted yield will not be prologue for the future, in our opinion.

Stay the course.

Our portfolios are comprised of great companies selling below intrinsic value. We own drug companies benefitting from new product introductions, rising margins and above average yields; capital goods and industrials growing 1.5X GNP with rising margins generating huge free cash flow; technology at a fair price to growth, including semis, with rising margins and huge free cash flow; cable companies with content generating huge cash flow; low cost industrial commodity companies generating huge free cash flow with well above market yields, housing related companies benefitting from lower interest rates and many special situations where internal developments will close the gap between current prices and intrinsic value. Our portfolio sells at a multiple below the average of the S&P despite higher growth rates and a dividend yield above the 10-year treasury. We remain flat the dollar and own no bonds.

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

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.